Datasets:

ali77sina

/

SEC-just-text

like 0

TYSON FOODS INC

100493

10-K

0000100493-17-000133

Document UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K [X] | Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 ----+----------------------------------------------------------------------------------------- | For the fiscal year ended | September 30, 2017 ----+------------------------------------------------------------------------------------------+------------------- [ ] | Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 ----+----------------------------------------------------------------------------------------- | For the transition period from to ----+----------------------------------------------------------------------------------------- 001-14704 (Commission File Number) ______________________________________________ TYSON FOODS, INC. (Exact name of registrant as specified in its charter) ______________________________________________ Delaware | 71-0225165 --------------------------------------------------------------+------------------------------------- (State or other jurisdiction ofincorporation or organization) | (I.R.S. Employer Identification No.) --------------------------------------------------------------+------------------------------------- 2200 West Don Tyson Parkway, Springdale, Arkansas | 72762-6999 --------------------------------------------------------------+------------------------------------- (Address of principal executive offices) | (Zip Code) --------------------------------------------------------------+------------------------------------- Registrant’s telephone number, including area code: | (479) 290-4000 --------------------------------------------------------------+------------------------------------- Securities Registered Pursuant to Section 12(b) of the Act: Title of Each Class | Name of Each Exchange on Which Registered --------------------------------------+------------------------------------------ Class A Common Stock, Par Value $0.10 | New York Stock Exchange --------------------------------------+------------------------------------------ Securities Registered Pursuant to Section 12(g) of the Act: Not Applicable Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes [ X ] No [ ] Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes [ ] No [X] Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [] Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company or an emerging growth company. See definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act. Large accelerated filer | x | Accelerated filer | o ------------------------+--------------------------------------------------+---------------------------+-- Non-accelerated filer | o (Do not check if a smaller reporting company) | Smaller reporting company | o ------------------------+--------------------------------------------------+---------------------------+-- | | Emerging growth company | o ------------------------+--------------------------------------------------+---------------------------+-- If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of September 30, 2017 . Class | Outstanding Shares ------------------------------------------------------+------------------- Class A Common Stock, $0.10 Par Value (Class A stock) | 297,596,071 ------------------------------------------------------+------------------- Class B Common Stock, $0.10 Par Value (Class B stock) | 70,010,755 ------------------------------------------------------+------------------- On April 1, 2017 , the aggregate market value of the registrant’s Class A Common Stock, $0.10 par value (Class A stock), and Class B Common Stock, $0.10 par value (Class B stock), held by non-affiliates of the registrant was $17,568,317,217 and $663,691 , respectively. Class B stock is not publicly listed for trade on any exchange or market system. However, Class B stock is convertible into Class A stock on a share-for-share basis, so the market value was calculated based on the market price of Class A stock. On October 28, 2017 , there were 297,708,610 shares of Class A stock and 70,010,355 shares of Class B stock outstanding. INCORPORATION BY REFERENCE Portions of the registrant’s definitive Proxy Statement for the registrant’s Annual Meeting of Shareholders to be held February 8, 2018 , are incorporated by reference into Part III of this Annual Report on Form 10-K. TABLE OF CONTENTS ----------------- | | PAGE ------------------+--------------------------------------------------------------------------------------------------------------+----- PART I | | ------------------+--------------------------------------------------------------------------------------------------------------+----- Item 1. | Business | 2 ------------------+--------------------------------------------------------------------------------------------------------------+----- Item 1A. | Risk Factors | 6 ------------------+--------------------------------------------------------------------------------------------------------------+----- Item 1B. | Unresolved Staff Comments | 15 ------------------+--------------------------------------------------------------------------------------------------------------+----- Item 2. | Properties | 15 ------------------+--------------------------------------------------------------------------------------------------------------+----- Item 3. | Legal Proceedings | 16 ------------------+--------------------------------------------------------------------------------------------------------------+----- Item 4. | Mine Safety Disclosures | 17 ------------------+--------------------------------------------------------------------------------------------------------------+----- PART II | | ------------------+--------------------------------------------------------------------------------------------------------------+----- Item 5. | Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities | 19 ------------------+--------------------------------------------------------------------------------------------------------------+----- Item 6. | Selected Financial Data | 21 ------------------+--------------------------------------------------------------------------------------------------------------+----- Item 7. | Management’s Discussion and Analysis of Financial Condition and Results of Operations | 23 ------------------+--------------------------------------------------------------------------------------------------------------+----- Item 7A. | Quantitative and Qualitative Disclosures About Market Risk | 43 ------------------+--------------------------------------------------------------------------------------------------------------+----- Item 8. | Financial Statements and Supplementary Data | 45 ------------------+--------------------------------------------------------------------------------------------------------------+----- Item 9. | Changes in and Disagreements With Accountants on Accounting and Financial Disclosure | 90 ------------------+--------------------------------------------------------------------------------------------------------------+----- Item 9A. | Controls and Procedures | 90 ------------------+--------------------------------------------------------------------------------------------------------------+----- Item 9B. | Other Information | 90 ------------------+--------------------------------------------------------------------------------------------------------------+----- PART III | | ------------------+--------------------------------------------------------------------------------------------------------------+----- Item 10. | Directors, Executive Officers and Corporate Governance | 91 ------------------+--------------------------------------------------------------------------------------------------------------+----- Item 11. | Executive Compensation | 91 ------------------+--------------------------------------------------------------------------------------------------------------+----- Item 12. | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters | 92 ------------------+--------------------------------------------------------------------------------------------------------------+----- Item 13. | Certain Relationships and Related Transactions, and Director Independence | 92 ------------------+--------------------------------------------------------------------------------------------------------------+----- Item 14. | Principal Accounting Fees and Services | 92 ------------------+--------------------------------------------------------------------------------------------------------------+----- PART IV | | ------------------+--------------------------------------------------------------------------------------------------------------+----- Item 15. | Exhibits, Financial Statement Schedules | 93 ------------------+--------------------------------------------------------------------------------------------------------------+----- Item 16. | Form 10-K Summary | 103 ------------------+--------------------------------------------------------------------------------------------------------------+----- 1 PART I ITEM 1. BUSINESS GENERAL Tyson Foods, Inc. and its subsidiaries (collectively, the “Company,” “we,” “us,” “our,” “Tyson Foods” or “Tyson”) (NYSE: TSN) is one of the world’s largest food companies and a recognized leader in protein. Founded in 1935 by John W. Tyson and grown under three generations of family leadership, the Company has a broad portfolio of products and brands like Tyson®, Jimmy Dean®, Hillshire Farm®, Ball Park®, Wright®, Aidells®, ibp® and State Fair®. Tyson Foods innovates continually to make protein more sustainable, tailor food for everywhere it’s available and raise the world’s expectations for how much good food can do. Headquartered in Springdale, Arkansas, the company had approximately 122,000 team members on September 30, 2017. Through its Core Values, Tyson Foods strives to operate with integrity, create value for its shareholders, customers, communities and team members and serve as a steward of the animals, land and environment entrusted to it. Some of the key factors influencing our business are customer demand for our products; the ability to maintain and grow relationships with customers and introduce new and innovative products to the marketplace; accessibility of international markets; market prices for our products; the cost and availability of live cattle and hogs, raw materials and feed ingredients; and operating efficiencies of our facilities. We operate a fully vertically-integrated chicken production process. Our integrated operations consist of breeding stock, contract growers, feed production, processing, further-processing, marketing and transportation of chicken and related allied products, including animal and pet food ingredients. Through our wholly-owned subsidiary, Cobb-Vantress, Inc., we are one of the leading poultry breeding stock suppliers in the world. Investing in breeding stock research and development allows us to breed into our flocks the characteristics found to be most desirable. We also process live fed cattle and hogs and fabricate dressed beef and pork carcasses into primal and sub-primal meat cuts, case ready beef and pork and fully-cooked meats. In addition, we derive value from allied products such as hides and variety meats sold to further processors and others. We produce a wide range of fresh, value-added, frozen and refrigerated food products. Our products are marketed and sold primarily by our sales staff to grocery retailers, grocery wholesalers, meat distributors, warehouse club stores, military commissaries, industrial food processing companies, chain restaurants or their distributors, live markets, international export companies and domestic distributors who serve restaurants, foodservice operations such as plant and school cafeterias, convenience stores, hospitals and other vendors. Additionally, sales to the military and a portion of sales to international markets are made through independent brokers and trading companies. On June 7, 2017, we acquired and consolidated AdvancePierre Foods Holdings, Inc. ("AdvancePierre"), a producer and distributor of value-added, convenient, ready-to-eat sandwiches, sandwich components and other entrées and snacks. AdvancePierre's results of operations are included in the Prepared Foods and Chicken segments. For further description of this transaction, refer to Part II, Item 8, Notes to Consolidated Financial Statements, Note 3: Acquisitions and Dispositions. As part of our commitment to innovation and growth, in fiscal 2017 we launched a venture capital fund focused on investing in companies developing breakthrough technologies, business models and products to sustainably feed a growing world population. The Tyson New Ventures LLC, fund is used to broaden our exposure to innovative, new forms of protein and ways of sustainably producing food to complement the Company's continuing investments in innovation in our core Beef, Pork, Chicken and Prepared Foods businesses. FINANCIAL INFORMATION OF SEGMENTS We operate in four reportable segments: Beef, Pork, Chicken and Prepared Foods. Other primarily includes our foreign chicken production operations in China and India, third-party merger and integration costs and corporate overhead related to Tyson New Ventures, LLC. The contribution of each segment to net sales and operating income (loss), and the identifiable assets attributable to each segment, are set forth in Part II, Item 8, Notes to Consolidated Financial Statements, Note 17: Segment Reporting. DESCRIPTION OF SEGMENTS Beef: Beef includes our operations related to processing live fed cattle and fabricating dressed beef carcasses into primal and sub-primal meat cuts and case-ready products. Products are marketed domestically to food retailers, foodservice distributors, restaurant operators, hotel chains and noncommercial foodservice establishments such as schools, healthcare facilities, the military and other food processors, as well as to international export markets. This segment also includes sales from allied products such as hides and variety meats, as well as logistics operations to move products through the supply chain. 2 Pork: Pork includes our operations related to processing live market hogs and fabricating pork carcasses into primal and sub-primal cuts and case-ready products. Products are marketed domestically to food retailers, foodservice distributors, restaurant operators, hotel chains and noncommercial foodservice establishments such as schools, healthcare facilities, the military and other food processors, as well as to international export markets. This segment also includes our live swine group, related allied product processing activities and logistics operations to move products through the supply chain. Chicken: Chicken includes our domestic operations related to raising and processing live chickens into, and purchasing raw materials for, fresh, frozen and value-added chicken products, as well as sales from allied products. Our value-added chicken products primarily include breaded chicken strips, nuggets, patties and other ready-to-fix or fully cooked chicken parts. Products are marketed domestically to food retailers, foodservice distributors, restaurant operators, hotel chains and noncommercial foodservice establishments such as schools, healthcare facilities, the military and other food processors, as well as to international export markets. This segment also includes logistics operations to move products through our domestic supply chain and the global operations of our chicken breeding stock subsidiary. Prepared Foods: Prepared Foods includes our operations related to manufacturing and marketing frozen and refrigerated food products and logistics operations to move products through the supply chain. This segment includes brands such as Jimmy Dean®, Hillshire Farm®, Ball Park®, Wright®, State Fair®, Van's®, Sara Lee® and Chef Pierre®, as well as artisanal brands Aidells®, Gallo Salame®, and Golden Island®. Products primarily include ready-to-eat sandwiches, sandwich components such as flame-grilled hamburgers and Philly steaks, pepperoni, bacon, breakfast sausage, turkey, lunchmeat, hot dogs, pizza crusts and toppings, flour and corn tortilla products, desserts, appetizers, snacks, prepared meals, ethnic foods, soups, sauces, side dishes, meat dishes, breadsticks and processed meats. Products are marketed domestically to food retailers, foodservice distributors, restaurant operators, hotel chains and noncommercial foodservice establishments such as schools, healthcare facilities, the military and other food processors, as well as to international export markets. RAW MATERIALS AND SOURCES OF SUPPLY Beef: The primary raw materials used in our beef operations are live cattle. We do not have facilities of our own to raise cattle but employ cattle buyers located throughout cattle producing areas who visit independent feed yards and public auctions and buy live cattle on the open spot market. These buyers are trained to select high quality animals, and we continually measure their performance. We also enter into various risk-sharing and procurement arrangements with producers to secure a supply of livestock for our facilities. Although we generally expect adequate supply of live cattle in the regions we operate, there may be periods of imbalance in supply and demand. Pork: The primary raw materials used in our pork operations are live hogs. The majority of our live hog supply is obtained through various procurement relationships with independent producers. We employ hog buyers who make purchase agreements of various time durations as well as purchase hogs on a daily basis, generally a few days before the animals are processed. These buyers are trained to select high quality animals, and we continually measure their performance. We believe the supply of live hogs is adequate for our present needs. Additionally, we raise a small number of weanling swine to sell to independent finishers and supply a minimal amount of market hogs and live swine for our own processing needs. Chicken: The primary raw materials used in our domestic chicken operations are corn and soybean meal used as feed and live chickens raised primarily by independent contract growers. Our vertically-integrated chicken process begins with the grandparent breeder flocks and ends with broilers for processing. Breeder flocks (i.e., grandparents) are raised to maturity in grandparent growing and laying farms where fertile eggs are produced. Fertile eggs are incubated at the grandparent hatchery and produce pullets (i.e., parents). Pullets are sent to breeder houses, and the resulting eggs are sent to our hatcheries. Once chicks have hatched, they are sent to broiler farms. There, contract growers care for and raise the chicks according to our standards, with advice from our technical service personnel, until the broilers reach the desired processing weight. Adult chickens are transported to processing plants where they are harvested and converted into finished products, which are then sent to distribution centers and delivered to customers. We operate feed mills to produce scientifically-formulated feeds. In fiscal 2017 , corn, soybean meal and other feed ingredients were major production costs, representing roughly 55% of our cost of growing a live chicken domestically. In addition to feed ingredients to grow the chickens, we use cooking ingredients, packaging materials and cryogenic agents. We believe our sources of supply for these materials are adequate for our present needs, and we do not anticipate any difficulty in acquiring these materials in the future. While we produce nearly all our inventory of breeder chickens and live broilers, we also purchase ice-packed or deboned chicken, including no antibiotics ever (sometimes referred to as "NAE") certified chicken, to meet production and sales requirements. Prepared Foods: The primary raw materials used in our prepared foods operations are commodity based raw materials, including beef, pork, chicken, turkey, corn, flour, vegetables, bread, breading, cheese, eggs, seasonings, and other cooking ingredients. Some of these raw materials are provided by our other segments, while others may be purchased from numerous suppliers and manufacturers. We believe the sources of supply of raw materials are adequate for our present needs. 3 SEASONAL DEMAND Demand for beef, chicken and certain prepared foods products, such as hot dogs and smoked sausage, generally increases during the spring and summer months and generally decreases during the winter months. Pork and certain other prepared foods products, such as prepared meals, meat dishes, appetizers, frozen pies and breakfast sausage, generally experience increased demand during the winter months, primarily due to the holiday season, while demand generally decreases during the spring and summer months. CUSTOMERS Wal-Mart Stores, Inc. accounted for 17.3% of our fiscal 2017 consolidated sales. Sales to Wal-Mart Stores, Inc. were included in all of our segments. Any extended discontinuance of sales to this customer could, if not replaced, have a material impact on our operations. No other single customer or customer group represented more than 10% of fiscal 2017 consolidated sales. COMPETITION Our food products compete with those of other food producers and processors and certain prepared food manufacturers. Additionally, our food products compete in markets around the world. We seek to achieve a leading market position for our products via our principal marketing and competitive strategy, which includes: • | identifying target markets for value-added products; --+----------------------------------------------------- • | concentrating production, sales and marketing efforts to appeal to and enhance demand from those markets; and --+-------------------------------------------------------------------------------------------------------------- • | utilizing our national distribution systems and customer support services. --+--------------------------------------------------------------------------- Past efforts indicate customer demand can be increased and sustained through application of our marketing strategy, as supported by our distribution systems. The principal competitive elements are price, product safety and quality, brand identification, innovation, breadth and depth of product offerings, availability of products, customer service and credit terms. FOREIGN OPERATIONS We sold products in approximately 117 countries in fiscal 2017 . Major sales markets include Canada, Central America, China, the European Union, Japan, Mexico, the Middle East, South Korea and Taiwan. We have the following foreign operations: • | Cobb-Vantress, a chicken breeding stock subsidiary, has business interests in Argentina, Brazil, China, the Dominican Republic, India, Japan, the Netherlands, New Zealand, the Philippines, Spain, Turkey, the United Kingdom and Venezuela. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Tyson Rizhao, located in Rizhao, China, is a vertically-integrated chicken production operation. --+------------------------------------------------------------------------------------------------- • | Tyson Dalong, a joint venture in China in which we have a majority interest, is a chicken further-processing facility. --+----------------------------------------------------------------------------------------------------------------------- • | Tyson Nantong, located in Nantong, China, is a vertically-integrated chicken production operation. --+--------------------------------------------------------------------------------------------------- • | Godrej Tyson Foods, a joint venture in India in which we have a majority interest, is primarily a chicken processing business. --+------------------------------------------------------------------------------------------------------------------------------- • | Tyson Mexico Trading Company, a Mexican subsidiary, sells chicken products primarily through co-packer arrangements. --+--------------------------------------------------------------------------------------------------------------------- We continue to evaluate growth opportunities in foreign countries. Additional information regarding export sales and long-lived assets located in foreign countries is set forth in Part II, Item 8, Notes to Consolidated Financial Statements, Note 17: Segment Reporting. RESEARCH AND DEVELOPMENT We conduct continuous research and development activities to improve product development, to automate manual processes in our processing plants and growout operations, and to improve chicken breeding stock. With regards to our food products we have two research and development locations, our Discovery Center in Springdale, Arkansas, and another center located in Downers Grove, Illinois. The centers include more than 80,000 square feet of United States Department of Agriculture ("USDA") pilot plant space, two consumer sensory and focus group areas, a packaging lab and 25 research kitchens. The centers enable us to bring new market-leading retail and foodservice products to the customer quickly and efficiently. Research and development costs totaled $113 million , $96 million , and $75 million in fiscal 2017 , 2016 and 2015 , respectively. ENVIRONMENTAL REGULATION AND FOOD SAFETY Our facilities for processing beef, pork, chicken, turkey and prepared foods, milling feed and housing live chickens and swine are subject to a variety of international, federal, state and local environmental laws and regulations, which include provisions relating to the discharge of materials into the environment and generally provide for protection of the environment. We believe we are in substantial compliance with such applicable laws and regulations and are not aware of any violations of such laws and regulations likely to result in material penalties or material increases in compliance costs. The cost of compliance with such laws and regulations has not had a material adverse effect on our capital expenditures, earnings or competitive position, and except as described below, is not anticipated to have a material adverse effect in the future. 4 Congress, the United States Environmental Protection Agency and some states continue to consider various options to control greenhouse gas emissions. It is unclear at this time what options, if any, will be finalized, and whether such options would have a direct impact on the Company. Due to continuing uncertainty surrounding this issue, it is premature to speculate on the specific nature of impacts that imposition of greenhouse gas emission controls would have on us and whether such impacts would have a material adverse effect. We work to ensure our products meet high standards of food safety and quality. In addition to our own internal Food Safety and Quality Assurance oversight and review, our beef, pork, chicken, and prepared foods products are subject to inspection prior to distribution, primarily by the USDA and the United States Food and Drug Administration. We are also participants in the United States Hazard Analysis Critical Control Point program and are subject to the Sanitation Standard Operating Procedures and the Public Health Security and Bioterrorism Preparedness and Response Act of 2002. Additionally, our foreign operations are subject to various other food safety and quality assurance oversight and review. EMPLOYEES AND LABOR RELATIONS As of September 30, 2017 , we employed approximately 122,000 employees. Approximately 117,000 employees were employed in the United States, and 5,000 employees were employed in foreign countries, primarily in China. Approximately 31,000 employees in the United States were subject to collective bargaining agreements with various labor unions, with approximately 10% of those employees at locations either under negotiation for contract renewal or included under agreements expiring in fiscal 2018 . The remaining agreements expire over the next several years. Approximately 4,000 employees in foreign countries were subject to collective bargaining agreements. We believe our overall relations with our workforce are good. MARKETING AND DISTRIBUTION Our principal marketing objective is to be the preferred provider of beef, pork, chicken, and prepared foods products for our customers and consumers. We build the Tyson®, Jimmy Dean®, Hillshire Farm®, Ball Park®, Wright®, Aidells®, ibp® and State Fair® brands while supporting strong regional and emerging brands primarily through well-defined, product-specific advertising, marketing, and public relations efforts focused toward key consumer targets with specific needs. We identify growth and business opportunities through consumer and customer insights derived via leading research and analytic capabilities. We utilize our national distribution system and customer support services to achieve the leading market position for our products and brands. We have the ability to produce and ship fresh, frozen and refrigerated products worldwide. Domestically, our distribution system extends to a broad network of food distributors and is supported by our owned or leased cold storage warehouses, public cold storage facilities and our transportation system. Our distribution centers accumulate fresh and frozen products so we can fill and consolidate partial-truckload orders into full truckloads, thereby decreasing shipping costs while increasing customer service. In addition, we provide our customers a wide selection of products that do not require large volume orders. Our distribution system enables us to supply large or small quantities of products to meet customer requirements anywhere in the continental United States. Internationally, we utilize both rail and truck refrigerated transportation to domestic ports, where consolidations take place to transport to foreign destinations. PATENTS AND TRADEMARKS We have filed a number of patents relating to our processes and products that either have been approved or are in the process of review. Because we do a significant amount of brand name and product line advertising to promote our products, we consider the protection of our trademarks to be important to our marketing efforts and have registered and applied for the registration of a number of trademarks. We also have developed non-public proprietary information regarding our production processes and other product-related matters. We utilize internal procedures and safeguards to protect the confidentiality of such information and, where appropriate, seek patent and/or other protection for the technology we utilize. INDUSTRY PRACTICES Our agreements with customers are generally short-term, primarily due to the nature of our products, industry practices and fluctuations in supply, demand and price for such products. In certain instances where we are selling further processed products to large customers, we may enter into written agreements whereby we will act as the exclusive or preferred supplier to the customer, with pricing terms that are either fixed or variable. AVAILABILITY OF SEC FILINGS AND CORPORATE GOVERNANCE DOCUMENTS ON INTERNET WEBSITE We maintain an internet website for investors at http://ir.tyson.com. On this website, we make available, free of charge, annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, XBRL (eXtensible Business Reporting Language) reports, and all amendments to any of those reports, as soon as reasonably practicable after we electronically file such reports with, or furnish such reports to, the Securities and Exchange Commission. Also available on the website for investors are the Corporate Governance Principles, Audit Committee charter, Compensation and Leadership Development Committee charter, Governance and Nominating Committee charter, Strategy and Acquisitions Committee charter, Code of Conduct and Whistleblower Policy. Our corporate governance documents are available in print, free of charge to any shareholder who requests them. 5 CAUTIONARY STATEMENTS RELEVANT TO FORWARD-LOOKING INFORMATION FOR THE PURPOSE OF “SAFE HARBOR” PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 Certain information in this report constitutes forward-looking statements. Such forward-looking statements include, but are not limited to, current views and estimates of our outlook for fiscal 2018, other future economic circumstances, industry conditions in domestic and international markets, our performance and financial results (e.g., debt levels, return on invested capital, value-added product growth, capital expenditures, tax rates, access to foreign markets and dividend policy). These forward-looking statements are subject to a number of factors and uncertainties that could cause our actual results and experiences to differ materially from anticipated results and expectations expressed in such forward-looking statements. We wish to caution readers not to place undue reliance on any forward-looking statements, which speak only as of the date made. We undertake no obligation to update any forward-looking statements, whether as a result of new information, future events or otherwise. Among the factors that may cause actual results and experiences to differ from anticipated results and expectations expressed in such forward-looking statements are the following: (i) fluctuations in the cost and availability of inputs and raw materials, such as live cattle, live swine, feed grains (including corn and soybean meal) and energy; (ii) market conditions for finished products, including competition from other global and domestic food processors, supply and pricing of competing products and alternative proteins and demand for alternative proteins; (iii) outbreak of a livestock disease (such as avian influenza (AI) or bovine spongiform encephalopathy (BSE)), which could have an adverse effect on livestock we own, the availability of livestock we purchase, consumer perception of certain protein products or our ability to access certain domestic and foreign markets; (iv) the integration of AdvancePierre Foods Holdings, Inc.; (v) the effectiveness of our financial fitness program; (vi) the implementation of an enterprise resource planning system; (vii) access to foreign markets together with foreign economic conditions, including currency fluctuations, import/export restrictions and foreign politics; (viii) changes in availability and relative costs of labor and contract growers and our ability to maintain good relationships with employees, labor unions, contract growers and independent producers providing us livestock; (ix) issues related to food safety, including costs resulting from product recalls, regulatory compliance and any related claims or litigation; (x) changes in consumer preference and diets and our ability to identify and react to consumer trends; (xi) effectiveness of advertising and marketing programs; (xii) our ability to leverage brand value propositions; (xiii) risks associated with leverage, including cost increases due to rising interest rates or changes in debt ratings or outlook; (xiv) impairment in the carrying value of our goodwill or indefinite life intangible assets; (xv) compliance with and changes to regulations and laws (both domestic and foreign), including changes in accounting standards, tax laws, environmental laws, agricultural laws and occupational, health and safety laws; (xvi) adverse results from litigation; (xvii) cyber incidents, security breaches or other disruptions of our information technology systems; (xviii) our ability to make effective acquisitions or joint ventures and successfully integrate newly acquired businesses into existing operations; (xix) risks associated with our commodity purchasing activities; (xx) the effect of, or changes in, general economic conditions; (xxi) significant marketing plan changes by large customers or loss of one or more large customers; (xxii) impacts on our operations caused by factors and forces beyond our control, such as natural disasters, fire, bioterrorism, pandemics or extreme weather; (xxiii) failure to maximize or assert our intellectual property rights; (xxiv) our participation in a multiemployer pension plan; (xxv) the Tyson Limited Partnership’s ability to exercise significant control over the Company; (xxvi) effects related to changes in tax rates, valuation of deferred tax assets and liabilities, or tax laws and their interpretation; (xxvii) volatility in capital markets or interest rates; and (xxviii) those factors listed under Item 1A. “Risk Factors.” ITEM 1A. RISK FACTORS These risks, which should be considered carefully with the information provided elsewhere in this report, could materially adversely affect our business, financial condition or results of operations. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition or results of operations. Fluctuations in commodity prices and in the availability of raw materials, especially feed grains, live cattle, live swine and other inputs could negatively impact our earnings. Our results of operations and financial condition, as well as the selling prices for our products, are dependent upon the cost and supply of commodities and raw materials such as beef, pork, poultry, corn, soybean, packaging materials and energy and, to a lesser extent, cheese, fruit, seasoning blends, flour, corn syrup, corn oils, butter and sugar. Corn, soybean meal and other feed ingredients, for instance, represented roughly 55% of our cost of growing a live chicken in fiscal 2017 . Production and pricing of these commodities are determined by constantly changing market forces of supply and demand over which we have limited or no control. Such factors include, among other things, weather patterns throughout the world, outbreaks of disease, the global level of supply inventories and demand for grains and other feed ingredients, as well as agricultural and energy policies of domestic and foreign governments. Volatility in our commodity and raw material costs directly impact our gross margin and profitability. The Company’s objective is to offset commodity price increases with pricing actions over time. However, we may not be able to increase our product prices enough to sufficiently offset increased raw material costs due to consumer price sensitivity or the pricing postures of our competitors. In addition, if we increase prices to offset higher costs, we could experience lower demand for our products and sales volumes. Conversely, decreases in our commodity and other input costs may create pressure on us to decrease our prices. While we use derivative financial instruments, primarily futures and options, to reduce the effect of changing prices and as a mechanism to procure the underlying commodity, we do not fully hedge against changes in commodities prices. 6 Over time, if we are unable to price our products to cover increased costs, to offset operating cost increases with continuous improvement savings or are not successful in our commodity hedging program, then commodity and raw material price volatility or increases could materially and adversely affect our profitability, financial condition and results of operations. The prices we receive for our products may fluctuate due to competition from other food producers and processors. The food industry in general is intensely competitive. We face competition from other food producers and processors that have various product ranges and geographic reach. Some of the factors on which we compete include: pricing, product safety and quality, brand identification, innovation, breadth and depth of product offerings, availability of our products (including distribution channels used, such as e-commerce) and competing products, customer service, and credit terms. From time to time in response to these competitive pressures or to maintain market share, we may need to reduce the prices for some of our products or increase or reallocate spending on marketing, advertising and promotions and new product innovation. Such pressures also may restrict our ability to increase prices in response to raw material and other cost increases. Any reduction in prices as a result of competitive pressures, or any failure to increase prices to offset cost increases, could harm our profit margins. If we reduce prices but we cannot increase sales volumes to offset the price changes, then our financial condition and results of operations will suffer. Alternatively, if we do not reduce our prices and our competitors seek advantage through pricing or promotional changes, our revenues and market share could be adversely affected. Outbreaks of livestock diseases can adversely impact our ability to conduct our operations and the supply and demand for our products. Supply of and demand for our products can be adversely impacted by outbreaks of livestock diseases, which can have a significant impact on our financial results. Efforts are taken to control disease risks by adherence to good production practices and extensive precautionary measures designed to ensure the health of livestock. However, outbreaks of disease and other events, which may be beyond our control, either in our own livestock or livestock owned by independent producers who sell livestock to us, could significantly affect demand for our products, consumer perceptions of certain protein products, the availability of livestock for purchase by us and our ability to conduct our operations. Moreover, the outbreak of livestock diseases, particularly in our Chicken segment, could have a significant effect on the livestock we own by requiring us to, among other things, destroy any affected livestock. Furthermore, an outbreak of disease could result in governmental restrictions on the import and export of our products to or from our suppliers, facilities or customers. This could also result in negative publicity that may have an adverse effect on our ability to market our products successfully and on our financial results. The integration of AdvancePierre may be more difficult, costly or time consuming than expected, and the acquisition may not result in any or all of the anticipated benefits, including cost synergies. The success of the acquisition of AdvancePierre, including the realization of the anticipated benefits, will depend in part on our ability to successfully integrate AdvancePierre’s businesses in an efficient and effective manner. We may not be able to accomplish this integration process smoothly or successfully. The necessity of coordinating geographically separated organizations, systems and facilities and addressing possible differences in business backgrounds, corporate cultures and management philosophies may increase the difficulties of integration. Failure to effectively integrate the businesses could adversely impact the expected benefits of the acquisition, including cost synergies arising from supply chain efficiencies, merchandising activities and overlapping general and administrative functions. The integration of two large companies is complex, and we will be required to devote significant management attention and incur substantial costs to integrate AdvancePierre's and Tyson’s business practices, policies, cultures and operations. This diversion of our management’s attention from day-to-day business operations and the execution and pursuit of strategic plans and initiatives could result in performance shortfalls, which could adversely impact the combined company’s business, operations and financial results. The integration process could also result in the loss of key employees, which could adversely impact the combined company’s future financial results. Furthermore, during the integration planning process, we may encounter additional challenges and difficulties, including those related to, without limitation, managing a larger combined company; streamlining supply chains, consolidating corporate and administrative infrastructures and eliminating overlapping operations; retaining our existing vendors and customers; unanticipated issues in integrating information technology, communications and other systems; and unforeseen and unexpected liabilities related to the acquisition of AdvancePierre. Delays encountered in the integration could adversely impact the business, financial condition and operations of the combined company. We continue to evaluate our estimates of synergies to be realized from the AdvancePierre acquisition and refine them. Our actual cost savings could differ materially from our current estimates. Actual cost savings, the costs required to realize the cost savings and the source of the cost savings could differ materially from our estimates, and we cannot assure you that we will achieve the full amount of cost savings on the schedule anticipated or at all or that these cost savings programs will not have other adverse effects on our business. In light of these uncertainties, you should not place undue reliance on our estimated cost savings. 7 Finally, we may not be able to achieve the targeted operating or long-term strategic benefits of the AdvancePierre acquisition in a timely manner or at all or could incur higher transition costs than anticipated. An inability to realize the full extent of, or any of, the anticipated benefits of the AdvancePierre acquisition, as well as any delays encountered in the integration process, could have an adverse effect on our business, results of operations and financial condition. We may not realize any or all of the anticipated benefits of our financial fitness program, which may prove to be more difficult, costly, or time consuming than expected. In the fourth quarter of fiscal 2017, our Board of Directors approved a multi-year restructuring program (the “Financial Fitness Program”), which is expected to contribute to the Company’s overall strategy of financial fitness through increased operational effectiveness and overhead reduction. For more information regarding this program, refer to the heading “Overview” set forth in Part II, “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this report. The success of the Financial Fitness Program, including the realization of the anticipated benefits, will depend in part on our ability to successfully implement the program in an efficient and effective manner. The implementation of the Financial Fitness Program may be more difficult, costly, or time consuming than expected, and the Financial Fitness Program may not result in any or all of the anticipated benefits. If we are unable to implement the Financial Fitness Program smoothly or successfully, or we otherwise do not capture the anticipated savings, our business, results of operations and financial condition for future periods could be negatively impacted. In addition, we may incur higher costs associated with reductions in overhead than anticipated, and the reduction in overhead could result in performance shortfalls. The Financial Fitness Program may become a distraction for our organization and may disrupt our ongoing business operations; cause deterioration in employee morale; disrupt or weaken the internal control structures of the affected business operations; and result in negative publicity which could affect our corporate reputation. If we are unable to successfully manage the negative consequences of the Financial Fitness Program, our business, results of operations and financial condition for future periods could be adversely affected. We may experience difficulties in implementing an enterprise resource planning system over the next few years. We are engaged in a multi-year implementation of an enterprise resource planning (“ERP”) system. Such an implementation is a major undertaking from a financial, management, and personnel perspective. The implementation of the ERP system may prove to be more difficult, costly, or time consuming than expected, and there can be no assurance that this system will continue to be beneficial to the extent anticipated. Any disruptions, delays or deficiencies in the design and implementation of our new ERP system could adversely affect our ability to process orders, ship products, send invoices and track payments, fulfill contractual obligations, produce financial reports, or otherwise operate our business. As we implement our new ERP system, our exposure to system attacks may be elevated because we will be running old and new processes in parallel and must simultaneously protect both the new system and legacy systems. If we are unable to implement the ERP system smoothly or successfully, or we otherwise do not capture anticipated benefits, our business, results of operations and financial condition for future periods could be negatively impacted. Additionally, our implementation of the ERP system may involve greater utilization of third-party “cloud” computing services in connection with our business operations. Problems faced by us or our third-party “cloud” computing providers, including technological or business-related disruptions, as well as cybersecurity threats, could adversely impact our business, results of operations and financial condition for future periods. We are subject to risks associated with our international activities, which could negatively affect our sales to customers in foreign countries, as well as our operations and assets in such countries. In fiscal 2017 , we sold products to approximately 117 countries. Major sales markets include Canada, Central America, China, the European Union, Japan, Mexico, the Middle East, South Korea and Taiwan. Our sales to customers in foreign countries for fiscal 2017 totaled $4.5 billion, of which $3.9 billion related to export sales from the United States. In addition, we had approximately $217 million of long-lived assets located in foreign countries, primarily Brazil, China, European Union and India, at the end of fiscal 2017 . As a result, we are subject to various risks and uncertainties relating to international sales and operations, including: • | imposition of tariffs, quotas, trade barriers and other trade protection measures imposed by foreign countries regarding the importation of beef, pork, poultry, and prepared foods products, in addition to import or export licensing requirements imposed by various foreign countries; --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | closing of borders by foreign countries to the import of beef, pork, and poultry products due to animal disease or other perceived health or safety issues; --+------------------------------------------------------------------------------------------------------------------------------------------------------------ • | impact of currency exchange rate fluctuations between the United States dollar and foreign currencies, particularly the Brazilian real, the British pound sterling, the Canadian dollar, the Chinese renminbi, the European euro, the Japanese yen and the Mexican peso; --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | political and economic conditions; --+----------------------------------- • | difficulties and costs to comply with, and enforcement of remedies under, a wide variety of complex domestic and international laws, treaties and regulations, including, without limitation, the United States Foreign Corrupt Practices Act and economic and trade sanctions enforced by the United States Department of the Treasury’s Office of Foreign Assets Control; --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 8 • | different regulatory structures and unexpected changes in regulatory environments; --+----------------------------------------------------------------------------------- • | tax rates that may exceed those in the United States and earnings that may be subject to withholding requirements and incremental taxes upon repatriation; --+----------------------------------------------------------------------------------------------------------------------------------------------------------- • | potentially negative consequences from changes in tax laws; and --+---------------------------------------------------------------- • | distribution costs, disruptions in shipping or reduced availability of freight transportation. --+----------------------------------------------------------------------------------------------- Negative consequences relating to these risks and uncertainties could jeopardize or limit our ability to transact business in one or more of those markets where we operate or in other developing markets and could adversely affect our financial results. We depend on the availability of, and good relations with, our employees. We have approximately 122,000 employees, approximately 35,000 of whom are covered by collective bargaining agreements or are members of labor unions. Our operations depend on the availability and relative costs of labor and maintaining good relations with employees and the labor unions. If we fail to maintain good relations with our employees or with the labor unions, we may experience labor strikes or work stoppages, which could adversely affect our financial results. If we are unable to attract, hire or retain key employees or a highly skilled and diverse global workforce, it could have a negative impact on our business, financial condition or results of operations. Our continued growth requires us to attract, hire, retain and develop key employees, including our executive officers and senior management team, and maintain a highly skilled and diverse global workforce. We compete to attract and hire highly skilled employees and our own employees are highly sought after by our competitors and other companies. Competition could cause us to lose talented employees, and unplanned turnover could deplete our institutional knowledge and result in increased costs due to increased competition for employees. We depend on contract growers and independent producers to supply us with livestock. We contract primarily with independent contract growers to raise the live chickens and turkeys processed in our poultry operations. A majority of our cattle and hogs are purchased from independent producers who sell livestock to us under marketing contracts or on the open market. If we do not attract and maintain contracts with growers or maintain marketing and purchasing relationships with independent producers, our production operations could be negatively affected. If our products become contaminated, we may be subject to product liability claims and product recalls, which could adversely affect our financial results and damage our reputation. Our products may be subject to contamination by disease-producing organisms or pathogens, such as Listeria monocytogenes, Salmonella and E. coli. These organisms and pathogens are found generally in the environment and there is a risk that one or more, as a result of food processing, could be present in our products. These organisms and pathogens also can be introduced to our products as a result of improper handling at the further-processing, foodservice or consumer level. These risks may be controlled, but may not be eliminated, by adherence to good manufacturing practices and finished product testing. We have little, if any, control over handling procedures once our products have been shipped for distribution. Even an inadvertent shipment of contaminated products may be a violation of law and may lead to increased risk of exposure to product liability claims, increased scrutiny and penalties, including injunctive relief and plant closings, by federal and state regulatory agencies, and adverse publicity, which could exacerbate the associated negative consumer reaction. Any of these occurrences may have an adverse effect on our financial results. In addition, we may be required to recall some of our products if they spoil, become contaminated, are tampered with or are mislabeled. A widespread product recall could result in significant losses due to the costs of a recall, the destruction of product inventory and lost sales due to the unavailability of product for a period of time. Such a product recall also could result in adverse publicity, damage to our reputation, and a loss of consumer confidence in our products, which could have a material adverse effect on our business results and the value of our brands. Changes in consumer preference and failure to maintain favorable consumer perception of our brands and products could negatively impact our business. The food industry in general is subject to changing consumer trends, demands and preferences. Trends within the food industry change often, and failure to identify and react to changes in these trends could lead to, among other things, reduced demand and price reductions for our brands and products. We strive to respond to consumer preferences and social expectations, but we may not be successful in our efforts. We could be adversely affected if consumers lose confidence in the safety and quality of certain food products or ingredients, or the food safety system generally. Prolonged negative perceptions concerning the health implications of certain food products or ingredients or loss of confidence in the food safety system generally could influence consumer preferences and acceptance of some of our products and marketing programs. Continued negative perceptions and failure to satisfy consumer preferences could materially and adversely affect our product sales, financial condition and results of operations. 9 We have a number of iconic brands with significant value. Maintaining and continually enhancing the value of these brands is critical to the success of our business. Brand value is based in large part on consumer perceptions. Success in promoting and enhancing brand value depends in large part on our ability to provide high-quality products. Brand value could diminish significantly due to a number of factors, including consumer perception that we have acted in an irresponsible manner, adverse publicity about our products (whether or not valid), our failure to maintain the quality of our products, the failure of our products to deliver consistently positive consumer experiences or the products becoming unavailable to consumers. Failure to continually innovate and successfully launch new products and maintain our brand image through marketing investment could adversely impact our operating results. Our financial success is dependent on anticipating changes in consumer preferences, purchasing behaviors and dietary habits and successfully developing and launching new products and product extensions that consumers want in the channels where they shop. We devote significant resources to new product development and product extensions, however we may not be successful in developing innovative new products or our new products may not be commercially successful. To the extent we are not able to effectively gauge the direction of our key markets and successfully identify, develop, manufacture and market new or improved products in these changing markets, such as adapting to emerging e-commerce channels, our financial results and our competitive position will suffer. In addition, our introduction of new products or product extensions may generate litigation or other legal proceedings against us by competitors claiming infringement of their intellectual property or other rights, which could negatively impact our results of operations. We also seek to maintain and extend the image of our brands through marketing investments, including advertising, consumer promotions and trade spend. Due to inherent risks in the marketplace associated with advertising, promotions and new product introductions, including uncertainties about trade and consumer acceptance, our marketing investments may not prove successful in maintaining or increasing our market share and could result in lower sales and profits. Continuing global focus on health and wellness, including weight management, and increasing media attention to the role of food marketing could adversely affect our brand image or lead to stricter regulations and greater scrutiny of food marketing practices. Our success in maintaining, extending and expanding our brand image also depends on our ability to adapt to a rapidly changing media environment, including our increasing reliance on social media and online dissemination of advertising campaigns. The growing use of social and digital media increases the speed and extent that information or misinformation and opinions can be shared. Negative posts or comments about us, our brands or our products on social or digital media could seriously damage our reputation and brand image. We are subject to a variety of legal and regulatory restrictions on how and to whom we market our products, for instance marketing to children, which may limit our ability to maintain or extend our brand image. If we do not maintain or extend our brand image, then our product sales, financial condition and results of operations could be materially and adversely affected. Failure to leverage our brand value propositions to compete against private label products, especially during economic downturn, may adversely affect our profitability. In many product categories, we compete not only with other widely advertised branded products, but also with private label products that generally are sold at lower prices. Consumers are more likely to purchase our products if they believe that our products provide a higher quality and greater value than less expensive alternatives. If the difference in quality between our brands and private label products narrows, or if there is a perception of such a narrowing, consumers may choose not to buy our products at prices that are profitable for us. In addition, in periods of economic uncertainty, consumers tend to purchase more lower-priced private label or other economy brands. To the extent this occurs, we could experience a reduction in the sales volume of our higher margin products or a shift in our product mix to lower margin offerings. In addition, in times of economic uncertainty, consumers reduce the amount of food that they consume away from home at our foodservice customers, which in turn reduces our product sales. Our level of indebtedness and the terms of our indebtedness could negatively impact our business and liquidity position. Our indebtedness, including borrowings under our revolving credit facility and commercial paper program, may increase from time to time for various reasons, including fluctuations in operating results, working capital needs, capital expenditures and possible acquisitions, joint ventures or other significant initiatives. Our consolidated indebtedness level could adversely affect our business because: • | it may limit or impair our ability to obtain financing in the future; --+---------------------------------------------------------------------- • | our credit ratings (or any decrease to our credit ratings) could restrict or impede our ability to access capital markets at desired interest rates and increase our borrowing costs; --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | it may reduce our flexibility to respond to changing business and economic conditions or to take advantage of business opportunities that may arise; --+----------------------------------------------------------------------------------------------------------------------------------------------------- • | a portion of our cash flow from operations must be dedicated to interest payments on our indebtedness and is not available for other purposes; and --+--------------------------------------------------------------------------------------------------------------------------------------------------- • | it may restrict our ability to pay dividends. --+---------------------------------------------- 10 Our revolving credit and term loan facilities contain affirmative and negative covenants that, among other things, may limit or restrict our ability to: create liens and encumbrances; incur debt; merge, dissolve, liquidate or consolidate; make acquisitions and investments; dispose of or transfer assets; change the nature of our business; engage in certain transactions with affiliates; and enter into hedging transactions, in each case, subject to certain qualifications and exceptions. In addition, we are required to maintain minimum interest expense coverage and maximum debt to capitalization ratios. Our senior notes also contain affirmative and negative covenants that, among other things, may limit or restrict our ability to: create liens; engage in certain sale/leaseback transactions; and engage in certain consolidations, mergers and sales of assets. An impairment in the carrying value of our goodwill or indefinite life intangible assets could negatively impact our consolidated results of operations and net worth. Goodwill and indefinite life intangible assets are initially recorded at fair value and not amortized, but are reviewed for impairment at least annually or more frequently if impairment indicators arise. In assessing the carrying value of goodwill and indefinite life intangible assets, we make estimates and assumptions about sales, operating margins, growth rates, royalty rates, EBITDA multiples, and discount rates based on budgets, business plans, economic projections, anticipated future cash flows and marketplace data. There are inherent uncertainties related to these factors and management’s judgment in applying these factors. Goodwill valuations have been calculated principally using an income approach. The income approach is based on the present value of future cash flows of each reporting unit and are believed to reflect market participant views which would exist in an exit transaction. Indefinite life intangible asset valuations have been calculated principally using relief-from-royalty and excess earnings approaches and are believed to reflect market participant views which would exist in an exit transaction. Under these valuation approaches, we are required to make various judgmental assumptions about appropriate discount rates. Disruptions in global credit and other financial markets and deterioration of economic conditions, could, among other things, cause us to increase the discount rate used in the valuations. We could be required to evaluate the recoverability of goodwill and indefinite life intangible assets prior to the annual assessment if we experience disruptions to the business, unexpected significant declines in operating results, divestiture of a significant component of our business or sustained market capitalization declines. These types of events and the resulting analyses could result in impairment charges in the future, which could be substantial. As of September 30, 2017 , we had $ 13.4 billion of goodwill and indefinite life intangible assets, which represented approximately 48% of total assets. New or more stringent domestic and international government regulations could impose material costs on us and could adversely affect our business. Our operations are subject to extensive federal, state and foreign laws and regulations by authorities that oversee food safety standards and processing, packaging, storage, distribution, advertising, labeling and export of our products. See “Environmental Regulation and Food Safety” in Item 1 of this Annual Report on Form 10-K. Changes in laws or regulations that impose additional regulatory requirements on us could increase our cost of doing business or restrict our actions, causing our results of operations to be adversely affected. For example, increased governmental interest in advertising practices may result in regulations that could require us to change or restrict our advertising practices. Increased government regulations to limit carbon dioxide and other greenhouse gas emissions as a result of concern over climate change may result in increased compliance costs, capital expenditures and other financial obligations for us. We use natural gas, diesel fuel and electricity in the manufacturing and distribution of our products. Legislation or regulation affecting these inputs could materially affect our profitability. In addition, climate change could affect our ability to procure needed commodities at costs and in quantities we currently experience and may require us to make additional unplanned capital expenditures. Legal claims, class action lawsuits, other regulatory enforcement actions, or failure to comply with applicable legal standards or requirements could affect our product sales, reputation and profitability. We operate in a highly-regulated environment with constantly evolving legal and regulatory frameworks. Consequently, we are subject to heightened risk of legal claims or other regulatory enforcement actions. Although we have implemented policies and procedures designed to ensure compliance with existing laws and regulations, there can be no assurance that our employees, contractors, or agents will not violate our policies and procedures. Moreover, a failure to maintain effective control processes could lead to violations, unintentional or otherwise, of laws and regulations. Legal claims or regulatory enforcement actions arising out of our failure or alleged failure to comply with applicable laws and regulations, including those contained in Item 3, Legal Proceedings and Part II, Item 8, Notes to Consolidated Financial Statements, Note 20: Commitments and Contingencies in this Annual Report on Form 10-K, could subject us to civil and criminal penalties, including debarment from governmental contracts that could materially and adversely affect our product sales, reputation, financial condition and results of operations. Loss of or failure to obtain necessary permits and registrations could delay or prevent us from meeting current product demand, introducing new products, building new facilities or acquiring new businesses and could adversely affect operating results. 11 The Company is subject to stringent environmental regulation and potentially subject to environmental litigation, proceedings, and investigations. Our past and present business operations and ownership and operation of real property are subject to stringent federal, state, and local environmental laws and regulations pertaining to the discharge of materials into the environment, and the handling and disposition of wastes (including solid and hazardous wastes) or otherwise relating to protection of the environment. Compliance with these laws and regulations, and the ability to comply with any modifications to these laws and regulations, is material to our business. New matters or sites may be identified in the future that will require additional investigation, assessment, or expenditures. In addition, some of our facilities have been in operation for many years and, over time, we and other prior operators of these facilities may have generated and disposed of wastes that now may be considered hazardous. Future discovery of contamination of property underlying or in the vicinity of our present or former properties or manufacturing facilities and/or waste disposal sites could require us to incur additional expenses. The occurrence of any of these events, the implementation of new laws and regulations, or stricter interpretation of existing laws or regulations, could adversely affect our financial results. We are increasingly dependent on information technology, and our business and reputation could suffer if we are unable to protect our information technology systems against, or effectively respond to, cyber-attacks, other cyber incidents or security breaches or if our information technology systems are otherwise disrupted. Information technology is an important part of our business operations and we increasingly rely on information technology systems to manage business data and increase efficiencies in our production and distribution facilities and inventory management processes. We also use information technology to process financial information and results of operations for internal reporting purposes and to comply with regulatory, legal and tax requirements. In addition, we depend on information technology for digital marketing and electronic communications between our facilities, personnel, customers and suppliers. Like other companies, our information technology systems may be vulnerable to a variety of disruptions, including but not limited to the process of upgrading or replacing software, databases or components thereof, natural disasters, terrorist attacks, telecommunications failures, computer viruses, cyber-attacks, hackers, unauthorized access attempts and other security issues. Attempted cyber-attacks and other cyber incidents are occurring more frequently, are constantly evolving in nature, are becoming more sophisticated and are being made by groups and individuals with a wide range of motives and expertise. We have implemented and continue to evaluate security initiatives and disaster recovery plans to mitigate our exposure to these risks, but these measures may not be adequate. Any significant failure of our systems, including failures that prevent our systems from functioning as intended or our failure to timely identify or appropriately respond to cyber-attacks or other cyber incidents, could cause transaction errors, processing inefficiencies, loss of customers and sales, have negative consequences on our employees and our business partners, have a negative impact on our operations or business reputation and expose us to liability, litigation and regulatory enforcement actions. In addition, if we are unable to prevent security breaches, we may suffer financial and reputational damage or penalties because of the unauthorized disclosure of confidential information belonging to us or to our business partners, customers, consumers or suppliers. Finally, the disclosure of non-public information through external media channels could lead to the loss of intellectual property or damage our reputation and brand image. Similar risks exist with respect to the third-party vendors that we rely upon for aspects of our information technology support services and administrative functions, including health and benefit plan administration and certain finance and accounting functions, and systems managed, hosted, provided and/or used by third parties and their vendors. If we pursue strategic acquisitions or divestitures, we may not be able to successfully consummate favorable transactions or successfully integrate acquired businesses. We periodically evaluate potential acquisitions, joint ventures and other initiatives, and may seek to expand our business through the acquisition of companies, processing plants, technologies, products and services. Acquisitions and joint ventures involve financial and operational risks and uncertainties, including: • | challenges in realizing the anticipated benefits of the transaction; --+--------------------------------------------------------------------- • | difficulty integrating acquired businesses, technologies, operations and personnel with our existing business; --+--------------------------------------------------------------------------------------------------------------- • | diversion of management attention in connection with negotiating transactions and integrating the businesses acquired; --+----------------------------------------------------------------------------------------------------------------------- • | difficulty identifying suitable candidates or consummating a transaction on terms that are favorable to us; --+------------------------------------------------------------------------------------------------------------ • | challenges in retaining the acquired businesses' customers and key employees; --+------------------------------------------------------------------------------ • | inability to implement and maintain consistent standards, controls, procedures and information systems; --+-------------------------------------------------------------------------------------------------------- • | exposure to unforeseen or undisclosed liabilities of acquired companies; and --+----------------------------------------------------------------------------- • | the availability and terms of additional debt or equity financing for any transaction. --+--------------------------------------------------------------------------------------- We may not be able to address these risks and successfully develop these acquired companies or businesses into profitable units. If we are unable to do this, such expansion could adversely affect our financial results. 12 Additionally, from time to time, we may divest businesses that do not meet our strategic objectives or do not meet our growth or profitability targets. We may not be able to complete desired or proposed divestitures on terms favorable to us. Gains or losses on the sales of, or lost operating income from, those businesses may affect our profitability and margins. Moreover, we may incur asset impairment charges related to divestitures that reduce our profitability. Our divestiture activities may present financial, managerial and operational risks. Those risks include diversion of management attention from existing businesses, difficulties separating personnel and financial and other systems, possible need for providing transition services to buyers, adverse effects on existing business relationships with suppliers and customers and indemnities and potential disputes with the buyers. Any of these factors could adversely affect our product sales, financial condition and results of operations. On April 24, 2017, we announced our intent to sell three non-protein businesses, Sara Lee® Frozen Bakery, Kettle and Van’s®, which are all a part of our Prepared Foods segment, as part of our strategic focus on protein-packed brands. We anticipate we will close the transactions by the end of calendar 2017. Market fluctuations could negatively impact our operating results as we hedge certain transactions. Our business is exposed to fluctuating market conditions. We use derivative financial instruments to reduce our exposure to various market risks including changes in commodity prices, interest rates and foreign exchange rates. We hold certain positions, primarily in grain and livestock futures, that do not qualify as hedges for financial reporting purposes. These positions are marked to fair value, and the unrealized gains and losses are reported in earnings at each reporting date. Therefore, losses on these contracts will adversely affect our reported operating results. While these contracts reduce our exposure to changes in prices for commodity products, the use of such instruments may ultimately limit our ability to benefit from favorable commodity prices. Deterioration of economic conditions could negatively impact our business. Our business may be adversely affected by changes in economic conditions, including inflation, interest rates, access to capital markets, consumer spending rates, energy availability and costs (including fuel surcharges) and the effects of governmental initiatives to manage economic conditions. Any such changes could adversely affect the demand for our products, or the cost and availability of our needed raw materials, cooking ingredients and packaging materials, thereby negatively affecting our financial results. Disruptions in global credit and other financial markets and deterioration of economic conditions could, among other things: • | make it more difficult or costly for us to obtain financing for our operations or investments or to refinance our debt in the future; --+-------------------------------------------------------------------------------------------------------------------------------------- • | cause our lenders to depart from prior credit industry practice and make more difficult or expensive the granting of any amendment of, or waivers under, our credit agreements to the extent we may seek them in the future; --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | impair the financial condition of some of our customers and suppliers, thereby increasing customer bad debts or non-performance by suppliers; --+---------------------------------------------------------------------------------------------------------------------------------------------- • | negatively impact global demand for protein products, which could result in a reduction of sales, operating income and cash flows; --+----------------------------------------------------------------------------------------------------------------------------------- • | decrease the value of our investments in equity and debt securities, including our marketable debt securities, company-owned life insurance and pension and other postretirement plan assets; --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | negatively impact our commodity purchasing activities if we are required to record losses related to derivative financial instruments; or --+------------------------------------------------------------------------------------------------------------------------------------------ • | impair the financial viability of our insurers. --+------------------------------------------------ The loss of one or more of our largest customers could negatively impact our business. Our business could suffer significant setbacks in sales and operating income if our customers’ plans and/or markets change significantly or if we lost one or more of our largest customers, including, for example, Wal-Mart Stores, Inc., which accounted for 17.3% of our sales in fiscal 2017 . Our retail customers typically do not enter into written contracts, and if they do sign contracts, they generally are limited in scope and duration. There can be no assurance that significant customers will continue to purchase our products in the same mix or quantities or on the same terms as in the past. Alternative retail channels, such as convenience stores, dollar stores, drug stores, club stores and Internet-based retailers have increased their market share. This trend towards alternative channels is expected to continue in the future. If we are not successful in expanding sales in alternative retail channels, our business or financial results may be adversely impacted. Many of our customers, such as supermarkets, warehouse clubs and food distributors, have consolidated in recent years, and consolidation is expected to continue throughout the United States and in other major markets. These consolidations have produced large, sophisticated customers with increased buying power who are more capable of operating with reduced inventories, opposing price increases, and demanding lower pricing, increased promotional programs and specifically tailored products. These customers also may use shelf space currently used for our products for their own private label products. Because of these trends, our volume growth could slow or we may need to lower prices or increase promotional spending for our products. The loss of a significant customer or a material reduction in sales to, or adverse change to trade terms with, a significant customer could materially and adversely affect our product sales, financial condition and results of operations. 13 Extreme factors or forces beyond our control could negatively impact our business. Our ability to make, move and sell products is critical to our success. Natural disasters, fire, bioterrorism, pandemic or extreme weather, including droughts, floods, excessive cold or heat, hurricanes or other storms, could impair the health or growth of livestock or interfere with our operations due to power outages, fuel shortages, decrease in availability of water, damage to our production and processing facilities or disruption of transportation channels or unfavorably impact the demand for, or our consumers’ ability to purchase our products, among other things. Any of these factors could have an adverse effect on our financial results. Failure to maximize or to successfully assert our intellectual property rights could impact our competitiveness. We consider our intellectual property rights, particularly and most notably our trademarks, but also our trade secrets, patents and copyrights, to be a significant and valuable aspect of our business. We attempt to protect our intellectual property rights through a combination of trademark, trade secret, patent and copyright laws, as well as licensing agreements, third-party nondisclosure and assignment agreements and policing of third-party misuses of our intellectual property. We cannot be sure that these intellectual property rights will be maximized or that they can be successfully asserted. There is a risk that we will not be able to obtain and perfect our own or, where appropriate, license intellectual property rights necessary to support new product introductions. We cannot be sure that these rights, if obtained, will not be invalidated, circumvented or challenged in the future. In addition, even if such rights are obtained in the United States, the laws of some of the other countries in which our products are or may be sold do not protect our intellectual property rights to the same extent as the laws of the United States. Our failure to perfect or successfully assert our intellectual property rights could make us less competitive and could have an adverse effect on our business, operating results and financial condition. Participation in a Multiemployer Pension Plan could adversely affect our business. Through our wholly owned subsidiary, Hillshire Brands, we participate in a “multiemployer” pension plan administered by a labor union representing some of its employees. We are required to make periodic contributions to this plan to allow them to meet their pension benefit obligations to their participants. Our required contributions to this fund could increase because of a shrinking contribution base as a result of the insolvency or withdrawal of other companies that currently contribute to this fund, inability or failure of withdrawing companies to pay their withdrawal liability, lower than expected returns on pension fund assets or other funding deficiencies. In the event that we withdraw from participation in this plan, then applicable law could require us to make an additional lump-sum contribution to the plan, and we would have to reflect that as an expense in our consolidated statement of operations and as a liability on our consolidated balance sheet. Our withdrawal liability would depend on the extent of the plan's funding of vested benefits. The multiemployer plan in which we participate is reported to have significant underfunded liabilities. Such underfunding could increase the size of our potential withdrawal liability. In the event a withdrawal or partial withdrawal was to occur with respect to the multiemployer plan, the impact to our consolidated financial statements could be material. Tyson Limited Partnership can exercise significant control. As of September 30, 2017 , Tyson Limited Partnership (the "TLP") owns 99.985% of the outstanding shares of the Company's Class B Common Stock, $0.10 par value (Class B stock) and the TLP and members of the Tyson family own, in the aggregate, 2.07% of the outstanding shares of the Company's Class A Common Stock, $0.10 par value (Class A stock), giving them, collectively, control of approximately 70.78% of the total voting power of the Company's outstanding voting stock. At this time, the TLP does not have a managing general partner, as such, the management rights of the managing general partner may be exercised by a majority of the percentage interests of the general partners. As of September 30, 2017 , Mr. John Tyson, Chairman of the Board of Directors, has 33.33% of the general partner percentage interests, and Ms. Barbara Tyson, a director of the Company, has 11.115% general partner percentage interests (the remaining general partnership interests are held by the Donald J. Tyson Revocable Trust (44.44%) and Harry C. Erwin, III (11.115%)). As a result of these holdings, positions and directorships, the partners in the TLP have the ability to exert substantial influence or actual control over our management and affairs and over substantially all matters requiring action by our stockholders, including amendments to our restated certificate of incorporation and by-laws, the election and removal of directors, any proposed merger, consolidation or sale of all or substantially all of our assets and other corporate transactions. This concentration of ownership may also delay or prevent a change in control otherwise favored by our other stockholders and could depress our stock price. Additionally, as a result of the TLP's significant ownership of our outstanding voting stock, we are eligible for “controlled company” exemptions from certain corporate governance requirements of the New York Stock Exchange. We may incur additional tax expense or become subject to additional tax liabilities. We are subject to taxes in the United States and numerous foreign jurisdictions. Significant judgment is required in determining our provision for income taxes. Our total income tax expense could be affected by changes in tax rates in various jurisdictions, changes in the valuation of deferred tax assets and liabilities or changes in tax laws or their interpretation. We are also subject to the examination of our tax returns and other tax matters by the Internal Revenue Service and other tax authorities. There can be no assurance as to the outcome of these examinations. If a taxing authority disagrees with the positions we have taken, we could face additional tax liability, including interest and penalties, which could adversely affect our financial results. 14 Volatility in the capital markets or interest rates could adversely impact our pension costs and the funded status of our pension plans. We sponsor a number of defined benefit plans for employees in the United States. The difference between plan obligations and assets, which signifies the funded status of the plans, is a significant factor in determining the net periodic benefit costs of the pension plans and our ongoing funding requirements. As of September 30, 2017 , the funded status of our defined benefit pension plans was an underfunded position of $ 195 million , as compared to an underfunded position of $ 336 million at the end of fiscal 2016 . Changes in interest rates and the market value of plan assets can impact the funded status of the plans and cause volatility in the net periodic benefit cost and our future funding requirements. The exact amount of cash contributions made to pension plans in any year is dependent upon a number of factors, including minimum funding requirements. ITEM 1B. UNRESOLVED STAFF COMMENTS None. ITEM 2. PROPERTIES We have production and distribution operations in the following states: Alabama, Arizona, Arkansas, California, Delaware, Florida, Georgia, Illinois, Indiana, Iowa, Kansas, Kentucky, Maine, Maryland, Michigan, Mississippi, Missouri, Nebraska, New Jersey, North Carolina, Oklahoma, Ohio, Pennsylvania, South Carolina, Tennessee, Texas, Virginia, Washington and Wisconsin. We also have sales offices throughout the United States. Additionally, we have sales offices, facilities or participate in joint venture operations in Argentina, Brazil, Canada, China, the Dominican Republic, Hong Kong, India, Japan, Mexico, the Netherlands, New Zealand, the Philippines, South Korea, Spain, Taiwan, Turkey, the United Arab Emirates, the United Kingdom and Venezuela. | Number of Facilities -------------------------------------+--------------------- | Owned | | Leased | | Total -------------------------------------+----------------------+------------------------------------------+--------+----------------------------------------+------ Beef Segment Production Facilities | 12 | | — | | 12 -------------------------------------+----------------------+------------------------------------------+--------+----------------------------------------+------ Pork Segment Production Facilities | 9 | | — | | 9 -------------------------------------+----------------------+------------------------------------------+--------+----------------------------------------+------ Chicken Segment: | | | -------------------------------------+----------------------+------------------------------------------+------- Processing plants(1) | 47 | | 1 | | 48 -------------------------------------+----------------------+------------------------------------------+--------+----------------------------------------+------ Rendering plants | 9 | | — | | 9 -------------------------------------+----------------------+------------------------------------------+--------+----------------------------------------+------ Blending mills | 2 | | — | | 2 -------------------------------------+----------------------+------------------------------------------+--------+----------------------------------------+------ Feed mills | 33 | | — | | 33 -------------------------------------+----------------------+------------------------------------------+--------+----------------------------------------+------ Broiler hatcheries | 59 | | 3 | | 62 -------------------------------------+----------------------+------------------------------------------+--------+----------------------------------------+------ Breeder houses | 457 | | 44 | | 501 -------------------------------------+----------------------+------------------------------------------+--------+----------------------------------------+------ Broiler farm houses | 50 | | — | | 50 -------------------------------------+----------------------+------------------------------------------+--------+----------------------------------------+------ Pet treats plant | 1 | | — | | 1 -------------------------------------+----------------------+------------------------------------------+--------+----------------------------------------+------ Prepared Foods Segment: | | | | -------------------------------------+----------------------+------------------------------------------+--------+--------------------------------------- Processing plants(1) | 38 | | 4 | | 42 -------------------------------------+----------------------+------------------------------------------+--------+----------------------------------------+------ Turkey operation facilities | 6 | | — | | 6 -------------------------------------+----------------------+------------------------------------------+--------+----------------------------------------+------ Distribution Centers(2) | 12 | | 2 | | 14 -------------------------------------+----------------------+------------------------------------------+--------+----------------------------------------+------ Cold Storage Facilities(2) | 51 | | 1 | | 52 -------------------------------------+----------------------+------------------------------------------+--------+----------------------------------------+------ Research and Development Facilities | 1 | | 1 | | 2 -------------------------------------+----------------------+------------------------------------------+--------+----------------------------------------+------ | | Capacity(3)per week atSeptember 30, 2017 | | Fiscal 2017Average CapacityUtilization | -------------------------------------+----------------------+------------------------------------------+--------+----------------------------------------+------ Beef Production Facilities | | 162,000 head | | 80 | % -------------------------------------+----------------------+------------------------------------------+--------+----------------------------------------+------ Pork Production Facilities | | 456,000 head | | 93 | % -------------------------------------+----------------------+------------------------------------------+--------+----------------------------------------+------ Chicken Production Facilities | | 39 million head | | 89 | % -------------------------------------+----------------------+------------------------------------------+--------+----------------------------------------+------ Prepared Foods Processing Facilities | | 88 million pounds | | 85 | % -------------------------------------+----------------------+------------------------------------------+--------+----------------------------------------+------ (1) | Certain facilities acquired in the AdvancePierre acquisition produce products that are reported in both the Chicken and Prepared Foods segments. For presentation purposes, the acquired facilities are reflected in the segment that had the majority of the facility’s production. As a result, two facilities were added to the Chicken segment and eight facilities were added to the Prepared Foods segment. ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ (2) | Includes a leased Distribution Center and a leased Cold Storage Facility acquired in the AdvancePierre acquisition. ----+-------------------------------------------------------------------------------------------------------------------- (3) Capacity per week based on the following: Beef and Pork (six day week) and Chicken and Prepared Foods (five day week). 15 Beef: Beef plants include various phases of harvesting live cattle and fabricating beef products. We also have various plants which have rendering operations along with tanneries and hide treatment operations. The Beef segment includes three case-ready operations that share facilities with the Pork segment. One of the beef facilities contains a tallow refinery. Pork: Pork plants include various phases of harvesting live hogs and fabricating pork products and allied products. The Pork segment includes three case-ready operations that share facilities with the Beef segment. Chicken: Chicken processing plants include various phases of harvesting, dressing, cutting, packaging, deboning and further-processing. We also have 29 animal nutrition operations, nine of which are associated with the Chicken rendering plants, 19 within various Chicken processing facilities and one pet treats plant. The blending mills, feed mills and broiler hatcheries have sufficient capacity to meet the needs of the chicken growout operations. Prepared Foods: Prepared Foods plants process fresh and frozen chicken, turkey, beef, pork and other raw materials into ready-to-eat sandwiches, sandwich components such as flame-grilled hamburgers and Philly steaks, pizza toppings, branded and processed meats, desserts, appetizers, prepared meals, ethnic foods, soups, sauces, side dishes, pizza crusts, flour and corn tortilla products and meat dishes. In addition, our foreign chicken production operations in China and India include four processing plants, two rendering plants, three feed mills and five broiler hatcheries. The processing plants include various phases of harvesting, dressing, cutting, packaging, deboning and further-processing chicken. The feed mills and broiler hatcheries generally have sufficient capacity to meet the needs of the foreign chicken growout operations. We believe our present facilities are generally adequate and suitable for our current purposes; however, seasonal fluctuations in inventories and production may occur as a reaction to market demands for certain products. We regularly engage in construction and other capital improvement projects intended to expand capacity and improve the efficiency of our processing and support facilities. We also consider the efficiencies of our operations and may from time to time consider changing the number or type of plants we operate to align with our capacity needs. ITEM 3. LEGAL PROCEEDINGS Refer to the description of certain legal proceedings pending against us under Part II, Item 8, Notes to Consolidated Financial Statements, Note 20: Commitments and Contingencies, which discussion is incorporated herein by reference. Listed below are certain additional legal proceedings involving the Company and/or its subsidiaries. On January 27, 2017, Haff Poultry, Inc., Craig Watts, Johnny Upchurch, Jonathan Walters and Brad Carr, acting on behalf of themselves and a putative class of broiler chicken farmers, filed a class action complaint against us and certain of our poultry subsidiaries, as well as several other vertically-integrated poultry processing companies, in the United States District Court for the Eastern District of Oklahoma. On March 28, 2017, a second class action complaint making similar claims on behalf of a similarly defined putative class was filed in the United States District Court for the Eastern District of Oklahoma. Plaintiffs in the two cases sought to have the matters consolidated, and, on July 10, 2017, filed a consolidated amended complaint styled In re Broiler Chicken Grower Litigation. The plaintiffs allege, among other things, that the defendants colluded not to compete for broiler raising services “with the purpose and effect of fixing, maintaining, and/or stabilizing grower compensation below competitive levels.” The plaintiffs also allege that the defendants “agreed to share detailed data on [g]rower compensation with one another, with the purpose and effect of artificially depressing [g]rower compensation below competitive levels.” The plaintiffs contend these alleged acts constitute violations of the Sherman Antitrust Act and Section 202 of the Grain Inspection, Packers and Stockyards Act of 1921. The plaintiffs are seeking treble damages, pre- and post-judgment interest, costs, and attorneys’ fees on behalf of the putative class. We and the other defendants filed a motion to dismiss on September 8, 2017. That motion is pending. On April 23, 2015, the United States Environmental Protection Agency (EPA) issued a Finding and Notice of Violation (NOV) to Tyson Foods, Inc. and our subsidiary, Southwest Products, LLC, alleging violations of the California Truck and Bus Regulation. The NOV alleged that certain diesel-powered trucks operated by us in California did not comply with California’s emission requirements for in-use trucks and that we did not verify the compliance status of independent carriers hired to carry products in California. In January 2016, the EPA proposed that we pay a civil penalty of $283,990 to resolve these allegations. In June 2017, the EPA withdrew this proposal and referred the matter to the California Air Resources Board (CARB). We are cooperating with the CARB and, in July 2017, we signed a tolling agreement with the CARB. The CARB has not yet made a demand in the matter. 16 On June 17, 2014, the Missouri attorney general filed a civil lawsuit against us in the Circuit Court of Barry County, Missouri, concerning an incident that occurred in May 2014 in which some feed supplement was discharged from our plant in Monett, Missouri, to the City of Monett’s wastewater treatment plant allegedly leading to a fish kill in a local stream and odor issues around the plant. In January 2015, a consent judgment was entered that resolved the lawsuit. The judgment required payment of $540,000, which included amounts for penalties, cost recovery and supplemental environmental projects. We subsequently satisfied all these requirements, and the consent judgment was terminated in January 2017. Following a criminal investigation by the EPA into the incident, one of the Company’s subsidiaries, Tyson Poultry, Inc., pled guilty to two misdemeanor violations of the federal Clean Water Act pursuant to a plea agreement conditionally approved on September 27, 2017 by the United States District Court for the Western District of Missouri. Under the terms of the plea agreement, Tyson Poultry, Inc. has agreed to pay a $2 million fine, to make a $500,000 community service payment and to fund third-party environmental audits of numerous feed mills and wastewater treatment plants. The court will determine whether to grant final approval of the terms of the plea agreement at a future sentencing hearing to be scheduled following the completion of a pre-sentencing report. On June 19, 2005, the Attorney General and the Secretary of the Environment of the State of Oklahoma filed a complaint in the United States District Court for the Northern District of Oklahoma against Tyson Foods, Inc., three subsidiaries and six other poultry integrators. The complaint, which was subsequently amended, asserts a number of state and federal causes of action including, but not limited to, counts under the Comprehensive Environmental Response, Compensation, and Liability Act, Resource Conservation and Recovery Act, and state-law public nuisance theories. Oklahoma alleges that the defendants and certain contract growers who were not joined in the lawsuit polluted the surface waters, groundwater and associated drinking water supplies of the Illinois River Watershed through the land application of poultry litter. Oklahoma’s claims were narrowed through various rulings issued before and during trial and its claims for natural resource damages were dismissed by the district court in a ruling issued on July 22, 2009, which was subsequently affirmed on appeal by the Tenth Circuit Court of Appeals. A non-jury trial of the remaining claims including Oklahoma’s request for injunctive relief began on September 24, 2009. Closing arguments were held on February 11, 2010. The district court has not yet rendered its decision from the trial. Other Matters: As of September 30, 2017, we had approximately 122,000 employees and, at any time, have various employment practices matters outstanding. In the aggregate, these matters are significant to the Company, and we devote significant resources to managing employment issues. Additionally, we are subject to other lawsuits, investigations and claims (some of which involve substantial amounts) arising out of the conduct of our business. While the ultimate results of these matters cannot be determined, they are not expected to have a material adverse effect on our consolidated results of operations or financial position. ITEM 4. MINE SAFETY DISCLOSURES Not applicable. 17 EXECUTIVE OFFICERS OF THE COMPANY Each of our executive officers serve one-year terms from the date of their election, or until their successors are appointed and qualified. No family relationships exist among these officers. The name, title, age (as of September 30, 2017) and calendar year of initial election to executive office of our executive officers are listed below: Name | Title | Age | Year ElectedExecutive Officer --------------------+----------------------------------------------------------------+-----+------------------------------ John Tyson | Chairman of the Board of Directors | 64 | 2011 --------------------+----------------------------------------------------------------+-----+------------------------------ Curt T. Calaway | Senior Vice President, Controller and Chief Accounting Officer | 44 | 2012 --------------------+----------------------------------------------------------------+-----+------------------------------ Sally Grimes | Group President Prepared Foods | 46 | 2014 --------------------+----------------------------------------------------------------+-----+------------------------------ Thomas P. Hayes | President and Chief Executive Officer | 52 | 2014 --------------------+----------------------------------------------------------------+-----+------------------------------ Dennis Leatherby | Executive Vice President and Chief Financial Officer | 57 | 1994 --------------------+----------------------------------------------------------------+-----+------------------------------ Mary Oleksiuk | Executive Vice President and Chief Human Resources Officer | 55 | 2014 --------------------+----------------------------------------------------------------+-----+------------------------------ Doug Ramsey | Group President Poultry | 48 | 2017 --------------------+----------------------------------------------------------------+-----+------------------------------ Scott Rouse | Chief Customer Officer | 54 | 2017 --------------------+----------------------------------------------------------------+-----+------------------------------ Stephen Stouffer | President Fresh Meats | 57 | 2013 --------------------+----------------------------------------------------------------+-----+------------------------------ David L. Van Bebber | Executive Vice President and General Counsel | 61 | 2008 --------------------+----------------------------------------------------------------+-----+------------------------------ Noel White | Group President Fresh Meats & International | 59 | 2009 --------------------+----------------------------------------------------------------+-----+------------------------------ John Tyson has served as Chairman of the Board of Directors since 1998 and was previously Chief Executive Officer of the Company from 2001 until 2006. Mr. Tyson was initially employed by the Company in 1973. Curt T. Calaway was appointed Senior Vice President, Controller and Chief Accounting Officer in 2012, after serving as Vice President, Audit and Compliance since 2008. Mr. Calaway was initially employed by the Company in 2006. Sally Grimes was appointed Group President, Prepared Foods in August 2017, after serving as President, North American Retail since February 2017, Chief Global Growth Officer and President International since October 2016, President, International and Chief Global Growth Officer since August 2016, and Chief Global Growth Officer since June 2015 following her appointment as President and Global Growth Officer in 2014. Ms. Grimes previously served as Senior Vice President, Chief Innovation Officer and President, Gourmet Food Group of Hillshire Brands since 2012. Hillshire Brands was acquired by the Company in 2014. Thomas P. Hayes was appointed Chief Executive Officer in December 2016 following his appointment as President in June 2016. Prior to that, he served as the Chief Commercial Officer since June 2015 after being appointed President, Foodservice in 2014. Mr. Hayes previously served as Executive Vice President and Chief Supply Chain Officer of Hillshire Brands since 2012. Mr. Hayes was initially employed by the Sara Lee Corporation, the predecessor to Hillshire Brands, in 2006. Dennis Leatherby was appointed Executive Vice President and Chief Financial Officer in 2008. Mr. Leatherby was initially employed by the Company in 1990. Mary Oleksiuk was appointed Executive Vice President and Chief Human Resources Officer in September 2014. Ms. Oleksiuk previously served as Senior Vice President, Chief Human Resources Officer for Hillshire Brands since 2012. Doug Ramsey was appointed Group President, Poultry in August 2017, after serving as President Poultry since March 2017. Mr. Ramsey previously served as Senior Vice President Big Bird/Fowl since 2014, and Senior Vice President and GM Value since 2011. Mr. Ramsey was initially employed by the Company in 1992. Scott Rouse was appointed Chief Customer Officer in September 2014, after serving as Senior Vice President Customer Development since 2006. Mr. Rouse was initially employed by the Company in 2004. Stephen R. Stouffer was appointed President, Fresh Meats in 2013, after serving as Senior Vice President, Beef Margin Management since 2012. Mr. Stouffer was initially employed by IBP, inc. in 1982. IBP, inc. was acquired by the Company in 2001. David L. Van Bebber was appointed Executive Vice President and General Counsel in 2008. Mr. Van Bebber was initially employed by Lane Processing in 1982. Lane Processing was acquired by the Company in 1986. Noel White was appointed Group President, Fresh Meats/International in August 2017, after serving as President, Poultry since 2013, after serving as Senior Group Vice President, Fresh Meats since 2009. Mr. White was initially employed by IBP, inc. in 1983. 18 PART II ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES We have issued and outstanding two classes of capital stock, Class A stock and Class B stock. Holders of Class B stock may convert such stock into Class A stock on a share-for-share basis. Holders of Class B stock are entitled to 10 votes per share and holders of Class A stock are entitled to one vote per share on matters submitted to shareholders for approval. As of October 28, 2017 , there were approximately 20,000 holders of record of our Class A stock and six holders of record of our Class B stock. DIVIDENDS Cash dividends cannot be paid to holders of Class B stock unless they are simultaneously paid to holders of Class A stock. The per share amount of the cash dividend paid to holders of Class B stock cannot exceed 90% of the cash dividend simultaneously paid to holders of Class A stock. We have paid uninterrupted quarterly dividends on common stock each year since 1977. In fiscal 2017 , the annual dividend rate for Class A stock was $0.90 per share and the annual dividend rate for Class B stock was $0.81 per share. In fiscal 2016 , the annual dividend rate for Class A stock was $0.60 per share and the annual dividend rate for Class B stock was $0.54 per share. On November 10, 2017, the Board of Directors increased the quarterly dividend previously declared on August 10, 2017, to $0.30 per share on our Class A stock and $0.27 per share on our Class B stock. The increased quarterly dividend is payable on December 15, 2017, to shareholders of record at the close of business on December 1, 2017. Also on November 10, 2017, the Board of Directors declared a quarterly dividend of $0.30 per share on our Class A stock and $0.27 per share on our Class B stock, payable on March 15, 2018, to shareholders of record at the close of business on March 1, 2018. We anticipate the remaining quarterly dividends in fiscal 2018 will be $0.30 and $0.27 per share of our Class A and Class B stock, respectively. This results in an annual dividend rate in fiscal 2018 of $1.20 for Class A shares and $1.08 for Class B shares, or a 33% increase compared to the fiscal 2017 annual dividend rate. We also continue to anticipate our annual dividends to increase approximately $0.10 per share per year. MARKET INFORMATION Our Class A stock is traded on the New York Stock Exchange under the symbol “TSN.” No public trading market currently exists for our Class B stock. The high and low sales prices of our Class A stock for each quarter of fiscal 2017 and 2016 are represented in the table below. | 2017 | | 2016 ---------------+-------+-------+----- | High | | | Low | | High | | | Low ---------------+-------+-------+------+-------+-------+-------+---+-------+------ First Quarter | $ | 75.33 | | | 55.72 | | $ | 54.42 | | $ | 42.89 ---------------+-------+-------+------+-------+-------+-------+---+-------+-------+---+------ Second Quarter | 67.14 | | | 61.00 | | 68.17 | | | 48.52 ---------------+-------+-------+------+-------+-------+-------+---+-------+------ Third Quarter | 66.87 | | | 57.20 | | 70.44 | | | 59.45 ---------------+-------+-------+------+-------+-------+-------+---+-------+------ Fourth Quarter | 70.80 | | | 58.36 | | 77.05 | | | 65.83 ---------------+-------+-------+------+-------+-------+-------+---+-------+------ ISSUER PURCHASES OF EQUITY SECURITIES The table below provides information regarding our purchases of Class A stock during the periods indicated. Period | TotalNumber ofSharesPurchased | | AveragePrice Paidper Share | | Total Number of SharesPurchased as Part ofPublicly AnnouncedPlans or Programs | | Maximum Number ofShares that May Yet BePurchased Under the Plansor Programs (1) | --------------------------------+-------------------------------+-----+----------------------------+-------+-------------------------------------------------------------------------------+---+---------------------------------------------------------------------------------+----------- Jul. 2, 2017 to Jul. 29, 2017 | 69,962 | | $ | 61.36 | | — | | 27,821,995 --------------------------------+-------------------------------+-----+----------------------------+-------+-------------------------------------------------------------------------------+---+---------------------------------------------------------------------------------+----------- Jul. 30, 2017 to Sept. 2, 2017 | 82,328 | | 64.40 | | — | | 27,821,995 | --------------------------------+-------------------------------+-----+----------------------------+-------+-------------------------------------------------------------------------------+---+---------------------------------------------------------------------------------+----------- Sept. 3, 2017 to Sept. 30, 2017 | 42,451 | | 65.57 | | — | | 27,821,995 | --------------------------------+-------------------------------+-----+----------------------------+-------+-------------------------------------------------------------------------------+---+---------------------------------------------------------------------------------+----------- Total | 194,741 | (2) | $ | 63.56 | | — | (3) | 27,821,995 --------------------------------+-------------------------------+-----+----------------------------+-------+-------------------------------------------------------------------------------+---+---------------------------------------------------------------------------------+----------- (1) | On February 7, 2003, we announced our Board of Directors approved a program to repurchase up to 25 million shares of Class A common stock from time to time in open market or privately negotiated transactions. On May 3, 2012, our Board of Directors approved an increase of 35 million shares, on January 30, 2014, our Board of Directors approved an increase of 25 million shares and, on February 4, 2016, our Board of Directors approved an increase of 50 million shares under the program. The program has no fixed or scheduled termination date. ----+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (2) | We purchased 194,741 shares during the period that were not made pursuant to our previously announced stock repurchase program, but were purchased to fund certain Company obligations under our equity compensation plans. These transactions included 178,162 shares purchased in open market transactions and 16,579 shares withheld to cover required tax withholdings on the vesting of restricted stock. ----+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (3) | These shares were purchased during the period pursuant to our previously announced stock repurchase program. ----+------------------------------------------------------------------------------------------------------------- 19 PERFORMANCE GRAPH The following graph shows a five-year comparison of cumulative total returns for our Class A stock, the Standard & Poor’s (S&P) 500 Index our previous peer group and our current peer group of companies described below. | Fiscal Years Ended --------------------+------------------- | 9/29/12 | | 9/28/13 | | | 9/27/14 | | 10/3/15 | 10/1/16 | | 9/30/17 | --------------------+--------------------+--------+---------+---+--------+---------+---+---------+---------+--------+---------+-- Tyson Foods, Inc. | $ | 100.00 | | $ | 181.00 | | $ | 240.79 | $ | 285.92 | | $ | 485.58 | $ | 465.00 --------------------+--------------------+--------+---------+---+--------+---------+---+---------+---------+--------+---------+---+--------+---+------- S&P 500 Index | 100.00 | | 119.34 | | | 142.89 | | 154.00 | 160.94 | | 194.44 | --------------------+--------------------+--------+---------+---+--------+---------+---+---------+---------+--------+---------+-- Previous Peer Group | 100.00 | | 121.82 | | | 140.64 | | 154.48 | 174.37 | | 171.50 | --------------------+--------------------+--------+---------+---+--------+---------+---+---------+---------+--------+---------+-- Current Peer Group | 100.00 | | 115.59 | | | 132.52 | | 140.88 | 160.33 | | 159.82 | --------------------+--------------------+--------+---------+---+--------+---------+---+---------+---------+--------+---------+-- The total cumulative return on investment (change in the year-end stock price plus reinvested dividends), which is based on the stock price or composite index at the end of fiscal 2012, is presented for each of the periods for the Company, the S&P 500 Index, the previous peer group and our current peer group. The changes from our previous peer group to our current peer group was that our previous group included Sanderson Farms and our current peer group includes the addition of the Kraft Heinz Company and The Coca-Cola Company. The complete list of our current peer group includes: Archer-Daniels-Midland Company, Bunge Limited, Campbell Soup Company, ConAgra Foods, Inc., Dean Foods Company, General Mills, Inc., Hormel Foods Corp., Kellogg Co., Kraft Heinz Company, McCormick & Co., Mondelez International Inc., PepsiCo, Inc., Pilgrim's Pride Corporation, The Coca-Cola Company, The Hershey Company and The J.M. Smucker Company. The graph compares the performance of the Company's Class A common stock with that of the S&P 500 Index and both peer groups, with the return of each company in the peer groups weighted on market capitalization. The stock price performance of the Company's Class A common stock shown in the above graph is not necessarily indicative of future stock price performance. The information in this "Performance Graph" section shall not be deemed to be "soliciting material" or to be "filed" with the Securities and Exchange Commission or subject to Regulation 14A or 14C, or to the liabilities of Section 18 of the Securities Exchange Act of 1934. 20 ITEM 6. SELECTED FINANCIAL DATA FIVE-YEAR FINANCIAL SUMMARY in millions, except per share, percentage and ratio data | ---------------------------------------------------------+------- | 2017 | | 2016 | | | 2015 | | | 2014 | | 2013 | ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+---+--------+---+--------+------- Summary of Operations | | | | | | | | ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+-- Sales | $ | 38,260 | | $ | 36,881 | | | $ | 41,373 | | $ | 37,580 | $ | 34,374 ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+---+--------+---+--------+--------+---+------- Operating income | 2,931 | | 2,833 | | | 2,169 | | | 1,430 | | 1,375 | ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+---+--------+---+--------+------- Net interest expense | 272 | | 243 | | | 284 | | | 125 | | 138 | ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+---+--------+---+--------+------- Income from continuing operations | 1,778 | | 1,772 | | | 1,224 | | | 856 | | 848 | ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+---+--------+---+--------+------- Loss from discontinued operation, net of tax | — | | — | | | — | | | — | | (70 | ) ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+---+--------+---+--------+------- Net income | 1,778 | | 1,772 | | | 1,224 | | | 856 | | 778 | ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+---+--------+---+--------+------- Net income attributable to Tyson | 1,774 | | 1,768 | | | 1,220 | | | 864 | | 778 | ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+---+--------+---+--------+------- Diluted net income per share attributable to Tyson: | | | | | | | | ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+-- Income from continuing operations | 4.79 | | 4.53 | | | 2.95 | | | 2.37 | | 2.31 | ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+---+--------+---+--------+------- Loss from discontinued operation | — | | — | | | — | | | — | | (0.19 | ) ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+---+--------+---+--------+------- Net income | 4.79 | | 4.53 | | | 2.95 | | | 2.37 | | 2.12 | ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+---+--------+---+--------+------- Dividends declared per share: | | | | | | | | ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+-- Class A | 0.975 | | 0.650 | | | 0.425 | | | 0.325 | | 0.310 | ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+---+--------+---+--------+------- Class B | 0.878 | | 0.585 | | | 0.383 | | | 0.294 | | 0.279 | ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+---+--------+---+--------+------- Balance Sheet Data | | | | | | | | ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+-- Cash and cash equivalents | $ | 318 | | $ | 349 | | | $ | 688 | | $ | 438 | $ | 1,145 ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+---+--------+---+--------+--------+---+------- Total assets | 28,066 | | 22,373 | | | 22,969 | | | 23,906 | | 12,167 | ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+---+--------+---+--------+------- Total debt | 10,203 | | 6,279 | | | 6,690 | | | 8,128 | | 2,398 | ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+---+--------+---+--------+------- Shareholders’ equity | 10,559 | | 9,624 | | | 9,706 | | | 8,904 | | 6,233 | ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+---+--------+---+--------+------- Other Key Financial Measures | | | | | | | | ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+-- Depreciation and amortization | $ | 761 | | $ | 705 | | | $ | 711 | | $ | 530 | $ | 519 ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+---+--------+---+--------+--------+---+------- Capital expenditures | 1,069 | | 695 | | | 854 | | | 632 | | 558 | ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+---+--------+---+--------+------- EBITDA | 3,648 | | 3,538 | | | 2,906 | | | 1,897 | | 1,818 | ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+---+--------+---+--------+------- Return on invested capital | 16.3 | % | 18.1 | % | | 13.4 | % | | 11.9 | % | 18.5 | % ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+---+--------+---+--------+------- Effective tax rate for continuing operations | 32.3 | % | 31.8 | % | | 36.3 | % | | 31.6 | % | 32.6 | % ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+---+--------+---+--------+------- Total debt to capitalization | 49.1 | % | 39.5 | % | | 40.8 | % | | 47.7 | % | 27.8 | % ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+---+--------+---+--------+------- Book value per share | $ | 28.72 | | $ | 25.67 | | | $ | 24.25 | | $ | 21.86 | $ | 18.13 ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+---+--------+---+--------+--------+---+------- Stock price high | 75.33 | | 77.05 | | | 45.10 | | | 44.24 | | 32.40 | ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+---+--------+---+--------+------- Stock price low | 55.72 | | 42.89 | | | 37.02 | | | 27.33 | | 15.93 | ---------------------------------------------------------+--------+--------+--------+---+--------+--------+---+---+--------+---+--------+------- Notes to Five-Year Financial Summary a. | Fiscal 2017 net income included $103 million pretax expense of AdvancePierre purchase accounting and acquisition related costs, pretax impairment charges of $52 million related to our San Diego Prepared Foods operation and $45 million related to the expected sale of a non-protein business and pretax restructuring and related charges of $150 million. ---+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- b. | Fiscal 2016 net income included $53 million related to the recognition of previously unrecognized tax benefits and audit settlements. In fiscal 2016, we adopted new accounting guidance, retrospectively, requiring classification of debt issuance costs as a reduction of the carrying value of the debt. In doing so, $29 million, $35 million, $50 million and $10 million of deferred issuance costs have been reclassified from Other Assets to Long-Term Debt in our Consolidated Balance Sheets for fiscal 2016, 2015, 2014 and 2013 respectively. This change is reflected above in total assets, total debt, total debt to capitalization and return on invested capital ratios. ---+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- c. | Fiscal 2015 was a 53-week year, while the other years presented were 52-week years. Fiscal 2015 included a $169 million pretax impairment charge related to our China operation, $57 million pretax expense related to merger and integration costs, $59 million pretax impairment charges related to our Prepared Foods network optimization, $12 million pretax charges related to Denison impairment and plant closure costs, $8 million pretax gain related to net insurance proceeds (net of costs) related to a legacy Hillshire Brands plant fire, $21 million pretax gain on the sale of equity securities, $161 million pretax gain on the sale of the Mexico operation, $39 million pretax gain related to the impact of the additional week in fiscal 2015 and $26 million unrecognized tax benefit gain. ---+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- d. | Fiscal 2014 included a $42 million pretax impairment charge and other costs related to the sale of our Brazil operation and Mexico's undistributed earnings tax, $197 million pretax expense related to the Hillshire Brands acquisition, integration and costs associated with our Prepared Foods improvement plan, $40 million pretax expense related to the Hillshire Brands post-closing results, purchase price accounting, and costs related to a legacy Hillshire Brands plant fire, $27 million pretax expense related to the Hillshire Brands acquisition financing incremental interest cost and $52 million unrecognized tax benefit gain. ---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ e. | Fiscal 2013 included a $19 million currency translation adjustment gain recognized in conjunction with the receipt of proceeds constituting the final resolution of our investment in Canada. Additionally, in fiscal 2013 we determined our Weifang operation (Weifang) was no longer core to the execution of our strategy in China. In July 2013, we completed the sale of Weifang. Non-cash charges related to the impairment of assets in Weifang amounted to $56 million in fiscal 2013. ---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- f. | Return on invested capital is calculated by dividing operating income by the sum of the average of beginning and ending total debt and shareholders’ equity less cash and cash equivalents. ---+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- g. | For the total debt to capitalization calculation, capitalization is defined as total debt plus total shareholders’ equity. ---+--------------------------------------------------------------------------------------------------------------------------- h. | Book value per share is calculated by dividing shareholders’ equity by the sum of Class A and B shares outstanding and the remaining minimum shares that were to be issued from our tangible equity units for each period. ---+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 21 i. | "EBITDA" is a Non-GAAP measure and defined as net income less interest income, plus interest, taxes, depreciation and amortization. A reconciliation of net income to EBITDA immediately follows. ---+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- EBITDA RECONCILIATIONS A reconciliation of net income to EBITDA is as follows: in millions, except ratio data | --------------------------------+----- | 2017 | | 2016 | | | 2015 | | | 2014 | | | 2013 | --------------------------------+------+--------+------+---+-------+------+---+-------+-------+---+---+--------+------ Net income | $ | 1,778 | | $ | 1,772 | | | 1,224 | | | $ | 856 | | $ | 778 | --------------------------------+------+--------+------+---+-------+------+---+-------+-------+---+---+--------+-------+---+-----+------ Less: Interest income | (7 | ) | (6 | ) | | (9 | ) | | (7 | ) | | (7 | ) --------------------------------+------+--------+------+---+-------+------+---+-------+-------+---+---+--------+------ Add: Interest expense | 279 | | 249 | | | 293 | | | 132 | | | 145 | --------------------------------+------+--------+------+---+-------+------+---+-------+-------+---+---+--------+------ Add: Income tax expense (a) | 850 | | 826 | | | 697 | | | 396 | | | 411 | --------------------------------+------+--------+------+---+-------+------+---+-------+-------+---+---+--------+------ Add: Depreciation | 642 | | 617 | | | 609 | | | 494 | | | 474 | --------------------------------+------+--------+------+---+-------+------+---+-------+-------+---+---+--------+------ Add: Amortization (b) | 106 | | 80 | | | 92 | | | 26 | | | 17 | --------------------------------+------+--------+------+---+-------+------+---+-------+-------+---+---+--------+------ EBITDA | $ | 3,648 | | $ | 3,538 | | | $ | 2,906 | | | $ | 1,897 | | $ | 1,818 --------------------------------+------+--------+------+---+-------+------+---+-------+-------+---+---+--------+-------+---+-----+------ Total gross debt | $ | 10,203 | | $ | 6,279 | | | $ | 6,690 | | | $ | 8,128 | | $ | 2,398 --------------------------------+------+--------+------+---+-------+------+---+-------+-------+---+---+--------+-------+---+-----+------ Less: Cash and cash equivalents | (318 | ) | (349 | ) | | (688 | ) | | (438 | ) | | (1,145 | ) --------------------------------+------+--------+------+---+-------+------+---+-------+-------+---+---+--------+------ Less: Short-term investments | (3 | ) | (4 | ) | | (2 | ) | | (1 | ) | | (1 | ) --------------------------------+------+--------+------+---+-------+------+---+-------+-------+---+---+--------+------ Total net debt | $ | 9,882 | | $ | 5,926 | | | $ | 6,000 | | | $ | 7,689 | | $ | 1,252 --------------------------------+------+--------+------+---+-------+------+---+-------+-------+---+---+--------+-------+---+-----+------ Ratio Calculations: | | | | | | | | --------------------------------+------+--------+------+---+-------+------+---+------ Gross debt/EBITDA | 2.8x | | 1.8x | | | 2.3x | | | 4.3x | | | 1.3x | --------------------------------+------+--------+------+---+-------+------+---+-------+-------+---+---+--------+------ Net debt/EBITDA | 2.7x | | 1.7x | | | 2.1x | | | 4.1x | | | 0.7x | --------------------------------+------+--------+------+---+-------+------+---+-------+-------+---+---+--------+------ (a) | Includes income tax expense of discontinued operation. ----+------------------------------------------------------- (b) | Excludes the amortization of debt issuance and debt discount expense of $13 million, $8 million, $10 million, $10 million and $28 million for fiscal 2017, 2016, 2015, 2014 and 2013, respectively, as it is included in Interest expense. ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- EBITDA represents net income, net of interest, income tax and depreciation and amortization. Net debt to EBITDA represents the ratio of our debt, net of cash and short-term investments, to EBITDA. EBITDA and net debt to EBITDA are presented as supplemental financial measurements in the evaluation of our business. We believe the presentation of these financial measures helps investors to assess our operating performance from period to period, including our ability to generate earnings sufficient to service our debt, and enhances understanding of our financial performance and highlights operational trends. These measures are widely used by investors and rating agencies in the valuation, comparison, rating and investment recommendations of companies; however, the measurements of EBITDA and net debt to EBITDA may not be comparable to those of other companies, which limits their usefulness as comparative measures. EBITDA and net debt to EBITDA are not measures required by or calculated in accordance with generally accepted accounting principles (GAAP) and should not be considered as substitutes for net income or any other measure of financial performance reported in accordance with GAAP or as a measure of operating cash flow or liquidity. EBITDA is a useful tool for assessing, but is not a reliable indicator of, our ability to generate cash to service our debt obligations because certain of the items added to net income to determine EBITDA involve outlays of cash. As a result, actual cash available to service our debt obligations will be different from EBITDA. Investors should rely primarily on our GAAP results, and use non-GAAP financial measures only supplementally, in making investment decisions. 22 ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS DESCRIPTION OF THE COMPANY We are one of the world’s largest food companies and a recognized leader in protein. Founded in 1935 by John W. Tyson and grown under three generations of family leadership, the Company has a broad portfolio of products and brands like Tyson®, Jimmy Dean®, Hillshire Farm®, Ball Park®, Wright®, Aidells®, ibp® and State Fair®. Some of the key factors influencing our business are customer demand for our products; the ability to maintain and grow relationships with customers and introduce new and innovative products to the marketplace; accessibility of international markets; market prices for our products; the cost and availability of live cattle and hogs, raw materials and feed ingredients; and operating efficiencies of our facilities. We operate in four reportable segments: Beef, Pork, Chicken, and Prepared Foods. Other primarily includes our foreign chicken production operations in China and India, third-party merger and integration costs and corporate overhead related to Tyson New Ventures, LLC. On June 7, 2017, we acquired and consolidated AdvancePierre Foods Holdings, Inc. ("AdvancePierre"), a producer and distributor of value-added, convenient, ready-to-eat sandwiches, sandwich components and other entrées and snacks. AdvancePierre's results from operations subsequent to the acquisition closing are included in the Prepared Foods and Chicken segments. OVERVIEW • | Fiscal year – Our accounting cycle resulted in a 52-week year for both fiscal 2017 and 2016 and a 53-week year for fiscal 2015. --+-------------------------------------------------------------------------------------------------------------------------------- • | General – Our fiscal 2017 operating income grew 3% compared to fiscal 2016 to a record $2,931 million, which was led by record earnings in our Beef and Pork segments. The Beef segment's operating income improved $530 million and the Pork segment improved $117 million in fiscal 2017 due to favorable market conditions and strong operational execution. Our Chicken segment's lower operating income was impacted by increased operating costs and $56 million of restructuring and related charges. Our Prepared Foods segment's lower operating income was impacted by increased operating costs, impairments of $52 million related to our San Diego Prepared Foods operation and $45 million related to the expected sale of a non-protein business and $82 million of restructuring and related charges. In addition, we incurred an incremental $95 million of compensation and benefit integration expense in fiscal 2017, as we continued to integrate and make investments in our talent, and incurred $85 million of AdvancePierre purchase accounting and acquisition related operating costs. Sales increased 4% in fiscal 2017 over fiscal 2016, primarily due to increased sales volumes and increased beef, pork and chicken prices, as well as the net incremental impact of AdvancePierre's sales of $508 million. --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Market Environment – According to the United States Department of Agriculture (USDA), domestic protein production (beef, pork, chicken and turkey) increased approximately 3% in fiscal 2017 compared to fiscal 2016. The Beef segment experienced strong export demand and more favorable domestic market conditions associated with an increase in cattle supply. The Pork segment had favorable market conditions associated with strong demand for our pork products and improved export markets. There was stronger demand for our chicken products and reduced feed ingredient costs of $80 million, which benefited the Chicken segment. Our Prepared Foods segment had improved demand for our retail products but experienced a decline in foodservice and higher input costs of $50 million. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Margins – Our total operating margin was 7.7% in fiscal 2017. Operating margins by segment were as follows: --+------------------------------------------------------------------------------------------------------------ • | Beef – 5.9% --+------------ • | Pork – 12.3% --+------------- • | Chicken –9.2% (included $56 million of restructuring and related charges) --+-------------------------------------------------------------------------- • | Prepared Foods – 5.9% (included $52 million impairment related to our San Diego Prepared Foods operation, $45 million impairment related to the expected sale of a non-protein business, $82 million of restructuring and related charges and $34 million of purchase accounting and acquisition related costs from the acquisition of AdvancePierre.) --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Hillshire Integration – The impact of the The Hillshire Brands Company ("Hillshire Brands") synergies, along with the profit improvement plan related to our legacy Prepared Foods business, had a positive incremental impact of approximately $90 million in fiscal 2017 above the $258 million captured in fiscal 2016 and $322 million captured in fiscal 2015, for a total of $670 million of synergies realized. The majority of these benefits were realized in the Prepared Foods segment and were partially used to invest in innovation, new product launches and supporting the growth of our brands. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Liquidity – During fiscal 2017, we generated $2.6 billion of operating cash flows. At September 30, 2017, we had $1.0 billion of liquidity, which included $318 million of cash and cash equivalents and the availability under our revolving credit facility after deducting amounts outstanding under our commercial paper program. --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 23 • | Strategy - In fiscal 2017, we announced our strategy to sustainably feed the world with the fastest growing portfolio of protein-packed brands. We intend to accomplish this by growing our portfolio of protein-packed brands and delivering food at scale, which will be enabled by driving profitable growth with and for our customers through differentiated capabilities and creating fuel for reinvestment through a disciplined financial fitness model. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | On June 7, 2017, we acquired all of the outstanding stock of AdvancePierre as part of our overall strategy. The purchase price was equal to $40.25 per share in cash for AdvancePierre's outstanding common stock, or approximately $3.2 billion. We funded the acquisition with existing cash on hand, net proceeds from the issuance of new senior notes, as well as borrowings under our commercial paper program and new term loan facility. AdvancePierre’s results from operations subsequent to the acquisition closing are included in the Prepared Foods and Chicken segments. For further description refer to Part II, Item 8, Notes to the Consolidated Financial Statements, Note 3: Acquisition and Dispositions. --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | On April 24, 2017, we announced our intent to sell three non-protein businesses, Sara Lee® Frozen Bakery, Kettle and Van’s®, which are all included in our Prepared Foods segment, as part of our strategic focus on protein-packed brands. We have reclassified the assets and liabilities related to these businesses to assets and liabilities held for sale in our Consolidated Balance Sheet as of September 30, 2017. In the fourth quarter of 2017, we recorded an impairment charge totaling $45 million related to one of these businesses due to a revised estimate of the business’ fair value based on current expected net sales proceeds. The impairment charge was recorded in Cost of Sales in our Consolidated Statement of Income for fiscal 2017, and consisted of goodwill and intangible assets previously classified within assets held for sale. We anticipate we will close the transactions by the end of calendar 2017, or early calendar 2018, and expect to record a net pretax gain as a result of the sale of these businesses. For further description refer to Part II, Item 8, Notes to the Consolidated Financial Statements, Note 3: Acquisition and Dispositions. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ • | In the fourth quarter of fiscal 2017, our Board of Directors approved a multi-year restructuring program (the “Financial Fitness Program”), which is expected to contribute to the Company’s overall strategy of financial fitness through increased operational effectiveness and overhead reduction. Through a combination of synergies from the integration of AdvancePierre and additional elimination of non-valued added costs, the Financial Fitness Program is estimated to result in cumulative net savings of $200 million in fiscal 2018, $400 million in fiscal 2019 including new savings of $200 million, and $600 million in fiscal 2020 including additional savings of $200 million. Approximately 50-60% of these net savings, which are focused on supply chain, procurement, and overhead improvements, are expected to be realized in the Prepared Foods segment with the majority of the remaining net savings impacting the Chicken segment. Additionally, we estimate that approximately 75% of the net savings will be reflected in Cost of Sales in our Consolidated Statement of Income, with the remaining in Selling, General and Administrative. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- As part of the Financial Fitness Program, we anticipate eliminating approximately 500 positions across several areas and job levels with most of the eliminated positions originating from the corporate offices in Springdale, Arkansas; Chicago, Illinois; and Cincinnati, Ohio. As a result, in the fourth quarter of fiscal 2017, the Company recognized restructuring and related charges of $150 million that consisted of $53 million severance and employee related costs, $72 million technology impairment and related costs, and $25 million for contract termination costs. The Company currently anticipates the Financial Fitness Program will result in cumulative pretax charges, once implemented, of approximately $215 million which consist primarily of severance and employee related costs, asset impairments, accelerated depreciation, incremental costs to implement new technology, and contract termination costs. The following tables set forth the pretax impact of restructuring and related charges incurred in fiscal 2017 in the Consolidated Statements of Income and the pretax impact by our reportable segments. For further description refer to Part II, Item 8, Notes to the Consolidated Financial Statements, Note 6: Restructuring and Related Charges. in millions ----------------------------------------------- | 2017 | ------------------------------------------------+------+---- Cost of Sales | $ | 35 ------------------------------------------------+------+---- Selling, general and administrative expenses | 115 | ------------------------------------------------+------+---- Total restructuring and related charges, pretax | $ | 150 ------------------------------------------------+------+---- 24 | in millions | ------------------------------------------------+--------------+---- | 2017 charges | | Estimated 2018 charges | | Total estimated Financial Fitness Program charges ------------------------------------------------+--------------+-----+------------------------+---+-------------------------------------------------- Beef | $ | 8 | | $ | 6 | $ | 14 ------------------------------------------------+--------------+-----+------------------------+---+---------------------------------------------------+---+---- Pork | 3 | | 2 | | 5 ------------------------------------------------+--------------+-----+------------------------+---+-------------------------------------------------- Chicken | 56 | | 32 | | 88 ------------------------------------------------+--------------+-----+------------------------+---+-------------------------------------------------- Prepared Foods | 82 | | 25 | | 107 ------------------------------------------------+--------------+-----+------------------------+---+-------------------------------------------------- Other | 1 | | — | | 1 ------------------------------------------------+--------------+-----+------------------------+---+-------------------------------------------------- Total restructuring and related charges, pretax | $ | 150 | | $ | 65 | $ | 215 ------------------------------------------------+--------------+-----+------------------------+---+---------------------------------------------------+---+---- | in millions, except per share data | -----------------------------------------------------+------------------------------------+------ | 2017 | | 2016 | | | 2015 -----------------------------------------------------+------------------------------------+-------+------+---+-------+----- Net income attributable to Tyson | $ | 1,774 | | $ | 1,768 | | $ | 1,220 -----------------------------------------------------+------------------------------------+-------+------+---+-------+------+---+------ Net income attributable to Tyson - per diluted share | 4.79 | | 4.53 | | | 2.95 -----------------------------------------------------+------------------------------------+-------+------+---+-------+----- 2017 – Included the following items: • | $103 million pretax, or ($0.18) per diluted share, of AdvancePierre purchase accounting and acquisition related costs, which included a $36 million purchase accounting adjustment for the amortization of the fair value step-up of inventory, $49 million of acquisition related costs and $18 million of acquisition bridge financing fees. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | $150 million pretax, or ($0.15) per diluted share, of restructuring and related charges. --+----------------------------------------------------------------------------------------- • | $52 million pretax, or ($0.09) per diluted share, impairment charge related to our San Diego Prepared Foods operation. --+----------------------------------------------------------------------------------------------------------------------- • | $45 million pretax, or $0.01 per diluted share, impairment net of tax benefit related to the expected sale of a non-protein business. --+-------------------------------------------------------------------------------------------------------------------------------------- 2016 – Included the following items: • | $53 million post tax, or $0.14 per diluted share, related to recognition of previously unrecognized tax benefits and audit settlements. --+---------------------------------------------------------------------------------------------------------------------------------------- 2015 – Included the following items: • | $169 million pretax, or ($0.41) per diluted share, related to an impairment charge in China. --+--------------------------------------------------------------------------------------------- • | $59 million pretax, or ($0.09) per diluted share, related to Prepared Foods network optimization impairment charges. --+--------------------------------------------------------------------------------------------------------------------- • | $57 million pretax, or ($0.09) per diluted share, related to merger and integration costs. --+------------------------------------------------------------------------------------------- • | $12 million pretax, or ($0.02) per diluted share, related to closure and impairment charges related to the ceasing of beef operations at our Denison facility. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------- • | $161 million pretax, or $0.24 per diluted share, related to a gain on sale of the Mexico operation. --+---------------------------------------------------------------------------------------------------- • | $39 million pretax, or $0.06 per diluted share, related to the additional week in fiscal 2015. --+----------------------------------------------------------------------------------------------- • | $26 million post tax, or $0.06 per diluted share, related to recognition of previously unrecognized tax benefits. --+------------------------------------------------------------------------------------------------------------------ • | $21 million pretax, or $0.03 per diluted share, related to a gain on sale of equity securities. --+------------------------------------------------------------------------------------------------ • | $8 million pretax, or $0.02 per diluted share, of insurance proceeds (net of costs) related to a legacy Hillshire Brands plant fire. --+------------------------------------------------------------------------------------------------------------------------------------- 25 SUMMARY OF RESULTS Sales | in millions | ------------------------------+-------------+------- | 2017 | | 2016 | | | 2015 ------------------------------+-------------+--------+-------+----+--------+----- Sales | $ | 38,260 | | $ | 36,881 | | $ | 41,373 ------------------------------+-------------+--------+-------+----+--------+------+---+------- Change in sales volume | 1.0 | % | (4.6 | )% | | ------------------------------+-------------+--------+-------+----+--------+----- Change in average sales price | 2.7 | % | (6.5 | )% | | ------------------------------+-------------+--------+-------+----+--------+----- Sales growth | 3.7 | % | (10.9 | )% | | ------------------------------+-------------+--------+-------+----+--------+----- 2017 vs. 2016 – • | Sales Volume – Sales were positively impacted by an increase in sales volume, which accounted for an increase of $477 --+---------------------------------------------------------------------------------------------------------------------- million. Each segment had an increase in sales volume with the Beef and Prepared Foods segments contributing to the majority of the increase driven by better demand for our beef products and incremental volumes from the acquisition of AdvancePierre. • | Average Sales Price – Sales were positively impacted by higher average sales prices, which accounted for an increase of $902 million. Each segment had an increase in average sales price with the Pork, Chicken and Prepared Foods segments contributing to the majority of the increase due to strong demand for our pork products, improved mix and higher chicken pricing in our Chicken segment and better product mix in our Prepared Foods segment which was positively impacted by the acquisition of AdvancePierre. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | The above amounts include a net increase of $508 million related to the inclusion of AdvancePierre results post --+---------------------------------------------------------------------------------------------------------------- acquisition. 2016 vs. 2015 – • | Sales Volume – Sales were negatively impacted by lower sales volume, which accounted for a decrease of $1.9 billion. Each segment had a decline in sales volume primarily attributed to the additional week in fiscal 2015. The decrease in sales volume was also attributable to the divestitures of the Mexico and Brazil chicken production operations in fiscal 2015. When excluding these impacts along with the divestiture of our Heinold Hog Markets business in the first quarter of fiscal 2015, total company sales volume increased 0.1%. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ • | Average Sales Price – Sales were negatively impacted by lower average sales prices, which accounted for a decrease of $2.6 billion. Each segment had a decrease in average sales prices largely due to decreased pricing associated with lower beef, pork, and chicken prices, with the largest decrease in the Beef segment. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ Cost of Sales | in millions | ---------------------------------------+-------------+------- | 2017 | | 2016 | | | 2015 | ---------------------------------------+-------------+--------+-------+---+--------+-------+-- Cost of sales | $ | 33,177 | | $ | 32,184 | | | $ | 37,456 ---------------------------------------+-------------+--------+-------+---+--------+-------+---+---+------- Gross profit | 5,083 | | 4,697 | | | 3,917 | ---------------------------------------+-------------+--------+-------+---+--------+-------+-- Cost of sales as a percentage of sales | 86.7 | % | 87.3 | % | | 90.5 | % ---------------------------------------+-------------+--------+-------+---+--------+-------+-- 2017 vs 2016 – • | Cost of sales increased $993 million. Higher input cost per pound increased cost of sales $588 million while higher sales volume increased cost of sales $405 million. These amounts include a net increase of $425 million related to the inclusion of AdvancePierre results post acquisition, which included $36 million from the fair value step-up of inventory as part of purchase accounting. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | The $588 million impact of higher input cost per pound was primarily driven by: --+-------------------------------------------------------------------------------- • | Increase of approximately $170 million in our Chicken segment related to increase in freight, growout expenses and outside meat purchases, partially offset by a decrease in feed costs of $80 million. --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Increase due to impairment charges of $44 million related to our San Diego Prepared Foods operation and $45 million related to the expected sale of a non-protein business, in addition to an increase of $17 million related to net costs associated with fires at two chicken plants. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Increase in raw material and other input costs of approximately $50 million in our Prepared Foods segment. --+----------------------------------------------------------------------------------------------------------- • | Increase in live hog costs of approximately $40 million in our Pork segment. --+----------------------------------------------------------------------------- • | Increase of $35 million related to restructuring and related charges. --+---------------------------------------------------------------------- • | Increase in input cost per pound related to the acquisition of AdvancePierre on June 7, 2017. --+---------------------------------------------------------------------------------------------- • | Increase due to net realized derivative losses of $79 million for fiscal 2017, compared to net realized derivative gains of $96 million for fiscal 2016 due to our risk management activities. These amounts exclude offsetting impacts --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 26 from related physical purchase transactions, which are included in the change in live cattle and hog costs and raw material and feed costs described above. Additionally, cost of sales increased due to net unrealized losses of $40 million for fiscal 2017, compared to net unrealized gains of $11 million for fiscal 2016, primarily due to our Beef segment commodity risk management activities. • | Decrease in live cattle costs of approximately $600 million in our Beef segment. --+--------------------------------------------------------------------------------- • | Remainder of net change is mostly due to increased cost per pound from a mix upgrade in the Chicken segment as we increased sales volume in value-added products as well as increased operating costs, freight, and plant variances across all segments, which also included $71 million of compensation and benefit integration expense. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ • | The $405 million impact of higher sales volume was driven by increases in sales volume in all segments, with the majority of the increase in the Beef and Prepared Foods segment. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 2016 vs. 2015 – • | Cost of sales decreased by approximately $5.3 billion. Lower input costs per pound decreased cost of sales approximately $3.6 billion and lower sales volume decreased cost of sales approximately $1.7 billion. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | The approximate $3.6 billion impact of lower input costs was primarily driven by: --+---------------------------------------------------------------------------------- • | Decrease in live cattle cost of approximately $2.6 billion in our Beef segment. --+-------------------------------------------------------------------------------- • | Decrease in live hog costs of approximately $360 million in our Pork segment. --+------------------------------------------------------------------------------ • | Decrease in raw material and other input costs of approximately $300 million in our Prepared Foods segment. --+------------------------------------------------------------------------------------------------------------ • | Decreases in feed costs of approximately $170 million in our Chicken segment. --+------------------------------------------------------------------------------ • | Decrease due to net realized derivative gains of $96 million in fiscal 2016, compared to net realized derivative losses of $102 million in fiscal 2015 due to our risk management activities. These amounts exclude offsetting impacts from related physical purchase transactions, which are included in the change in live cattle and hog costs and raw material and feed costs described above. Additionally, cost of sales increased due to net unrealized gains of $11 million in fiscal 2016, compared to net unrealized gains of $80 million in fiscal 2015, primarily due to our Beef, Pork, and Chicken segment commodity risk management activities. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | The $1.7 billion impact of lower sales volume was primarily due to the sale of our Mexico chicken production operation in fiscal 2015 along with the additional week in fiscal 2015. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Selling, General and Administrative | in millions | ------------------------------------+-------------+------ | 2017 | | 2016 | | | 2015 | ------------------------------------+-------------+-------+------+---+-------+------+-- Selling, general and administrative | $ | 2,152 | | $ | 1,864 | | | $ | 1,748 ------------------------------------+-------------+-------+------+---+-------+------+---+---+------ As a percentage of sales | 5.6 | % | 5.1 | % | | 4.2 | % ------------------------------------+-------------+-------+------+---+-------+------+-- 2017 vs 2016 • | Increase of $288 million in selling, general and administrative was primarily driven by: --+----------------------------------------------------------------------------------------- • | Increase of $124 million related to the AdvancePierre acquisition, which was composed of $49 million in acquisition related costs, $37 million in incremental amortization and $38 million from the inclusion of AdvancePierre results post-acquisition. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Increase of $115 million from restructuring and related charges. --+----------------------------------------------------------------- • | Increase of $53 million in employee costs including $34 million in non-restructuring severance related expenses and $24 million compensation and benefit integration expense, which was partially offset by reduced incentive-based compensation. --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Increase of $8 million due to an impairment related to our San Diego Prepared Foods operation. --+----------------------------------------------------------------------------------------------- • | Remainder of net change was primarily related to professional fees. --+-------------------------------------------------------------------- 2016 vs. 2015 – • | Increase of $116 million in selling, general and administrative was primarily driven by: --+----------------------------------------------------------------------------------------- • | Increase of $88 million related to marketing, advertising and promotion expense to drive sales growth. --+------------------------------------------------------------------------------------------------------- • | Increase of $71 million of employee costs including payroll and stock-based and incentive-based compensation. --+-------------------------------------------------------------------------------------------------------------- • | Increase of $11 million related to bad debt expense. --+----------------------------------------------------- • | Increase of $17 million in all other primarily related to professional fees, information technology costs and rent. --+-------------------------------------------------------------------------------------------------------------------- • | Decrease of $26 million due to a reduction in amortization and other expense related to our intangible assets. --+--------------------------------------------------------------------------------------------------------------- • | Decrease of $25 million related to fiscal 2015 sale of our chicken production operations in Brazil and Mexico. --+--------------------------------------------------------------------------------------------------------------- • | Decrease of $20 million of merger and integration costs. --+--------------------------------------------------------- 27 Interest Income | in millions | ----------------+-------------+--- | 2017 | | | 2016 | | | 2015 ----------------+-------------+----+---+------+---+----+----- | $ | (7 | ) | | $ | (6 | ) | $ | (9 | ) ----------------+-------------+----+---+------+---+----+------+---+----+-- 2017/2016/2015 – Interest income remained relatively flat due to continued low interest rates. Interest Expense | in millions | --------------------------+-------------+---- | 2017 | | 2016 | | | 2015 --------------------------+-------------+-----+------+---+-----+----- Cash interest expense | $ | 278 | | $ | 248 | | $ | 293 --------------------------+-------------+-----+------+---+-----+------+---+---- Non-cash interest expense | 1 | | 1 | | | — --------------------------+-------------+-----+------+---+-----+----- Total Interest Expense | $ | 279 | | $ | 249 | | $ | 293 --------------------------+-------------+-----+------+---+-----+------+---+---- 2017/2016/2015 – • | Cash interest expense primarily included interest expense related to the coupon rates for senior notes and term loans and commitment/letter of credit fees incurred on our revolving credit facilities. The increase in cash interest expense in fiscal 2017 was primarily due to debt issued in connection with the AdvancePierre acquisition. The decrease in cash interest expense in fiscal 2016 was primarily due to a reduction of our debt. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Non-cash interest expense primarily included amounts related to the amortization of debt issuance costs and discounts/premiums on note issuances, offset by interest capitalized. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Other (Income) Expense, net | in millions | ----------------------------+-------------+--- | 2017 | | 2016 | | | 2015 ----------------------------+-------------+----+------+---+----+----- | $ | 31 | | $ | (8 | ) | $ | (36 | ) ----------------------------+-------------+----+------+---+----+------+---+-----+-- 2017 – Included $28 million of legal costs related to two former subsidiaries of Hillshire Brands, which were sold by Hillshire Brands in 1986 and 1994. Also, included $18 million of bridge financing fees related to the AdvancePierre acquisition and $19 million of income from equity earnings in joint ventures. 2016 – Included $12 million of equity earnings in joint ventures and $4 million in net foreign currency exchange losses. 2015 – Included $12 million of equity earnings in joint ventures and $21 million of gains on the sale of equity securities. Effective Tax Rate | -------------------+----- | 2017 | | 2016 | | 2015 | -------------------+------+---+------+---+------+-- | 32.3 | % | 31.8 | % | 36.3 | % -------------------+------+---+------+---+------+-- The effective tax rate on continuing operations was impacted by a number of items which result in a difference between our effective tax rate and the United States statutory rate of 35%. The table below reflects significant items impacting the rate as indicated. 2017 – • | Domestic production activity deduction reduced the rate 3.1%. --+-------------------------------------------------------------- • | State income taxes increased the rate 2.3%. --+-------------------------------------------- 2016 – • | Domestic production activity deduction reduced the rate 2.6%. --+-------------------------------------------------------------- • | Unrecognized tax benefits activity, mostly related to expiration of statutes of limitations and settlements with taxing authorities, reduced the rate 1.7%. --+------------------------------------------------------------------------------------------------------------------------------------------------------------ • | State income taxes increased the rate 2.7%. --+-------------------------------------------- 2015 – • | Domestic production activity deduction reduced the rate 3.7%. --+-------------------------------------------------------------- • | Unrecognized tax benefits activity, mostly related to expiration of statutes of limitations, reduced the rate 1.8%. --+-------------------------------------------------------------------------------------------------------------------- • | State income taxes increased the rate 3.1%. --+-------------------------------------------- • | Foreign rate differences and valuation allowances increased the rate 3.8%. --+--------------------------------------------------------------------------- 28 SEGMENT RESULTS We operate in four reportable segments: Beef, Pork, Chicken, and Prepared Foods. Other primarily includes our foreign chicken production operations in China and India, third-party merger and integration costs and corporate overhead related to Tyson New Ventures, LLC. On June 7, 2017, we acquired AdvancePierre, a producer and distributor of value-added, convenient, ready-to-eat sandwiches, sandwich components and other entrées and snacks. AdvancePierre's results from operations subsequent to the acquisition closing are included in the Prepared Foods and Chicken segments. The following table is a summary of segment sales and operating income (loss), which is how we measure segment income (loss). | | | | | | | | | in millions | -------------------+--------+--------+-------------------------+--------+---+--------+--------+---+-------------+------- | Sales | | Operating Income (Loss) -------------------+--------+--------+------------------------ | 2017 | | | 2016 | | | 2015 | | | 2017 | | 2016 | | 2015 | -------------------+--------+--------+-------------------------+--------+---+--------+--------+---+-------------+--------+---+-------+-------+-------+-- Beef | $ | 14,823 | | | $ | 14,513 | | | $ | 17,236 | | $ | 877 | | $ | 347 | $ | (66 | ) -------------------+--------+--------+-------------------------+--------+---+--------+--------+---+-------------+--------+---+-------+-------+-------+---+-------+---+-------+-- Pork | 5,238 | | | 4,909 | | | 5,262 | | | 645 | | 528 | | 380 | -------------------+--------+--------+-------------------------+--------+---+--------+--------+---+-------------+--------+---+-------+-------+-------+-- Chicken | 11,409 | | | 10,927 | | | 11,390 | | | 1,053 | | 1,305 | | 1,366 | -------------------+--------+--------+-------------------------+--------+---+--------+--------+---+-------------+--------+---+-------+-------+-------+-- Prepared Foods | 7,853 | | | 7,346 | | | 7,822 | | | 462 | | 734 | | 588 | -------------------+--------+--------+-------------------------+--------+---+--------+--------+---+-------------+--------+---+-------+-------+-------+-- Other | 349 | | | 380 | | | 879 | | | (106 | ) | (81 | ) | (99 | ) -------------------+--------+--------+-------------------------+--------+---+--------+--------+---+-------------+--------+---+-------+-------+-------+-- Intersegment Sales | (1,412 | ) | | (1,194 | ) | | (1,216 | ) | | — | | — | | — | -------------------+--------+--------+-------------------------+--------+---+--------+--------+---+-------------+--------+---+-------+-------+-------+-- Total | $ | 38,260 | | | $ | 36,881 | | | $ | 41,373 | | $ | 2,931 | | $ | 2,833 | $ | 2,169 | -------------------+--------+--------+-------------------------+--------+---+--------+--------+---+-------------+--------+---+-------+-------+-------+---+-------+---+-------+-- Beef Segment Results | | | | | | | in millions | ---------------------------+------+--------+------+-----+--------+----------------------+-------------+------ | 2017 | | 2016 | | | Change 2017 vs. 2016 | | 2015 | | Change 2016vs. 2015 | ---------------------------+------+--------+------+-----+--------+----------------------+-------------+-------+----+---------------------+------- Sales | $ | 14,823 | | $ | 14,513 | | $ | 310 | | $ | 17,236 | | $ | (2,723 | ) ---------------------------+------+--------+------+-----+--------+----------------------+-------------+-------+----+---------------------+--------+---+---+--------+-- Sales Volume Change | | | | 1.8 | % | | | (1.1 | )% ---------------------------+------+--------+------+-----+--------+----------------------+-------------+-------+--- Average Sales Price Change | | | | 0.4 | % | | | (14.9 | )% ---------------------------+------+--------+------+-----+--------+----------------------+-------------+-------+--- Operating Income (Loss) | $ | 877 | | $ | 347 | | $ | 530 | | $ | (66 | ) | $ | 413 | ---------------------------+------+--------+------+-----+--------+----------------------+-------------+-------+----+---------------------+--------+---+---+--------+-- Operating Margin | 5.9 | % | 2.4 | % | | | (0.4 | )% | ---------------------------+------+--------+------+-----+--------+----------------------+-------------+-------+--- 2017 vs. 2016 – • | Sales Volume – Sales volume increased due to improved availability of cattle supply, stronger domestic demand for our beef products and increased exports. --+----------------------------------------------------------------------------------------------------------------------------------------------------------- • | Average Sales Price – Average sales price increased as demand for our beef products and strong exports outpaced the increase in live cattle supplies. --+------------------------------------------------------------------------------------------------------------------------------------------------------ • | Operating Income – Operating income increased due to more favorable market conditions as we maximized our revenues relative to the decline in live fed cattle costs, partially offset by higher operating costs. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 2016 vs. 2015 – • | Sales Volume – Sales volume decreased due to the additional week in fiscal 2015. When excluding the additional week in fiscal 2015, sales volume increased 0.8% due to increased availability of cattle supply and better demand for our beef products despite a reduction in live cattle processing capacity due to the closure of our Denison, Iowa, facility in the fourth quarter of fiscal 2015. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ • | Average Sales Price – Average sales price decreased due to higher domestic availability of beef supplies and lower livestock cost. --+----------------------------------------------------------------------------------------------------------------------------------- • | Operating Income – Operating income increased due to more favorable market conditions as we maximized our revenues relative to the decline in live fed cattle cost, in addition to reduced losses from mark-to-market open derivative positions and lower-of-cost-or market inventory adjustments that were incurred in the fourth quarter of fiscal 2015, partially offset by higher operating costs. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 29 Pork Segment Results | | | | | | | in millions | ---------------------------+------+-------+------+-----+-------+----------------------+-------------+----- | 2017 | | 2016 | | | Change 2017 vs. 2016 | | 2015 | | Change 2016 vs. 2015 | ---------------------------+------+-------+------+-----+-------+----------------------+-------------+------+----+----------------------+------ Sales | $ | 5,238 | | $ | 4,909 | | $ | 329 | | $ | 5,262 | $ | (353 | ) ---------------------------+------+-------+------+-----+-------+----------------------+-------------+------+----+----------------------+-------+---+------+-- Sales Volume Change | | | | 0.6 | % | | | (2.5 | )% ---------------------------+------+-------+------+-----+-------+----------------------+-------------+------+--- Average Sales Price Change | | | | 6.1 | % | | | (4.4 | )% ---------------------------+------+-------+------+-----+-------+----------------------+-------------+------+--- Operating Income | $ | 645 | | $ | 528 | | $ | 117 | | $ | 380 | $ | 148 | ---------------------------+------+-------+------+-----+-------+----------------------+-------------+------+----+----------------------+-------+---+------+-- Operating Margin | 12.3 | % | 10.8 | % | | | 7.2 | % | ---------------------------+------+-------+------+-----+-------+----------------------+-------------+------+--- 2017 vs. 2016 – • | Sales Volume – Sales volume increased due to strong demand for our pork products and increased exports. --+-------------------------------------------------------------------------------------------------------- • | Average Sales Price – Average sales price increased as demand for our pork products and strong exports outpaced the increase in live hog supplies. --+--------------------------------------------------------------------------------------------------------------------------------------------------- • | Operating Income – Operating income increased as we maximized our revenues relative to the live hog markets, partially attributable to stronger export markets and operational and mix performance, which were partially offset by higher operating costs. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 2016 vs. 2015 – • | Sales Volume – Sales volume decreased due to the divestiture of our Heinold Hog Markets business in the first quarter of fiscal 2015 and the additional week in fiscal 2015. Excluding these impacts, sales volume grew 1.2%, driven by better demand for our pork products. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Average Sales Price – Average sale price decreased due to increased live hog supplies and lower livestock cost. --+---------------------------------------------------------------------------------------------------------------- • | Operating Income – Operating income increased as we maximized our revenues relative to the decline in live hog markets and due to better plant utilization associated with increased volume processed, which were partially offset by higher operating costs, losses incurred in our live hog operation and the additional week in fiscal 2015. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ Chicken Segment Results | | | | | | | in millions | ---------------------------+------+--------+------+-----+--------+---------------------+-------------+----- | 2017 | | 2016 | | | Change 2017vs. 2016 | | 2015 | | Change 2016vs. 2015 | ---------------------------+------+--------+------+-----+--------+---------------------+-------------+------+----+---------------------+------- Sales | $ | 11,409 | | $ | 10,927 | | $ | 482 | | $ | 11,390 | $ | (463 | ) ---------------------------+------+--------+------+-----+--------+---------------------+-------------+------+----+---------------------+--------+---+------+-- Sales Volume Change | | | | 1.2 | % | | | (2.6 | )% ---------------------------+------+--------+------+-----+--------+---------------------+-------------+------+--- Average Sales Price Change | | | | 3.1 | % | | | (1.5 | )% ---------------------------+------+--------+------+-----+--------+---------------------+-------------+------+--- Operating Income | $ | 1,053 | | $ | 1,305 | | $ | (252 | ) | $ | 1,366 | $ | (61 | ) ---------------------------+------+--------+------+-----+--------+---------------------+-------------+------+----+---------------------+--------+---+------+-- Operating Margin | 9.2 | % | 11.9 | % | | | 12.0 | % | ---------------------------+------+--------+------+-----+--------+---------------------+-------------+------+--- 2017 vs. 2016 – • | Sales Volume – Sales volume was up due to better demand for our chicken products along with the incremental volume from the AdvancePierre acquisition. --+------------------------------------------------------------------------------------------------------------------------------------------------------- • | Average Sales Price – Average sales price increased due to sales mix changes. --+------------------------------------------------------------------------------ • | Operating Income – Operating income for fiscal 2017 was below prior year record results due to higher operating costs, which included increased compensation and benefit integration expense of $41 million, $17 million of incremental net costs attributable to two plant fires, in addition to restructuring and related charges of $56 million, partially offset with lower feed ingredient costs of approximately $80 million. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 2016 vs. 2015 – • | Sales Volume – Sales volume decreased primarily due to the additional week in fiscal 2015, in addition to a planned temporary decrease in production in the fourth quarter of fiscal 2016 while we transitioned our mix to sell more value-added and less commodity products along with optimizing our mix and our buy versus grow strategy. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Average Sales Price – Average sales price decreased as feed costs declined, partially offset by mix changes. --+------------------------------------------------------------------------------------------------------------- • | Operating Income – Operating income was negatively impacted by the additional week in fiscal 2015 along with increases in operating costs and marketing, advertising and promotion expenses, partially offset by lower feed costs of $170 million. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 30 Prepared Foods Segment Results | | | | | | in millions -------------------------------+------+-------+------+-----+-------+--------------------- | 2017 | | 2016 | | | Change 2017 vs. 2016 | | 2015 | | Change 2016vs. 2015 | -------------------------------+------+-------+------+-----+-------+----------------------+-----+------+----+---------------------+------ Sales | $ | 7,853 | | $ | 7,346 | | $ | 507 | | $ | 7,822 | $ | (476 | ) -------------------------------+------+-------+------+-----+-------+----------------------+-----+------+----+---------------------+-------+---+------+-- Sales Volume Change | | | | 3.2 | % | | | (2.8 | )% -------------------------------+------+-------+------+-----+-------+----------------------+-----+------+--- Average Sales Price Change | | | | 3.6 | % | | | (3.4 | )% -------------------------------+------+-------+------+-----+-------+----------------------+-----+------+--- Operating Income | $ | 462 | | $ | 734 | | $ | (272 | ) | $ | 588 | $ | 146 | -------------------------------+------+-------+------+-----+-------+----------------------+-----+------+----+---------------------+-------+---+------+-- Operating Margin | 5.9 | % | 10.0 | % | | | 7.5 | % | -------------------------------+------+-------+------+-----+-------+----------------------+-----+------+--- 2017 vs. 2016 – • | Sales Volume – Sales volume increased due to improved demand for our retail products and incremental volumes from the AdvancePierre acquisition, partially offset by declines in foodservice. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Average Sales Price – Average sales price increased due to better product mix which was positively impacted by the acquisition of AdvancePierre as well as higher input costs of $50 million. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Operating Income – Operating income decreased due to impairments of $52 million related to our San Diego operation and of $45 million related to the expected sale of a non-protein business, $30 million of compensation and benefit integration expense, $34 million related to AdvancePierre purchase accounting and acquisition related costs, $82 million of restructuring and related charges, in addition to higher operating costs at some of our facilities. Additionally, Prepared Foods operating income was positively impacted by $538 million in synergies, of which $97 million was incremental synergies in fiscal 2017 above the $156 million of synergies realized in fiscal 2016 and $285 million realized in fiscal 2015. The positive impact of these synergies to operating income was partially offset with investments in innovation, new product launches and supporting the growth of our brands. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 2016 vs. 2015 – • | Sales Volume – Sales volume decreased due to the additional week in fiscal 2015 and lower sales volume in the first six months of fiscal 2016 due to changes in sales mix and the carryover effect of the 2015 turkey avian influenza occurrence into the first half of fiscal 2016. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Average Sales Price – Average sales price decreased primarily due to a decline in input costs, partially offset by a change in product mix. --+-------------------------------------------------------------------------------------------------------------------------------------------- • | Operating Income – Operating income increased due to mix changes as well as lower input costs of approximately $300 million, partially offset with higher marketing, advertising, and promotion spend along with the additional week in fiscal 2015. Additionally, Prepared Foods operating income was positively impacted by $441 million in synergies, of which $156 million was incremental synergies in fiscal 2016 above the $285 million of synergies realized in fiscal 2015. The positive impact of these synergies to operating income was partially offset with heavy investments in innovation, new product launches and supporting the growth of our brands. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Other Results | | | | | | in millions | ---------------+------+-----+------+---+-----+---------------------+-- | 2017 | | 2016 | | | Change 2017vs. 2016 | | | 2015 | | Change 2016vs. 2015 | ---------------+------+-----+------+---+-----+---------------------+---+---+------+---+---------------------+---- Sales | $ | 349 | | $ | 380 | | | $ | (31 | ) | $ | 879 | $ | (499 | ) ---------------+------+-----+------+---+-----+---------------------+---+---+------+---+---------------------+-----+---+------+-- Operating Loss | (106 | ) | (81 | ) | | (25 | ) | | (99 | ) | 18 | ---------------+------+-----+------+---+-----+---------------------+---+---+------+---+---------------------+---- 2017 vs. 2016 – • | Sales – Sales decreased due to a decline in average sales price and foreign produced sales volume. --+--------------------------------------------------------------------------------------------------- • | Operating loss – Operating loss increased primarily from $43 million of AdvancePierre third-party acquisition related costs, partially offset by better performance at our China operation and reduced other merger and integration costs outside of AdvancePierre. --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 2016 vs. 2015 – • | Sales – Sales decreased due to the sale of the Mexico and Brazil chicken production operations in fiscal 2015. --+--------------------------------------------------------------------------------------------------------------- • | Operating loss – Operating loss improved due to better performance at our China operation and reduced third-party merger and integration costs partially offset by the results of the Mexico chicken production operation sold in fiscal 2015. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 31 LIQUIDITY AND CAPITAL RESOURCES Our cash needs for working capital, capital expenditures, growth opportunities, the repurchases of senior notes, repayment of term loans and share repurchases are expected to be met with current cash on hand, cash flows provided by operating activities, or short-term borrowings. Based on our current expectations, we believe our liquidity and capital resources will be sufficient to operate our business. However, we may take advantage of opportunities to generate additional liquidity or refinance existing debt through capital market transactions. The amount, nature and timing of any capital market transactions will depend on our operating performance and other circumstances; our then-current commitments and obligations; the amount, nature and timing of our capital requirements; any limitations imposed by our current credit arrangements; and overall market conditions. Cash Flows from Operating Activities | | | in millions | ------------------------------------------------+------+-------+-------------+----- | 2017 | | | 2016 | | | 2015 | ------------------------------------------------+------+-------+-------------+------+---+-------+------+-- Net income | $ | 1,778 | | | $ | 1,772 | | | $ | 1,224 ------------------------------------------------+------+-------+-------------+------+---+-------+------+---+---+------ Non-cash items in net income: | | | | | ------------------------------------------------+------+-------+-------------+------+-- Depreciation and amortization | 761 | | | 705 | | | 711 | ------------------------------------------------+------+-------+-------------+------+---+-------+------+-- Deferred income taxes | (39 | ) | | 84 | | | 38 | ------------------------------------------------+------+-------+-------------+------+---+-------+------+-- Gain on dispositions of businesses | — | | | — | | | (177 | ) ------------------------------------------------+------+-------+-------------+------+---+-------+------+-- Impairment of assets | 214 | | | 45 | | | 285 | ------------------------------------------------+------+-------+-------------+------+---+-------+------+-- Stock-based compensation expense | 92 | | | 81 | | | 69 | ------------------------------------------------+------+-------+-------------+------+---+-------+------+-- Other, net | (57 | ) | | (34 | ) | | 71 | ------------------------------------------------+------+-------+-------------+------+---+-------+------+-- Net changes in operating assets and liabilities | (150 | ) | | 63 | | | 349 | ------------------------------------------------+------+-------+-------------+------+---+-------+------+-- Net cash provided by operating activities | $ | 2,599 | | | $ | 2,716 | | | $ | 2,570 ------------------------------------------------+------+-------+-------------+------+---+-------+------+---+---+------ • | Gain on dispositions of businesses in fiscal 2015 primarily relates to the sale of the Mexico chicken production operation. --+---------------------------------------------------------------------------------------------------------------------------- • | Impairment of assets included the following: --+--------------------------------------------- • | 2017 – Included a $73 million impairment of assets associated with restructuring and related charges, $45 million impairment related to the expected sale of a non-protein business and an impairment of $51 million related to our San Diego Prepared Foods operation. For further description regarding these charges refer to Part II, Item 8, Notes to Consolidated Financial Statements, Note 3: Acquisitions and Dispositions, Note 6: Restructuring and Related Charges and Note 10: Other Income and Charges. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | 2015 – Included $59 million of impairment charges related to our Prepared Foods network optimization and $169 million of impairments related to our China operation. For further description regarding these charges refer to Part II, Item 8, Notes to Consolidated Financial Statements, Note 3: Acquisitions and Dispositions and Note 10: Other Income and Charges. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ • | Other, net increase in fiscal 2015 is primarily driven by non-cash pension expense. --+------------------------------------------------------------------------------------ • | Cash flows associated with changes in operating assets and liabilities: --+------------------------------------------------------------------------ • | 2017 – Decreased primarily due to higher accounts receivable and inventory, partially offset by increased accounts payable and increased accrued salaries and wages. The higher accounts receivable, inventory and accounts payable balances are primarily attributable to price increases associated with higher input costs and the timing of sales and payments. The increase in accrued salaries and wages is primarily attributable to the restructuring accrual. For further description regarding this accrual refer to Part II, Item 8, Notes to Consolidated Financial Statements, Note 6: Restructuring and Related Charges. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | 2016 – Increased primarily due to decreased inventory and accounts receivable balances and increased accrual for incentive compensation, which were partially offset by decreased accounts payable, increased tax receivable and contributions to pension plans. The decreased inventory, accounts receivable and accounts payable balances were largely due to decreased raw material costs and timing of sales and payments. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | 2015 – Increased primarily due to the decrease in inventory and accounts receivable balances and an increase in taxes payable, partially offset by the decrease in accounts payable. The decreased inventory, accounts receivable and accounts payable balances were largely due to decreased raw material costs and timing of sales and payments. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 32 Cash Flows from Investing Activities | | | | in millions | --------------------------------------------------------+--------+--------+---+-------------+-- | 2017 | | | 2016 | | | 2015 --------------------------------------------------------+--------+--------+---+-------------+---+------+----- Additions to property, plant and equipment | $ | (1,069 | ) | | $ | (695 | ) | $ | (854 | ) --------------------------------------------------------+--------+--------+---+-------------+---+------+------+---+------+-- (Purchases of)/Proceeds from marketable securities, net | (18 | ) | | (9 | ) | | 14 --------------------------------------------------------+--------+--------+---+-------------+---+------+----- Acquisitions, net of cash acquired | (3,081 | ) | | — | | | — --------------------------------------------------------+--------+--------+---+-------------+---+------+----- Proceeds from sale of businesses | — | | | — | | | 539 --------------------------------------------------------+--------+--------+---+-------------+---+------+----- Other, net | 4 | | | 20 | | | 31 --------------------------------------------------------+--------+--------+---+-------------+---+------+----- Net cash used for investing activities | $ | (4,164 | ) | | $ | (684 | ) | $ | (270 | ) --------------------------------------------------------+--------+--------+---+-------------+---+------+------+---+------+-- • | Additions to property, plant and equipment included spending for production growth, safety and animal well-being, in addition to acquiring new equipment, infrastructure replacements and upgrades to maintain competitive standing and position us for future opportunities. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ • | Capital spending for fiscal 2018 is expected to approximate $1.4 billion and will include spending for production growth, safety, animal well-being, infrastructure replacements and upgrades, and operational improvements that will result in production and labor efficiencies, yield improvements and sales channel flexibility. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Purchases of marketable securities included funding for our deferred compensation plans. --+----------------------------------------------------------------------------------------- • | Proceeds from sale of businesses primarily included proceeds, net of cash transferred, from the sale of the Mexico and Brazil operations. --+------------------------------------------------------------------------------------------------------------------------------------------ • | Acquisition, net of cash acquired, in fiscal 2017 related to acquiring AdvancePierre as part of our strategy to sustainably feed the world with the fastest growing portfolio of protein-packed brands. AdvancePierre's results from operations subsequent to the acquisition closing are included in the Prepared Foods and Chicken segments. For further description regarding this transaction refer to Part II, Item 8, Notes to the Consolidated Financial Statements, Note 3: Acquisition and Dispositions. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ Cash Flows from Financing Activities | | | | in millions | -----------------------------------------------------+--------+--------+---+-------------+-- | 2017 | | | 2016 | | | 2015 | -----------------------------------------------------+--------+--------+---+-------------+---+--------+--------+-- Payments on debt | $ | (3,159 | ) | | $ | (714 | ) | | $ | (1,995 | ) -----------------------------------------------------+--------+--------+---+-------------+---+--------+--------+---+---+--------+-- Proceeds from issuance of long-term debt | 5,444 | | | 1 | | | 501 | -----------------------------------------------------+--------+--------+---+-------------+---+--------+--------+-- Borrowings on revolving credit facility | 1,810 | | | 1,065 | | | 1,345 | -----------------------------------------------------+--------+--------+---+-------------+---+--------+--------+-- Payments on revolving credit facility | (2,110 | ) | | (765 | ) | | (1,345 | ) -----------------------------------------------------+--------+--------+---+-------------+---+--------+--------+-- Proceeds from issuance of commercial paper | 8,138 | | | — | | | — | -----------------------------------------------------+--------+--------+---+-------------+---+--------+--------+-- Repayments of commercial paper | (7,360 | ) | | — | | | — | -----------------------------------------------------+--------+--------+---+-------------+---+--------+--------+-- Payment of AdvancePierre TRA liability | (223 | ) | | — | | | — | -----------------------------------------------------+--------+--------+---+-------------+---+--------+--------+-- Purchases of Tyson Class A common stock | (860 | ) | | (1,944 | ) | | (495 | ) -----------------------------------------------------+--------+--------+---+-------------+---+--------+--------+-- Dividends | (319 | ) | | (216 | ) | | (147 | ) -----------------------------------------------------+--------+--------+---+-------------+---+--------+--------+-- Stock options exercised | 154 | | | 128 | | | 84 | -----------------------------------------------------+--------+--------+---+-------------+---+--------+--------+-- Other, net | 15 | | | 68 | | | 17 | -----------------------------------------------------+--------+--------+---+-------------+---+--------+--------+-- Net cash provided by (used for) financing activities | $ | 1,530 | | | $ | (2,377 | ) | | $ | (2,035 | ) -----------------------------------------------------+--------+--------+---+-------------+---+--------+--------+---+---+--------+-- • | Payments on debt included – --+---------------------------- • | 2017 – We extinguished $1,146 million of AdvancePierre's debt, which we assumed in the acquisition, and fully retired the $1,800 million term loan tranche due June 2020, which was issued as part of the AdvancePierre acquisition financing. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | 2016 – We fully retired the $638 million outstanding balance of our 6.60% senior notes due April 2016. --+------------------------------------------------------------------------------------------------------- • | 2015 – We fully retired the $401 million outstanding balance of the 2.75% senior notes due September 2015 and paid $353 million related to the 5-year tranche A term loan facility and $1,172 million related to the 3-year tranche A term loan facility. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Proceeds from issuance of long-term debt and borrowings/payments on revolving credit facility – --+------------------------------------------------------------------------------------------------ • | 2017 – Proceeds from issuance of long-term debt included a $1,800 million term loan and $2,743 million from senior unsecured notes after original issue discounts of $7 million, to fund the AdvancePierre acquisition. In addition, proceeds from issuance of long-term debt included $899 million of senior unsecured notes after original issue discounts of $1 million that was used to repay amounts outstanding under the term loan tranche due June 2020. We had net payments on our revolving credit facility of $300 million in fiscal 2017, which was used for general corporate purposes. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 33 • | 2016 – We had borrowings of $1,065 million and payments of $765 million on our revolving credit facility for fiscal 2016. We utilized our revolving credit facility to balance our cash position with the retirement of the 2016 Notes and changes in working capital. Additionally, total debt of our foreign subsidiaries was $7 million at October 1, 2016, $6 million of which is classified as long-term in our Consolidated Balance Sheets. --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | 2015 – $500 million from term loans, the full balance of which was used to prepay outstanding borrowings under the 3-year tranche A term loan facility. In addition, we had borrowings and payments on our revolver of $1,345 million for fiscal 2015. We utilized our revolving credit facility to balance our cash position with term loan deleveraging and changes in working capital. Additionally, total debt of our foreign subsidiaries was $10 million at October 3, 2015, all of which is classified as long-term in our Consolidated Balance Sheets. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Proceeds from issuance and repayment of short-term debt in the form of commercial paper – --+------------------------------------------------------------------------------------------ • | 2017- We had net issuances of $778 million in unsecured short-term promissory notes (commercial paper) pursuant to our commercial paper program. We used the net proceeds from the commercial paper program as partial financing for the AdvancePierre acquisition and for general corporate purposes. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Payments on TRA obligation in the acquisition of AdvancePierre – --+----------------------------------------------------------------- • | 2017- AdvancePierre Tax Receivable Agreement (TRA) liability of $223 million was paid to its former shareholders as a result of our assumption of this obligation in the acquisition of AdvancePierre. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Purchases of Tyson Class A common stock include – --+-------------------------------------------------- • | $797 million, $1,868 million, and $455 million for shares repurchased pursuant to our share repurchase program in fiscal 2017, 2016 and 2015, respectively. --+------------------------------------------------------------------------------------------------------------------------------------------------------------ • | $63 million, $76 million and $40 million for shares repurchased to fund certain obligations under our equity compensation plans in fiscal 2017, 2016 and 2015, respectively. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | We currently do not plan to repurchase shares, other than to fund obligations under equity compensation programs, until we reach our net debt to EBITDA target of around 2x. We currently anticipate reaching this goal by the third quarter of fiscal 2018. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Dividends paid during fiscal 2017 included a 50% increase to our fiscal 2016 quarterly dividend rate. --+------------------------------------------------------------------------------------------------------ • | Other, net increase in fiscal 2016 is primarily driven by tax benefits associated with stock option exercises. --+--------------------------------------------------------------------------------------------------------------- Liquidity | | | | | | | in millions | --------------------------+----------------------------+----------------+-------+----------------------------------------------+---+---+----------------------------+------ | CommitmentsExpiration Date | FacilityAmount | | Outstanding Letters ofCredit (no draw downs) | | | Outstanding AmountBorrowed | | | AmountAvailable --------------------------+----------------------------+----------------+-------+----------------------------------------------+---+---+----------------------------+-------+---+---------------- Cash and cash equivalents | | | | | | | $ | 318 | --------------------------+----------------------------+----------------+-------+----------------------------------------------+---+---+----------------------------+-------+-- Short-term investments | | | | | | | 3 | --------------------------+----------------------------+----------------+-------+----------------------------------------------+---+---+----------------------------+------ Revolving credit facility | May 2022 | $ | 1,500 | | $ | 8 | | | $ | — | 1,492 --------------------------+----------------------------+----------------+-------+----------------------------------------------+---+---+----------------------------+-------+---+-----------------+------ Commercial Paper | | | | | | | (778 | ) --------------------------+----------------------------+----------------+-------+----------------------------------------------+---+---+----------------------------+------ Total liquidity | | | | | | | $ | 1,035 | --------------------------+----------------------------+----------------+-------+----------------------------------------------+---+---+----------------------------+-------+-- • | Liquidity includes cash and cash equivalents, short-term investments, and availability under our revolving credit facility, less outstanding commercial paper balance. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | At September 30, 2017, we had current debt of $906 million, which we intend to repay with cash generated from our operating activities and other liquidity sources. --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | The revolving credit facility supports our short-term funding needs and letters of credit and also serves to backstop our commercial paper program. The letters of credit issued under this facility are primarily in support of leasing obligations and workers’ compensation insurance programs. Our maximum borrowing under the revolving credit facility during fiscal 2017 was $590 million. --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | We expect net interest expense will approximate $325 million for fiscal 2018. --+------------------------------------------------------------------------------ • | At September 30, 2017, approximately $308 million of our cash was held in the accounts of our foreign subsidiaries. Generally, we do not rely on the foreign cash as a source of funds to support our ongoing domestic liquidity needs. Rather, we manage our worldwide cash requirements by reviewing available funds among our foreign subsidiaries and the cost effectiveness with which those funds can be accessed. The repatriation of cash balances from certain of our foreign subsidiaries could have adverse tax consequences or be subject to regulatory capital requirements; however, those balances are generally available without legal restrictions to fund ordinary business operations. United States income taxes, net of applicable foreign tax credits, have not been provided on undistributed earnings of foreign subsidiaries. Our intention is to reinvest the cash held by foreign subsidiaries permanently or to repatriate the cash only when it is tax efficient to do so. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Our ratio of short-term assets to short-term liabilities ("current ratio") was 1.55 to 1 and 1.77 to 1 at September 30, 2017, and October 1, 2016, respectively. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------- 34 Capital Resources Credit Facility Cash flows from operating activities and current cash on hand are our primary sources of liquidity for funding debt service, capital expenditures, dividends and share repurchases. We also have a revolving credit facility, with a committed capacity of $1.5 billion, to provide additional liquidity for working capital needs, letters of credit and to backstop our commercial paper program. As of September 30, 2017 , we had no outstanding borrowings and $8 million of outstanding letters of credit issued under this facility, none of which were drawn upon, which left $1,492 million available for borrowing. Our revolving credit facility is funded by a syndicate of 41 banks, with commitments ranging from $0.3 million to $106 million per bank. The syndicate includes bank holding companies that are required to be adequately capitalized under federal bank regulatory agency requirements. Commercial Paper Program Our commercial paper program provides a low-cost source of borrowing to fund general corporate purposes including working capital requirements. The maximum borrowing capacity under the commercial paper program is $800 million. The maturities of the notes may vary, but may not exceed 397 days from the date of issuance. As of September 30, 2017 , $778 million was outstanding under this program with maturities less than 45 days. Capitalization To monitor our credit ratings and our capacity for long-term financing, we consider various qualitative and quantitative factors. We monitor the ratio of our net debt to EBITDA as support for our long-term financing decisions. At September 30, 2017 , and October 1, 2016 , the ratio of our net debt to EBITDA was 2.7x and 1.7x, respectively. Refer to Part II, Item 6, Selected Financial Data, for an explanation and reconciliation to comparable GAAP measures. The increase in this ratio for fiscal 2017 is primarily a result of the incremental debt from the AdvancePierre acquisition. Credit Ratings Term Loans: Tranche B due August 2019 and Tranche B due August 2020 Standard & Poor's Rating Services, a Standard & Poor's Financial Services LLC business (S&P), credit rating for both term loans is "BBB." Moody’s Investor Service, Inc. (Moody's) credit rating for both term loans is "Baa2." Fitch Ratings, a wholly owned subsidiary of Fimlac, S.A. (Fitch) credit rating for both term loans is "BBB." The below table outlines the borrowing spread on the outstanding principal balances of our term loans that correspond to the ratings levels from S&P, Moody's and Fitch. Ratings Level (S&P/Moody's/Fitch) | Tranche B due August 2019 Borrowing Spread | | Tranche B due August 2020 Borrowing Spread | ----------------------------------+--------------------------------------------+---+--------------------------------------------+-- BBB+/Baa1/BBB+ or higher | 1.250 | % | 0.750 | % ----------------------------------+--------------------------------------------+---+--------------------------------------------+-- BBB/Baa2/BBB (current level) | 1.500 | % | 0.800 | % ----------------------------------+--------------------------------------------+---+--------------------------------------------+-- BBB-/Baa3/BBB- | 1.750 | % | 1.125 | % ----------------------------------+--------------------------------------------+---+--------------------------------------------+-- BB+/Ba1/BB+ | 2.000 | % | 1.375 | % ----------------------------------+--------------------------------------------+---+--------------------------------------------+-- BB/Ba2/BB or lower | 2.500 | % | 1.375 | % ----------------------------------+--------------------------------------------+---+--------------------------------------------+-- Revolving Credit Facility S&P’s corporate credit rating for Tyson Foods, Inc. is "BBB." Moody’s, senior unsecured, long-term debt rating for Tyson Foods, Inc. is "Baa2." Fitch's issuer default rating for Tyson Foods, Inc. is "BBB." The below table outlines the fees paid on the unused portion of the facility (Facility Fee Rate) and letter of credit fees (Undrawn Letter of Credit Fee and Borrowing Spread) depending on the rating levels of Tyson Foods, Inc. from S&P, Moody's and Fitch. Ratings Level (S&P/Moody's/Fitch) | Facility Fee Rate | | Undrawn Letter of Credit Fee and Borrowing Spread | ----------------------------------+-------------------+---+---------------------------------------------------+-- A-/A3/A- or above | 0.100 | % | 1.000 | % ----------------------------------+-------------------+---+---------------------------------------------------+-- BBB+/Baa1/BBB+ | 0.125 | % | 1.125 | % ----------------------------------+-------------------+---+---------------------------------------------------+-- BBB/Baa2/BBB (current level) | 0.150 | % | 1.250 | % ----------------------------------+-------------------+---+---------------------------------------------------+-- BBB-/Baa3/BBB- | 0.200 | % | 1.500 | % ----------------------------------+-------------------+---+---------------------------------------------------+-- BB+/Ba1/BB+ or lower | 0.250 | % | 1.750 | % ----------------------------------+-------------------+---+---------------------------------------------------+-- In the event the rating levels are split, the applicable fees and spread will be based upon the rating level in effect for two of the rating agencies, or, if all three rating agencies have different rating levels, the applicable fees and spread will be based upon the rating level that is between the rating levels of the other two rating agencies. 35 Debt Covenants Our revolving credit and term loan facilities contain affirmative and negative covenants that, among other things, may limit or restrict our ability to: create liens and encumbrances; incur debt; merge, dissolve, liquidate or consolidate; make acquisitions and investments; dispose of or transfer assets; change the nature of our business; engage in certain transactions with affiliates; and enter into hedging transactions, in each case, subject to certain qualifications and exceptions. In addition, we are required to maintain minimum interest expense coverage and maximum debt-to-capitalization ratios. Our senior notes also contain affirmative and negative covenants that, among other things, may limit or restrict our ability to: create liens; engage in certain sale/leaseback transactions; and engage in certain consolidations, mergers and sales of assets. We were in compliance with all debt covenants at September 30, 2017 . Pension Plans As further described in Part II, Item 8, Notes to Consolidated Financial Statements, Note 15: Pensions and Other Postretirement Benefits, the funded status of our defined benefit pension plans is defined as the amount the projected benefit obligation exceeds the plan assets. The funded status of the plans is an underfunded position of $ 195 million at the end of fiscal 2017 as compared to an underfunded position of $ 336 million at the end of fiscal 2016. We expect to contribute approximately $38 million of cash to our pension plans in fiscal 2018 as compared to approximately $53 million in fiscal 2017 and $64 million in fiscal 2016. The exact amount of cash contributions made to pension plans in any year is dependent upon a number of factors, including minimum funding requirements. As a result, the actual funding in fiscal 2018 may be different from the estimate. OFF-BALANCE SHEET ARRANGEMENTS We do not have any off-balance sheet arrangements material to our financial position or results of operations. The off-balance sheet arrangements we have are guarantees of debt of outside third parties, including leases and grower loans, and residual value guarantees covering certain operating leases for various types of equipment. See Part II, Item 8, Notes to Consolidated Financial Statements, Note 20: Commitments and Contingencies for further discussion. 36 CONTRACTUAL OBLIGATIONS The following table summarizes our contractual obligations as of September 30, 2017 : | | in millions ------------------------------------+------------------------+------------ | Payments Due by Period ------------------------------------+----------------------- | 2018 | | 2019-2020 | | | 2021-2022 | | 2023 and thereafter | Total | ------------------------------------+------------------------+-------------+-----------+---+-------+-----------+---+---------------------+-------+------ Debt and capital lease obligations: | | | | | | | ------------------------------------+------------------------+-------------+-----------+---+-------+-----------+-- Principal payments (1) | $ | 906 | | $ | 3,274 | | $ | 1,518 | $ | 4,552 | $ | 10,250 ------------------------------------+------------------------+-------------+-----------+---+-------+-----------+---+---------------------+-------+-------+---+------- Interest payments (2) | 341 | | 613 | | | 492 | | 2,159 | 3,605 | ------------------------------------+------------------------+-------------+-----------+---+-------+-----------+---+---------------------+-------+------ Guarantees (3) | 22 | | 57 | | | 44 | | 15 | 138 | ------------------------------------+------------------------+-------------+-----------+---+-------+-----------+---+---------------------+-------+------ Operating lease obligations (4) | 137 | | 174 | | | 80 | | 73 | 464 | ------------------------------------+------------------------+-------------+-----------+---+-------+-----------+---+---------------------+-------+------ Purchase obligations (5) | 1,750 | | 646 | | | 195 | | 110 | 2,701 | ------------------------------------+------------------------+-------------+-----------+---+-------+-----------+---+---------------------+-------+------ Capital expenditures (6) | 1,084 | | 303 | | | — | | — | 1,387 | ------------------------------------+------------------------+-------------+-----------+---+-------+-----------+---+---------------------+-------+------ Other long-term liabilities (7) | — | | — | | | — | | — | 581 | ------------------------------------+------------------------+-------------+-----------+---+-------+-----------+---+---------------------+-------+------ Total contractual commitments | $ | 4,240 | | $ | 5,067 | | $ | 2,329 | $ | 6,909 | $ | 19,126 ------------------------------------+------------------------+-------------+-----------+---+-------+-----------+---+---------------------+-------+-------+---+------- (1) | In the event of a default on payment, acceleration of the principal payments could occur. ----+------------------------------------------------------------------------------------------ (2) | Interest payments include interest on all outstanding debt. Payments are estimated for variable rate and variable term debt based on effective interest rates at September 30, 2017, and expected payment dates. ----+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (3) | Amounts include guarantees of debt of outside third parties, which consist of leases and grower loans, all of which are substantially collateralized by the underlying assets, as well as residual value guarantees covering certain operating leases for various types of equipment. The amounts included are the maximum potential amount of future payments. ----+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (4) | Amounts include minimum lease payments under lease agreements. ----+--------------------------------------------------------------- (5) | Amounts include agreements to purchase goods or services that are enforceable and legally binding and specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. The purchase obligations amount included items, such as future purchase commitments for grains, livestock contracts and fixed grower fees, that provide terms that meet the above criteria. For certain grain purchase commitments with a fixed quantity provision, we have assumed the future obligations under the commitment based on available commodity futures prices as published in observable active markets as of September 30, 2017. We have excluded future purchase commitments for contracts that do not meet these criteria. Purchase orders are not included in the table, as a purchase order is an authorization to purchase and is cancelable. Contracts for goods or services that contain termination clauses without penalty have also been excluded. ----+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (6) | Amounts include estimated amounts to complete buildings and equipment under construction as of September 30, 2017. ----+------------------------------------------------------------------------------------------------------------------- (7) | Other long-term liabilities primarily consist of deferred compensation, deferred income, self-insurance, and asset retirement obligations. We are unable to reliably estimate the amount of these payments beyond fiscal 2018; therefore, we have only included the total liability in the table above. We also have employee benefit obligations consisting of pensions and other postretirement benefits of $258 million that are excluded from the table above. A discussion of the Company's pension and postretirement plans, including funding matters, is included in Part II, Item 8, Notes to Consolidated Financial Statements, Note 15: Pensions and Other Postretirement Benefits. ----+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- In addition to the amounts shown above in the table, we have unrecognized tax benefits of $296 million and related interest and penalties of $63 million at September 30, 2017 , recorded as liabilities. The potential maximum contractual obligation associated with our cash flow assistance programs at September 30, 2017 , based on the estimated fair values of the livestock supplier’s net tangible assets on that date, aggregated to approximately $380 million . There were no receivables under these programs at September 30, 2017. RECENTLY ISSUED/ADOPTED ACCOUNTING PRONOUNCEMENTS Refer to the discussion under Part II, Item 8, Notes to Consolidated Financial Statements, Note 1: Business and Summary of Significant Accounting Policies and Note 2: Changes in Accounting Principles. 37 CRITICAL ACCOUNTING ESTIMATES The preparation of consolidated financial statements requires us to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The following is a summary of certain accounting estimates we consider critical. Description | Judgments and Uncertainties | Effect if Actual Results Differ FromAssumptions -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Contingent liabilities | | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- We are subject to lawsuits, investigations and other claims related to wage and hour/labor, environmental, product, taxing authorities and other matters, and are required to assess the likelihood of any adverse judgments or outcomes to these matters, as well as potential ranges of probable losses. A determination of the amount of reserves and disclosures required, if any, for these contingencies is made after considerable analysis of each individual issue. We accrue for contingent liabilities when an assessment of the risk of loss is probable and can be reasonably estimated. We disclose contingent liabilities when the risk of loss is reasonably possible or probable. | Our contingent liabilities contain uncertainties because the eventual outcome will result from future events, and determination of current reserves requires estimates and judgments related to future changes in facts and circumstances, differing interpretations of the law and assessments of the amount of damages, and the effectiveness of strategies or other factors beyond our control. | We have not made any material changes in the accounting methodology used to establish our contingent liabilities during the past three fiscal years. We do not believe there is a reasonable likelihood there will be a material change in the estimates or assumptions used to calculate our contingent liabilities. However, if actual results are not consistent with our estimates or assumptions, we may be exposed to gains or losses that could be material. -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Marketing, advertising and promotion costs | | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- We promote our products with marketing, advertising, trade promotions, and consumer incentives. These programs include, but are not limited to, coupons, discounts, rebates, volume-based incentives, cooperative advertising, and other programs.Marketing, advertising, and promotion costs are charged to operations in the period incurred. We accrue costs based on the estimated performance, historical utilization and redemption rates of each program.Cash consideration given to customers is considered a reduction in the price of our products, thus recorded as a reduction to sales. The remainder of marketing, advertising and promotion costs is recorded as a selling, general and administrative expense. | Recognition of the costs related to these programs contains uncertainties due to judgment required in estimating the potential performance, utilization and redemption rates of each program.These estimates are based on many factors, including experience of similar promotional programs. | We have not made any material changes in the accounting methodology used to establish our marketing, advertising, and promotion accruals during the past three fiscal years.We do not believe there is a reasonable likelihood there will be a material change in the estimates or assumptions used to calculate our marketing, advertising, and promotion accruals. However, if actual results are not consistent with our estimates or assumptions, we may be exposed to gains or losses that could be material.A 10% change in our marketing, advertising, and promotion accruals at September 30, 2017, would impact pretax earnings by approximately $15 million. -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 38 Description | Judgments and Uncertainties | Effect if Actual Results Differ FromAssumptions -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Accrued self-insurance | | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- We are self-insured for certain losses related to health and welfare, workers’ compensation, auto liability and general liability claims. We use an independent third-party actuary to assist in determining our self-insurance liability. We and the actuary consider a number of factors when estimating our self-insurance liability, including claims experience, demographic factors, severity factors and other actuarial assumptions. We periodically review our estimates and assumptions with our third-party actuary to assist us in determining the adequacy of our self-insurance liability. Our policy is to maintain an accrual within the central to high point of the actuarial range. | Our self-insurance liability contains uncertainties due to assumptions required and judgment used. Costs to settle our obligations, including legal and healthcare costs, could increase or decrease causing estimates of our self-insurance liability to change. Incident rates, including frequency and severity, could increase or decrease causing estimates in our self-insurance liability to change. | We have not made any material changes in the accounting methodology used to establish our self-insurance liability during the past three fiscal years. We do not believe there is a reasonable likelihood there will be a material change in the estimates or assumptions used to calculate our self-insurance liability. However, if actual results are not consistent with our estimates or assumptions, we may be exposed to gains or losses that could be material. A 10% increase in the actuarial estimate at September 30, 2017, would result in an increase in the amount we recorded for our self-insurance liability of approximately $27 million. A 10% decrease in the actuarial estimate at September 30, 2017, would result in a decrease in the amount we recorded for our self-insurance liability of approximately $11 million. -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 39 Description | Judgments and Uncertainties | Effect if Actual Results Differ FromAssumptions ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Defined benefit pension plans | | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- We sponsor nine defined benefit pension plans that provide retirement benefits to certain employees. We also participate in a multi-employer plan that provides defined benefits to certain employees covered by collective bargaining agreements. Such plans are usually administered by a board of trustees composed of the management of the participating companies and labor representatives.We use independent third-party actuaries to assist us in determining our pension obligations and net periodic benefit cost. We and the actuaries review assumptions that include estimates of the present value of the projected future pension payment to all plan participants, taking into consideration the likelihood of potential future events such as salary increases and demographic experience. We accumulate and amortize the effect of actuarial gains and losses over future periods.Net periodic benefit cost for the defined benefit pension plans was $28 million in fiscal 2017. The projected benefit obligation was $1,707 million at the end of fiscal 2017. Unrecognized actuarial gain was $44 million at the end of fiscal 2017. We currently expect net periodic benefit cost for fiscal 2018 to be approximately $15 million, excluding the pending settlement as described in Note 15: Pension and Other Postretirement Benefits.Plan assets are currently comprised of approximately 87% fixed income securities and 9% equity securities. Fixed income securities can include, but are not limited to, direct bond investments and pooled or indirect bond investments. Other investments may include, but are not limited to, international and domestic equities, real estate, commodities and private equity.We expect to contribute approximately $38 million of cash to our pension plans in fiscal 2018. The exact amount of cash contributions made to pension plans in any year is dependent upon a number of factors, including minimum funding requirements. | Our defined benefit pension plans contain uncertainties due to assumptions required and judgments used. The key assumptions used in developing the required estimates include such factors as discount rates, expected returns on plan assets, retirement rates, and mortality. These assumptions can have a material impact upon the funded status and the net periodic benefit cost. The discount rates were determined using a cash flow matching technique whereby the rates of a yield curve, developed from high-quality debt securities, were applied to the benefit obligations to determine the appropriate discount rate. In determining the long-term rate of return on plan assets, we first examined historical rates of return for the various asset classes within the plans. We then determined a long-term projected rate-of-return based on expected returns. Investment, management and other fees paid out of plan assets are factored into the determination of asset return assumptions. Retirement rates are based primarily on actual plan experience, while standard actuarial tables are used to estimate mortality. It is reasonably likely that changes in external factors will result in changes to the assumptions used to measure pension obligations and net periodic benefit cost in future periods. The risks of participating in multi-employer plans are different from single-employer plans. The net pension cost of the multi-employer plans is equal to the annual contribution determined in accordance with the provisions of negotiated labor contracts. Assets contributed to such plans are not segregated or otherwise restricted to provide benefits only to our employees. The future cost of these plans is dependent on a number of factors including the funded status of the plans and the ability of the other participating companies to meet ongoing funding obligations. | We have not made any material changes in the accounting methodology used to establish our pension obligations and net periodic benefit cost during the past three fiscal years.We do not believe there is a reasonable likelihood there will be a material change in the estimates or assumptions used to calculate our pension obligations and net periodic benefit cost. However, if actual results are not consistent with our estimates or assumptions, they are accumulated and amortized over future periods and, therefore generally affect the net periodic benefit cost in future periods.A 1% increase in the discount rate at September 30, 2017, would result in a decrease in the projected benefit obligation and net periodic benefit cost of approximately $187 million and $19 million, respectively. A 1% decrease in the discount rate at September 30, 2017, would result in an increase in the projected benefit obligation and net periodic benefit cost of approximately $229 million and $14 million, respectively. A 1% change in the return on plan assets at September 30, 2017, would impact the net periodic benefit cost by approximately $15 million.The sensitivities reflect the impact of changing one assumption at a time with the remaining assumptions held constant. Economic factors and conditions often affect multiple assumptions simultaneously and that the effect of changes in assumptions are not necessarily linear. ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 40 Description | Judgments and Uncertainties | Effect if Actual Results Differ FromAssumptions -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Income taxes | | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- We estimate total income tax expense based on statutory tax rates and tax planning opportunities available to us in various jurisdictions in which we earn income.Federal income tax includes an estimate for taxes on earnings of foreign subsidiaries expected to be taxable upon remittance to the United States, except for earnings considered to be indefinitely invested in the foreign subsidiary.Deferred income taxes are recognized for the future tax effects of temporary differences between financial and income tax reporting using tax rates in effect for the years in which the differences are expected to reverse.Valuation allowances are recorded when it is likely a tax benefit will not be realized for a deferred tax asset.We record unrecognized tax benefit liabilities for known or anticipated tax issues based on our analysis of whether, and the extent to which, additional taxes will be due. | Changes in tax laws and rates could affect recorded deferred tax assets and liabilities in the future.Changes in projected future earnings could affect the recorded valuation allowances in the future.Our calculations related to income taxes contain uncertainties due to judgment used to calculate tax liabilities in the application of complex tax regulations across the tax jurisdictions where we operate.Our analysis of unrecognized tax benefits contains uncertainties based on judgment used to apply the more likely than not recognition and measurement thresholds. | We do not believe there is a reasonable likelihood there will be a material change in the tax related balances or valuation allowances. However, due to the complexity of some of these uncertainties, the ultimate resolution may result in a payment that is materially different from the current estimate of the tax liabilities.To the extent we prevail in matters for which unrecognized tax benefit liabilities have been established, or are required to pay amounts in excess of our recorded unrecognized tax benefit liabilities, our effective tax rate in a given financial statement period could be materially affected. An unfavorable tax settlement would require use of our cash and generally result in an increase in our effective tax rate in the period of resolution. A favorable tax settlement would generally be recognized as a reduction in our effective tax rate in the period of resolution. -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Impairment of long-lived assets and definite life intangibles | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Long-lived assets and definite life intangibles are evaluated for impairment whenever events or changes in circumstances indicate the carrying value may not be recoverable. Examples include a significant adverse change in the extent or manner in which we use the asset, a change in its physical condition, or an unexpected change in financial performance. When evaluating long-lived assets and definite life intangibles for impairment, we compare the carrying value of the asset to the asset’s estimated undiscounted future cash flows. An impairment is indicated if the estimated future cash flows are less than the carrying value of the asset. For assets held for sale, we compare the carrying value of the disposal group to fair value. The impairment is the excess of the carrying value over the fair value of the asset. We recorded impairment charges related to long-lived assets and definite life intangibles of $214 million, $45 million and $262 million, in fiscal 2017, 2016 and 2015, respectively. | Our impairment analysis contains uncertainties due to judgment in assumptions, including useful lives and intended use of assets, observable market valuations, forecasted sales, operating margins, growth rates, royalty rates and discount rates based on budgets, business plans, economic projections, anticipated future cash flows and marketplace data that reflects the risk inherent in future cash flows to determine fair value. | We have not made any material changes in the accounting methodology used to evaluate the impairment of long-lived assets or definite life intangibles during the last three fiscal years. We do not believe there is a reasonable likelihood there will be a material change in the estimates or assumptions used to calculate impairments or useful lives of long-lived assets or definite life intangibles. However, if actual results are not consistent with our estimates and assumptions used to calculate estimated future cash flows, we may be exposed to impairment losses that could be material. We periodically conduct projects to strategically evaluate optimization of such items as network capacity, manufacturing efficiencies and business technology. Additionally, we continue to evaluate our international operations and strategies. If we have a significant change in strategies, outlook, or a manner in which we plan to use these assets, we may be exposed to future impairments. ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 41 Impairment of goodwill and indefinite life intangible assets Description: Goodwill is evaluated for impairment by first performing a qualitative assessment to determine whether a quantitative goodwill test is necessary. If it is determined, based on qualitative factors, the fair value of the reporting unit may be more likely than not less than its carrying amount or if significant changes to macro-economic factors related to the reporting unit have occurred that could materially impact fair value, a quantitative goodwill impairment test would be required. The quantitative test compares the fair value of a reporting unit with its carrying amount. We can elect to forgo the qualitative assessment and perform the quantitative test. In January 2017, the FASB issued updated guidance simplifying the accounting for goodwill impairment. The guidance removes Step 2 of the goodwill impairment test, which required a hypothetical purchase price allocation. A goodwill impairment will now be the amount by which a reporting unit's carrying value exceeds its fair value, not to exceed the carrying amount of goodwill. We early adopted this guidance in the third quarter of fiscal 2017; however, the adoption did not have an impact to our fiscal 2017 goodwill impairment assessment. For further description of this new guidance, refer to Part II, Item 8, Notes to Consolidated Financial Statements, Note 2: Changes in Accounting Principles. For indefinite life intangible assets, a qualitative assessment can also be performed to determine whether the existence of events and circumstances indicates it is more likely than not an intangible asset is impaired. Similar to goodwill, we can also elect to forgo the qualitative test for indefinite life intangible assets and perform the quantitative test. Upon performing the quantitative test, if the carrying value of the intangible asset exceeds its fair value, an impairment loss is recognized in an amount equal to that excess. We elected to forgo the qualitative assessment on our indefinite life intangible assets for the fiscal 2017 impairment test. We have elected to make the first day of the fourth quarter the annual impairment assessment date for goodwill and indefinite life intangible assets. However, we could be required to evaluate the recoverability of goodwill and indefinite life intangible assets prior to the required annual assessment if, among other things, we experience disruptions to the business, unexpected significant declines in operating results, divestiture of a significant component of the business or a sustained decline in market capitalization. Judgments and Uncertainties: We estimate the fair value of our reporting units using a combination of various valuation techniques, including an income approach (discounted cash flow analysis) and market approaches (EBITDA multiples of comparable publicly-traded companies and precedent transactions). Our primary technique is discounted cash flow analysis. These approaches use significant unobservable inputs, or Level 3 inputs, as defined by the fair value hierarchy and requires us to make various judgmental assumptions about sales, operating margins, growth rates and discount rates. We include assumptions about sales, operating margins and growth rates which consider our budgets, business plans and economic projections, and are believed to reflect market participant views which would exist in an exit transaction. Assumptions are also made for varying perpetual growth rates for periods beyond the long-term business plan period. Generally, we utilize normalized operating margin assumptions based on future expectations and operating margins historically realized in the reporting units' industries. Our Prepared Foods reporting unit, which is our Prepared Foods operating segment, had goodwill at September 30, 2017, totaling $3,678 million. We generally assumed operating margins in future years would be in our normalized range of 10% to 12%, as we believe this is consistent with market participant views in an exit transaction. Had we assumed future operating margins consistent with those realized in the current fiscal year, we would have failed the quantitative step of the annual impairment test, which may have resulted in a material goodwill impairment loss. The current year Prepared Foods reporting unit results were not indicative of future market participant expectations in an exit transaction primarily due to unusual items in fiscal 2017 including $213 million of charges related to an acquisition, impairment of our San Diego operation, impairment associated with the expected sale of a non-protein business, and restructuring and related charges. Additionally, we are in the process of divesting three non-protein businesses and integrating AdvancePierre’s prepared operations into the Prepared Foods reporting unit, as well as executing our Financial Fitness Program which should collectively improve operating results in future periods. To pass the first step of the annual impairment test in fiscal 2017, the Prepared Foods reporting unit’s projected operating margins, utilizing the discounted cash flow valuation technique, had to average 6.6% (breakeven). We exceeded the breakeven operating margin level for the first nine months of fiscal 2017, as well as each of the previous two fiscal years, and expect to well exceed it in fiscal 2018 and in future years. The fair value of our indefinite life intangible assets is calculated principally using relief-from-royalty and multi-period excess earnings valuation approaches, which uses significant unobservable inputs, or Level 3 inputs, as defined by the fair value hierarchy, and is believed to reflect market participant views which would exist in an exit transaction. Under these valuation approaches, we are required to make estimates and assumptions about sales, operating margins, growth rates, royalty rates and discount rates based on budgets, business plans, economic projections, anticipated future cash flows and marketplace data. Our impairment analysis contains uncertainties due to uncontrollable events that could positively or negatively impact the anticipated future economic and operating conditions. Effect if Actual Results Differ From Assumptions: We have not made any material changes in the accounting methodology used to evaluate impairment of goodwill and intangible assets during the last three years. 42 During fiscal 2017, 2016 and 2015, all of our material reporting units that underwent a quantitative test passed the goodwill impairment analysis. In fiscal 2015, we recorded a $23 million full impairment of an immaterial reporting unit’s goodwill. Some of the inherent estimates and assumptions used in determining fair value of the reporting units and indefinite life intangible assets are outside the control of management, including interest rates, cost of capital, tax rates, market EBITDA comparables and credit ratings. While we believe we have made reasonable estimates and assumptions to calculate the fair value of the reporting units and indefinite life intangibles, it is possible a material change could occur. If our actual results are not consistent with our estimates and assumptions used to calculate fair value, it could result in additional material impairments of our goodwill. All of our material reporting units' estimated fair value exceeded their carrying value by more than 20% at the date of their most recent estimated fair value determination. Consequently, we do not currently consider any of our material reporting units at significant risk of impairment. The discount rate used in our annual goodwill impairment test increased to 6.7% in fiscal 2017 from 6.2% in fiscal 2016. Discount rates continue to be low compared to historical levels. A 54% increase in the discount rate would have caused the carrying value of our Prepared Foods reporting unit, with $3,678 million of goodwill at September 30, 2017, to exceed its discounted cash flows' fair value. Our fiscal 2017, 2016, and 2015 indefinite life intangible assets impairment analysis did not result in an impairment charge. All indefinite life intangible assets’ estimated fair value exceeded their carrying value by more than 20% at the date of their most recent estimated fair value determination. Consequently, we do not currently consider any of our material indefinite life intangible assets at significant risk of impairment. The discount rate used in our annual indefinite life intangible assets impairment test was 7.9% in fiscal 2017 and fiscal 2016. A 20% increase in the discount rate would have caused the carrying value of one intangible asset, which has a carrying value of $533 million, to exceed fair value. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market risk relating to our operations results primarily from changes in commodity prices, interest rates and foreign exchange rates, as well as credit risk concentrations. To address certain of these risks, we enter into various derivative transactions as described below. If a derivative instrument is accounted for as a hedge, depending on the nature of the hedge, changes in the fair value of the instrument either will be offset against the change in fair value of the hedged assets, liabilities or firm commitments through earnings, or be recognized in other comprehensive income (loss) until the hedged item is recognized in earnings. The ineffective portion of an instrument’s change in fair value is recognized immediately. Additionally, we hold certain positions, primarily in grain and livestock futures that either do not meet the criteria for hedge accounting or are not designated as hedges. With the exception of normal purchases and normal sales that are expected to result in physical delivery, we record these positions at fair value, and the unrealized gains and losses are reported in earnings at each reporting date. Changes in market value of derivatives used in our risk management activities relating to forward sales contracts are recorded in sales. Changes in market value of derivatives used in our risk management activities surrounding inventories on hand or anticipated purchases of inventories are recorded in cost of sales. The sensitivity analyses presented below are the measures of potential losses of fair value resulting from hypothetical changes in market prices related to commodities. Sensitivity analyses do not consider the actions we may take to mitigate our exposure to changes, nor do they consider the effects such hypothetical adverse changes may have on overall economic activity. Actual changes in market prices may differ from hypothetical changes. Commodities Risk: We purchase certain commodities, such as grains and livestock in the course of normal operations. As part of our commodity risk management activities, we use derivative financial instruments, primarily futures and options, to reduce the effect of changing prices and as a mechanism to procure the underlying commodity. However, as the commodities underlying our derivative financial instruments can experience significant price fluctuations, any requirement to mark-to-market the positions that have not been designated or do not qualify as hedges could result in volatility in our results of operations. Contract terms of a hedge instrument closely mirror those of the hedged item providing a high degree of risk reduction and correlation. Contracts designated and highly effective at meeting this risk reduction and correlation criteria are recorded using hedge accounting. The following table presents a sensitivity analysis resulting from a hypothetical change of 10% in market prices as of September 30, 2017 , and October 1, 2016 , on the fair value of open positions. The fair value of such positions is a summation of the fair values calculated for each commodity by valuing each net position at quoted futures prices. The market risk exposure analysis included hedge and non-hedge derivative financial instruments. 43 Effect of 10% change in fair value | in millions | -----------------------------------+-------------+--- | 2017 | | 2016 | -----------------------------------+-------------+----+------+-- Livestock: | | -----------------------------------+-------------+--- Live Cattle | $ | 23 | | $ | 5 -----------------------------------+-------------+----+------+---+-- Lean Hogs | 16 | | 7 | -----------------------------------+-------------+----+------+-- Grain: | | -----------------------------------+-------------+--- Corn | 17 | | 26 | -----------------------------------+-------------+----+------+-- Soy Meal | 13 | | 8 | -----------------------------------+-------------+----+------+-- Interest Rate Risk: At September 30, 2017 , we had variable rate debt of $2,756 million with a weighted average interest rate of 1.9% . A hypothetical 10% increase in interest rates effective at September 30, 2017 , and October 1, 2016 , would have a minimal effect on interest expense. Additionally, changes in interest rates impact the fair value of our fixed-rate debt. At September 30, 2017 , we had fixed-rate debt of $ 7,447 million with a weighted average interest rate of 4.1% . Market risk for fixed-rate debt is estimated as the potential increase in fair value, resulting from a hypothetical 10% decrease in interest rates. A hypothetical 10% decrease in interest rates would have increased the fair value of our fixed-rate debt by approximately $ 150 million at September 30, 2017 , and $71 million at October 1, 2016 . The fair values of our debt were estimated based on quoted market prices and/or published interest rates. We have interest rate risk associated with our pension and post-retirement benefit obligations. Changes in interest rates impact the liabilities associated with these benefit plans as well as the amount of income or expense recognized for these plans. Declines in the value of the plan assets could diminish the funded status of the pension plans and potentially increase the requirements to make cash contributions to these plans. See Part II, Item 8, Notes to Consolidated Financial Statements, Note 15: Pensions and Other Postretirement Benefits for additional information. Foreign Currency Risk: We have foreign exchange exposure from fluctuations in foreign currency exchange rates primarily as a result of certain receivable and payable balances. The primary currencies we have exposure to are the Brazilian real, the British pound sterling, the Canadian dollar, the Chinese renminbi, the European euro, the Japanese yen and the Mexican peso. We periodically enter into foreign exchange forward and option contracts to hedge some portion of our foreign currency exposure. A hypothetical 10% change in foreign exchange rates effective at September 30, 2017 , and October 1, 2016 , related to the foreign exchange forward and option contracts would have a $7 million and $3 million impact, respectively, on pretax income. Concentrations of Credit Risk: Our financial instruments exposed to concentrations of credit risk consist primarily of cash equivalents and trade receivables. Our cash equivalents are in high quality securities placed with major banks and financial institutions. Concentrations of credit risk with respect to receivables are limited due to our large number of customers and their dispersion across geographic areas. We perform periodic credit evaluations of our customers’ financial condition and generally do not require collateral. At September 30, 2017 , and October 1, 2016 , 18.6% and 18.9% , respectively, of our net accounts receivable balance was due from Wal-Mart Stores, Inc. No other single customer or customer group represented greater than 10% of net accounts receivable. 44 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA TYSON FOODS, INC. CONSOLIDATED STATEMENTS OF INCOME | Three years ended September 30, 2017 | ----------------------------------------------------------+--------------------------------------+------- | in millions, except per share data | ----------------------------------------------------------+--------------------------------------+------- | 2017 | | 2016 | | | 2015 | ----------------------------------------------------------+--------------------------------------+--------+--------+---+--------+--------+-- Sales | $ | 38,260 | | $ | 36,881 | | | $ | 41,373 ----------------------------------------------------------+--------------------------------------+--------+--------+---+--------+--------+---+---+------- Cost of Sales | 33,177 | | 32,184 | | | 37,456 | ----------------------------------------------------------+--------------------------------------+--------+--------+---+--------+--------+-- Gross Profit | 5,083 | | 4,697 | | | 3,917 | ----------------------------------------------------------+--------------------------------------+--------+--------+---+--------+--------+-- Selling, General and Administrative | 2,152 | | 1,864 | | | 1,748 | ----------------------------------------------------------+--------------------------------------+--------+--------+---+--------+--------+-- Operating Income | 2,931 | | 2,833 | | | 2,169 | ----------------------------------------------------------+--------------------------------------+--------+--------+---+--------+--------+-- Other (Income) Expense: | | | | ----------------------------------------------------------+--------------------------------------+--------+--------+-- Interest income | (7 | ) | (6 | ) | | (9 | ) ----------------------------------------------------------+--------------------------------------+--------+--------+---+--------+--------+-- Interest expense | 279 | | 249 | | | 293 | ----------------------------------------------------------+--------------------------------------+--------+--------+---+--------+--------+-- Other, net | 31 | | (8 | ) | | (36 | ) ----------------------------------------------------------+--------------------------------------+--------+--------+---+--------+--------+-- Total Other (Income) Expense | 303 | | 235 | | | 248 | ----------------------------------------------------------+--------------------------------------+--------+--------+---+--------+--------+-- Income before Income Taxes | 2,628 | | 2,598 | | | 1,921 | ----------------------------------------------------------+--------------------------------------+--------+--------+---+--------+--------+-- Income Tax Expense | 850 | | 826 | | | 697 | ----------------------------------------------------------+--------------------------------------+--------+--------+---+--------+--------+-- Net Income | 1,778 | | 1,772 | | | 1,224 | ----------------------------------------------------------+--------------------------------------+--------+--------+---+--------+--------+-- Less: Net Income Attributable to Noncontrolling Interests | 4 | | 4 | | | 4 | ----------------------------------------------------------+--------------------------------------+--------+--------+---+--------+--------+-- Net Income Attributable to Tyson | $ | 1,774 | | $ | 1,768 | | | $ | 1,220 ----------------------------------------------------------+--------------------------------------+--------+--------+---+--------+--------+---+---+------- Weighted Average Shares Outstanding: | | | | ----------------------------------------------------------+--------------------------------------+--------+--------+-- Class A Basic | 296 | | 315 | | | 335 | ----------------------------------------------------------+--------------------------------------+--------+--------+---+--------+--------+-- Class B Basic | 70 | | 70 | | | 70 | ----------------------------------------------------------+--------------------------------------+--------+--------+---+--------+--------+-- Diluted | 370 | | 390 | | | 413 | ----------------------------------------------------------+--------------------------------------+--------+--------+---+--------+--------+-- Net Income Per Share Attributable to Tyson: | | | | ----------------------------------------------------------+--------------------------------------+--------+--------+-- Class A Basic | $ | 4.94 | | $ | 4.67 | | | $ | 3.06 ----------------------------------------------------------+--------------------------------------+--------+--------+---+--------+--------+---+---+------- Class B Basic | $ | 4.45 | | $ | 4.24 | | | $ | 2.79 ----------------------------------------------------------+--------------------------------------+--------+--------+---+--------+--------+---+---+------- Diluted | $ | 4.79 | | $ | 4.53 | | | $ | 2.95 ----------------------------------------------------------+--------------------------------------+--------+--------+---+--------+--------+---+---+------- Dividends Declared Per Share: | | | | ----------------------------------------------------------+--------------------------------------+--------+--------+-- Class A | $ | 0.975 | | $ | 0.650 | | | $ | 0.425 ----------------------------------------------------------+--------------------------------------+--------+--------+---+--------+--------+---+---+------- Class B | $ | 0.878 | | $ | 0.585 | | | $ | 0.383 ----------------------------------------------------------+--------------------------------------+--------+--------+---+--------+--------+---+---+------- See accompanying notes. 45 TYSON FOODS, INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME | Three years ended September 30, 2017 | --------------------------------------------------------------------+--------------------------------------+------ | in millions | --------------------------------------------------------------------+--------------------------------------+------ | 2017 | | 2016 | | | 2015 | --------------------------------------------------------------------+--------------------------------------+-------+-------+---+-------+-------+-- Net Income | $ | 1,778 | | $ | 1,772 | | | $ | 1,224 --------------------------------------------------------------------+--------------------------------------+-------+-------+---+-------+-------+---+---+------ Other Comprehensive Income (Loss), Net of Taxes: | | | | --------------------------------------------------------------------+--------------------------------------+-------+-------+-- Derivatives accounted for as cash flow hedges | — | | (1 | ) | | 2 | --------------------------------------------------------------------+--------------------------------------+-------+-------+---+-------+-------+-- Investments | (1 | ) | — | | | (1 | ) --------------------------------------------------------------------+--------------------------------------+-------+-------+---+-------+-------+-- Currency translation | 6 | | 4 | | | 36 | --------------------------------------------------------------------+--------------------------------------+-------+-------+---+-------+-------+-- Postretirement benefits | 56 | | 42 | | | 20 | --------------------------------------------------------------------+--------------------------------------+-------+-------+---+-------+-------+-- Total Other Comprehensive Income (Loss), Net of Taxes | 61 | | 45 | | | 57 | --------------------------------------------------------------------+--------------------------------------+-------+-------+---+-------+-------+-- Comprehensive Income | 1,839 | | 1,817 | | | 1,281 | --------------------------------------------------------------------+--------------------------------------+-------+-------+---+-------+-------+-- Less: Comprehensive Income Attributable to Noncontrolling Interests | 4 | | 4 | | | 4 | --------------------------------------------------------------------+--------------------------------------+-------+-------+---+-------+-------+-- Comprehensive Income Attributable to Tyson | $ | 1,835 | | $ | 1,813 | | | $ | 1,277 --------------------------------------------------------------------+--------------------------------------+-------+-------+---+-------+-------+---+---+------ See accompanying notes. 46 TYSON FOODS, INC. CONSOLIDATED BALANCE SHEETS September 30, 2017, and October 1, 2016 | --------------------------------------------------------------------------------------------------------+------- in millions, except share and per share data | --------------------------------------------------------------------------------------------------------+------- | 2017 | | 2016 | --------------------------------------------------------------------------------------------------------+--------+--------+--------+-- Assets | | --------------------------------------------------------------------------------------------------------+--------+------- Current Assets: | | --------------------------------------------------------------------------------------------------------+--------+------- Cash and cash equivalents | $ | 318 | | $ | 349 --------------------------------------------------------------------------------------------------------+--------+--------+--------+---+------- Accounts receivable, net | 1,675 | | 1,542 | --------------------------------------------------------------------------------------------------------+--------+--------+--------+-- Inventories | 3,239 | | 2,732 | --------------------------------------------------------------------------------------------------------+--------+--------+--------+-- Other current assets | 219 | | 265 | --------------------------------------------------------------------------------------------------------+--------+--------+--------+-- Assets held for sale | 807 | | — | --------------------------------------------------------------------------------------------------------+--------+--------+--------+-- Total Current Assets | 6,258 | | 4,888 | --------------------------------------------------------------------------------------------------------+--------+--------+--------+-- Net Property, Plant and Equipment | 5,568 | | 5,170 | --------------------------------------------------------------------------------------------------------+--------+--------+--------+-- Goodwill | 9,324 | | 6,669 | --------------------------------------------------------------------------------------------------------+--------+--------+--------+-- Intangible Assets, net | 6,243 | | 5,084 | --------------------------------------------------------------------------------------------------------+--------+--------+--------+-- Other Assets | 673 | | 562 | --------------------------------------------------------------------------------------------------------+--------+--------+--------+-- Total Assets | $ | 28,066 | | $ | 22,373 --------------------------------------------------------------------------------------------------------+--------+--------+--------+---+------- Liabilities and Shareholders’ Equity | | --------------------------------------------------------------------------------------------------------+--------+------- Current Liabilities: | | --------------------------------------------------------------------------------------------------------+--------+------- Current debt | $ | 906 | | $ | 79 --------------------------------------------------------------------------------------------------------+--------+--------+--------+---+------- Accounts payable | 1,698 | | 1,511 | --------------------------------------------------------------------------------------------------------+--------+--------+--------+-- Other current liabilities | 1,424 | | 1,172 | --------------------------------------------------------------------------------------------------------+--------+--------+--------+-- Liabilities held for sale | 4 | | — | --------------------------------------------------------------------------------------------------------+--------+--------+--------+-- Total Current Liabilities | 4,032 | | 2,762 | --------------------------------------------------------------------------------------------------------+--------+--------+--------+-- Long-Term Debt | 9,297 | | 6,200 | --------------------------------------------------------------------------------------------------------+--------+--------+--------+-- Deferred Income Taxes | 2,979 | | 2,545 | --------------------------------------------------------------------------------------------------------+--------+--------+--------+-- Other Liabilities | 1,199 | | 1,242 | --------------------------------------------------------------------------------------------------------+--------+--------+--------+-- Commitments and Contingencies (Note 20) | | | --------------------------------------------------------------------------------------------------------+--------+--------+------- Shareholders’ Equity: | | --------------------------------------------------------------------------------------------------------+--------+------- Common stock ($0.10 par value): | | --------------------------------------------------------------------------------------------------------+--------+------- Class A-authorized 900 million shares, issued 378 million shares in 2017 and 364 million shares in 2016 | 38 | | 36 | --------------------------------------------------------------------------------------------------------+--------+--------+--------+-- Convertible Class B-authorized 900 million shares, issued 70 million shares | 7 | | 7 | --------------------------------------------------------------------------------------------------------+--------+--------+--------+-- Capital in excess of par value | 4,378 | | 4,355 | --------------------------------------------------------------------------------------------------------+--------+--------+--------+-- Retained earnings | 9,776 | | 8,348 | --------------------------------------------------------------------------------------------------------+--------+--------+--------+-- Accumulated other comprehensive gain (loss) | 16 | | (45 | ) --------------------------------------------------------------------------------------------------------+--------+--------+--------+-- Treasury stock, at cost – 80 million shares in 2017 and 73 million shares in 2016 | (3,674 | ) | (3,093 | ) --------------------------------------------------------------------------------------------------------+--------+--------+--------+-- Total Tyson Shareholders’ Equity | 10,541 | | 9,608 | --------------------------------------------------------------------------------------------------------+--------+--------+--------+-- Noncontrolling Interests | 18 | | 16 | --------------------------------------------------------------------------------------------------------+--------+--------+--------+-- Total Shareholders’ Equity | 10,559 | | 9,624 | --------------------------------------------------------------------------------------------------------+--------+--------+--------+-- Total Liabilities and Shareholders’ Equity | $ | 28,066 | | $ | 22,373 --------------------------------------------------------------------------------------------------------+--------+--------+--------+---+------- See accompanying notes. 47 TYSON FOODS, INC. CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY | | | | | Three years ended September 30, 2017 -----------------------------------------------------------+--------+---+-------+--------+------------------------------------- | | | | | | in millions | -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+------ | 2017 | | 2016 | | 2015 -----------------------------------------------------------+--------+---+-------+--------+------------------------------------- | Shares | | | Amount | | Shares | | | Amount | | | Shares | | | Amount | -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+---+----+--------+---+-----+--------+-- Class A Common Stock: | | | | | | | | | | -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+-- Balance at beginning of year | 364 | | | $ | 36 | | 346 | | | $ | 35 | | | 346 | | | $ | 35 -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+---+----+--------+---+-----+--------+---+---+--- Issuance of Class A common stock | 14 | | | 2 | | 18 | | | 1 | | | — | | | — | -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+---+----+--------+---+-----+--------+-- Balance at end of year | 378 | | | 38 | | 364 | | | 36 | | | 346 | | | 35 | -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+---+----+--------+---+-----+--------+-- Class B Common Stock: | | | | | | | | | | -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+-- Balance at beginning and end of year | 70 | | | 7 | | 70 | | | 7 | | | 70 | | | 7 | -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+---+----+--------+---+-----+--------+-- Capital in Excess of Par Value: | | | | | | | | | | -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+-- Balance at beginning of year | | | 4,355 | | | | 4,307 | | | | | 4,257 | -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+---+----+--------+-- Stock-based compensation | | | 23 | | | | 48 | | | | | 50 | -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+---+----+--------+-- Balance at end of year | | | 4,378 | | | | 4,355 | | | | | 4,307 | -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+---+----+--------+-- Retained Earnings: | | | | | | | | | | -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+-- Balance at beginning of year | | | 8,348 | | | | 6,813 | | | | | 5,748 | -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+---+----+--------+-- Net income attributable to Tyson | | | 1,774 | | | | 1,768 | | | | | 1,220 | -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+---+----+--------+-- Dividends | | | (346 | ) | | | (233 | ) | | | | (155 | ) -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+---+----+--------+-- Balance at end of year | | | 9,776 | | | | 8,348 | | | | | 6,813 | -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+---+----+--------+-- Accumulated Other Comprehensive Income (Loss), Net of Tax: | | | | | | | | | | -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+-- Balance at beginning of year | | | (45 | ) | | | (90 | ) | | | | (147 | ) -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+---+----+--------+-- Other Comprehensive Income (Loss) | | | 61 | | | | 45 | | | | | 57 | -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+---+----+--------+-- Balance at end of year | | | 16 | | | | (45 | ) | | | | (90 | ) -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+---+----+--------+-- Treasury Stock: | | | | | | | | | | -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+-- Balance at beginning of year | 73 | | | (3,093 | ) | 47 | | | (1,381 | ) | | 40 | | | (1,010 | ) -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+---+----+--------+---+-----+--------+-- Purchase of Class A common stock | 14 | | | (860 | ) | 32 | | | (1,944 | ) | | 12 | | | (495 | ) -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+---+----+--------+---+-----+--------+-- Stock-based compensation | (7 | ) | | 279 | | (6 | ) | | 232 | | | (5 | ) | | 124 | -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+---+----+--------+---+-----+--------+-- Balance at end of year | 80 | | | (3,674 | ) | 73 | | | (3,093 | ) | | 47 | | | (1,381 | ) -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+---+----+--------+---+-----+--------+-- Total Shareholders’ Equity Attributable to Tyson | | | $ | 10,541 | | | | $ | 9,608 | | | | | $ | 9,691 | -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+---+----+--------+---+-----+--------+-- Equity Attributable to Noncontrolling Interests: | | | | | | | | | | -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+-- Balance at beginning of year | | | $ | 16 | | | | $ | 15 | | | | | $ | 14 | -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+---+----+--------+---+-----+--------+-- Net income attributable to noncontrolling interests | | | 4 | | | | 4 | | | | | 4 | -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+---+----+--------+-- Contributions by noncontrolling interest | | | — | | | | — | | | | | — | -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+---+----+--------+-- Distributions to noncontrolling interest | | | (2 | ) | | | (3 | ) | | | | (1 | ) -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+---+----+--------+-- Net foreign currency translation adjustment and other | | | — | | | | — | | | | | (2 | ) -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+---+----+--------+-- Total Equity Attributable to Noncontrolling Interests | | | $ | 18 | | | | $ | 16 | | | | | $ | 15 | -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+---+----+--------+---+-----+--------+-- Total Shareholders’ Equity | | | $ | 10,559 | | | | $ | 9,624 | | | | | $ | 9,706 | -----------------------------------------------------------+--------+---+-------+--------+--------------------------------------+-------------+-------+---+--------+---+----+--------+---+-----+--------+-- See accompanying notes. 48 TYSON FOODS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS | Three years ended September 30, 2017 | ------------------------------------------------------------------------------+--------------------------------------+------ | in millions | ------------------------------------------------------------------------------+--------------------------------------+------ | 2017 | | 2016 | | | 2015 | ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Cash Flows From Operating Activities: | | | | ------------------------------------------------------------------------------+--------------------------------------+-------+--------+-- Net income | $ | 1,778 | | $ | 1,772 | | | $ | 1,224 ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+---+---+------ Adjustments to reconcile net income to cash provided by operating activities: | | | | ------------------------------------------------------------------------------+--------------------------------------+-------+--------+-- Depreciation | 642 | | 617 | | | 609 | ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Amortization | 119 | | 88 | | | 102 | ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Deferred income taxes | (39 | ) | 84 | | | 38 | ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Loss on dispositions of businesses | — | | — | | | (177 | ) ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Impairment of assets | 214 | | 45 | | | 285 | ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Share-based compensation expense | 92 | | 81 | | | 69 | ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Other, net | (57 | ) | (34 | ) | | 71 | ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- (Increase) decrease in accounts receivable | (55 | ) | 73 | | | 66 | ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- (Increase) decrease in inventories | (246 | ) | 148 | | | 220 | ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Increase (decrease) in accounts payable | 61 | | (130 | ) | | (162 | ) ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Increase (decrease) in income taxes payable/receivable | 55 | | (19 | ) | | 177 | ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Increase (decrease) in interest payable | 16 | | (1 | ) | | (23 | ) ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Net changes in other operating assets and liabilities | 19 | | (8 | ) | | 71 | ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Cash Provided by Operating Activities | 2,599 | | 2,716 | | | 2,570 | ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Cash Flows From Investing Activities: | | | | ------------------------------------------------------------------------------+--------------------------------------+-------+--------+-- Additions to property, plant and equipment | (1,069 | ) | (695 | ) | | (854 | ) ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Purchases of marketable securities | (79 | ) | (46 | ) | | (38 | ) ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Proceeds from sale of marketable securities | 61 | | 37 | | | 52 | ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Acquisitions, net of cash acquired | (3,081 | ) | — | | | — | ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Proceeds from sale of businesses | — | | — | | | 539 | ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Other, net | 4 | | 20 | | | 31 | ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Cash Used for Investing Activities | (4,164 | ) | (684 | ) | | (270 | ) ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Cash Flows From Financing Activities: | | | | ------------------------------------------------------------------------------+--------------------------------------+-------+--------+-- Payments on debt | (3,159 | ) | (714 | ) | | (1,995 | ) ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Proceeds from issuance of long-term debt | 5,444 | | 1 | | | 501 | ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Borrowings on revolving credit facility | 1,810 | | 1,065 | | | 1,345 | ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Payments on revolving credit facility | (2,110 | ) | (765 | ) | | (1,345 | ) ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Proceeds from issuance of commercial paper | 8,138 | | — | | | — | ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Repayments of commercial paper | (7,360 | ) | — | | | — | ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Payment of AdvancePierre TRA liability | (223 | ) | — | | | — | ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Purchases of Tyson Class A common stock | (860 | ) | (1,944 | ) | | (495 | ) ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Dividends | (319 | ) | (216 | ) | | (147 | ) ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Stock options exercised | 154 | | 128 | | | 84 | ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Other, net | 15 | | 68 | | | 17 | ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Cash Provided by (Used for) Financing Activities | 1,530 | | (2,377 | ) | | (2,035 | ) ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Effect of Exchange Rate Change on Cash | 4 | | 6 | | | (15 | ) ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Decrease in Cash and Cash Equivalents | (31 | ) | (339 | ) | | 250 | ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Cash and Cash Equivalents at Beginning of Year | 349 | | 688 | | | 438 | ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+-- Cash and Cash Equivalents at End of Year | $ | 318 | | $ | 349 | | | $ | 688 ------------------------------------------------------------------------------+--------------------------------------+-------+--------+---+-------+--------+---+---+------ See accompanying notes. 49 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS TYSON FOODS, INC. NOTE 1: BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Description of Business: Tyson Foods, Inc. (collectively, “Company,” “we,” “us” or “our”), is one of the world's largest food companies and a recognized leader in protein. Founded in 1935 by John W. Tyson and grown under three generations of family leadership, the Company has a broad portfolio of products and brands like Tyson®, Jimmy Dean®, Hillshire Farm®, Ball Park®, Wright®, Aidells®, ibp® and State Fair®. We innovate continually to make protein more sustainable, tailor food for everywhere it’s available and raise the world’s expectations for how much good food can do. Consolidation: The consolidated financial statements include the accounts of all wholly-owned subsidiaries, as well as majority-owned subsidiaries over which we exercise control and, when applicable, entities for which we have a controlling financial interest or variable interest entities for which we are the primary beneficiary. All significant intercompany accounts and transactions have been eliminated in consolidation. Fiscal Year: We utilize a 52- or 53-week accounting period ending on the Saturday closest to September 30. The Company’s accounting cycle resulted in a 52-week year for fiscal 2017 and fiscal 2016 and a 53-week year for fiscal 2015 . Cash and Cash Equivalents: Cash equivalents consist of investments in short-term, highly liquid securities having original maturities of three months or less, which are made as part of our cash management activity. The carrying values of these assets approximate their fair values. We primarily utilize a cash management system with a series of separate accounts consisting of lockbox accounts for receiving cash, concentration accounts where funds are moved to, and several zero-balance disbursement accounts for funding payroll, accounts payable, livestock procurement, grower payments, etc. As a result of our cash management system, checks issued, but not presented to the banks for payment, may result in negative book cash balances. These negative book cash balances are included in accounts payable and other current liabilities. At September 30, 2017 , and October 1, 2016 , checks outstanding in excess of related book cash balances totaled approximately $237 million and $261 million , respectively. Accounts Receivable: We record accounts receivable at net realizable value. This value includes an appropriate allowance for estimated uncollectible accounts to reflect any loss anticipated on the accounts receivable balances and charged to the provision for doubtful accounts. We calculate this allowance based on our history of write-offs, level of past due accounts and relationships with and economic status of our customers. At September 30, 2017 , and October 1, 2016 , our allowance for uncollectible accounts was $34 million and $33 million , respectively. We generally do not have collateral for our receivables, but we do periodically evaluate the credit worthiness of our customers. Inventories: Processed products, livestock and supplies and other are valued at the lower of cost or market. Cost includes purchased raw materials, live purchase costs, growout costs (primarily feed, grower pay and catch and haul costs), labor and manufacturing and production overhead, which are related to the purchase and production of inventories. In fiscal 2017, 63% of the cost of inventories was determined by the first-in, first-out ("FIFO") method as compared to 61% in fiscal 2016. The remaining cost of inventories for both years is determined by the weighted-average method. The following table reflects the major components of inventory at September 30, 2017 , and October 1, 2016 : | | | in millions | -------------------+------+-------+-------------+----- | 2017 | | | 2016 | -------------------+------+-------+-------------+------+-- Processed products | $ | 1,947 | | | $ | 1,530 -------------------+------+-------+-------------+------+---+------ Livestock | 874 | | | 772 | -------------------+------+-------+-------------+------+-- Supplies and other | 418 | | | 430 | -------------------+------+-------+-------------+------+-- Total inventory | $ | 3,239 | | | $ | 2,732 -------------------+------+-------+-------------+------+---+------ Property, Plant and Equipment: Property, plant and equipment are stated at cost and generally depreciated on a straight-line method over the estimated lives for buildings and leasehold improvements of 10 to 33 years , machinery and equipment of three to 12 years and land improvements and other of three to 20 years . Major repairs and maintenance costs that significantly extend the useful life of the related assets are capitalized. Normal repairs and maintenance costs are charged to operations. We review the carrying value of long-lived assets at each balance sheet date if indication of impairment exists. Recoverability is assessed using undiscounted cash flows based on historical results and current projections of earnings before interest, taxes, depreciation and amortization. We measure impairment as the excess of carrying value over the fair value of an asset. The fair value of an asset is generally measured using discounted cash flows including market participant assumptions of future operating results and discount rates. 50 Goodwill and Intangible Assets: Definite life intangibles are initially recorded at fair value and amortized over the estimated period of benefit. Brands and trademarks are generally amortized using the straight-line method over 20 years or less. Customer relationships are generally amortized over seven to 20 years based on the pattern of revenue expected to be generated from the use of the asset. Amortization expense is generally recognized in selling, general, and administrative expense. We review the carrying value of definite life intangibles at each balance sheet date if indication of impairment exists. Recoverability is assessed using undiscounted cash flows based on historical results and current projections of earnings before interest, taxes, depreciation and amortization. We measure impairment as the excess of carrying value over the fair value of the definite life intangible asset. We use various valuation techniques to estimate fair value, with the primary techniques being discounted cash flows, relief-from-royalty and multi-period excess earnings valuation approaches, which use significant unobservable inputs, or Level 3 inputs, as defined by the fair value hierarchy. Under these valuation approaches, we are required to make estimates and assumptions about sales, operating margins, growth rates, royalty rates and discount rates based on budgets, business plans, economic projections, anticipated future cash flows and marketplace data. Goodwill and indefinite life intangible assets are initially recorded at fair value and not amortized, but are reviewed for impairment at least annually or more frequently if impairment indicators arise. Our goodwill is allocated by reporting unit and is evaluated for impairment by first performing a qualitative assessment to determine whether a quantitative goodwill test is necessary. If it is determined, based on qualitative factors, the fair value of the reporting unit may be more likely than not less than carrying amount, or if significant changes to macro-economic factors related to the reporting unit have occurred that could materially impact fair value, a quantitative goodwill impairment test would be required. Additionally, we can elect to forgo the qualitative assessment and perform the quantitative test. In January 2017, the Financial Accounting Standards Board (“FASB”) issued updated guidance simplifying the accounting for goodwill impairment. The guidance removes Step 2 of the goodwill impairment test, which required a hypothetical purchase price allocation. A goodwill impairment will now be the amount by which a reporting unit's carrying value exceeds its fair value, not to exceed the carrying amount of goodwill. We early adopted this guidance in the third quarter of fiscal 2017; however, the adoption did not have an impact to our fiscal 2017 goodwill impairment assessment. We have elected to make the first day of the fourth quarter the annual impairment assessment date for goodwill and indefinite life intangible assets. We estimate the fair value of our reporting units using a combination of various valuation techniques, including an income approach (discounted cash flow analysis) and market approaches (earnings before interest, taxes, depreciation and amortization or "EBITDA" multiples of comparable publicly-traded companies and precedent transactions). Our primary technique is discounted cash flow analysis. These approaches use significant unobservable inputs, or Level 3 inputs, as defined by the fair value hierarchy and requires us to make various judgmental assumptions about sales, operating margins, growth rates and discount rates which consider our budgets, business plans and economic projections, and are believed to reflect market participant views which would exist in an exit transaction. Assumptions are also made for varying perpetual growth rates for periods beyond the long-term business plan period. Generally, we utilize normalized operating margin assumptions based on future expectations and operating margins historically realized in the reporting units' industries. Some of the inherent estimates and assumptions used in determining fair value of the reporting units are outside the control of management, including interest rates, cost of capital, tax rates, market EBITDA comparables and credit ratings. While we believe we have made reasonable estimates and assumptions to calculate the fair value of the reporting units, it is possible a material change could occur. If our actual results are not consistent with our estimates and assumptions used to calculate fair value, it could result in additional material impairments of our goodwill. The discount rate used in our annual goodwill impairment test increased to 6.7% in fiscal 2017 from 6.2% in fiscal 2016. During fiscal 2017, 2016 and 2015, the fair value of each of our material reporting units' exceeded its carrying value. In fiscal 2015, we recorded a $23 million full impairment of an immaterial reporting unit’s goodwill. For our indefinite life intangible assets, a qualitative assessment can also be performed to determine whether the existence of events and circumstances indicates it is more likely than not an intangible asset is impaired. Similar to goodwill, we can also elect to forgo the qualitative test for indefinite life intangible assets and perform the quantitative test. Upon performing the quantitative test, if the carrying value of the intangible asset exceeds its fair value, an impairment loss is recognized in an amount equal to that excess. The fair value of our indefinite life intangible assets is calculated principally using relief-from-royalty and multi-period excess earnings valuation approaches, which use significant unobservable inputs, or Level 3 inputs, as defined by the fair value hierarchy, and is believed to reflect market participant views which would exist in an exit transaction. Under these valuation approaches, we are required to make estimates and assumptions about sales, operating margins, growth rates, royalty rates and discount rates based on budgets, business plans, economic projections, anticipated future cash flows and marketplace data. During fiscal 2017, 2016 and 2015, the fair value of each of our indefinite life intangible assets exceeded its carrying value. The discount rate used in our indefinite life intangible test was 7.9% in fiscal 2017 and 2016. 51 Investments: We have investments in joint ventures and other entities. We generally use the cost method of accounting when our voting interests are less than 20 percent. We use the equity method of accounting when our voting interests are in excess of 20 percent and we do not have a controlling interest or a variable interest in which we are the primary beneficiary. Investments in joint ventures and other entities are reported in the Consolidated Balance Sheets in Other Assets. We also have investments in marketable debt securities. We have determined all of our marketable debt securities are available-for-sale investments. These investments are reported at fair value based on quoted market prices as of the balance sheet date, with unrealized gains and losses, net of tax, recorded in other comprehensive income. The amortized cost of debt securities is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization is recorded in interest income. The cost of securities sold is based on the specific identification method. Realized gains and losses on the sale of debt securities and declines in value judged to be other than temporary are recorded on a net basis in other income. Interest and dividends on securities classified as available-for-sale are recorded in interest income. Accrued Self-Insurance: We use a combination of insurance and self-insurance mechanisms in an effort to mitigate the potential liabilities for health and welfare, workers’ compensation, auto liability and general liability risks. Liabilities associated with our risks retained are estimated, in part, by considering claims experience, demographic factors, severity factors and other actuarial assumptions. Other Current Liabilities: Other current liabilities at September 30, 2017 , and October 1, 2016 , include: | in millions | -----------------------------------------------------+-------------+------ | 2017 | | 2016 | -----------------------------------------------------+-------------+-------+------+-- Accrued salaries, wages and benefits | $ | 673 | | $ | 563 -----------------------------------------------------+-------------+-------+------+---+------ Accrued marketing, advertising and promotion expense | 146 | | 212 | -----------------------------------------------------+-------------+-------+------+-- Other | 605 | | 397 | -----------------------------------------------------+-------------+-------+------+-- Total other current liabilities | $ | 1,424 | | $ | 1,172 -----------------------------------------------------+-------------+-------+------+---+------ Defined Benefit Plans: We recognize the funded status of defined pension and postretirement plans in the Consolidated Balance Sheets. The funded status is measured as the difference between the fair value of the plan assets and the benefit obligation. We measure our plan assets and liabilities at the end of our fiscal year. For a defined benefit pension plan, the benefit obligation is the projected benefit obligation; for any other defined benefit postretirement plan, such as a retiree health care plan, the benefit obligation is the accumulated postretirement benefit obligation. Any overfunded status is recognized as an asset and any underfunded status is recognized as a liability. Any transitional asset/liability, prior service cost or actuarial gain/loss that has not yet been recognized as a component of net periodic cost is recognized in accumulated other comprehensive income. Accumulated other comprehensive income will be adjusted as these amounts are subsequently recognized as a component of net periodic benefit costs in future periods. Derivative Financial Instruments: We purchase certain commodities, such as grains and livestock in the course of normal operations. As part of our commodity risk management activities, we use derivative financial instruments, primarily futures and options, to reduce our exposure to various market risks related to these purchases, as well as to changes in foreign currency exchange rates. Contract terms of a financial instrument qualifying as a hedge instrument closely mirror those of the hedged item, providing a high degree of risk reduction and correlation. Contracts designated and highly effective at meeting risk reduction and correlation criteria are recorded using hedge accounting. If a derivative instrument is accounted for as a hedge, changes in the fair value of the instrument will be offset either against the change in fair value of the hedged assets, liabilities or firm commitments through earnings or recognized in other comprehensive income (loss) until the hedged item is recognized in earnings. The ineffective portion of an instrument’s change in fair value is immediately recognized in earnings as a component of cost of sales. Instruments we hold as part of our risk management activities that do not meet the criteria for hedge accounting are marked to fair value with unrealized gains or losses reported currently in earnings. Changes in market value of derivatives used in our risk management activities relating to forward sales contracts are recorded in sales, while changes surrounding inventories on hand or anticipated purchases of inventories or supplies are recorded in cost of sales. We generally do not hedge anticipated transactions beyond 18 months. Litigation Reserves: There are a variety of legal proceedings pending or threatened against us. Accruals are recorded when it is probable a liability has been incurred and the amount of the liability can be reasonably estimated based on current law, progress of each case, opinions and views of legal counsel and other advisers, our experience in similar matters and intended response to the litigation. These amounts, which are not discounted and are exclusive of claims against third parties, are adjusted periodically as assessment efforts progress or additional information becomes available. We expense amounts for administering or litigating claims as incurred. Accruals for legal proceedings are included in Other current liabilities in the Consolidated Balance Sheets. Revenue Recognition: We recognize revenue when title and risk of loss are transferred to customers, which is generally on delivery based on terms of sale. Revenue is recognized as the net amount estimated to be received after deducting estimated amounts for discounts, trade allowances and product returns. 52 Freight Expense: Freight expense associated with products shipped to customers is recognized in cost of sales. Marketing and Promotion Costs: We promote our products with marketing, advertising, trade promotions, and consumer incentives, which include, but are not limited to, coupons, discounts, rebates, and volume-based incentives. Marketing and promotion costs are charged to operations in the period incurred. Customer incentive and trade promotion activities are recorded as a reduction to sales based on amounts estimated as being due to customers, based primarily on historical utilization and redemption rates, while other marketing and promotional activities are recorded as selling, general and administrative expense. Advertising Expenses: Advertising expense is charged to operations in the period incurred and is recorded as selling, general and administrative expense. Advertising expense totaled $ 238 million , $238 million and $181 million in fiscal 2017 , 2016 and 2015 , respectively. Research and Development: Research and development costs are expensed as incurred. Research and development costs totaled $113 million , $96 million and $75 million in fiscal 2017 , 2016 and 2015 , respectively. Use of Estimates: The consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States, which require us to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. Recently Issued Accounting Pronouncements: In August 2017, the FASB issued guidance that eases certain documentation and assessment requirements of hedge effectiveness and modifies the accounting for components excluded from the assessment. Some of the modifications include the ineffectiveness of derivative gain/loss in highly effective cash flow hedge to be recorded in OCI, the change in fair value of derivative to be recorded in the same income statement line as hedged item, and additional disclosures required on the cumulative basis adjustment in fair value hedges and the effect of hedging on financial statement lines for components excluded from the assessment. The amendment also simplifies the application of hedge accounting in certain situations to permit new hedging strategies to be eligible for hedge accounting. The guidance is effective for annual reporting periods and interim periods within those annual reporting periods beginning after December 15, 2018, our fiscal 2020. Early adoption is permitted and the modified retrospective transition method should be applied. We are currently evaluating the impact this guidance will have on our consolidated financial statements. In May 2017, the FASB issued guidance that clarifies which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting in Topic 718. The guidance is effective for annual reporting periods and interim periods within those annual reporting periods beginning after December 15, 2017, our fiscal 2019. Early adoption is permitted and the prospective transition method should be applied to awards modified on or after the adoption date. We are currently evaluating the impact this guidance will have on our consolidated financial statements. In March 2017, the FASB issued guidance which shortens the amortization period for certain callable debt securities held at a premium. Specifically, the amendments require the premium to be amortized to the earliest call date. The guidance is effective for annual reporting periods and interim periods within those annual reporting periods beginning after December 15, 2018, our fiscal 2020. Early adoption is permitted and the modified retrospective transition method should be applied. We are currently evaluating the impact this guidance will have on our consolidated financial statements. In March 2017, the FASB issued guidance which will change the presentation of net periodic benefit cost related to employer sponsored defined benefit plans and other postretirement benefits. Service cost will be included within the same income statement line item as other compensation costs arising from services rendered during the period, while other components of net periodic benefit pension cost will be presented separately outside of operating income. Additionally, only the service cost component will be eligible for capitalization when applicable. The guidance is effective for annual reporting periods and interim periods within those annual reporting periods beginning after December 15, 2017, our fiscal 2019. Early adoption is permitted and the retrospective transition method should be applied for the presentation of the service cost component and the other components of net periodic pension cost and net periodic postretirement benefit cost in the income statement, and the prospective transition method should be applied, on and after the effective date, for the capitalization of the service cost component of net periodic pension cost and net periodic postretirement benefit in assets. We plan to adopt this guidance beginning in the first quarter of fiscal 2019. We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements. In November 2016, the FASB issued guidance which requires entities to show the changes in the total of cash, cash equivalents, restricted cash and restricted cash equivalents in the statement of cash flows. The guidance is effective for annual reporting periods and interim periods within those annual reporting periods beginning after December 15, 2017, our fiscal 2019. Early adoption is permitted and the retrospective transition method should be applied. We are currently evaluating the impact this guidance will have on our consolidated financial statements. 53 In October 2016, the FASB issued guidance which requires companies to recognize the income tax effects of intercompany sales and transfers of assets, other than inventory, in the period in which the transfer occurs. The guidance is effective for annual reporting periods and interim periods within those annual reporting periods beginning after December 15, 2017, our fiscal 2019. Early adoption is permitted and the modified retrospective transition method should be applied. We are currently evaluating the impact this guidance will have on our consolidated financial statements. In August 2016, the FASB issued guidance which aims to eliminate diversity in practice in how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The guidance is effective for annual reporting periods and interim periods within those annual reporting periods beginning after December 15, 2017, our fiscal 2019. Early adoption is permitted and the retrospective transition method should be applied. We are currently evaluating the impact this guidance will have on our consolidated financial statements. In June 2016, the FASB issued guidance that provides more decision-useful information about the expected credit losses on financial instruments and changes the loss impairment methodology. The guidance is effective for annual reporting periods and interim periods within those annual reporting periods beginning after December 15, 2019, our fiscal 2021. Early adoption is permitted for annual reporting periods and interim periods within those annual reporting periods beginning after December 15, 2018, our fiscal 2020. The application of the guidance requires various transition methods depending on the specific amendment. We are currently evaluating the impact this guidance will have on our consolidated financial statements. In March 2016, the FASB issued guidance which simplifies several aspects of the accounting for employee share-based payment transactions, including the accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classification of related amounts within the statement of cash flows and impact on earnings per share. The guidance is effective for annual reporting periods and interim periods within those annual reporting periods beginning after December 15, 2016, our fiscal 2018. Early adoption is permitted and the application of the guidance requires various transition methods depending on the specific amendment. We adopted this guidance in the first quarter of fiscal 2018. The guidance requires all income tax effects of share-based payment awards to be recognized in the consolidated statements of income when the awards vest or are settled, which is a change from the current guidance that requires such activity to be recorded in capital in excess of par value within stockholders' equity. We adopted this guidance prospectively which may create volatility in our effective tax rate when adopted depending largely on future events and other factors which may include our stock price, timing of stock option exercises, and the value realized upon vesting or exercise of shares compared to the grant date fair value of those shares. Under the new guidance, companies can also make an accounting policy election to either estimate forfeitures each period or to account for forfeitures as they occur. We changed our accounting policy to account for forfeitures as they occur using the modified retrospective transition method and expect the impact of this change on our consolidated financial statements to be immaterial. The guidance also changes the presentation of excess tax benefits from a financing activity to an operating activity in the consolidated statements of cash flows. We applied this change prospectively and do not expect a material impact on our consolidated statements of cash flows. In February 2016, the FASB issued guidance which created new accounting and reporting guidelines for leasing arrangements. The guidance requires lessees to recognize a right-of-use asset and lease liability for all leases with terms of more than 12 months. Recognition, measurement and presentation of expenses and cash flows arising from a lease will depend on classification as a finance or operating lease. The guidance also requires qualitative and quantitative disclosures regarding the amount, timing, and uncertainty of cash flows arising from leases. The guidance is effective for annual reporting periods and interim periods within those annual reporting periods beginning after December 15, 2018, our fiscal 2020. Early adoption is permitted and the modified retrospective method should be applied. While we are still evaluating the impact this guidance will have on our consolidated financial statements and related disclosures, we have completed our initial scoping reviews and have made progress in our assessment phase as we continue to identify our leasing processes that will be impacted by the new standard. We have also made progress in developing the policy elections we will make upon adoption and we are implementing software to meet the reporting requirements of this standard. We expect our financial statement disclosures will be expanded to present additional details of our leasing arrangements. At this time, we are unable to reasonably estimate the expected increase in assets and liabilities on our consolidated balance sheets or the impacts to our consolidated financial statements upon adoption. In January 2016, the FASB issued guidance that requires most equity investments be measured at fair value, with subsequent other changes in fair value recognized in net income. The guidance also impacts financial liabilities under the fair value option and the presentation and disclosure requirements on the classification and measurement of financial instruments. The guidance is effective for annual reporting periods and interim periods within those annual reporting periods beginning after December 15, 2017, our fiscal 2019. It should be applied by means of a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption, unless, equity securities do not have readily determinable fair values, in which case, the amendments should be applied prospectively. We are currently evaluating the impact this guidance will have on our consolidated financial statements. In July 2015, the FASB issued guidance which requires management to evaluate inventory at the lower of cost and net realizable value. The guidance is effective for annual reporting periods and interim periods within those annual reporting periods beginning after December 15, 2016, our fiscal 2018. The prospective transition method should be applied. We adopted this guidance in the first quarter of fiscal 2018 and do not expect this guidance to have a material impact on our consolidated financial statements. 54 In May 2014, the FASB issued guidance changing the criteria for recognizing revenue. The guidance provides for a single five-step model to be applied to all revenue contracts with customers. The standard also requires additional financial statement disclosures that will enable users to understand the nature, amount, timing and uncertainty of revenue and cash flows relating to customer contracts. Companies have an option to use either a retrospective approach or cumulative effect adjustment approach to implement the standard. This guidance is effective for annual reporting periods and interim periods within those annual reporting periods beginning after December 15, 2017, our fiscal 2019. Early adoption is permitted for fiscal years beginning after December 15, 2016, our fiscal 2018. We plan to adopt this guidance using the modified retrospective transition method beginning in the first quarter of fiscal 2019. We continue to evaluate the impact of the adoption of this guidance, but currently, we do not expect the new guidance to materially impact our consolidated financial statements other than additional disclosure requirements. NOTE 2: CHANGES IN ACCOUNTING PRINCIPLES In January 2017, the FASB issued guidance which removes step 2 from the goodwill impairment test. As a result, an entity should perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount and should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting units' fair value. The guidance is effective for annual or interim goodwill impairment tests in fiscal years beginning after December 15, 2019, our fiscal 2021. Early adoption is permitted for annual or interim goodwill impairment tests performed on testing dates after January 1, 2017, and the prospective transition method should be applied. We adopted this guidance, prospectively, in the third quarter of fiscal 2017. The adoption did not have a material impact on our consolidated financial statements. In October 2016, the FASB issued guidance on how a reporting entity, that is the single decision maker of a variable interest entity ("VIE"), should treat indirect interests in the entity held through related parties that are under common control with the reporting entity, when determining whether it is the primary beneficiary of that VIE. This guidance is effective for annual reporting periods and interim periods within those annual reporting periods, beginning after December 15, 2016, our fiscal 2018. We were required to adopt this guidance at the same time that we adopted the amendments in ASU 2015-02; therefore, we early adopted this guidance, retrospectively, in the first quarter of fiscal 2017. The adoption did not have a material impact on our consolidated financial statements. In April 2015, the FASB issued guidance on the recognition of fees paid by a customer for cloud computing arrangements. The guidance clarifies that if a cloud computing arrangement includes a software license, the customer should account for the software license consistent with the acquisition of other software licenses. If the arrangement does not include a software license, the customer should account for the arrangement as a service contract. The guidance is effective for annual reporting periods and interim periods within those annual reporting periods beginning after December 15, 2015, our fiscal 2017, and should be applied prospectively or retrospectively. We adopted this guidance, prospectively, in the first quarter of fiscal 2017. As a result, prior period balances were not retrospectively adjusted. The adoption did not have a material impact on our consolidated financial statements. In February 2015, the FASB issued guidance changing the analysis procedures that a reporting entity must perform to determine whether it should consolidate certain types of legal entities. All legal entities are subject to reevaluation under the revised consolidation model. The new guidance affects the following areas: (1) limited partnerships and similar legal entities, (2) evaluating fees paid to a decision maker or a service provider as a variable interest, (3) the effect of fee arrangements on the primary beneficiary determination, (4) the effect of related parties on the primary beneficiary determination, and (5) certain investment funds. This guidance is effective for annual reporting periods and interim periods within those annual reporting periods beginning after December 15, 2015, our fiscal 2017. We adopted this guidance, retrospectively, in the first quarter of fiscal 2017. The adoption did not have a material impact on our consolidated financial statements. NOTE 3: ACQUISITIONS AND DISPOSITIONS Acquisitions On June 7, 2017, we acquired all of the outstanding common stock of AdvancePierre Foods Holdings, Inc. ("AdvancePierre") as part of our strategy to sustainably feed the world with the fastest growing portfolio of protein-packed brands. The purchase price was equal to $40.25 per share for AdvancePierre's outstanding common stock, or approximately $3.2 billion . We funded the acquisition with existing cash on hand, net proceeds from the issuance of new senior notes and a new term loan facility, as well as borrowings under our commercial paper program (refer to Note 7: Debt). AdvancePierre's results from operations subsequent to the acquisition closing are included in the Prepared Foods and Chicken segments. The following table summarizes the preliminary purchase price allocation and fair values of the assets acquired and liabilities assumed at the acquisition date. Certain estimated values for the acquisition, including goodwill, intangible assets, property, plant and equipment, and deferred income taxes, are not yet finalized and are subject to revision as additional information becomes available and more detailed analyses are completed. The purchase price was allocated based on information available at acquisition date. During the fourth quarter of fiscal 2017, we recorded measurement period adjustments which increased goodwill by $60 million , primarily related to updated valuations for intangible assets and deferred income taxes based on additional information regarding assets and liabilities assumed. 55 | in millions | ----------------------------------------------------------+-------------+------- Cash and cash equivalents | | $ | 126 ----------------------------------------------------------+-------------+--------+------ Accounts receivable | | 80 | ----------------------------------------------------------+-------------+--------+------ Inventories | | 272 | ----------------------------------------------------------+-------------+--------+------ Other current assets | | 5 | ----------------------------------------------------------+-------------+--------+------ Property, Plant and Equipment | | 302 | ----------------------------------------------------------+-------------+--------+------ Goodwill | | 2,982 | ----------------------------------------------------------+-------------+--------+------ Intangible Assets | | 1,515 | ----------------------------------------------------------+-------------+--------+------ Current debt | | (1,148 | ) ----------------------------------------------------------+-------------+--------+------ Accounts payable | | (114 | ) ----------------------------------------------------------+-------------+--------+------ Other current liabilities | | (97 | ) ----------------------------------------------------------+-------------+--------+------ Tax receivable agreement (TRA) due to former shareholders | | (223 | ) ----------------------------------------------------------+-------------+--------+------ Long-Term Debt | | (33 | ) ----------------------------------------------------------+-------------+--------+------ Deferred Income Taxes | | (457 | ) ----------------------------------------------------------+-------------+--------+------ Other Liabilities | | (3 | ) ----------------------------------------------------------+-------------+--------+------ Net assets acquired | | $ | 3,207 ----------------------------------------------------------+-------------+--------+------ The fair value of identifiable intangible assets is as follows: | | | in millions | -------------------------------------+-------------+------------------------------+-------------+------ Intangible Asset Category | Type | Life in Years | Fair Value -------------------------------------+-------------+------------------------------+------------ Brands & Trademarks | Amortizable | Weighted Average of 15 years | $ | 390 -------------------------------------+-------------+------------------------------+-------------+------ Customer Relationships | Amortizable | Weighted Average of 15 years | 1,125 | -------------------------------------+-------------+------------------------------+-------------+------ Total identifiable intangible assets | | | $ | 1,515 -------------------------------------+-------------+------------------------------+-------------+------ As a result of the acquisition, we recognized a total of $2,982 million of goodwill. The purchase price was assigned to assets acquired and liabilities assumed based on their estimated fair values as of the date of acquisition, and any excess was allocated to goodwill, as shown in the table above. Goodwill represents the value we expect to achieve through the implementation of operational synergies and growth opportunities. The allocation of goodwill to our reporting units is pending finalization of the expected synergies and the impact of the synergies to our reporting units. Of the goodwill acquired, $163 million related to previous AdvancePierre acquisitions is expected to be deductible for tax purposes. We used various valuation techniques to determine fair value, with the primary techniques being discounted cash flow analysis, relief-from-royalty, and multi-period excess earnings valuation approaches, which use significant unobservable inputs, or Level 3 inputs, as defined by the fair value hierarchy. Under these valuation approaches, we are required to make estimates and assumptions about sales, operating margins, growth rates, royalty rates and discount rates based on budgets, business plans, economic projections, anticipated future cash flows and marketplace data. The acquisition of AdvancePierre was accounted for using the acquisition method of accounting, and consequently, the results of operations for AdvancePierre are reported in our consolidated financial statements from the date of acquisition. AdvancePierre's results from the date of acquisition, which included a net increase $508 million of Sales, were insignificant to the overall Consolidated Statements of Income. The following unaudited pro forma information presents the combined results of operations as if the acquisition of AdvancePierre had occurred at the beginning of fiscal 2016. AdvancePierre's pre-acquisition results have been added to our historical results. The pro forma results contained in the table below include adjustments for amortization of acquired intangibles, depreciation expense, interest expense related to the financing and related income taxes. Any potential cost savings or other operational efficiencies that could result from the acquisition are not included in these pro forma results. The 2016 pro forma results include transaction related expenses incurred by AdvancePierre prior to the acquisition of $84 million , including items such as consultant fees, accelerated stock compensation and other deal costs; transaction related expenses incurred by the Company of $67 million , including fees paid to third parties, financing costs and other deal costs; and $36 million of expense related to the fair value inventory adjustment at the date of acquisition. These pro forma results have been prepared for comparative purposes only and are not necessarily indicative of the results of operations as they would have been had the acquisitions occurred on the assumed dates, nor is it necessarily an indication of future operating results. 56 | in millions (unaudited) | -------------------------------------------------------------+-------------------------+------- | 2017 | | 2016 | -------------------------------------------------------------+-------------------------+--------+-------+-- Pro forma sales | $ | 39,330 | | $ | 38,406 -------------------------------------------------------------+-------------------------+--------+-------+---+------- Pro forma net income attributable to Tyson | 1,837 | | 1,686 | -------------------------------------------------------------+-------------------------+--------+-------+-- Pro forma net income per diluted share attributable to Tyson | $ | 4.97 | | $ | 4.32 -------------------------------------------------------------+-------------------------+--------+-------+---+------- On November 10, 2017, we acquired all of the outstanding shares of a valued-added protein business for $225 million , subject to certain adjustments, which will be included in our Prepared Foods and Chicken segments. Dispositions On April 24, 2017, we announced our intent to sell three non-protein businesses as part of our strategic focus on protein-packed brands. These businesses, which are all part of our Prepared Foods segment, include Sara Lee® Frozen Bakery, Kettle and Van’s® and produce items such as frozen desserts, waffles, snack bars, and soups, sauces and sides. The sale is also expected to include the Chef Pierre®, Bistro Collection®, Kettle Collection™, and Van’s® brands, a license to use the Sara Lee® brand in various channels, as well as our Tarboro, North Carolina, Fort Worth, Texas, and Traverse City, Michigan, prepared foods facilities. We have reclassified the assets and liabilities related to these businesses to assets and liabilities held for sale in our Consolidated Balance Sheet as of September 30, 2017. In the fourth quarter of 2017, we recorded an impairment charge totaling $45 million , related to one of these businesses due to a revised estimate of the business’ fair value based on current expected net sales proceeds. The impairment charge was recorded in Cost of Sales in our Consolidated Statement of Income for fiscal 2017, and consisted of goodwill and intangible assets previously classified within assets held for sale. In October 2017, we executed a definitive asset purchase agreement to sell our Kettle operation for $125 million , subject to certain contingencies including regulatory approval. We anticipate we will close the Kettle and remaining transactions by the end of calendar 2017, or early calendar 2018, and expect to record a net pretax gain as a result of the sale of these businesses. The Company concluded the businesses were not significant disposal groups and did not represent a strategic shift, and therefore were not classified as discontinued operations for any of the periods presented. The following table summarizes the net assets and liabilities held for sale: | in millions | ----------------------------------+--------------------+---- | September 30, 2017 ----------------------------------+------------------- Assets held for sale: | ----------------------------------+------------------- Accounts receivable, net | $ | 2 ----------------------------------+--------------------+---- Inventories | 109 | ----------------------------------+--------------------+---- Net Property, Plant and Equipment | 192 | ----------------------------------+--------------------+---- Other current assets | 1 | ----------------------------------+--------------------+---- Goodwill | 312 | ----------------------------------+--------------------+---- Intangible Assets, net | 191 | ----------------------------------+--------------------+---- Total assets held for sale | $ | 807 ----------------------------------+--------------------+---- Liabilities held for sale: | ----------------------------------+------------------- Accounts payable | $ | 1 ----------------------------------+--------------------+---- Other current liabilities | 3 | ----------------------------------+--------------------+---- Total liabilities held for sale | $ | 4 ----------------------------------+--------------------+---- In fiscal 2014, we announced our plan to sell our Brazil and Mexico operations, which are included in Other for segment reporting, to JBS SA for $575 million in cash less debt and other adjustments. We completed the sale of the Brazil operation in the first quarter of fiscal 2015 and received net proceeds of $148 million including working capital, net debt adjustments and cash transferred. The sale did not result in a significant gain or loss as the carrying value of the Brazil operation approximated the sales proceeds at the time of sale. We completed the sale of the Mexico operation in the fourth quarter of fiscal 2015 and received net proceeds of approximately $374 million including working capital, net debt adjustments and cash transferred. As a result of the sale, we recorded a pretax gain of $161 million , which was reflected in Cost of Sales in our Consolidated Statements of Income. We utilized the net proceeds to retire the 2.75% senior notes due September 2015. In the fourth quarter of fiscal 2015, to better align our overall production capacity with then-current cattle supplies, we ceased beef operations at our Denison, Iowa plant. As a result, we recorded $12 million in closure and impairment charges during the fourth quarter of fiscal 2015. These charges impacted the Beef segment’s operating income and were reflected in Cost of Sales in our Consolidated Statements of Income. 57 In the fourth quarter of fiscal 2015, we recorded a $59 million impairment and other related charges associated with a Prepared Foods project designed to optimize the combined Tyson and Hillshire Brands network capacity and to enhance manufacturing efficiencies for the future. These charges were reflected in the Prepared Foods segment’s operating income in the fourth quarter of fiscal 2015, of which $49 million was included in the Consolidated Statements of Income in Cost of Sales and $10 million was included in the Consolidated Statements of Income in Selling, General and Administrative. As a result of this project, we sold our Chicago, Illinois, hospitality plant in June 2016 and closed our Jefferson, Wisconsin, plant in July 2016. The sale of our Chicago, Illinois, plant and closure of our Jefferson, Wisconsin, plant did not have a significant impact on the Company's operating results. In the third quarter of fiscal 2015, as part of our ongoing efforts to increase efficiencies in our Chicken business, we closed our Buena Vista, Georgia, plant. The closure costs did not have a significant impact on the Company's operating results. NOTE 4: PROPERTY, PLANT AND EQUIPMENT The following table reflects major categories of property, plant and equipment and accumulated depreciation at September 30, 2017 , and October 1, 2016 : | in millions | -------------------------------------------+-------------+------ | 2017 | | 2016 | -------------------------------------------+-------------+-------+--------+-- Land | $ | 138 | | $ | 126 -------------------------------------------+-------------+-------+--------+---+------ Building and leasehold improvements | 3,878 | | 3,662 | -------------------------------------------+-------------+-------+--------+-- Machinery and equipment | 7,111 | | 6,789 | -------------------------------------------+-------------+-------+--------+-- Land improvements and other | 323 | | 300 | -------------------------------------------+-------------+-------+--------+-- Buildings and equipment under construction | 492 | | 290 | -------------------------------------------+-------------+-------+--------+-- | 11,942 | | 11,167 | -------------------------------------------+-------------+-------+--------+-- Less accumulated depreciation | 6,374 | | 5,997 | -------------------------------------------+-------------+-------+--------+-- Net property, plant and equipment | $ | 5,568 | | $ | 5,170 -------------------------------------------+-------------+-------+--------+---+------ Approximately $1,387 million will be required to complete buildings and equipment under construction at September 30, 2017 . 58 NOTE 5: GOODWILL AND INTANGIBLE ASSETS The following table reflects goodwill activity for fiscal 2017 and 2016 : in millions | --------------------------------+------ | Beef | | Pork | | | Chicken | | PreparedFoods | | Other(a) | | Unallocated | | | Consolidated | --------------------------------+-------+-------+------+---+-----+---------+---+---------------+---+----------+-------+-------------+---+----+--------------+-- Balance at October 3, 2015 | | | | | | | | | | --------------------------------+-------+-------+------+---+-----+---------+---+---------------+---+--------- Goodwill | $ | 1,236 | | $ | 423 | | $ | 1,563 | | $ | 4,005 | | $ | 57 | | | $ | — | $ | 7,284 --------------------------------+-------+-------+------+---+-----+---------+---+---------------+---+----------+-------+-------------+---+----+--------------+---+---+-------+---+------ Accumulated impairment losses | (560 | ) | — | | | — | | — | | (57 | ) | — | | | (617 | ) --------------------------------+-------+-------+------+---+-----+---------+---+---------------+---+----------+-------+-------------+---+----+--------------+-- | 676 | | 423 | | | 1,563 | | 4,005 | | — | | — | | | 6,667 | --------------------------------+-------+-------+------+---+-----+---------+---+---------------+---+----------+-------+-------------+---+----+--------------+-- Fiscal 2016 Activity: | | | | | | | | | | --------------------------------+-------+-------+------+---+-----+---------+---+---------------+---+--------- Currency translation and other | — | | — | | | 2 | | — | | — | | — | | | 2 | --------------------------------+-------+-------+------+---+-----+---------+---+---------------+---+----------+-------+-------------+---+----+--------------+-- Balance at October 1, 2016 | | | | | | | | | | --------------------------------+-------+-------+------+---+-----+---------+---+---------------+---+--------- Goodwill | 1,236 | | 423 | | | 1,565 | | 4,005 | | 57 | | — | | | 7,286 | --------------------------------+-------+-------+------+---+-----+---------+---+---------------+---+----------+-------+-------------+---+----+--------------+-- Accumulated impairment losses | (560 | ) | — | | | — | | — | | (57 | ) | — | | | (617 | ) --------------------------------+-------+-------+------+---+-----+---------+---+---------------+---+----------+-------+-------------+---+----+--------------+-- | $ | 676 | | $ | 423 | | $ | 1,565 | | $ | 4,005 | | $ | — | | | $ | — | $ | 6,669 --------------------------------+-------+-------+------+---+-----+---------+---+---------------+---+----------+-------+-------------+---+----+--------------+---+---+-------+---+------ Fiscal 2017 Activity: | | | | | | | | | | --------------------------------+-------+-------+------+---+-----+---------+---+---------------+---+--------- Acquisition | — | | — | | | — | | — | | — | | 2,982 | | | 2,982 | --------------------------------+-------+-------+------+---+-----+---------+---+---------------+---+----------+-------+-------------+---+----+--------------+-- Reclass to assets held for sale | — | | — | | | — | | (327 | ) | — | | — | | | (327 | ) --------------------------------+-------+-------+------+---+-----+---------+---+---------------+---+----------+-------+-------------+---+----+--------------+-- Balance at September 30, 2017 | | | | | | | | | | --------------------------------+-------+-------+------+---+-----+---------+---+---------------+---+--------- Goodwill | 1,236 | | 423 | | | 1,565 | | 3,678 | | 57 | | 2,982 | | | 9,941 | --------------------------------+-------+-------+------+---+-----+---------+---+---------------+---+----------+-------+-------------+---+----+--------------+-- Accumulated impairment losses | (560 | ) | — | | | — | | — | | (57 | ) | — | | | (617 | ) --------------------------------+-------+-------+------+---+-----+---------+---+---------------+---+----------+-------+-------------+---+----+--------------+-- | $ | 676 | | $ | 423 | | $ | 1,565 | | $ | 3,678 | | $ | — | | | $ | 2,982 | $ | 9,324 --------------------------------+-------+-------+------+---+-----+---------+---+---------------+---+----------+-------+-------------+---+----+--------------+---+---+-------+---+------ (a) Other included the goodwill from our foreign chicken operation. On June 7, 2017, we acquired and consolidated AdvancePierre. The allocation of goodwill to our reportable segments is pending finalization of the expected synergies and the impact of the synergies to our reporting units. The following table reflects intangible assets by type at September 30, 2017 , and October 1, 2016 : in millions | --------------------------------------------------+------ | 2017 | | 2016 | --------------------------------------------------+-------+-------+-------+-- Amortizable intangible assets: | | --------------------------------------------------+-------+------ Brands and trademarks | $ | 738 | | $ | 590 --------------------------------------------------+-------+-------+-------+---+------ Customer relationships | 1,639 | | 564 | --------------------------------------------------+-------+-------+-------+-- Patents, intellectual property and other | 114 | | 114 | --------------------------------------------------+-------+-------+-------+-- Land use rights | 9 | | 9 | --------------------------------------------------+-------+-------+-------+-- Total gross amortizable intangible assets | $ | 2,500 | | $ | 1,277 --------------------------------------------------+-------+-------+-------+---+------ Less accumulated amortization | 335 | | 271 | --------------------------------------------------+-------+-------+-------+-- Total net amortizable intangible assets | $ | 2,165 | | $ | 1,006 --------------------------------------------------+-------+-------+-------+---+------ Brands and trademarks not subject to amortization | 4,078 | | 4,078 | --------------------------------------------------+-------+-------+-------+-- Total intangible assets | $ | 6,243 | | $ | 5,084 --------------------------------------------------+-------+-------+-------+---+------ Amortization expense of $107 million , $80 million and $92 million was recognized during fiscal 2017 , 2016 and 2015 , respectively. We estimate amortization expense on intangible assets for the next five fiscal years subsequent to September 30, 2017 , will be: 2018 - $194 million ; 2019 - $189 million ; 2020 - $185 million ; 2021 - $170 million ; 2022 - $160 million . 59 NOTE 6: RESTRUCTURING AND RELATED CHARGES In the fourth quarter of fiscal 2017, our Board of Directors approved a multi-year restructuring program (the “Financial Fitness Program”), which is expected to contribute to the Company’s overall strategy of financial fitness through increased operational effectiveness and overhead reduction. The Company currently anticipates the Financial Fitness Program will result in cumulative pretax charges, once implemented, of approximately $215 million which consist primarily of severance and employee related costs, asset impairments, accelerated depreciation, incremental costs to implement new technology, and contract termination costs. As part of this program, we anticipate eliminating approximately 500 positions across several areas and job levels with most of the eliminated positions originating from the corporate offices in Springdale, Arkansas; Chicago, Illinois; and Cincinnati, Ohio. In the fourth quarter of fiscal 2017, the Company recognized restructuring and related charges of $150 million associated with the program. The following table reflects the pretax impact of restructuring and related charges in the Consolidated Statements of Income: in millions | ------------------------------------------------+----- | 2017 | ------------------------------------------------+------+---- Cost of Sales | $ | 35 ------------------------------------------------+------+---- Selling, General and Administrative expenses | 115 | ------------------------------------------------+------+---- Total restructuring and related charges, pretax | $ | 150 ------------------------------------------------+------+---- The following table reflects the pretax impact of restructuring and related charges incurred in fiscal 2017 and the estimated charges in fiscal 2018 by our reportable segments: | in millions | ------------------------------------------------+--------------+---- | 2017 charges | | Estimated 2018 charges | | Total estimated Financial Fitness Program charges ------------------------------------------------+--------------+-----+------------------------+---+-------------------------------------------------- Beef | $ | 8 | | $ | 6 | $ | 14 ------------------------------------------------+--------------+-----+------------------------+---+---------------------------------------------------+---+---- Pork | 3 | | 2 | | 5 ------------------------------------------------+--------------+-----+------------------------+---+-------------------------------------------------- Chicken | 56 | | 32 | | 88 ------------------------------------------------+--------------+-----+------------------------+---+-------------------------------------------------- Prepared Foods | 82 | | 25 | | 107 ------------------------------------------------+--------------+-----+------------------------+---+-------------------------------------------------- Other | 1 | | — | | 1 ------------------------------------------------+--------------+-----+------------------------+---+-------------------------------------------------- Total restructuring and related charges, pretax | $ | 150 | | $ | 65 | $ | 215 ------------------------------------------------+--------------+-----+------------------------+---+---------------------------------------------------+---+---- For fiscal 2017, the restructuring and related charges consisted of $53 million severance and employee related costs, $72 million technology impairment and related costs, and $25 million for contract termination costs. The expected fiscal 2018 restructuring and related charges are expected to approximate $5 million of employee related costs, $25 million of incremental costs to implement new technology, $34 million in accelerated depreciation, and $1 million of other charges. The timing and actual amounts of these estimated charges may change. The following table reflects our liability related to restructuring which was recognized in other current liabilities in our Consolidated Balance Sheet as of September 30, 2017: in millions | -------------------------------------+---------------------- | Restructuring charges | Payments | Other | Ending liability -------------------------------------+-----------------------+----------+-------+----------------- Severance and employee related costs | $ | 51 | | $ | 4 | $ | — | $ | 47 -------------------------------------+-----------------------+----------+-------+------------------+---+----+---+---+--- Contract termination | 22 | | — | | — | 22 | -------------------------------------+-----------------------+----------+-------+------------------+---+----+-- Total | $ | 73 | | $ | 4 | $ | — | $ | 69 -------------------------------------+-----------------------+----------+-------+------------------+---+----+---+---+--- 60 NOTE 7: DEBT The following table reflects major components of debt as of September 30, 2017 , and October 1, 2016 : | | | in millions | ------------------------------------------------------------------------------+--------+-------+-------------+------ | 2017 | | | 2016 | ------------------------------------------------------------------------------+--------+-------+-------------+-------+-- Revolving credit facility | $ | — | | | $ | 300 ------------------------------------------------------------------------------+--------+-------+-------------+-------+---+------ Commercial Paper | 778 | | | — | ------------------------------------------------------------------------------+--------+-------+-------------+-------+-- Senior notes: | | | ------------------------------------------------------------------------------+--------+-------+------------ 7.00% Notes due May 2018 | 120 | | | 120 | ------------------------------------------------------------------------------+--------+-------+-------------+-------+-- Notes due May 2019 (2019 Floating-Rate Notes) (1.77% at 09/30/2017) | 300 | | | — | ------------------------------------------------------------------------------+--------+-------+-------------+-------+-- 2.65% Notes due August 2019 | 1,000 | | | 1,000 | ------------------------------------------------------------------------------+--------+-------+-------------+-------+-- Notes due June 2020 (June 2020 Floating-Rate Notes) (1.87% at 09/30/2017) | 350 | | | — | ------------------------------------------------------------------------------+--------+-------+-------------+-------+-- Notes due August 2020 (August 2020 Floating-Rate Notes) (1.76% at 09/30/2017) | 400 | | | — | ------------------------------------------------------------------------------+--------+-------+-------------+-------+-- 4.10% Notes due September 2020 | 282 | | | 284 | ------------------------------------------------------------------------------+--------+-------+-------------+-------+-- 2.25% Notes due August 2021 (2021 Notes) | 500 | | | — | ------------------------------------------------------------------------------+--------+-------+-------------+-------+-- 4.50% Senior notes due June 2022 | 1,000 | | | 1,000 | ------------------------------------------------------------------------------+--------+-------+-------------+-------+-- 3.95% Notes due August 2024 | 1,250 | | | 1,250 | ------------------------------------------------------------------------------+--------+-------+-------------+-------+-- 3.55% Notes due June 2027 (2027 Notes) | 1,350 | | | — | ------------------------------------------------------------------------------+--------+-------+-------------+-------+-- 7.00% Notes due January 2028 | 18 | | | 18 | ------------------------------------------------------------------------------+--------+-------+-------------+-------+-- 6.13% Notes due November 2032 | 162 | | | 163 | ------------------------------------------------------------------------------+--------+-------+-------------+-------+-- 4.88% Notes due August 2034 | 500 | | | 500 | ------------------------------------------------------------------------------+--------+-------+-------------+-------+-- 5.15% Notes due August 2044 | 500 | | | 500 | ------------------------------------------------------------------------------+--------+-------+-------------+-------+-- 4.55% Notes due June 2047 (2047 Notes) | 750 | | | — | ------------------------------------------------------------------------------+--------+-------+-------------+-------+-- Discount on senior notes | (15 | ) | | (8 | ) ------------------------------------------------------------------------------+--------+-------+-------------+-------+-- Term loans: | | | ------------------------------------------------------------------------------+--------+-------+------------ Tranche B due August 2019 (2.75% at 09/30/2017) | 427 | | | 552 | ------------------------------------------------------------------------------+--------+-------+-------------+-------+-- Tranche B due August 2020 (2.05% at 09/30/2017) | 500 | | | 500 | ------------------------------------------------------------------------------+--------+-------+-------------+-------+-- Amortizing Notes - Tangible Equity Units (see Note 8: Equity) | — | | | 71 | ------------------------------------------------------------------------------+--------+-------+-------------+-------+-- Other | 81 | | | 58 | ------------------------------------------------------------------------------+--------+-------+-------------+-------+-- Unamortized debt issuance costs | (50 | ) | | (29 | ) ------------------------------------------------------------------------------+--------+-------+-------------+-------+-- Total debt | 10,203 | | | 6,279 | ------------------------------------------------------------------------------+--------+-------+-------------+-------+-- Less current debt | 906 | | | 79 | ------------------------------------------------------------------------------+--------+-------+-------------+-------+-- Total long-term debt | $ | 9,297 | | | $ | 6,200 ------------------------------------------------------------------------------+--------+-------+-------------+-------+---+------ Annual maturities of debt for the five fiscal years subsequent to September 30, 2017 , are: 2018 - $906 million ; 2019 - $1,737 million ; 2020 - $1,537 million ; 2021 - $511 million ; 2022 - $1,007 million . Revolving Credit Facility In May 2017, we amended our existing credit facility which, among other things, increased our line of credit from $1.25 billion to $1.50 billion . The facility supports short-term funding needs and letters of credit and will mature and the commitments thereunder will terminate in May 2022. Amounts available for borrowing under this facility totaled $1,492 million at September 30, 2017 , net of outstanding letters of credit. At September 30, 2017 , we had outstanding letters of credit issued under this facility totaling $8 million , none of which were drawn upon. We had an additional $85 million of bilateral letters of credit issued separately from the revolving credit facility, none of which were drawn upon. Our letters of credit are issued primarily in support of leasing obligations and workers’ compensation insurance programs. If in the future any of our subsidiaries shall guarantee any of our material indebtedness, such subsidiary shall be required to guarantee the indebtedness, obligations and liabilities under this facility. 61 August 2020 Floating-Rate Notes / 2021 Notes On August 21, 2017, we issued senior unsecured notes with an aggregate principal amount of $900 million , consisting of $400 million due August 2020 and $500 million due August 2021. We used the net proceeds from the issuance to repay amounts outstanding under our Term Loan Tranche due June 2020. The August 2020 Floating-Rate Notes carry an interest rate of 3-month LIBOR plus 0.45% and the 2021 Notes carry a fixed interest rate at 2.25% . Interest payments on the August 2020 Floating-Rate Notes are due quarterly on February 21, May 21, August 21 and November 21. Interest payments on the 2021 Notes are due semi-annually on February 23 and August 23. After the original issue discounts of $1 million , we received net proceeds of $899 million . In addition, we incurred debt issuance costs of $5 million related to this issuance. 2019 Floating-Rate / June 2020 Floating-Rate / 2027 / 2047 Notes In June 2017, as part of the financing for the AdvancePierre acquisition, we issued senior unsecured notes with an aggregate principal amount of $2,750 million , consisting of $300 million due May 2019, $350 million due June 2020, $1,350 million due June 2027, and $750 million due June 2047. The 2019 Floating-Rate Notes, June 2020 Floating-Rate Notes, 2027 Notes and 2047 Notes carry interest rates of 3-month LIBOR plus 0.45% , 3-month LIBOR plus 0.55% , 3.55% and 4.55% , respectively. Interest payments on the 2019 Floating-Rate Notes are due quarterly February 28, May 30, August 30, and November 30. Interest payments on the June 2020 Floating-Rate Notes are due quarterly March 2, June 2, September 2, and December 2. Interest payments on the 2027 Notes and 2047 Notes are due semi-annually on June 2 and December 2. After the original issue discounts of $7 million , we received net proceeds of $2,743 million . In addition, we incurred debt issuance costs of $22 million related to this issuance. Term Loan Tranche B due August 2020 On August 18, 2017, we amended our existing $500 million Term Loan Tranche B which extended the maturity of the loan from April 2019 to August 2020. Term Loan Tranche due June 2020 In June 2017, as part of the financing for the AdvancePierre acquisition, we borrowed $1,800 million under an unsecured term loan facility, which is due June 2020. The facility amortized at 2.5% per quarter and interest reset based on the selected LIBOR interest period plus 1.25% . We incurred debt issuance costs of $5 million related to this borrowing. In fiscal 2017, we repaid the full amount of the loan. AdvancePierre's Debt Extinguishment In June 2017, in connection with our AdvancePierre acquisition, we assumed $1,119 million of AdvancePierre's gross debt, which had an estimated fair value of approximately $1,181 million as of the acquisition date. We recorded the assumed debt at fair value and used the funds borrowed under our new senior notes and term loan to extinguish $1,146 million of the total outstanding balance. Additionally, we assumed a $223 million TRA liability due to AdvancePierre's former shareholders. The assumed debt and TRA liability were non-cash investing activities. Commercial Paper Program In 2017, we initiated a commercial paper program under which we may issue unsecured short-term promissory notes (commercial paper) up to an aggregate maximum principal amount of $800 million as of September 30, 2017 . We used the net proceeds from the commercial paper program as part of the financing for the AdvancePierre acquisition and for general corporate purposes. As of September 30, 2017 , we had $778 million of commercial paper outstanding at a weighted average interest rate of 1.37% with maturities of less than 45 days . Debt Covenants Our revolving credit and term loan facilities contain affirmative and negative covenants that, among other things, may limit or restrict our ability to: create liens and encumbrances; incur debt; merge, dissolve, liquidate or consolidate; make acquisitions and investments; dispose of or transfer assets; change the nature of our business; engage in certain transactions with affiliates; and enter into hedging transactions, in each case, subject to certain qualifications and exceptions. In addition, we are required to maintain minimum interest expense coverage and maximum debt-to-capitalization ratios. Our senior notes also contain affirmative and negative covenants that, among other things, may limit or restrict our ability to: create liens; engage in certain sale/leaseback transactions; and engage in certain consolidations, mergers and sales of assets. We were in compliance with all debt covenants at September 30, 2017 . 62 NOTE 8: EQUITY Capital Stock We have two classes of capital stock, Class Common A stock, $0.10 par value (Class A stock) and Class B Common Stock, $0.10 par value (Class B stock). Holders of Class B stock may convert such stock into Class A stock on a share-for-share basis. Holders of Class B stock are entitled to 10 votes per share, while holders of Class A stock are entitled to one vote per share on matters submitted to shareholders for approval. As of September 30, 2017 , Tyson Limited Partnership (the "TLP") owned 99.985% of the outstanding shares of Class B stock and the TLP and members of the Tyson family owned, in the aggregate, 2.07% of the outstanding shares of Class A stock, giving them, collectively, control of approximately 70.78% of the total voting power of the outstanding voting stock. The Class B stock is considered a participating security requiring the use of the two-class method for the computation of basic earnings per share. The two-class computation method for each period reflects the cash dividends paid for each class of stock, plus the amount of allocated undistributed earnings (losses) computed using the participation percentage, which reflects the dividend rights of each class of stock. Basic earnings per share were computed using the two-class method for all periods presented. The shares of Class B stock are considered to be participating convertible securities since the shares of Class B stock are convertible on a share-for-share basis into shares of Class A stock. Diluted earnings per share were computed assuming the conversion of the Class B shares into Class A shares as of the beginning of each period. Dividends Cash dividends cannot be paid to holders of Class B stock unless they are simultaneously paid to holders of Class A stock. The per share amount of the cash dividend paid to holders of Class B stock cannot exceed 90% of the cash dividend simultaneously paid to holders of Class A stock. We pay quarterly cash dividends to Class A and Class B shareholders. We paid Class A dividends per share of $0.90 , $0.60 , and $0.40 in fiscal 2017, 2016, and 2015, respectively. We paid Class B dividends per share of $0.81 , $0.54 , and $0.36 in fiscal 2017, 2016, and 2015, respectively. On November 10, 2017, the Board of Directors increased the quarterly dividend previously declared on August 10, 2017, to $0.30 per share on our Class A stock and $0.27 per share on our Class B stock. The increased quarterly dividend is payable on December 15, 2017, to shareholders of record at the close of business on December 1, 2017. Share Repurchases On February 4, 2016, our Board of Directors approved an increase of 50 million shares authorized for repurchase under our share repurchase program. As of September 30, 2017 , 27.8 million shares remained available for repurchase. The share repurchase program has no fixed or scheduled termination date and the timing and extent to which we repurchase shares will depend upon, among other things, our working capital needs, markets, industry conditions, liquidity targets, limitations under our debt obligations and regulatory requirements. In addition to the share repurchase program, we purchase shares on the open market to fund certain obligations under our equity compensation plans. A summary of cumulative share repurchases of our Class A stock for fiscal 2017, 2016 and 2015 is as follows: | | | | | | | | | in millions ------------------------------------------------------------+--------------------+-----------------+----+-----------------+---------+------+--------+----+------------ | September 30, 2017 | October 1, 2016 | | October 3, 2015 ------------------------------------------------------------+--------------------+-----------------+----+---------------- | Shares | Dollars | | Shares | Dollars | | Shares | | Dollars ------------------------------------------------------------+--------------------+-----------------+----+-----------------+---------+------+--------+----+------------ Shares repurchased: | | | | | | | | | ------------------------------------------------------------+--------------------+-----------------+----+-----------------+---------+------+--------+----+------------ Under share repurchase program | 12.5 | | $ | 797 | | 30.8 | | | $ | 1,868 | | 11.0 | | $ | 455 ------------------------------------------------------------+--------------------+-----------------+----+-----------------+---------+------+--------+----+-------------+-------+-----+------+----+---+---- To fund certain obligations under equity compensation plans | 1.0 | | 63 | | 1.3 | | | 76 | | | 0.9 | | 40 ------------------------------------------------------------+--------------------+-----------------+----+-----------------+---------+------+--------+----+-------------+-------+-----+------+--- Total share repurchases | 13.5 | | $ | 860 | | 32.1 | | | $ | 1,944 | | 11.9 | | $ | 495 ------------------------------------------------------------+--------------------+-----------------+----+-----------------+---------+------+--------+----+-------------+-------+-----+------+----+---+---- Tangible Equity Units In fiscal 2014, we completed the public issuance of 30 million , 4.75% tangible equity units (TEUs). Total proceeds, net of underwriting discounts and other expenses, were $1,454 million . Each TEU, which had a stated amount of $50 , was comprised of a prepaid stock purchase contract and a senior amortizing note due July 15, 2017. We allocated the proceeds from the issuance of the TEUs to equity and debt based on the relative fair values of the respective components of each TEU. The fair value of the prepaid stock purchase contracts, which was $1,295 million , was recorded in Capital in Excess of Par Value, net of issuance costs. The fair value of the senior amortizing notes, which was $205 million , was recorded in debt. Issuance costs associated with the TEU debt were recorded as deferred debt issuance cost and was amortized over the term of the instrument to July 15, 2017. 63 The aggregate values assigned upon issuance of each component of the TEU's, based on the relative fair value of the respective components of each TEU, were as follows: | | | in millions, except price per TEU ---------------+------------------+-------+---------------------------------- | Equity Component | | Debt Component | | Total ---------------+------------------+-------+-----------------------------------+-----+------ Price per TEU | $ | 43.17 | | | $ | 6.83 | | | $ | 50.00 ---------------+------------------+-------+-----------------------------------+-----+-------+------+-------+---+---+------ Gross Proceeds | 1,295 | | | 205 | | | 1,500 | ---------------+------------------+-------+-----------------------------------+-----+-------+------+-------+-- Issuance cost | (40 | ) | | (6 | ) | | (46 | ) ---------------+------------------+-------+-----------------------------------+-----+-------+------+-------+-- Net proceeds | $ | 1,255 | | | $ | 199 | | | $ | 1,454 ---------------+------------------+-------+-----------------------------------+-----+-------+------+-------+---+---+------ In July 2017, the Company made the final quarterly cash installment payment of $0.59 per senior amortizing note and issued the required remaining shares of its Class A stock upon automatic settlement of each outstanding purchase contract. NOTE 9: INCOME TAXES Detail of the provision for income taxes from continuing operations consists of the following: | | | | in millions | ---------+------+-----+------+-------------+---- | 2017 | | 2016 | | | 2015 ---------+------+-----+------+-------------+-----+----- Federal | $ | 755 | | $ | 710 | | $ | 564 ---------+------+-----+------+-------------+-----+------+---+---- State | 81 | | 118 | | | 89 ---------+------+-----+------+-------------+-----+----- Foreign | 14 | | (2 | ) | | 44 ---------+------+-----+------+-------------+-----+----- | $ | 850 | | $ | 826 | | $ | 697 ---------+------+-----+------+-------------+-----+------+---+---- Current | $ | 889 | | $ | 742 | | $ | 659 ---------+------+-----+------+-------------+-----+------+---+---- Deferred | (39 | ) | 84 | | | 38 ---------+------+-----+------+-------------+-----+----- | $ | 850 | | $ | 826 | | $ | 697 ---------+------+-----+------+-------------+-----+------+---+---- The reasons for the difference between the statutory federal income tax rate and our effective income tax rate from continuing operations are as follows: | 2017 | | 2016 | | 2015 | --------------------------------------------------+------+---+------+---+------+-- Federal income tax rate | 35.0 | % | 35.0 | % | 35.0 | % --------------------------------------------------+------+---+------+---+------+-- State income taxes | 2.3 | | 2.7 | | 3.1 | --------------------------------------------------+------+---+------+---+------+-- Unrecognized tax benefits, net | (0.1 | ) | (1.7 | ) | (1.8 | ) --------------------------------------------------+------+---+------+---+------+-- Domestic production deduction | (3.1 | ) | (2.6 | ) | (3.7 | ) --------------------------------------------------+------+---+------+---+------+-- Foreign rate differences and valuation allowances | 0.3 | | — | | 3.8 | --------------------------------------------------+------+---+------+---+------+-- Other | (2.1 | ) | (1.6 | ) | (0.1 | ) --------------------------------------------------+------+---+------+---+------+-- | 32.3 | % | 31.8 | % | 36.3 | % --------------------------------------------------+------+---+------+---+------+-- During fiscal 2017, the domestic production deduction decreased tax expense by $80 million , and state tax expense, net of federal tax benefit, was $61 million . During fiscal 2016, the domestic production deduction and changes in unrecognized tax benefits decreased tax expense by $68 million and $43 million , respectively, and state tax expense, net of federal tax benefit, was $70 million . During fiscal 2015, the domestic production deduction and changes in unrecognized tax benefits decreased tax expense by $72 million and $34 million , respectively, and state tax expense, net of federal tax benefit, was $ 59 million . Additionally, foreign rate differences, mostly driven by the China impairment, unfavorably impacted tax expense by $ 73 million . The sale of the Mexico and Brazil operations and related repatriation of proceeds did not have a significant impact on the effective income tax rate. Approximately $2,603 million , $2,543 million , and $1,908 million of income from continuing operations before income taxes for fiscal 2017 , 2016 and 2015 , respectively, were from our operations based in the United States. 64 We recognize deferred income taxes for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The tax effects of major items recorded as deferred tax assets and liabilities as of September 30, 2017 , and October 1, 2016 , are as follows: | | | | | | | in millions | -------------------------------------------+--------------+-----+--------------+-------------+---+-------+-------------+---- | 2017 | | 2016 -------------------------------------------+--------------+-----+------------- | Deferred Tax | | Deferred Tax -------------------------------------------+--------------+-----+------------- | Assets | | | Liabilities | | | Assets | | | Liabilities -------------------------------------------+--------------+-----+--------------+-------------+---+-------+-------------+-----+---+------------ Property, plant and equipment | $ | — | | | $ | 900 | | | $ | — | $ | 857 -------------------------------------------+--------------+-----+--------------+-------------+---+-------+-------------+-----+---+-------------+---+------ Intangible assets | — | | | 2,424 | | | — | | | 1,979 -------------------------------------------+--------------+-----+--------------+-------------+---+-------+-------------+-----+---+------------ Accrued expenses | 400 | | | — | | | 400 | | | — -------------------------------------------+--------------+-----+--------------+-------------+---+-------+-------------+-----+---+------------ Net operating loss and other carryforwards | 97 | | | — | | | 86 | | | — -------------------------------------------+--------------+-----+--------------+-------------+---+-------+-------------+-----+---+------------ Other | 204 | | | 273 | | | 140 | | | 259 -------------------------------------------+--------------+-----+--------------+-------------+---+-------+-------------+-----+---+------------ | $ | 701 | | | $ | 3,597 | | | $ | 626 | $ | 3,095 -------------------------------------------+--------------+-----+--------------+-------------+---+-------+-------------+-----+---+-------------+---+------ Valuation allowance | $ | (75 | ) | | | | $ | (72 | ) | -------------------------------------------+--------------+-----+--------------+-------------+---+-------+-------------+-----+---+------------ Net deferred tax liability | | | $ | 2,971 | | | | | $ | 2,541 -------------------------------------------+--------------+-----+--------------+-------------+---+-------+-------------+-----+---+------------ At September 30, 2017 , our gross state tax net operating loss carryforwards approximated $806 million and expire in fiscal years 2018 through 2035 . Gross foreign net operating loss carryforwards approximated $39 million and expire in fiscal years 2018 through 2028 . Gross federal net operating loss carryforwards approximated $12 million and expire in fiscal years 2031 through 2033. We also have tax credit carryforwards of approximately $52 million , of which $45 million expire in fiscal years 2018 through 2031 , and the remainder has no expiration. We have accumulated undistributed earnings of foreign subsidiaries aggregating approximately $182 million and $219 million at September 30, 2017 , and October 1, 2016 , respectively. The accumulated undistributed earnings at September 30, 2017 are expected to be indefinitely reinvested outside of the United States. If those earnings were distributed in the form of dividends or otherwise, we could be subject to federal income taxes (subject to an adjustment for foreign tax credits), state income taxes and withholding taxes payable to the various foreign countries. Due to the uncertainty of the manner in which the undistributed earnings would be brought back to the United States, the tax laws in effect at that time, as well as the availability of the Company to claim foreign tax credits, it is not currently practicable to estimate the tax liability that might be payable on the repatriation of these foreign earnings. The following table summarizes the activity related to our gross unrecognized tax benefits at September 30, 2017 , October 1, 2016 , and October 3, 2015 : | | | | in millions | -------------------------------------------------------------+------+-----+------+-------------+---- | 2017 | | 2016 | | | 2015 | -------------------------------------------------------------+------+-----+------+-------------+-----+------+-- Balance as of the beginning of the year | $ | 305 | | $ | 306 | | | $ | 272 -------------------------------------------------------------+------+-----+------+-------------+-----+------+---+---+---- Increases related to current year tax positions | 38 | | 35 | | | 78 | -------------------------------------------------------------+------+-----+------+-------------+-----+------+-- Increases related to prior year tax positions | 5 | | 31 | | | 11 | -------------------------------------------------------------+------+-----+------+-------------+-----+------+-- Increase related to AdvancePierre acquisition | 9 | | — | | | — | -------------------------------------------------------------+------+-----+------+-------------+-----+------+-- Reductions related to prior year tax positions | (27 | ) | (48 | ) | | (18 | ) -------------------------------------------------------------+------+-----+------+-------------+-----+------+-- Reductions related to settlements | (4 | ) | (7 | ) | | — | -------------------------------------------------------------+------+-----+------+-------------+-----+------+-- Reductions related to expirations of statutes of limitations | (10 | ) | (12 | ) | | (37 | ) -------------------------------------------------------------+------+-----+------+-------------+-----+------+-- Balance as of the end of the year | $ | 316 | | $ | 305 | | | $ | 306 -------------------------------------------------------------+------+-----+------+-------------+-----+------+---+---+---- The amount of unrecognized tax benefits, if recognized, that would impact our effective tax rate was $205 million at September 30, 2017 and October 1, 2016 . We classify interest and penalties on unrecognized tax benefits as income tax expense. At September 30, 2017 , and October 1, 2016 , before tax benefits, we had $63 million and $52 million , respectively, of accrued interest and penalties on unrecognized tax benefits. As of September 30, 2017 , we are subject to income tax examinations for United States federal income taxes for fiscal years 2013 through 2016. We are also subject to income tax examinations by major state and foreign jurisdictions for fiscal years 2005 through 2016 and 2002 through 2016, respectively. We estimate that during the next twelve months it is reasonably possible that unrecognized tax benefits could decrease by as much as $9 million primarily due to expiration of statutes in various jurisdictions. 65 NOTE 10: OTHER INCOME AND CHARGES During fiscal 2017, we recorded $28 million of legal costs related to two former subsidiaries of Hillshire Brands, which were sold by Hillshire Brands in 1986 and 1994, $18 million of acquisition bridge financing fees related to the AdvancePierre acquisition and $19 million of equity earnings in joint ventures, which were recorded in the Consolidated Statements of Income in Other, net. In the second quarter of fiscal 2017, we recorded a $52 million impairment charge related to our San Diego Prepared Foods operation. The impairment was comprised of $43 million of property, plant and equipment, $8 million of definite lived intangible assets and $1 million of other assets. This charge, of which $44 million was included in the Consolidated Statements of Income in Cost of Sales and $8 million was included in the Consolidated Statements of Income in Selling, General and Administrative, was triggered by a change in a co-manufacturing contract and ongoing losses. During fiscal 2016, we recorded $12 million of equity earnings in joint ventures and $4 million in net foreign currency exchange losses, which were recorded in the Consolidated Statements of Income in Other, net. During fiscal 2015, following the sale of our Mexico and Brazil chicken production operations, we reviewed our strategy and outlook for the remaining international businesses, which operations include our chicken production operations in China. Despite our belief in the potential for this business, our Chinese operations had not achieved profitability. Given the losses that were generated in this business, changes in the strategy and management of the business, and the depressed economic outlook for China at that time, we assessed our Chinese operations for potential impairment in the fourth quarter of fiscal 2015. As a result of this evaluation, during the fourth quarter of fiscal 2015, we recorded a $169 million impairment charge. The impairment was comprised of $126 million of property, plant and equipment, $23 million of goodwill and $20 million of other assets. The China operation is included in Other for segment reporting and the impairment was included in Cost of Sales in the Consolidated Statements of Income. During fiscal 2015, we recorded $12 million of equity earnings in joint ventures and $21 million of gains on the sale of equity securities, which were recorded in the Consolidated Statements of Income in Other, net. 66 NOTE 11: EARNINGS PER SHARE The earnings and weighted average common shares used in the computation of basic and diluted earnings per share are as follows: | in millions, except per share data | ------------------------------------------------------------------------------------------------------+------------------------------------+------ | 2017 | | 2016 | | | 2015 ------------------------------------------------------------------------------------------------------+------------------------------------+-------+-------+---+-------+------ Numerator: | | | | ------------------------------------------------------------------------------------------------------+------------------------------------+-------+-------+-- Net income | $ | 1,778 | | $ | 1,772 | | $ | 1,224 ------------------------------------------------------------------------------------------------------+------------------------------------+-------+-------+---+-------+-------+---+------ Less: Net income (loss) attributable to noncontrolling interests | 4 | | 4 | | | 4 ------------------------------------------------------------------------------------------------------+------------------------------------+-------+-------+---+-------+------ Net income attributable to Tyson | 1,774 | | 1,768 | | | 1,220 ------------------------------------------------------------------------------------------------------+------------------------------------+-------+-------+---+-------+------ Less dividends declared: | | | | ------------------------------------------------------------------------------------------------------+------------------------------------+-------+-------+-- Class A | 285 | | 192 | | | 129 ------------------------------------------------------------------------------------------------------+------------------------------------+-------+-------+---+-------+------ Class B | 61 | | 41 | | | 26 ------------------------------------------------------------------------------------------------------+------------------------------------+-------+-------+---+-------+------ Undistributed earnings | $ | 1,428 | | $ | 1,535 | | $ | 1,065 ------------------------------------------------------------------------------------------------------+------------------------------------+-------+-------+---+-------+-------+---+------ Class A undistributed earnings | $ | 1,177 | | $ | 1,279 | | $ | 896 ------------------------------------------------------------------------------------------------------+------------------------------------+-------+-------+---+-------+-------+---+------ Class B undistributed earnings | 251 | | 256 | | | 169 ------------------------------------------------------------------------------------------------------+------------------------------------+-------+-------+---+-------+------ Total undistributed earnings | $ | 1,428 | | $ | 1,535 | | $ | 1,065 ------------------------------------------------------------------------------------------------------+------------------------------------+-------+-------+---+-------+-------+---+------ Denominator: | | | | ------------------------------------------------------------------------------------------------------+------------------------------------+-------+-------+-- Denominator for basic earnings per share: | | | | ------------------------------------------------------------------------------------------------------+------------------------------------+-------+-------+-- Class A weighted average shares | 296 | | 315 | | | 335 ------------------------------------------------------------------------------------------------------+------------------------------------+-------+-------+---+-------+------ Class B weighted average shares, and shares under if-converted method for diluted earnings per share | 70 | | 70 | | | 70 ------------------------------------------------------------------------------------------------------+------------------------------------+-------+-------+---+-------+------ Effect of dilutive securities: | | | | ------------------------------------------------------------------------------------------------------+------------------------------------+-------+-------+-- Stock options and restricted stock | 4 | | 5 | | | 5 ------------------------------------------------------------------------------------------------------+------------------------------------+-------+-------+---+-------+------ Tangible Equity Units | — | | — | | | 3 ------------------------------------------------------------------------------------------------------+------------------------------------+-------+-------+---+-------+------ Denominator for diluted earnings per share – adjusted weighted average shares and assumed conversions | 370 | | 390 | | | 413 ------------------------------------------------------------------------------------------------------+------------------------------------+-------+-------+---+-------+------ Net Income Per Share Attributable to Tyson: | | | | ------------------------------------------------------------------------------------------------------+------------------------------------+-------+-------+-- Class A Basic | $ | 4.94 | | $ | 4.67 | | $ | 3.06 ------------------------------------------------------------------------------------------------------+------------------------------------+-------+-------+---+-------+-------+---+------ Class B Basic | $ | 4.45 | | $ | 4.24 | | $ | 2.79 ------------------------------------------------------------------------------------------------------+------------------------------------+-------+-------+---+-------+-------+---+------ Diluted | $ | 4.79 | | $ | 4.53 | | $ | 2.95 ------------------------------------------------------------------------------------------------------+------------------------------------+-------+-------+---+-------+-------+---+------ Approximately 1 million of our stock-based compensation shares were antidilutive for fiscal 2017. We had no stock-based compensation shares that were antidilutive for fiscal 2016 and approximately 5 million of our stock-based compensation shares that were antidilutive for fiscal 2015. These shares were not included in the dilutive earnings per share calculation. We have two classes of capital stock, Class A stock and Class B stock. Cash dividends cannot be paid to holders of Class B stock unless they are simultaneously paid to holders of Class A stock. The per share amount of cash dividends paid to holders of Class B stock cannot exceed 90% of the cash dividends paid to holders of Class A stock. We allocate undistributed earnings based upon a 1 to 0.9 ratio per share to Class A stock and Class B stock, respectively. We allocate undistributed earnings based on this ratio due to historical dividend patterns, voting control of Class B shareholders and contractual limitations of dividends to Class B stock. 67 NOTE 12: DERIVATIVE FINANCIAL INSTRUMENTS Our business operations give rise to certain market risk exposures mostly due to changes in commodity prices, foreign currency exchange rates and interest rates. We manage a portion of these risks through the use of derivative financial instruments to reduce our exposure to commodity price risk, foreign currency risk and interest rate risk. Our risk management programs are periodically reviewed by our Board of Directors' Audit Committee. These programs are monitored by senior management and may be revised as market conditions dictate. Our current risk management programs utilize industry-standard models that take into account the implicit cost of hedging. Risks associated with our market risks and those created by derivative instruments and the fair values are strictly monitored, using value-at-risk and stress tests. Credit risks associated with our derivative contracts are not significant as we minimize counterparty concentrations, utilize margin accounts or letters of credit, and deal with credit-worthy counterparties. Additionally, our derivative contracts are mostly short-term in duration and we generally do not make use of credit-risk-related contingent features. No significant concentrations of credit risk existed at September 30, 2017 . We had the following aggregated outstanding notional amounts related to our derivative financial instruments: | | in millions, except soy meal tons -----------------+----------------------+---------------------------------- | Metric | September 30, 2017 | October 1, 2016 -----------------+----------------------+-----------------------------------+---------------- Corn | Bushels | 55 | 50 -----------------+----------------------+-----------------------------------+---------------- Soy Meal | Tons | 475,200 | 389,700 -----------------+----------------------+-----------------------------------+---------------- Live Cattle | Pounds | 211 | 28 -----------------+----------------------+-----------------------------------+---------------- Lean Hogs | Pounds | 240 | 158 -----------------+----------------------+-----------------------------------+---------------- Foreign Currency | United States dollar | 58 | 38 -----------------+----------------------+-----------------------------------+---------------- We recognize all derivative instruments as either assets or liabilities at fair value in the Consolidated Balance Sheets, with the exception of normal purchases and normal sales expected to result in physical delivery. For those derivative instruments that are designated and qualify as hedging instruments, we designate the hedging instrument based upon the exposure being hedged (i.e., cash flow hedge or fair value hedge). We designate certain forward contracts as follows: • | Cash Flow Hedges – include certain commodity forward and option contracts of forecasted purchases (i.e., grains) and certain foreign exchange forward contracts. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Fair Value Hedges – include certain commodity forward contracts of firm commitments (i.e., livestock). --+------------------------------------------------------------------------------------------------------- Cash flow hedges Derivative instruments are designated as hedges against changes in the amount of future cash flows related to procurement of certain commodities utilized in our production processes. For the derivative instruments we designate and qualify as a cash flow hedge, the effective portion of the gain or loss on the derivative is reported as a component of other comprehensive income (OCI) and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. Gains and losses representing hedge ineffectiveness are recognized in earnings in the current period. Ineffectiveness related to our cash flow hedges was not significant during fiscal 2017 , 2016 and 2015 . As of September 30, 2017 , the net amounts expected to be reclassified into earnings within the next 12 months are pretax losses of $2 million . During fiscal 2017 , 2016 and 2015 , we did not reclassify significant pretax gains/losses into earnings as a result of the discontinuance of cash flow hedges. The following table sets forth the pretax impact of cash flow hedge derivative instruments in the Consolidated Statements of Income: | | | | | | | | | | in millions | -----------------------------------------------------------------+--------------------------------------------+----+---+------------------------------------------------+---+---------------------------------------------+------+---+----------------------+-------------+----- | Gain (Loss)Recognized in OCIon Derivatives | | | ConsolidatedStatements of IncomeClassification | | Gain (Loss)Reclassified fromOCI to Earnings | -----------------------------------------------------------------+--------------------------------------------+----+---+------------------------------------------------+---+---------------------------------------------+----- | 2017 | | | 2016 | | | 2015 | | | | 2017 | | 2016 | | | 2015 | -----------------------------------------------------------------+--------------------------------------------+----+---+------------------------------------------------+---+---------------------------------------------+------+---+----------------------+-------------+------+---------------+------+----+---+------+-- Cash Flow Hedge – Derivatives designated as hedging instruments: | | | | | | | | | | | | -----------------------------------------------------------------+--------------------------------------------+----+---+------------------------------------------------+---+---------------------------------------------+------+---+----------------------+-------------+------+-------------- Commodity contracts | $ | (3 | ) | | $ | (1 | ) | $ | (4 | ) | | Cost of Sales | $ | (4 | ) | | $ | 1 | $ | (7 | ) -----------------------------------------------------------------+--------------------------------------------+----+---+------------------------------------------------+---+---------------------------------------------+------+---+----------------------+-------------+------+---------------+------+----+---+------+---+---+---+----+-- Foreign exchange contracts | — | | | — | | | — | | Other Income/Expense | | — | | — | | | — | -----------------------------------------------------------------+--------------------------------------------+----+---+------------------------------------------------+---+---------------------------------------------+------+---+----------------------+-------------+------+---------------+------+----+---+------+-- Total | $ | (3 | ) | | $ | (1 | ) | $ | (4 | ) | | | $ | (4 | ) | | $ | 1 | $ | (7 | ) -----------------------------------------------------------------+--------------------------------------------+----+---+------------------------------------------------+---+---------------------------------------------+------+---+----------------------+-------------+------+---------------+------+----+---+------+---+---+---+----+-- 68 Fair value hedges We designate certain derivative contracts as fair value hedges of firm commitments to purchase live cattle for harvesting or feeder cattle for growout production. Our objective of these hedges is to minimize the risk of changes in fair value created by fluctuations in commodity prices associated with fixed price livestock firm commitments. For these derivative instruments we designate and qualify as a fair value hedge, the gain or loss on the derivative, as well as the offsetting gain or loss on the hedged item attributable to the hedged risk, are recognized in earnings in the same period. We include the gain or loss on the hedged items (i.e., livestock purchase firm commitments) in the same line item, Cost of Sales, as the offsetting gain or loss on the related livestock forward position. | in millions ---------------------------------+----------------------------------------------- | ConsolidatedStatements of IncomeClassification | 2017 | | | 2016 | | | 2015 | ---------------------------------+------------------------------------------------+------+-----+---+------+---+----+------+-- Gain (Loss) on forwards | Cost of Sales | $ | (20 | ) | | $ | 89 | | | $ | 17 ---------------------------------+------------------------------------------------+------+-----+---+------+---+----+------+---+---+--- Gain (Loss) on purchase contract | Cost of Sales | 20 | | | (89 | ) | | (17 | ) ---------------------------------+------------------------------------------------+------+-----+---+------+---+----+------+-- Ineffectiveness related to our fair value hedges was not significant during fiscal 2017 , 2016 and 2015 . Undesignated positions In addition to our designated positions, we also hold derivative contracts for which we do not apply hedge accounting. These include certain derivative instruments related to commodities price risk, including grains, livestock, energy and foreign currency risk. We mark these positions to fair value through earnings at each reporting date. The following table sets forth the pretax impact of the undesignated derivative instruments in the Consolidated Statements of Income: | | | | in millions | ---------------------------------------------------+------------------------------------------------+----------------------------------+-----+-------------+----- | ConsolidatedStatements of IncomeClassification | Gain (Loss)Recognizedin Earnings | ---------------------------------------------------+------------------------------------------------+----------------------------------+---- | | 2017 | | | 2016 | | | 2015 | ---------------------------------------------------+------------------------------------------------+----------------------------------+-----+-------------+------+---+-----+------+-- Derivatives not designated as hedging instruments: | | | | | | ---------------------------------------------------+------------------------------------------------+----------------------------------+-----+-------------+------+-- Commodity contracts | Sales | $ | 111 | | | $ | (73 | ) | | $ | (62 | ) ---------------------------------------------------+------------------------------------------------+----------------------------------+-----+-------------+------+---+-----+------+---+---+-----+-- Commodity contracts | Cost of Sales | (95 | ) | | 17 | | | (33 | ) ---------------------------------------------------+------------------------------------------------+----------------------------------+-----+-------------+------+---+-----+------+-- Foreign exchange contracts | Other Income/Expense | — | | | 2 | | | (4 | ) ---------------------------------------------------+------------------------------------------------+----------------------------------+-----+-------------+------+---+-----+------+-- Total | | $ | 16 | | | $ | (54 | ) | | $ | (99 | ) ---------------------------------------------------+------------------------------------------------+----------------------------------+-----+-------------+------+---+-----+------+---+---+-----+-- The fair value of all outstanding derivative instruments in the Consolidated Balance Sheets are included in Note 13: Fair Value Measurements. NOTE 13: FAIR VALUE MEASUREMENTS Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The fair value hierarchy contains three levels as follows: Level 1 — Unadjusted quoted prices available in active markets for the identical assets or liabilities at the measurement date. Level 2 — Other observable inputs available at the measurement date, other than quoted prices included in Level 1, either directly or indirectly, including: • | Quoted prices for similar assets or liabilities in active markets; --+------------------------------------------------------------------- • | Quoted prices for identical or similar assets in non-active markets; --+--------------------------------------------------------------------- • | Inputs other than quoted prices that are observable for the asset or liability; and --+------------------------------------------------------------------------------------ • | Inputs derived principally from or corroborated by other observable market data. --+--------------------------------------------------------------------------------- Level 3 — Unobservable inputs that cannot be corroborated by observable market data and reflect the use of significant management judgment. These values are generally determined using pricing models for which the assumptions utilize management’s estimates of market participant assumptions. 69 Assets and Liabilities Measured at Fair Value on a Recurring Basis The fair value hierarchy requires the use of observable market data when available. In instances where the inputs used to measure fair value fall into different levels of the fair value hierarchy, the fair value measurement has been determined based on the lowest level input significant to the fair value measurement in its entirety. Our assessment of the significance of a particular item to the fair value measurement in its entirety requires judgment, including the consideration of inputs specific to the asset or liability. The following tables set forth by level within the fair value hierarchy our financial assets and liabilities accounted for at fair value on a recurring basis according to the valuation techniques we used to determine their fair values: | | | | | | | in millions | ----------------------------------+---------+----+---------+---+-----+---------+-------------+------------ September 30, 2017 | Level 1 | | Level 2 | | | Level 3 | | Netting (a) | | Total | ----------------------------------+---------+----+---------+---+-----+---------+-------------+-------------+---+-------+---- Assets: | | | | | | | ----------------------------------+---------+----+---------+---+-----+---------+------------ Derivative Financial Instruments: | | | | | | | ----------------------------------+---------+----+---------+---+-----+---------+------------ Designated as hedges | $ | — | | $ | 10 | | $ | — | | $ | (1 | ) | $ | 9 ----------------------------------+---------+----+---------+---+-----+---------+-------------+-------------+---+-------+-----+---+---+---- Undesignated | — | | 24 | | | — | | (3 | ) | 21 | ----------------------------------+---------+----+---------+---+-----+---------+-------------+-------------+---+-------+---- Available for Sale Securities: | | | | | | | ----------------------------------+---------+----+---------+---+-----+---------+------------ Current | — | | 2 | | | 1 | | — | | 3 | ----------------------------------+---------+----+---------+---+-----+---------+-------------+-------------+---+-------+---- Non-current | — | | 45 | | | 50 | | — | | 95 | ----------------------------------+---------+----+---------+---+-----+---------+-------------+-------------+---+-------+---- Deferred Compensation Assets | 23 | | 272 | | | — | | — | | 295 | ----------------------------------+---------+----+---------+---+-----+---------+-------------+-------------+---+-------+---- Total Assets | $ | 23 | | $ | 353 | | $ | 51 | | $ | (4 | ) | $ | 423 ----------------------------------+---------+----+---------+---+-----+---------+-------------+-------------+---+-------+-----+---+---+---- Liabilities: | | | | | | | ----------------------------------+---------+----+---------+---+-----+---------+------------ Derivative Financial Instruments: | | | | | | | ----------------------------------+---------+----+---------+---+-----+---------+------------ Designated as hedges | $ | — | | $ | 9 | | $ | — | | $ | (9 | ) | $ | — ----------------------------------+---------+----+---------+---+-----+---------+-------------+-------------+---+-------+-----+---+---+---- Undesignated | — | | 21 | | | — | | (17 | ) | 4 | ----------------------------------+---------+----+---------+---+-----+---------+-------------+-------------+---+-------+---- Total Liabilities | $ | — | | $ | 30 | | $ | — | | $ | (26 | ) | $ | 4 ----------------------------------+---------+----+---------+---+-----+---------+-------------+-------------+---+-------+-----+---+---+---- October 1, 2016 | Level 1 | | Level 2 | | | Level 3 | | Netting (a) | | Total | ----------------------------------+---------+----+---------+---+-----+---------+-------------+-------------+---+-------+---- Assets: | | | | | | | ----------------------------------+---------+----+---------+---+-----+---------+------------ Derivative Financial Instruments: | | | | | | | ----------------------------------+---------+----+---------+---+-----+---------+------------ Designated as hedges | $ | — | | $ | 72 | | $ | — | | $ | (27 | ) | $ | 45 ----------------------------------+---------+----+---------+---+-----+---------+-------------+-------------+---+-------+-----+---+---+---- Undesignated | — | | 38 | | | — | | (34 | ) | 4 | ----------------------------------+---------+----+---------+---+-----+---------+-------------+-------------+---+-------+---- Available for Sale Securities: | | | | | | | ----------------------------------+---------+----+---------+---+-----+---------+------------ Current | — | | 2 | | | 2 | | — | | 4 | ----------------------------------+---------+----+---------+---+-----+---------+-------------+-------------+---+-------+---- Non-current | — | | 38 | | | 55 | | — | | 93 | ----------------------------------+---------+----+---------+---+-----+---------+-------------+-------------+---+-------+---- Deferred Compensation Assets | 18 | | 236 | | | — | | — | | 254 | ----------------------------------+---------+----+---------+---+-----+---------+-------------+-------------+---+-------+---- Total Assets | $ | 18 | | $ | 386 | | $ | 57 | | $ | (61 | ) | $ | 400 ----------------------------------+---------+----+---------+---+-----+---------+-------------+-------------+---+-------+-----+---+---+---- Liabilities: | | | | | | | ----------------------------------+---------+----+---------+---+-----+---------+------------ Derivative Financial Instruments: | | | | | | | ----------------------------------+---------+----+---------+---+-----+---------+------------ Designated as hedges | $ | — | | $ | 1 | | $ | — | | $ | (1 | ) | $ | — ----------------------------------+---------+----+---------+---+-----+---------+-------------+-------------+---+-------+-----+---+---+---- Undesignated | — | | 68 | | | — | | (68 | ) | — | ----------------------------------+---------+----+---------+---+-----+---------+-------------+-------------+---+-------+---- Total Liabilities | $ | — | | $ | 69 | | $ | — | | $ | (69 | ) | $ | — ----------------------------------+---------+----+---------+---+-----+---------+-------------+-------------+---+-------+-----+---+---+---- (a) | Our derivative assets and liabilities are presented in our Consolidated Balance Sheets on a net basis when a legally enforceable master netting arrangement exists between the counterparty to a derivative contract and us. At September 30, 2017, and October 1, 2016, we had $22 million and $8 million, respectively, of cash collateral posted with various counterparties where master netting arrangements exist and held no cash collateral. ----+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 70 The following table provides a reconciliation between the beginning and ending balance of debt securities measured at fair value on a recurring basis in the table above that used significant unobservable inputs (Level 3): | | | in millions | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----+-------------+---------------- | September 30, 2017 | | | October 1, 2016 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----+-------------+-----------------+-- Balance at beginning of year | $ | 57 | | | $ | 61 -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----+-------------+-----------------+---+--- Total realized and unrealized gains (losses): | | | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----+------------ Included in earnings | — | | | — | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----+-------------+-----------------+-- Included in other comprehensive income (loss) | (1 | ) | | — | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----+-------------+-----------------+-- Purchases | 13 | | | 12 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----+-------------+-----------------+-- Issuances | — | | | — | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----+-------------+-----------------+-- Settlements | (18 | ) | | (16 | ) -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----+-------------+-----------------+-- Balance at end of year | $ | 51 | | | $ | 57 -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----+-------------+-----------------+---+--- Total gains (losses) for the periods included in earnings attributable to the change in unrealized gains (losses) relating to assets and liabilities still held at end of year | $ | — | | | $ | — -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----+-------------+-----------------+---+--- The following methods and assumptions were used to estimate the fair value of each class of financial instrument: Derivative Assets and Liabilities: Our derivative financial instruments primarily include exchange-traded and over-the-counter contracts which are further described in Note 12: Derivative Financial Instruments. We record our derivative financial instruments at fair value using quoted market prices adjusted for credit and non-performance risk and internal models that use as their basis readily observable market inputs including current and forward market prices. We classify these instruments in Level 2 when quoted market prices can be corroborated utilizing observable current and forward commodity market prices on active exchanges or observable market transactions. Available for Sale Securities: Our investments in marketable debt securities are classified as available-for-sale and are reported at fair value based on pricing models and quoted market prices adjusted for credit and non-performance risk. Short-term investments with maturities of less than 12 months are included in Other current assets in the Consolidated Balance Sheets and primarily include certificates of deposit and commercial paper. All other marketable debt securities are included in Other Assets in the Consolidated Balance Sheets and have maturities ranging up to 32 years. We classify our investments in United States government, United States agency, certificates of deposit and commercial paper debt securities as Level 2 as fair value is generally estimated using discounted cash flow models that are primarily industry-standard models that consider various assumptions, including time value and yield curve as well as other readily available relevant economic measures. We classify certain corporate, asset-backed and other debt securities as Level 3 as there is limited activity or less observable inputs into valuation models, including current interest rates and estimated prepayment, default and recovery rates on the underlying portfolio or structured investment vehicle. Significant changes to assumptions or unobservable inputs in the valuation of our Level 3 instruments would not have a significant impact to our consolidated financial statements. | | | | | | | | in millions | ----------------------------------+---------------------+----+-----------------+-----------+---+----+-----------------------+-------------+-------------------- | September 30, 2017 | | October 1, 2016 ----------------------------------+---------------------+----+---------------- | AmortizedCost Basis | | | FairValue | | | UnrealizedGain/(Loss) | | AmortizedCost Basis | FairValue | | UnrealizedGain/(Loss) | ----------------------------------+---------------------+----+-----------------+-----------+---+----+-----------------------+-------------+---------------------+-----------+----+-----------------------+-- Available for Sale Securities: | | | | | | | | | ----------------------------------+---------------------+----+-----------------+-----------+---+----+-----------------------+-------------+-------------------- Debt Securities: | | | | | | | | | ----------------------------------+---------------------+----+-----------------+-----------+---+----+-----------------------+-------------+-------------------- United States Treasury and Agency | $ | 47 | | | $ | 47 | | $ | — | $ | 40 | | $ | 40 | $ | — ----------------------------------+---------------------+----+-----------------+-----------+---+----+-----------------------+-------------+---------------------+-----------+----+-----------------------+---+----+---+-- Corporate and Asset-Backed | 51 | | | 51 | | | — | | 56 | 57 | | 1 | ----------------------------------+---------------------+----+-----------------+-----------+---+----+-----------------------+-------------+---------------------+-----------+----+-----------------------+-- 71 Unrealized holding gains (losses), net of tax, are excluded from earnings and reported in OCI until the security is settled or sold. On a quarterly basis, we evaluate whether losses related to our available-for-sale securities are temporary in nature. Losses on equity securities are recognized in earnings if the decline in value is judged to be other than temporary. If losses related to our debt securities are determined to be other than temporary, the loss would be recognized in earnings if we intend, or more likely than not will be required, to sell the security prior to recovery. For debt securities in which we have the intent and ability to hold until maturity, losses determined to be other than temporary would remain in OCI, other than expected credit losses which are recognized in earnings. We consider many factors in determining whether a loss is temporary, including the length of time and extent to which the fair value has been below cost, the financial condition and near-term prospects of the issuer and our ability and intent to hold the investment for a period of time sufficient to allow for any anticipated recovery. We recognized no other than temporary impairment in earnings for fiscal 2017 and fiscal 2016. No other than temporary losses were deferred in OCI as of September 30, 2017 , and October 1, 2016 . Deferred Compensation Assets: We maintain non-qualified deferred compensation plans for certain executives and other highly compensated employees. Investments are generally maintained within a trust and include money market funds, mutual funds and life insurance policies. The cash surrender value of the life insurance policies is invested primarily in mutual funds. The investments are recorded at fair value based on quoted market prices and are included in Other Assets in the Consolidated Balance Sheets. We classify the investments which have observable market prices in active markets in Level 1 as these are generally publicly-traded mutual funds. The remaining deferred compensation assets are classified in Level 2, as fair value can be corroborated based on observable market data. Realized and unrealized gains (losses) on deferred compensation are included in earnings. Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis In addition to assets and liabilities that are recorded at fair value on a recurring basis, we record assets and liabilities at fair value on a nonrecurring basis. Generally, assets are recorded at fair value on a nonrecurring basis as a result of impairment charges. In the fourth quarter of fiscal 2017, we recorded an impairment charge totaling $45 million , related to one of the non-protein businesses held for sale, due to a revised estimate of the business’ fair value based on current expected net sales proceeds. The impairment charge was recorded in Cost of Sales in our Consolidated Statement of Income for fiscal 2017, and consisted of Goodwill and Intangible Assets previously classified within Assets held for sale. Our valuation included unobservable Level 3 inputs and was based on expected sales proceeds following a competitive bidding process. In the second quarter of fiscal 2017, we recorded a $52 million impairment charge related to our San Diego Prepared Foods operation. The impairment was comprised of $43 million of property, plant and equipment, $8 million of definite lived intangibles assets and $1 million of other assets. This charge, of which $44 million was included in the Consolidated Statements of Income in Cost of Sales and $8 million was included in the Consolidated Statements of Income in Selling, General and Administrative, was triggered by a change in a co-manufacturing contract and ongoing losses. Our valuation of these assets was primarily based on discounted cash flows and relief-from-royalty models, which included unobservable Level 3 inputs. We did not have any significant measurements of assets or liabilities at fair value on a nonrecurring basis subsequent to their initial recognition during fiscal 2016. In fiscal 2015, to better align our overall production capacity with then-current cattle supplies, we ceased beef operations at our Denison, Iowa, plant. As a result, we recorded a $12 million closure and impairment charges during the fourth quarter of fiscal 2015. These charges impacted the Beef segment’s operating income and were reflected in Cost of Sales in our Consolidated Statements of Income. Our valuation of these assets was primarily based on discounted cash flow models which included unobservable Level 3 inputs. In fiscal 2015, we recorded a $59 million impairment and other related charges associated with a Prepared Foods project designed to optimize the combined Tyson and Hillshire Brands network capacity and to enhance manufacturing efficiencies for the future. These charges were reflected in the Prepared Foods segment’s operating income, of which $49 million was included in the Consolidated Statements of Income in Cost of Sales and $10 million was included in the Consolidated Statements of Income in Selling, General and Administrative. Our valuation of these assets was primarily based on discounted cash flow models which included unobservable Level 3 inputs. Following the sale of our Mexico and Brazil chicken operations in fiscal 2015, we reviewed our long-term business strategy and outlook for the remaining international businesses, which operations include our chicken production operations in China and India. We assessed our Chinese operation for a potential impairment in fiscal 2015 and as a result of this evaluation, we recorded a $169 million charge to impair its long-lived assets to their fair value and to fully impair its goodwill. The China operation is included in Other for segment reporting and the impairment was included in Cost of Sales in the Consolidated Statements of Income. This impairment was comprised of $126 million of property, plant and equipment, $23 million of goodwill and $20 million of other assets. We utilized a discounted cash flow analysis which included unobservable Level 3 inputs. 72 Other Financial Instruments Fair value of our debt is principally estimated using Level 2 inputs based on quoted prices for those or similar instruments. Fair value and carrying value for our debt are as follows: | | | | | in millions | -----------+--------------------+--------+-----------------+---------------+-------------+------- | September 30, 2017 | | October 1, 2016 -----------+--------------------+--------+---------------- | FairValue | | | CarryingValue | | | FairValue | | CarryingValue -----------+--------------------+--------+-----------------+---------------+-------------+--------+-----------+---+-------------- Total Debt | $ | 10,591 | | | $ | 10,203 | | $ | 6,698 | $ | 6,279 -----------+--------------------+--------+-----------------+---------------+-------------+--------+-----------+---+---------------+---+------ Concentrations of Credit Risk Our financial instruments exposed to concentrations of credit risk consist primarily of cash and cash equivalents and accounts receivable. Our cash equivalents are in high quality securities placed with major banks and financial institutions. Concentrations of credit risk with respect to receivables are limited due to the large number of customers and their dispersion across geographic areas. We perform periodic credit evaluations of our customers’ financial condition and generally do not require collateral. At September 30, 2017 , and October 1, 2016 , 18.6% and 18.9% , respectively, of our net accounts receivable balance was due from Wal-Mart Stores, Inc. No other single customer or customer group represented greater than 10% of net accounts receivable. NOTE 14: STOCK-BASED COMPENSATION We issue shares under our stock-based compensation plans by issuing Class A stock from treasury. The total number of shares available for future grant under the Tyson Foods, Inc. 2000 Stock Incentive Plan (Incentive Plan) was 18,094,438 at September 30, 2017 . Stock Options Shareholders approved the Incentive Plan in January 2001. The Incentive Plan is administered by the Compensation and Leadership Development Committee of the Board of Directors (Compensation Committee). The Incentive Plan includes provisions for granting incentive stock options for shares of Class A stock at a price not less than the fair value at the date of grant. Nonqualified stock options may be granted at a price equal to or more than the fair value of Class A stock on the date the option is granted. Stock options under the Incentive Plan generally become exercisable ratably over three years from the date of grant and must be exercised within 10 years from the date of grant. Our policy is to recognize compensation expense on a straight-line basis over the requisite service period for the entire award. | Shares UnderOption | | WeightedAverage ExercisePrice Per Share | | Weighted AverageRemainingContractual Life(in Years) | | AggregateIntrinsic Value(in millions) | --------------------------------+--------------------+---+-----------------------------------------+-------+-----------------------------------------------------+-----+---------------------------------------+---- Outstanding, October 1, 2016 | 11,191,656 | | $ | 33.74 | | | | --------------------------------+--------------------+---+-----------------------------------------+-------+-----------------------------------------------------+-----+---------------------------------------+---- Exercised | (5,172,485 | ) | 31.17 | | | | --------------------------------+--------------------+---+-----------------------------------------+-------+-----------------------------------------------------+-----+-------------------------------------- Forfeited or expired | (87,361 | ) | 53.18 | | | | --------------------------------+--------------------+---+-----------------------------------------+-------+-----------------------------------------------------+-----+-------------------------------------- Granted | 1,615,708 | | 58.34 | | | | --------------------------------+--------------------+---+-----------------------------------------+-------+-----------------------------------------------------+-----+-------------------------------------- Outstanding, September 30, 2017 | 7,547,518 | | 40.54 | | 7.0 | | $ | 226 | --------------------------------+--------------------+---+-----------------------------------------+-------+-----------------------------------------------------+-----+---------------------------------------+-----+---- Exercisable, September 30, 2017 | 4,152,777 | | $ | 32.15 | | 6.0 | | $ | 159 --------------------------------+--------------------+---+-----------------------------------------+-------+-----------------------------------------------------+-----+---------------------------------------+-----+---- We generally grant stock options once a year. The weighted average grant-date fair value of options granted in fiscal 2017 , 2016 and 2015 was $13.42 , $11.47 and $11.51 , respectively. The fair value of each option grant is established on the date of grant using a binomial lattice method. We use historical volatility for a period of time comparable to the expected life of the option to determine volatility assumptions. Expected life is calculated based on the contractual term of each grant and takes into account the historical exercise and termination behavior of participants. Risk-free interest rates are based on the five-year Treasury bond rate. Assumptions as of the grant date used in the fair value calculation of each year’s grants are outlined in the following table. | 2017 | | 2016 | | 2015 | -------------------------+-------------+---+-------------+---+------+-- Expected life (in years) | 5.4 | | 6.4 | | 6.1 | -------------------------+-------------+---+-------------+---+------+-- Risk-free interest rate | 1.8 | % | 1.6 | % | 1.6 | % -------------------------+-------------+---+-------------+---+------+-- Expected volatility | 24.7 | % | 24.8 | % | 26.7 | % -------------------------+-------------+---+-------------+---+------+-- Expected dividend yield | 1.3% - 1.4% | | 1.2% - 2.6% | | 1.0 | % -------------------------+-------------+---+-------------+---+------+-- 73 We recognized stock-based compensation expense related to stock options, net of income taxes, of $22 million , $23 million and $27 million for fiscal 2017 , 2016 and 2015 , respectively. The related tax benefit for fiscal 2017 , 2016 and 2015 was $14 million , $15 million and $17 million , respectively. We had 4.1 million , 3.8 million and 3.8 million options vest in fiscal 2017 , 2016 and 2015 , respectively, with a grant date fair value of $47 million , $38 million and $32 million , respectively. In fiscal 2017 , 2016 and 2015 , we received cash of $154 million , $128 million and $84 million , respectively, for the exercise of stock options. Shares are issued from treasury for stock option exercises. The related tax benefit realized from stock options exercised during fiscal 2017 , 2016 and 2015 , was $65 million , $80 million and $30 million , respectively. The total intrinsic value of options exercised in fiscal 2017 , 2016 and 2015 , was $164 million , $204 million and $79 million , respectively. Cash flows resulting from tax deductions in excess of the compensation cost of those options (excess tax deductions) are classified as financing cash flows. We realized $42 million , $58 million and $19 million related to excess tax deductions during fiscal 2017 , 2016 and 2015 , respectively. As of September 30, 2017 , we had $ 15 million of total unrecognized compensation cost related to stock option plans that will be recognized over a weighted average period of 1 year . Restricted Stock We issue restricted stock at the market value as of the date of grant, with restrictions expiring over periods through fiscal 2019. Unearned compensation is recognized over the vesting period for the particular grant using a straight-line method. | Number of Shares | | WeightedAverage Grant-Date Fair ValuePer Share | | Weighted AverageRemainingContractual Life(in Years) | | AggregateIntrinsic Value(in millions) | ------------------------------+------------------+---+------------------------------------------------+-------+-----------------------------------------------------+-----+---------------------------------------+-- Nonvested, October 1, 2016 | 1,602,866 | | $ | 43.45 | | | | ------------------------------+------------------+---+------------------------------------------------+-------+-----------------------------------------------------+-----+---------------------------------------+-- Granted | 734,954 | | 58.96 | | | | ------------------------------+------------------+---+------------------------------------------------+-------+-----------------------------------------------------+-----+-------------------------------------- Dividends | 25,751 | | 50.64 | | | | ------------------------------+------------------+---+------------------------------------------------+-------+-----------------------------------------------------+-----+-------------------------------------- Vested | (506,773 | ) | 37.64 | | | | ------------------------------+------------------+---+------------------------------------------------+-------+-----------------------------------------------------+-----+-------------------------------------- Forfeited | (141,698 | ) | 52.02 | | | | ------------------------------+------------------+---+------------------------------------------------+-------+-----------------------------------------------------+-----+-------------------------------------- Nonvested, September 30, 2017 | 1,715,100 | | $ | 51.21 | | 1.3 | | $ | 121 ------------------------------+------------------+---+------------------------------------------------+-------+-----------------------------------------------------+-----+---------------------------------------+---+---- As of September 30, 2017 , we had $38 million of total unrecognized compensation cost related to restricted stock awards that will be recognized over a weighted average period of 2 years . We recognized stock-based compensation expense related to restricted stock, net of income taxes, of $18 million , $14 million and $9 million for fiscal 2017 , 2016 and 2015 , respectively. The related tax benefit for fiscal 2017 , 2016 and 2015 was $11 million , $9 million and $6 million , respectively. We had 0.5 million , 0.2 million and 0.5 million restricted stock awards vest in fiscal 2017 , 2016 and 2015 , respectively, with a grant date fair value of $19 million , $4 million and $10 million , respectively. Performance-Based Shares We award performance-based shares of our Class A stock to certain employees. These awards are typically granted once a year. Performance-based shares vest based upon the passage of time and the achievement of performance or market performance criteria, ranging from 0% to 200% , as determined by the Compensation Committee prior to the date of the award. Vesting periods for these awards are three years . We review progress toward the attainment of the performance criteria each quarter during the vesting period. When it is probable the minimum performance criteria for an award will be achieved, we begin recognizing the expense equal to the proportionate share of the total fair value of the Class A stock price on the grant date. The total expense recognized over the duration of performance awards will equal the Class A stock price on the date of grant multiplied by the number of shares ultimately awarded based on the level of attainment of the performance criteria. For grants with market performance criteria, the fair value is determined on the grant date and is calculated using the same inputs for expected volatility, expected dividend yield, and risk-free rate as stock options, noted above, with a duration of three years . The total expense recognized over the duration of the award will equal the fair value, regardless if the market performance criteria is met. 74 The following table summarizes the performance-based shares at the maximum award amounts based upon the respective performance share agreements. Actual shares that will vest depend on the level of attainment of the performance-based criteria. | Number of Shares | | WeightedAverage Grant-Date Fair ValuePer Share | | Weighted AverageRemainingContractual Life(in Years) | | AggregateIntrinsic Value(in millions) | ------------------------------+------------------+---+------------------------------------------------+-------+-----------------------------------------------------+-----+---------------------------------------+-- Nonvested, October 1, 2016 | 2,147,069 | | $ | 48.15 | | | | ------------------------------+------------------+---+------------------------------------------------+-------+-----------------------------------------------------+-----+---------------------------------------+-- Granted | 965,687 | | 47.73 | | | | ------------------------------+------------------+---+------------------------------------------------+-------+-----------------------------------------------------+-----+-------------------------------------- Vested | (389,797 | ) | 18.62 | | | | ------------------------------+------------------+---+------------------------------------------------+-------+-----------------------------------------------------+-----+-------------------------------------- Forfeited | (565,844 | ) | 38.05 | | | | ------------------------------+------------------+---+------------------------------------------------+-------+-----------------------------------------------------+-----+-------------------------------------- Nonvested, September 30, 2017 | 2,157,115 | | $ | 38.92 | | 1.3 | | $ | 152 ------------------------------+------------------+---+------------------------------------------------+-------+-----------------------------------------------------+-----+---------------------------------------+---+---- We recognized stock-based compensation expense related to performance shares, net of income taxes, of $16 million , $11 million and $5 million for fiscal 2017 , 2016 and 2015 , respectively. The related tax benefit for fiscal 2017 , 2016 and 2015 was $ 10 million , $7 million and $3 million , respectively. As of September 30, 2017 , we had $33 million of total unrecognized compensation based upon our progress toward the attainment of criteria related to performance-based share awards that will be recognized over a weighted average period of 2 years . NOTE 15: PENSIONS AND OTHER POSTRETIREMENT BENEFITS At September 30, 2017 , we had nine defined benefit pension plans consisting of six funded qualified plans, which are all frozen and noncontributory, and three unfunded non-qualified plans. The benefits provided under these plans are based on a formula using years of service and either a specified benefit rate or compensation level. The non-qualified defined benefit plans are for certain contracted officers and use a formula based on years of service and final average salary. We also have other postretirement benefit plans for which substantially all of our employees may receive benefits if they satisfy applicable eligibility criteria. The postretirement healthcare plans are contributory with participants’ contributions adjusted when deemed necessary. We have defined contribution retirement programs for various groups of employees. We recognized expenses of $78 million , $67 million and $62 million in fiscal 2017 , 2016 and 2015 , respectively. We use a fiscal year end measurement date for our defined benefit plans and other postretirement plans. We recognize the effect of actuarial gains and losses into earnings immediately for other postretirement plans rather than amortizing the effect over future periods. Other postretirement benefits include postretirement medical costs and life insurance. In the second quarter of fiscal 2017, we issued a notice of intent to terminate two of our qualified pension plans with a termination date of April 30, 2017. The settlements of the terminated plans are expected to occur in the fourth quarter of fiscal 2018 or the first quarter of fiscal 2019, through purchased annuities. Since the amount of the settlement depends on a number of factors determined as of the liquidation date, including the annuity pricing interest rate environment and asset experience, we are currently unable to determine the ultimate cost of the settlement. However, based on current market rates the one-time settlement charge at final liquidation is estimated to be in the range of approximately $25 million to $30 million . Contributions to purchase annuities at the time of settlement are expected to be minimal based upon the funded status of each plan at September 30, 2017. 75 Benefit Obligations and Funded Status The following table provides a reconciliation of the changes in the plans’ benefit obligations, assets and funded status at September 30, 2017 , and October 1, 2016 : | | | | | | | | | in millions | -----------------------------------------------+------------------+-------+----------------------+-------+----------+-------+------+---+-------------+----- | Pension Benefits | | Other Postretirement -----------------------------------------------+------------------+-------+--------------------- | Qualified | | Non-Qualified | | Benefits -----------------------------------------------+------------------+-------+----------------------+-------+--------- | 2017 | | | 2016 | | | 2017 | | | 2016 | | 2017 | | | 2016 | -----------------------------------------------+------------------+-------+----------------------+-------+----------+-------+------+---+-------------+------+---+------+------+---+------+-- Change in benefit obligation | | | | | | | | | | | -----------------------------------------------+------------------+-------+----------------------+-------+----------+-------+------+---+-------------+------+-- Benefit obligation at beginning of year | $ | 1,554 | | | $ | 1,785 | | | $ | 222 | | $ | 201 | | | $ | 36 | | $ | 114 | -----------------------------------------------+------------------+-------+----------------------+-------+----------+-------+------+---+-------------+------+---+------+------+---+------+---+-----+---+---+-----+-- Service cost | 2 | | | 8 | | | 11 | | | 6 | | 1 | | | 1 | -----------------------------------------------+------------------+-------+----------------------+-------+----------+-------+------+---+-------------+------+---+------+------+---+------+-- Interest cost | 57 | | | 65 | | | 8 | | | 9 | | 1 | | | 3 | -----------------------------------------------+------------------+-------+----------------------+-------+----------+-------+------+---+-------------+------+---+------+------+---+------+-- Plan amendments | — | | | — | | | — | | | — | | — | | | (58 | ) -----------------------------------------------+------------------+-------+----------------------+-------+----------+-------+------+---+-------------+------+---+------+------+---+------+-- Plan participants’ contributions | — | | | — | | | — | | | — | | — | | | 1 | -----------------------------------------------+------------------+-------+----------------------+-------+----------+-------+------+---+-------------+------+---+------+------+---+------+-- Actuarial (gain)/loss | (52 | ) | | 21 | | | 1 | | | 16 | | (1 | ) | | (15 | ) -----------------------------------------------+------------------+-------+----------------------+-------+----------+-------+------+---+-------------+------+---+------+------+---+------+-- Benefits paid | (84 | ) | | (339 | ) | | (12 | ) | | (10 | ) | (4 | ) | | (10 | ) -----------------------------------------------+------------------+-------+----------------------+-------+----------+-------+------+---+-------------+------+---+------+------+---+------+-- Other | — | | | 14 | | | — | | | — | | — | | | — | -----------------------------------------------+------------------+-------+----------------------+-------+----------+-------+------+---+-------------+------+---+------+------+---+------+-- Benefit obligation at end of year | 1,477 | | | 1,554 | | | 230 | | | 222 | | 33 | | | 36 | -----------------------------------------------+------------------+-------+----------------------+-------+----------+-------+------+---+-------------+------+---+------+------+---+------+-- Change in plan assets | | | | | | | | | | | -----------------------------------------------+------------------+-------+----------------------+-------+----------+-------+------+---+-------------+------+-- Fair value of plan assets at beginning of year | 1,440 | | | 1,576 | | | — | | | — | | — | | | — | -----------------------------------------------+------------------+-------+----------------------+-------+----------+-------+------+---+-------------+------+---+------+------+---+------+-- Actual return on plan assets | 115 | | | 135 | | | — | | | — | | — | | | — | -----------------------------------------------+------------------+-------+----------------------+-------+----------+-------+------+---+-------------+------+---+------+------+---+------+-- Employer contributions | 41 | | | 54 | | | 12 | | | 10 | | 4 | | | 9 | -----------------------------------------------+------------------+-------+----------------------+-------+----------+-------+------+---+-------------+------+---+------+------+---+------+-- Plan participants’ contributions | — | | | — | | | — | | | — | | — | | | 1 | -----------------------------------------------+------------------+-------+----------------------+-------+----------+-------+------+---+-------------+------+---+------+------+---+------+-- Benefits paid | (84 | ) | | (339 | ) | | (12 | ) | | (10 | ) | (4 | ) | | (10 | ) -----------------------------------------------+------------------+-------+----------------------+-------+----------+-------+------+---+-------------+------+---+------+------+---+------+-- Other | — | | | 14 | | | — | | | — | | — | | | — | -----------------------------------------------+------------------+-------+----------------------+-------+----------+-------+------+---+-------------+------+---+------+------+---+------+-- Fair value of plan assets at end of year | 1,512 | | | 1,440 | | | — | | | — | | — | | | — | -----------------------------------------------+------------------+-------+----------------------+-------+----------+-------+------+---+-------------+------+---+------+------+---+------+-- Funded status | $ | 35 | | | $ | (114 | ) | | $ | (230 | ) | $ | (222 | ) | | $ | (33 | ) | $ | (36 | ) -----------------------------------------------+------------------+-------+----------------------+-------+----------+-------+------+---+-------------+------+---+------+------+---+------+---+-----+---+---+-----+-- Amounts recognized in the Consolidated Balance Sheets consist of: | | | | | | | | | in millions | ---------------------------+------------------+----+----------------------+------+----------+------+------+---+-------------+----- | Pension Benefits | | Other Postretirement ---------------------------+------------------+----+--------------------- | Qualified | | Non-Qualified | | Benefits ---------------------------+------------------+----+----------------------+------+--------- | 2017 | | | 2016 | | | 2017 | | | 2016 | | 2017 | | | 2016 | ---------------------------+------------------+----+----------------------+------+----------+------+------+---+-------------+------+---+------+------+---+------+-- Other assets | $ | 44 | | | $ | — | | | $ | — | | $ | — | | | $ | — | | $ | — | ---------------------------+------------------+----+----------------------+------+----------+------+------+---+-------------+------+---+------+------+---+------+---+-----+---+---+-----+-- Other current liabilities | — | | | — | | | (11 | ) | | (9 | ) | (3 | ) | | (4 | ) ---------------------------+------------------+----+----------------------+------+----------+------+------+---+-------------+------+---+------+------+---+------+-- Other liabilities | (9 | ) | | (114 | ) | | (219 | ) | | (213 | ) | (30 | ) | | (32 | ) ---------------------------+------------------+----+----------------------+------+----------+------+------+---+-------------+------+---+------+------+---+------+-- Total assets (liabilities) | $ | 35 | | | $ | (114 | ) | | $ | (230 | ) | $ | (222 | ) | | $ | (33 | ) | $ | (36 | ) ---------------------------+------------------+----+----------------------+------+----------+------+------+---+-------------+------+---+------+------+---+------+---+-----+---+---+-----+-- 76 Amounts recognized in Accumulated Other Comprehensive Income consist of: | | | | | | | | in millions | -----------------------------------------------------+------------------+-----+----------------------+------+----------+----+------+-------------+----- | Pension Benefits | | Other Postretirement -----------------------------------------------------+------------------+-----+--------------------- | Qualified | | Non-Qualified | | Benefits -----------------------------------------------------+------------------+-----+----------------------+------+--------- | 2017 | | | 2016 | | | 2017 | | 2016 | 2017 | | 2016 | -----------------------------------------------------+------------------+-----+----------------------+------+----------+----+------+-------------+------+------+----+------+-- Accumulated other comprehensive (income)/loss: | | | | | | | | | -----------------------------------------------------+------------------+-----+----------------------+------+----------+----+------+-------------+----- Actuarial (gain) loss | $ | (94 | ) | | $ | 17 | | $ | 50 | $ | 55 | | $ | — | | $ | — | -----------------------------------------------------+------------------+-----+----------------------+------+----------+----+------+-------------+------+------+----+------+---+-----+---+---+-----+-- Prior service (credit) (a) | — | | | — | | | — | | — | (73 | ) | (98 | ) -----------------------------------------------------+------------------+-----+----------------------+------+----------+----+------+-------------+------+------+----+------+-- Total accumulated other comprehensive (income)/loss: | $ | (94 | ) | | $ | 17 | | $ | 50 | $ | 55 | | $ | (73 | ) | $ | (98 | ) -----------------------------------------------------+------------------+-----+----------------------+------+----------+----+------+-------------+------+------+----+------+---+-----+---+---+-----+-- (a) | The change in prior service credit is primarily attributed to the plan amendments to the other postretirement benefits as noted within the change in benefit obligation with remainder of the change being immaterial. ----+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- We had five and eight pension plans at September 30, 2017 , and October 1, 2016 , respectively, that had an accumulated benefit obligation in excess of plan assets. Plans with accumulated benefit obligations in excess of plan assets are as follows: | | | | | in millions | -------------------------------+------------------+-----+---------------+-------+-------------+------ | Pension Benefits -------------------------------+----------------- | Qualified | | Non-Qualified -------------------------------+------------------+-----+-------------- | 2017 | | | 2016 | | | 2017 | | 2016 -------------------------------+------------------+-----+---------------+-------+-------------+-------+------+---+----- Projected benefit obligation | $ | 361 | | | $ | 1,550 | | $ | 230 | $ | 222 -------------------------------+------------------+-----+---------------+-------+-------------+-------+------+---+------+---+---- Accumulated benefit obligation | 361 | | | 1,550 | | | 220 | | 207 -------------------------------+------------------+-----+---------------+-------+-------------+-------+------+---+----- Fair value of plan assets | 352 | | | 1,436 | | | — | | — -------------------------------+------------------+-----+---------------+-------+-------------+-------+------+---+----- The accumulated benefit obligation for all qualified pension plans was $1,477 million and $1,554 million at September 30, 2017 , and October 1, 2016 , respectively. Net Periodic Benefit Cost (Credit) Components of net periodic benefit cost (credit) for pension and postretirement benefit plans recognized in the Consolidated Statements of Income are as follows: | | | | | | | | | | | | | | in millions | --------------------------------------+------------------+---+----------------------+------+----------+----+------+---+---+------+---+------+----+-------------+----- | Pension Benefits | | Other Postretirement --------------------------------------+------------------+---+--------------------- | Qualified | | Non-Qualified | | Benefits --------------------------------------+------------------+---+----------------------+------+--------- | 2017 | | | 2016 | | | 2015 | | | 2017 | | 2016 | | | 2015 | | | 2017 | | | 2016 | | 2015 | --------------------------------------+------------------+---+----------------------+------+----------+----+------+---+---+------+---+------+----+-------------+------+---+----+------+---+---+------+---+------+---- Service cost | $ | 2 | | | $ | 8 | | | $ | 10 | | $ | 11 | | | $ | 6 | | | $ | 8 | | $ | 1 | | $ | 1 | | $ | 5 --------------------------------------+------------------+---+----------------------+------+----------+----+------+---+---+------+---+------+----+-------------+------+---+----+------+---+---+------+---+------+-----+---+---+-----+---+---+--- Interest cost | 57 | | | 65 | | | 78 | | | 8 | | 9 | | | 8 | | | 1 | | | 3 | | 7 | --------------------------------------+------------------+---+----------------------+------+----------+----+------+---+---+------+---+------+----+-------------+------+---+----+------+---+---+------+---+------+---- Expected return on plan assets | (59 | ) | | (65 | ) | | (102 | ) | | — | | — | | | — | | | — | | | — | | — | --------------------------------------+------------------+---+----------------------+------+----------+----+------+---+---+------+---+------+----+-------------+------+---+----+------+---+---+------+---+------+---- Amortization of prior service cost | — | | | — | | | — | | | — | | — | | | — | | | (25 | ) | | (20 | ) | (1 | ) --------------------------------------+------------------+---+----------------------+------+----------+----+------+---+---+------+---+------+----+-------------+------+---+----+------+---+---+------+---+------+---- Recognized actuarial loss (gain), net | 1 | | | 2 | | | 2 | | | 6 | | 5 | | | 4 | | | (1 | ) | | (15 | ) | 9 | --------------------------------------+------------------+---+----------------------+------+----------+----+------+---+---+------+---+------+----+-------------+------+---+----+------+---+---+------+---+------+---- Recognized settlement loss (gain) | 2 | | | (12 | ) | | 8 | | | — | | — | | | — | | | — | | | — | | (2 | ) --------------------------------------+------------------+---+----------------------+------+----------+----+------+---+---+------+---+------+----+-------------+------+---+----+------+---+---+------+---+------+---- Net periodic benefit cost (credit) | $ | 3 | | | $ | (2 | ) | | $ | (4 | ) | $ | 25 | | | $ | 20 | | | $ | 20 | | $ | (24 | ) | $ | (31 | ) | $ | 18 --------------------------------------+------------------+---+----------------------+------+----------+----+------+---+---+------+---+------+----+-------------+------+---+----+------+---+---+------+---+------+-----+---+---+-----+---+---+--- As of September 30, 2017 , the amounts expected to be reclassified into earnings within the next 12 months related to net periodic benefit cost for the qualified and non-qualified pension plans, excluding pending settlements, are $1 million and $4 million , respectively. As of September 30, 2017 , the amount expected to be reclassified into earnings within the next 12 months related to net periodic benefit credit for the other postretirement benefits is $25 million . 77 Assumptions Weighted average assumptions are as follows: | Pension Benefits | | Other Postretirement -----------------------------------------------------+------------------+---+--------------------- | Qualified | | Non-Qualified | | Benefits -----------------------------------------------------+------------------+---+----------------------+------+--------- | 2017 | | | 2016 | | 2015 | | 2017 | | 2016 | | 2015 | | 2017 | | 2016 | | 2015 | -----------------------------------------------------+------------------+---+----------------------+------+----------+------+---+------+---+------+---+------+---+------+---+------+---+------+-- Discount rate to determine net periodic benefit cost | 3.72 | % | | 4.47 | % | 4.32 | % | 3.77 | % | 4.41 | % | 4.36 | % | 3.09 | % | 3.54 | % | 3.97 | % -----------------------------------------------------+------------------+---+----------------------+------+----------+------+---+------+---+------+---+------+---+------+---+------+---+------+-- Discount rate to determine benefit obligations | 3.85 | % | | 3.72 | % | 4.47 | % | 3.88 | % | 3.77 | % | 4.41 | % | 3.39 | % | 3.09 | % | 3.54 | % -----------------------------------------------------+------------------+---+----------------------+------+----------+------+---+------+---+------+---+------+---+------+---+------+---+------+-- Rate of compensation increase | n/a | | | n/a | | 0.01 | % | 2.44 | % | 2.46 | % | 2.31 | % | n/a | | n/a | | n/a | -----------------------------------------------------+------------------+---+----------------------+------+----------+------+---+------+---+------+---+------+---+------+---+------+---+------+-- Expected return on plan assets | 4.21 | % | | 4.15 | % | 4.61 | % | n/a | | n/a | | n/a | | n/a | | n/a | | n/a | -----------------------------------------------------+------------------+---+----------------------+------+----------+------+---+------+---+------+---+------+---+------+---+------+---+------+-- To determine the expected return on plan assets assumption, we first examined historical rates of return for the various asset classes within the plans. We then determined a long-term projected rate-of-return based on expected returns. Our discount rate assumptions used to account for pension and other postretirement benefit plans reflect the rates at which the benefit obligations could be effectively settled. These were determined using a cash flow matching technique whereby the rates of a yield curve, developed from high-quality debt securities, were applied to the benefit obligations to determine the appropriate discount rate. As of September 30, 2017 and October 1, 2016, all pension and other postretirement benefit plans used the RP-2014 mortality tables. We have five other postretirement benefit plans which are healthcare and life insurance related. Two of these plans, which benefit obligations totaled $19 million at September 30, 2017 , were not impacted by healthcare cost trend rates as one consists of fixed annual payments and one is life insurance related. Two of the healthcare plans, which benefit obligations totaled $1 million at September 30, 2017 , were not impacted by healthcare cost trend rates due to plan amendments. The remaining plan, which the benefit obligation totaled $13 million at September 30, 2017 , utilized assumed healthcare cost trend rates of 9.1% and 7.3% for retirees who qualify and do not qualify for Medicare, respectively. The healthcare cost trend rate will be grading down to an ultimate rate of 4.5% in 2024/2025. A one-percentage-point change in assumed health-care cost trend rates would have the following effects: | | | in millions --------------------------------------------+-------------------------------+---+------------------------------ | One Percentage Point Increase | | One Percentage Point Decrease --------------------------------------------+-------------------------------+---+------------------------------ Effect on postretirement benefit obligation | $ | 1 | | $ | 1 --------------------------------------------+-------------------------------+---+-------------------------------+---+-- Plan Assets The following table sets forth the actual and target asset allocation for pension plan assets: | 2017 | | 2016 | | Target AssetAllocation | --------------------------+-------+---+-------+---+------------------------+-- Cash | 1.1 | % | 0.9 | % | — | % --------------------------+-------+---+-------+---+------------------------+-- Fixed Income Securities | 87.4 | | 85.4 | | 91.5 | --------------------------+-------+---+-------+---+------------------------+-- United States Stock Funds | 3.5 | | 3.7 | | 2.4 | --------------------------+-------+---+-------+---+------------------------+-- International Stock Funds | 5.6 | | 6.2 | | 4.0 | --------------------------+-------+---+-------+---+------------------------+-- Real Estate | 2.4 | | 3.8 | | 2.1 | --------------------------+-------+---+-------+---+------------------------+-- Total | 100.0 | % | 100.0 | % | 100.0 | % --------------------------+-------+---+-------+---+------------------------+-- Additionally, one of our foreign subsidiary pension plans had $28 million in plan assets held in an insurance trust at September 30, 2017 , and October 1, 2016 . The plan trustees have established a set of investment objectives related to the assets of the domestic pension plans and regularly monitor the performance of the funds and portfolio managers. Objectives for the pension assets are (i) to provide growth of capital and income, (ii) to achieve a target weighted average annual rate of return competitive with funds with similar investment objectives and (iii) to diversify to reduce risk. The target asset allocations are based upon the funded status of the plans. As pension obligations become better funded, we will lower risk by increasing the allocation to fixed income. 78 Our domestic plan assets consist mainly of common collective trusts which are primarily comprised of fixed income funds, equity securities and other investments. Fixed income securities can include, but are not limited to, direct bond investments, and pooled or indirect bond investments. Other investments may include, but are not limited to, international and domestic equities, real estate, commodities and private equity. Derivative instruments may also be used in concert with either fixed income or equity investments to achieve desired exposure or to hedge certain risks. Derivative instruments can include, but are not limited to, futures, options, swaps or swaptions. Our domestic plan assets also include mutual funds. We believe there are no significant concentrations of risk within our plan assets as of September 30, 2017 . The following tables show the categories of pension plan assets and the level under which fair values were determined in the fair value hierarchy, which is described in Note 13: Fair Value Measurements. | in millions | -----------------------------------------+-------------+--- September 30, 2017 | Level 1 | | Level 2 | | | Level 3 | | | Total -----------------------------------------+-------------+----+---------+---+---+---------+-------+---+------ Cash and cash equivalents | $ | 15 | | $ | — | | | $ | — | $ | 15 -----------------------------------------+-------------+----+---------+---+---+---------+-------+---+-------+---+--- Insurance contract at contract value (a) | — | | — | | | 28 | | | 28 -----------------------------------------+-------------+----+---------+---+---+---------+-------+---+------ Total assets in fair value hierarchy | $ | 15 | | $ | — | | | $ | 28 | $ | 43 -----------------------------------------+-------------+----+---------+---+---+---------+-------+---+-------+---+--- Investments measured at net asset value: | | | | | | -----------------------------------------+-------------+----+---------+---+---+-------- Common collective trusts (b) | | | | | | 1,469 | -----------------------------------------+-------------+----+---------+---+---+---------+------ Total plan assets | | | | | | $ | 1,512 | -----------------------------------------+-------------+----+---------+---+---+---------+-------+-- | in millions | -----------------------------------------+-------------+--- October 1, 2016 | Level 1 | | Level 2 | | | Level 3 | | Total | -----------------------------------------+-------------+----+---------+---+---+---------+---+-------+------ Cash and cash equivalents | $ | 13 | | $ | — | | $ | — | | $ | 13 -----------------------------------------+-------------+----+---------+---+---+---------+---+-------+-------+---+--- Insurance contract at contract value (a) | — | | — | | | 28 | | 28 | -----------------------------------------+-------------+----+---------+---+---+---------+---+-------+------ Total assets in fair value hierarchy | $ | 13 | | $ | — | | $ | 28 | | $ | 41 -----------------------------------------+-------------+----+---------+---+---+---------+---+-------+-------+---+--- Investments measured at net asset value: | | | | | | -----------------------------------------+-------------+----+---------+---+---+-------- Common collective trusts (b) | | | | | | | | 1,399 | -----------------------------------------+-------------+----+---------+---+---+---------+---+-------+------ Total plan assets | | | | | | | | $ | 1,440 -----------------------------------------+-------------+----+---------+---+---+---------+---+-------+------ (a) | We classify insurance contracts as Level 3 as there is limited activity or less observable inputs into valuation models, including current interest rates and estimated prepayment, default and recovery rates on the underlying portfolio or structured investment vehicle. The insurance contracts are valued using the plan’s own assumptions about the assumptions market participants would use in pricing the assets based on the best information available, such as investment manager pricing. Significant changes to assumptions or unobservable inputs in the valuation of our Level 3 instruments would not have a significant impact to our consolidated financial statements. ----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (b) | Funds that are measured at fair value using the net asset value (NAV) per share practical expedient have not been categorized in the fair value hierarchy. The amounts presented above are intended to permit reconciliation of the fair value hierarchy to the fair value of total plan assets in order to determine the amounts included in Other Assets and Other Liabilities in the Consolidated Balance Sheets. ----+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- A reconciliation of the change in the fair value measurement of the defined benefit plans’ consolidated assets using significant unobservable inputs (Level 3) is as follows: | | | in millions | --------------------------------------+--------------------+----+-------------+------ | Insurance contract | | | Total | --------------------------------------+--------------------+----+-------------+-------+-- Balance at October 1, 2016 | $ | 28 | | | $ | 28 --------------------------------------+--------------------+----+-------------+-------+---+--- Actual return on plan assets: | | | | --------------------------------------+--------------------+----+-------------+------ Assets still held at reporting date | — | | | — | --------------------------------------+--------------------+----+-------------+-------+-- Assets sold during the period | — | | | — | --------------------------------------+--------------------+----+-------------+-------+-- Purchases, sales and settlements, net | — | | | — | --------------------------------------+--------------------+----+-------------+-------+-- Transfers in and/or out of Level 3 | — | | | — | --------------------------------------+--------------------+----+-------------+-------+-- Balance at September 30, 2017 | $ | 28 | | | $ | 28 --------------------------------------+--------------------+----+-------------+-------+---+--- 79 Contributions Our policy is to fund at least the minimum contribution required to meet applicable federal employee benefit and local tax laws. In our sole discretion, we may from time to time fund additional amounts. Expected contributions to pension plans for fiscal 2018 are approximately $38 million . For fiscal 2017 , 2016 and 2015 , we funded $53 million , $64 million and $14 million plans, respectively, to pension plans. Estimated Future Benefit Payments The following benefit payments are expected to be paid: | | | | | in millions | ----------+------------------+----+----------------------+----+-------------+--- | Pension Benefits | | Other Postretirement ----------+------------------+----+--------------------- | Qualified | | Non-Qualified | | Benefits ----------+------------------+----+----------------------+----+------------ 2018 | $ | 82 | | | $ | 11 | | $ | 3 ----------+------------------+----+----------------------+----+-------------+----+----+---+-- 2019 | 83 | | | 11 | | | 3 ----------+------------------+----+----------------------+----+-------------+----+--- 2020 | 83 | | | 12 | | | 3 ----------+------------------+----+----------------------+----+-------------+----+--- 2021 | 84 | | | 12 | | | 3 ----------+------------------+----+----------------------+----+-------------+----+--- 2022 | 85 | | | 13 | | | 3 ----------+------------------+----+----------------------+----+-------------+----+--- 2023-2027 | 431 | | | 68 | | | 13 ----------+------------------+----+----------------------+----+-------------+----+--- The above benefit payments for other postretirement benefit plans are not expected to be offset by Medicare Part D subsidies in fiscal 2018. The above 2018 benefit payments do not include anticipated payments for a plan termination within two of our qualified pension plans. The plan termination process for these plans began on April, 30, 2017, and full settlement is expected to occur in the fourth quarter of fiscal 2018 or the first quarter of fiscal 2019. Multi-Employer Plans Additionally, we participate in a multi-employer plan that provides defined benefits to certain employees covered by collective bargaining agreements. Such plans are usually administered by a board of trustees composed of the management of the participating companies and labor representatives. The risks of participating in multi-employer plans are different from single-employer plans. Assets contributed to the multi-employer plan by one employer may be used to provide benefits to employees of other participating employers. If a participating employer stops contributing to the plan, the unfunded obligation of the plan may be borne by the remaining participating employers. If we stop participating in a plan, we may be required to pay that plan an amount based on the underfunded status of the plan, referred to as a withdrawal liability. Contributions to the pension funds were not in excess of 5% of the total plan contributions for plan year 2017. The net pension cost of the plan is equal to the annual contribution determined in accordance with the provisions of negotiated labor contracts. Contributions to the plan were $2 million and $1 million in fiscal 2017 and 2016, respectively. Assets contributed to such plans are not segregated or otherwise restricted to provide benefits only to our employees. The future cost of the plan is dependent on a number of factors including the funded status of the plan and the ability of the other participating companies to meet ongoing funding obligations. Our participation in this multi-employer plan for fiscal 2017 is outlined below. The EIN/Pension Plan Number column provides the Employer Identification Number (EIN) and the three-digit plan number. Unless otherwise noted, the most recent Pension Protection Act ("PPA") zone status available in fiscal 2017 and fiscal 2016 is for the plan's year beginning January 1, 2017, and 2016, respectively. The zone status is based on information that we have received from the plan and is certified by the plan's actuaries. The zone status is a secondary classification, critical and declining, within the red zone for fiscal 2017. Among other factors, plans in the red zone are generally less than 65 percent funded. Plans that are critical and declining status are projected to have an accumulated funding deficiency. The FIP/RP Status column indicates plans for which a financial improvement plan (FIP) or rehabilitation plan (RP) is either pending or has been implemented. The last column lists the expiration date(s) of the collective-bargaining agreements to which the plan is subject. There have been no significant changes that affect the comparability of contributions from year to year. 80 In addition to regular contributions, we could be obligated to pay additional contributions (known as complete or partial withdrawal liabilities) if it has unfunded vested benefits. | | PPA Zone Status | FIP/RP Status | Contributions (in millions) | | Surcharge Imposed | | -----------------------------------------------------------------------+-------------------------+-----------------+---------------+-----------------------------+-------------+-------------------+------+--- Pension Fund Plan Name | EIN/Pension Plan Number | 2017 | 2016 | | Implemented | 2017 | 2016 | | 2017 | | Expiration Date of Collective Bargaining Agreement(a) -----------------------------------------------------------------------+-------------------------+-----------------+---------------+-----------------------------+-------------+-------------------+------+----+------+-----+------------------------------------------------------ Bakery and Confectionery Union and Industry International Pension Fund | 52-6118572/001 | Red | Red | | Nov 2012 | | $2 | $1 | | 10% | | October 2015 -----------------------------------------------------------------------+-------------------------+-----------------+---------------+-----------------------------+-------------+-------------------+------+----+------+-----+-------------------------------------------------------+------------- (a) Renewal negotiations are in progress. NOTE 16: COMPREHENSIVE INCOME (LOSS) The components of accumulated other comprehensive loss are as follows: | | | in millions | -------------------------------------------------------------+------+----+-------------+----- | 2017 | | | 2016 | -------------------------------------------------------------+------+----+-------------+------+-- Accumulated other comprehensive income (loss), net of taxes: | | | -------------------------------------------------------------+------+----+------------ Unrealized net hedging loss | $ | (2 | ) | | $ | (2 | ) -------------------------------------------------------------+------+----+-------------+------+---+-----+-- Unrealized net gain on investments | — | | | 1 | -------------------------------------------------------------+------+----+-------------+------+-- Currency translation adjustment | (53 | ) | | (59 | ) -------------------------------------------------------------+------+----+-------------+------+-- Postretirement benefits reserve adjustments | 71 | | | 15 | -------------------------------------------------------------+------+----+-------------+------+-- Total accumulated other comprehensive loss | $ | 16 | | | $ | (45 | ) -------------------------------------------------------------+------+----+-------------+------+---+-----+-- The before and after tax changes in the components of other comprehensive income (loss) are as follows: | | | | | | | | | in millions | ---------------------------------------------------+------------+-----+-----------+---+------------+-----+-----------+----+-------------+---- | 2017 | | 2016 | | 2015 ---------------------------------------------------+------------+-----+-----------+---+----------- | Before Tax | Tax | After Tax | | Before Tax | Tax | After Tax | | Before Tax | Tax | After Tax ---------------------------------------------------+------------+-----+-----------+---+------------+-----+-----------+----+-------------+-----+---------- Derivatives accounted for as cash flow hedges: | | | | | | | | | | | ---------------------------------------------------+------------+-----+-----------+---+------------+-----+-----------+----+-------------+-----+---------- (Gain) loss reclassified to cost of sales | $ | 4 | | $ | (2 | ) | $ | 2 | | | $ | (1 | ) | $ | 1 | | $ | — | | | $ | 7 | $ | (3 | ) | $ | 4 ---------------------------------------------------+------------+-----+-----------+---+------------+-----+-----------+----+-------------+-----+-----------+----+---+---+-----+---+-----+----+-----+---+---+----+---+----+---+---+--- Unrealized gain (loss) | (3 | ) | 1 | | (2 | ) | | (1 | ) | — | | (1 | ) | | (4 | ) | 2 | | (2 | ) ---------------------------------------------------+------------+-----+-----------+---+------------+-----+-----------+----+-------------+-----+-----------+----+---+---+-----+---+-----+----+-----+-- Investments: | | | | | | | | | | | ---------------------------------------------------+------------+-----+-----------+---+------------+-----+-----------+----+-------------+-----+---------- (Gain) loss reclassified to other income/expense | — | | — | | — | | | — | | — | | — | | | (21 | ) | 8 | | (13 | ) ---------------------------------------------------+------------+-----+-----------+---+------------+-----+-----------+----+-------------+-----+-----------+----+---+---+-----+---+-----+----+-----+-- Unrealized gain (loss) | (1 | ) | — | | (1 | ) | | (1 | ) | 1 | | — | | | 21 | | (9 | ) | 12 | ---------------------------------------------------+------------+-----+-----------+---+------------+-----+-----------+----+-------------+-----+-----------+----+---+---+-----+---+-----+----+-----+-- Currency translation: | | | | | | | | | | | ---------------------------------------------------+------------+-----+-----------+---+------------+-----+-----------+----+-------------+-----+---------- Translation loss reclassified to cost of sales (a) | — | | — | | — | | | — | | — | | — | | | 115 | | (8 | ) | 107 | ---------------------------------------------------+------------+-----+-----------+---+------------+-----+-----------+----+-------------+-----+-----------+----+---+---+-----+---+-----+----+-----+-- Translation adjustment | 6 | | — | | 6 | | | 5 | | (1 | ) | 4 | | | (86 | ) | 15 | | (71 | ) ---------------------------------------------------+------------+-----+-----------+---+------------+-----+-----------+----+-------------+-----+-----------+----+---+---+-----+---+-----+----+-----+-- Postretirement benefits | 91 | | (35 | ) | 56 | | | 67 | | (25 | ) | 42 | | | 32 | | (12 | ) | 20 | ---------------------------------------------------+------------+-----+-----------+---+------------+-----+-----------+----+-------------+-----+-----------+----+---+---+-----+---+-----+----+-----+-- Total other comprehensive income (loss) | $ | 97 | | $ | (36 | ) | $ | 61 | | | $ | 69 | | $ | (24 | ) | $ | 45 | | | $ | 64 | $ | (7 | ) | $ | 57 ---------------------------------------------------+------------+-----+-----------+---+------------+-----+-----------+----+-------------+-----+-----------+----+---+---+-----+---+-----+----+-----+---+---+----+---+----+---+---+--- (a) Translation loss reclassified to Cost of Sales related to disposition of a foreign operation, which is further described in Note 3: Acquisitions and Dispositions. 81 NOTE 17: SEGMENT REPORTING We operate in four reportable segments: Beef, Pork, Chicken, and Prepared Foods. We measure segment profit as operating income (loss). Other primarily includes our foreign chicken production operations in China and India, third-party merger and integration costs and corporate overhead related to Tyson New Ventures, LLC. On June 7, 2017, we acquired AdvancePierre, a producer and distributor of value-added, convenient, ready-to-eat sandwiches, sandwich components and other entrées and snacks. AdvancePierre's results from operations subsequent to the acquisition closing are included in the Prepared Foods and Chicken segments. Beef: Beef includes our operations related to processing live fed cattle and fabricating dressed beef carcasses into primal and sub-primal meat cuts and case-ready products. Products are marketed domestically to food retailers, foodservice distributors, restaurant operators, hotel chains and noncommercial foodservice establishments such as schools, healthcare facilities, the military and other food processors, as well as to international export markets. This segment also includes sales from allied products such as hides and variety meats, as well as logistics operations to move products through the supply chain. Pork: Pork includes our operations related to processing live market hogs and fabricating pork carcasses into primal and sub-primal cuts and case-ready products. Products are marketed domestically to food retailers, foodservice distributors, restaurant operators, hotel chains and noncommercial foodservice establishments such as schools, healthcare facilities, the military and other food processors, as well as to international export markets. This segment also includes our live swine group, related allied product processing activities and logistics operations to move products through the supply chain. Chicken: Chicken includes our domestic operations related to raising and processing live chickens into, and purchasing raw materials for, fresh, frozen and value-added chicken products, as well as sales from allied products. Our value-added chicken products primarily include breaded chicken strips, nuggets, patties and other ready-to-fix or fully cooked chicken parts. Products are marketed domestically to food retailers, foodservice distributors, restaurant operators, hotel chains and noncommercial foodservice establishments such as schools, healthcare facilities, the military and other food processors, as well as to international export markets. This segment also includes logistics operations to move products through our domestic supply chain and the global operations of our chicken breeding stock subsidiary. Prepared Foods: Prepared Foods includes our operations related to manufacturing and marketing frozen and refrigerated food products and logistics operations to move products through the supply chain. This segment includes brands such as Jimmy Dean®, Hillshire Farm®, Ball Park®, Wright®, State Fair®, Van's®, Sara Lee® and Chef Pierre®, as well as artisanal brands Aidells®, Gallo Salame®, and Golden Island®. Products primarily include ready-to-eat sandwiches, sandwich components such as flame-grilled hamburgers and Philly steaks, pepperoni, bacon, breakfast sausage, turkey, lunchmeat, hot dogs, pizza crusts and toppings, flour and corn tortilla products, desserts, appetizers, snacks, prepared meals, ethnic foods, soups, sauces, side dishes, meat dishes, breadsticks and processed meats. Products are marketed domestically to food retailers, foodservice distributors, restaurant operators, hotel chains and noncommercial foodservice establishments such as schools, healthcare facilities, the military and other food processors, as well as to international export markets. We allocate expenses related to corporate activities to the segments, except for third-party merger and integration costs of $67 million , $37 million and $47 million in fiscal 2017, 2016 and 2015, respectively, and corporate overhead related to Tyson New Ventures, LLC, which are included in Other. Assets and additions to property, plant and equipment relating to corporate activities remain in Other. In addition, at September 30, 2017, we included $3 billion of goodwill associated with our acquisition of AdvancePierre in Other. The allocation of goodwill to our reportable segments is pending finalization of the expected synergies and the impact of the synergies to our reporting units. See Note 5: Goodwill and Intangible Assets for further description. 82 Information on segments and a reconciliation to income from continuing operations before income taxes are as follows: | in millions | -------------------------------------------+-------------+------- | Beef | | Pork | | | Chicken | | PreparedFoods | Other | | IntersegmentSales | | | Consolidated -------------------------------------------+-------------+--------+-------+---+-------+---------+---+---------------+-------+-------+-------------------+---+--------+------------- Fiscal 2017 | | | | | | | | | -------------------------------------------+-------------+--------+-------+---+-------+---------+---+---------------+------ Sales | $ | 14,823 | | $ | 5,238 | | $ | 11,409 | $ | 7,853 | | $ | 349 | | $ | (1,412 | ) | $ | 38,260 -------------------------------------------+-------------+--------+-------+---+-------+---------+---+---------------+-------+-------+-------------------+---+--------+--------------+---+--------+---+---+------- Operating Income (Loss) | 877 | | 645 | | | 1,053 | | 462 | (106 | ) | | | 2,931 | -------------------------------------------+-------------+--------+-------+---+-------+---------+---+---------------+-------+-------+-------------------+---+--------+------------- Total Other (Income) Expense | | | | | | | | | 303 | -------------------------------------------+-------------+--------+-------+---+-------+---------+---+---------------+-------+------ Income before Income Taxes | | | | | | | | | 2,628 | -------------------------------------------+-------------+--------+-------+---+-------+---------+---+---------------+-------+------ Depreciation and amortization | 92 | | 36 | | | 296 | | 315 | 9 | | | | 748 | -------------------------------------------+-------------+--------+-------+---+-------+---------+---+---------------+-------+-------+-------------------+---+--------+------------- Total Assets | 2,938 | | 1,132 | | | 6,630 | | 13,466 | 3,900 | | | | 28,066 | -------------------------------------------+-------------+--------+-------+---+-------+---------+---+---------------+-------+-------+-------------------+---+--------+------------- Additions to property, plant and equipment | 118 | | 101 | | | 492 | | 229 | 129 | | | | 1,069 | -------------------------------------------+-------------+--------+-------+---+-------+---------+---+---------------+-------+-------+-------------------+---+--------+------------- Fiscal 2016 | | | | | | | | | -------------------------------------------+-------------+--------+-------+---+-------+---------+---+---------------+------ Sales | $ | 14,513 | | $ | 4,909 | | $ | 10,927 | $ | 7,346 | | $ | 380 | | $ | (1,194 | ) | $ | 36,881 -------------------------------------------+-------------+--------+-------+---+-------+---------+---+---------------+-------+-------+-------------------+---+--------+--------------+---+--------+---+---+------- Operating Income (Loss) | 347 | | 528 | | | 1,305 | | 734 | (81 | ) | | | 2,833 | -------------------------------------------+-------------+--------+-------+---+-------+---------+---+---------------+-------+-------+-------------------+---+--------+------------- Total Other (Income) Expense | | | | | | | | | 235 | -------------------------------------------+-------------+--------+-------+---+-------+---------+---+---------------+-------+------ Income before Income Taxes | | | | | | | | | 2,598 | -------------------------------------------+-------------+--------+-------+---+-------+---------+---+---------------+-------+------ Depreciation and amortization | 94 | | 33 | | | 274 | | 286 | 10 | | | | 697 | -------------------------------------------+-------------+--------+-------+---+-------+---------+---+---------------+-------+-------+-------------------+---+--------+------------- Total Assets | 2,764 | | 1,039 | | | 5,836 | | 11,814 | 920 | | | | 22,373 | -------------------------------------------+-------------+--------+-------+---+-------+---------+---+---------------+-------+-------+-------------------+---+--------+------------- Additions to property, plant and equipment | 99 | | 68 | | | 281 | | 178 | 69 | | | | 695 | -------------------------------------------+-------------+--------+-------+---+-------+---------+---+---------------+-------+-------+-------------------+---+--------+------------- Fiscal 2015 | | | | | | | | | -------------------------------------------+-------------+--------+-------+---+-------+---------+---+---------------+------ Sales | $ | 17,236 | | $ | 5,262 | | $ | 11,390 | $ | 7,822 | | $ | 879 | | $ | (1,216 | ) | $ | 41,373 -------------------------------------------+-------------+--------+-------+---+-------+---------+---+---------------+-------+-------+-------------------+---+--------+--------------+---+--------+---+---+------- Operating Income (Loss) | (66 | ) | 380 | | | 1,366 | | 588 | (99 | ) | | | 2,169 | -------------------------------------------+-------------+--------+-------+---+-------+---------+---+---------------+-------+-------+-------------------+---+--------+------------- Total Other (Income) Expense | | | | | | | | | 248 | -------------------------------------------+-------------+--------+-------+---+-------+---------+---+---------------+-------+------ Income before Income Taxes | | | | | | | | | 1,921 | -------------------------------------------+-------------+--------+-------+---+-------+---------+---+---------------+-------+------ Depreciation and amortization | 97 | | 31 | | | 272 | | 280 | 21 | | | | 701 | -------------------------------------------+-------------+--------+-------+---+-------+---------+---+---------------+-------+-------+-------------------+---+--------+------------- Total Assets | 3,009 | | 927 | | | 5,731 | | 12,006 | 1,296 | | | | 22,969 | -------------------------------------------+-------------+--------+-------+---+-------+---------+---+---------------+-------+-------+-------------------+---+--------+------------- Additions to property, plant and equipment | 113 | | 50 | | | 405 | | 167 | 119 | | | | 854 | -------------------------------------------+-------------+--------+-------+---+-------+---------+---+---------------+-------+-------+-------------------+---+--------+------------- The Beef segment had sales of $386 million , $327 million and $351 million for fiscal 2017 , 2016 and 2015 , respectively, from transactions with other operating segments. The Pork segment had sales of $966 million , $840 million and $847 million for fiscal 2017 , 2016 and 2015 , respectively, from transactions with other operating segments. The Chicken segment had sales of $60 million , $27 million and $18 million for fiscal 2017 , 2016 and 2015 , respectively, from transactions with other operating segments. The aforementioned sales from intersegment transactions, which were at market prices, were included in the segment sales in the above table. Our largest customer, Wal-Mart Stores, Inc., accounted for 17.3% , 17.5% and 16.8% of consolidated sales in fiscal 2017 , 2016 and 2015 , respectively. Sales to Wal-Mart Stores, Inc. were included in all the segments. Any extended discontinuance of sales to this customer could, if not replaced, have a material impact on our operations. The majority of our operations are domiciled in the United States. Approximately 98% , 98% and 97% of sales to external customers for fiscal 2017 , 2016 and 2015 , respectively, were sourced from the United States. Approximately $21.6 billion and $17.3 billion of long-lived assets were located in the United States at September 30, 2017 , and October 1, 2016 , respectively. Excluding goodwill and intangible assets, long-lived assets located in the United States totaled approximately $6.0 billion and $5.6 billion at September 30, 2017 , and October 1, 2016 , respectively. Approximately $217 million and $204 million of long-lived assets were located in foreign countries, primarily Brazil, China, European Union and India, at September 30, 2017 , and October 1, 2016 , respectively. Excluding goodwill and intangible assets, long-lived assets in foreign countries totaled approximately $193 million and $180 million at September 30, 2017 , and October 1, 2016 , respectively. We sell certain products in foreign markets, primarily Canada, Central America, China, the European Union, Japan, Mexico, the Middle East, South Korea, and Taiwan. Our export sales from the United States totaled $3.9 billion , $3.5 billion and $4.1 billion for fiscal 2017 , 2016 and 2015 , respectively. Substantially all of our export sales are facilitated through unaffiliated brokers, marketing associations and foreign sales staffs. Sales of products produced in a country other than the United States were less than 10% of consolidated sales for each of fiscal 2017 , 2016 and 2015 . 83 NOTE 18: SUPPLEMENTAL CASH FLOWS INFORMATION The following table summarizes cash payments for interest and income taxes: | | | | in millions | -------------------------------------+------+-----+------+-------------+---- | 2017 | | 2016 | | | 2015 -------------------------------------+------+-----+------+-------------+-----+----- Interest, net of amounts capitalized | $ | 249 | | $ | 242 | | $ | 308 -------------------------------------+------+-----+------+-------------+-----+------+---+---- Income taxes, net of refunds | 779 | | 686 | | | 437 -------------------------------------+------+-----+------+-------------+-----+----- NOTE 19: TRANSACTIONS WITH RELATED PARTIES We have operating leases for two wastewater facilities with an entity owned by the Donald J. Tyson Revocable Trust (for which Mr. John Tyson, Chairman of the Company, is a trustee), Berry Street Waste Water Treatment Plant, LP ( 90% of which is owned by TLP), and the sisters of Mr. Tyson. Total payments of approximately $1 million in each of fiscal 2017 , 2016 and 2015 were paid to lease the facilities. As of September 30, 2017, the TLP, of which John Tyson and director Barbara Tyson are general partners, owned 70 million shares, or 99.985% of our outstanding Class B stock and, along with the members of the Tyson family, owned 6.2 million shares of Class A stock, giving it control of approximately 70.78% of the total voting power of our outstanding voting stock. In August 2017, the Company committed to invest $5 million for a 17.5% equity interest in Buchan Ltd., a Mauritian private holding company of poultry operations in sub-Saharan Africa. Acacia Foods, B.V. is committed to invest $9 million in Buchan Ltd. Donnie Smith, who during the first quarter of fiscal year 2017 was Chief Executive Officer of the Company, serves as the Chairman of Acacia Foods, B.V. and as a director of Buchan Ltd. John Randal Tyson (son of John Tyson) serves as a director of Buchan Ltd. for the Company. In fiscal 2017, the Company provided administrative services to the Tyson Limited Partnership, the beneficial owner of 70 million shares of Class B stock, and the Tyson Limited Partnership, through TLP Investment, L.P., reimbursed the Company $0.3 million . NOTE 20: COMMITMENTS AND CONTINGENCIES Commitments We lease equipment, properties and certain farms for which total rentals approximated $186 million , $172 million and $165 million , in fiscal 2017 , 2016 and 2015 , respectively. Most leases have initial terms of up to seven years, some with varying renewal periods. The most significant obligations assumed under the terms of the leases are the upkeep of the facilities and payments of insurance and property taxes. Minimum lease commitments under non-cancelable leases at September 30, 2017 , were: | in millions | ----------------+-------------+---- 2018 | $ | 137 ----------------+-------------+---- 2019 | 100 | ----------------+-------------+---- 2020 | 74 | ----------------+-------------+---- 2021 | 48 | ----------------+-------------+---- 2022 | 32 | ----------------+-------------+---- 2023 and beyond | 73 | ----------------+-------------+---- Total | $ | 464 ----------------+-------------+---- We guarantee obligations of certain outside third parties, consisting primarily of leases, debt and grower loans, which are substantially collateralized by the underlying assets. Terms of the underlying debt cover periods up to 10 years, and the maximum potential amount of future payments as of September 30, 2017 , was $28 million . We also maintain operating leases for various types of equipment, some of which contain residual value guarantees for the market value of the underlying leased assets at the end of the term of the lease. The remaining terms of the lease maturities cover periods over the next 10 years. The maximum potential amount of the residual value guarantees is $109 million , of which $100 million could be recoverable through various recourse provisions and an additional undeterminable recoverable amount based on the fair value of the underlying leased assets. The likelihood of material payments under these guarantees is not considered probable. At September 30, 2017 , and October 1, 2016 , no material liabilities for guarantees were recorded. 84 We have cash flow assistance programs in which certain livestock suppliers participate. Under these programs, we pay an amount for livestock equivalent to a standard cost to grow such livestock during periods of low market sales prices. The amounts of such payments that are in excess of the market sales price are recorded as receivables and accrue interest. Participating suppliers are obligated to repay these receivables balances when market sales prices exceed this standard cost, or upon termination of the agreement. Our potential maximum obligation associated with these programs is limited to the fair value of each participating livestock supplier’s net tangible assets. The potential maximum obligation as of September 30, 2017 , was approximately $380 million . There were no receivables under these programs at September 30, 2017 , and we had $2 million of receivables under this program at October 1, 2016 . This receivable is included, net of allowance for uncollectible amounts, in Accounts Receivable in our Consolidated Balance Sheets. Even though these programs are limited to the net tangible assets of the participating livestock suppliers, we also manage a portion of our credit risk associated with these programs by obtaining security interests in livestock suppliers’ assets. After analyzing residual credit risks and general market conditions, we had no allowance for these programs' estimated uncollectible receivables at September 30, 2017 , and October 1, 2016 . When constructing new facilities or making major enhancements to existing facilities, we will occasionally enter into incentive agreements with local government agencies in order to reduce certain state and local tax expenditures. Under these agreements, we transfer the related assets to various local government entities and receive Industrial Revenue Bonds. We immediately lease the facilities from the local government entities and have an option to re-purchase the facilities for a nominal amount upon tendering the Industrial Revenue Bonds to the local government entities at various predetermined dates. The Industrial Revenue Bonds and the associated obligations for the leases of the facilities offset, and the underlying assets remain in property, plant and equipment. At September 30, 2017 , total amounts under these types of arrangements totaled $505 million . Additionally, we enter into future purchase commitments for various items, such as grains, livestock contracts and fixed grower fees. At September 30, 2017 , these commitments totaled: | in millions | ----------------+-------------+------ 2018 | $ | 1,750 ----------------+-------------+------ 2019 | 374 | ----------------+-------------+------ 2020 | 272 | ----------------+-------------+------ 2021 | 118 | ----------------+-------------+------ 2022 | 77 | ----------------+-------------+------ 2023 and beyond | 110 | ----------------+-------------+------ Total | $ | 2,701 ----------------+-------------+------ Contingencies We are involved in various claims and legal proceedings. We routinely assess the likelihood of adverse judgments or outcomes to those matters, as well as ranges of probable losses, to the extent losses are reasonably estimable. We record accruals for such matters to the extent that we conclude a loss is probable and the financial impact, should an adverse outcome occur, is reasonably estimable. Such accruals are reflected in the Company’s consolidated financial statements. In our opinion, we have made appropriate and adequate accruals for these matters and believe the probability of a material loss beyond the amounts accrued to be remote; however, the ultimate liability for these matters is uncertain, and if accruals are not adequate, an adverse outcome could have a material effect on the consolidated financial condition or results of operations. Listed below are certain claims made against the Company and/or our subsidiaries for which the potential exposure is considered material to the Company’s consolidated financial statements. We believe we have substantial defenses to the claims made and intend to vigorously defend these matters. 85 Below are the details of six lawsuits involving our beef, pork and prepared foods plants in which certain present and past employees allege that we failed to compensate them for the time it takes to engage in pre- and post-shift activities, such as changing into and out of protective and sanitary clothing and walking to and from the changing area, work areas and break areas in violation of the Fair Labor Standards Act and various state laws. The plaintiffs seek back wages, liquidated damages, pre- and post-judgment interest, attorneys’ fees and costs. Each case is proceeding in its jurisdiction. • | Bouaphakeo (f/k/a Sharp), et al. v. Tyson Foods, Inc., N.D. Iowa, February 6, 2007 - A jury trial was held involving our Storm Lake, Iowa pork plant which resulted in a jury verdict in favor of the plaintiffs for violations of federal and state laws for pre- and post-shift work activities. The trial court also awarded the plaintiffs liquidated damages, resulting in total damages awarded in the amount of $5,784,758. The plaintiffs' counsel has also filed an application for attorneys' fees and expenses in the amount of $2,692,145. We appealed the jury's verdict and trial court's award to the Eighth Circuit Court of Appeals. The appellate court affirmed the jury verdict and judgment on August 25, 2014, and we filed a petition for rehearing on September 22, 2014, which was denied. We filed a petition for a writ of certiorari with the United States Supreme Court, which was granted on June 8, 2015, and oral arguments before the Supreme Court occurred on November 10, 2015. On March 22, 2016, the Supreme Court affirmed the appellate court’s rulings and remanded to the trial court to allocate the lump sum award among the class participants. On remand, the trial court determined that the lump sum award should be allocated to class participants according to the method prescribed by plaintiffs’ expert at trial. The trial court has yet to enter a judgment. Subsequently, a joint notice advising the court of a global settlement of this case, the Edwards matter (described below), and the consolidated Murray and DeVoss matter (also described below) was filed. The parties agreed to settle all three matters for a total payment of $12.6 million, inclusive of wages, penalties, interest, attorneys’ fees and costs, and costs of settlement administration. The trial court held an approval hearing on October 11, 2017 and we are awaiting the court’s decision. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Edwards, et al. v. Tyson Foods, Inc. d.b.a Tyson Fresh Meats, Inc., S.D. Iowa, March 20, 2008 - The trial court in this case, which involves our Perry and Waterloo, Iowa pork plants, decertified the state law class and granted other pre-trial motions that resulted in a judgment in our favor with respect to the plaintiffs’ claims. The plaintiffs have filed a motion to modify this judgment. A joint motion for preliminary approval of the collective and class action settlement was filed on July 7, 2017. Please see the above Bouaphakeo description for additional details of a global settlement. --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Murray, et al. v. Tyson Foods, Inc., C.D. Illinois, January 2, 2008; and DeVoss v. Tyson Foods, Inc. d.b.a. Tyson Fresh Meats, C.D. Illinois, March 2, 2011 - These cases involve our Joslin, Illinois beef plant and are in their preliminary stages. A joint notice of settlement and a request to stay the proceedings was filed with and granted by the court on June 28, 2017. Please see the above Bouaphakeo description for additional details of a global settlement. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Dozier, Southerland, et al. v. The Hillshire Brands Company, E.D. North Carolina, September 2, 2014 - This case involves our Tarboro, North Carolina prepared foods plant. On March 25, 2016, the parties filed a joint motion for settlement totaling $425,000, which includes all of the plaintiffs’ attorneys’ fees and costs. The court preliminarily approved the joint motion for settlement, and the final approval hearing is set for December 5, 2017. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- The Hillshire Brands Company was named as a defendant in an asbestos exposure case filed by Mark Lopez in May 2014 in the Superior Court of Alameda County, California. Mr. Lopez was diagnosed with mesothelioma in January 2014 and is now deceased. Mr. Lopez’s family members asserted negligence, premises liability and strict liability claims related to Mr. Lopez’s alleged asbestos exposure from 1954-1986 from the Union Sugar plant in Betteravia, California. The plant, which was sold in 1986, was owned by entities that were predecessors-in-interest to The Hillshire Brands Company. In August 2017, the jury returned a verdict of approximately $13 million in favor of the plaintiffs, and a judgment was entered. We intend to appeal the judgment. On September 2, 2016, Maplevale Farms, Inc., acting on behalf of itself and a putative class of direct purchasers of poultry products, filed a class action complaint against us and certain of our poultry subsidiaries, as well as several other poultry processing companies, in the Northern District of Illinois. Subsequent to the filing of this initial complaint, additional lawsuits making similar claims on behalf of putative classes of direct and indirect purchasers were filed in the United States District Court for the Northern District of Illinois. The court consolidated the complaints, for pre-trial purposes, into actions on behalf of three different putative classes: direct purchasers, indirect purchasers/consumers and commercial/institutional indirect purchasers. These three actions are styled In re Broiler Chicken Antitrust Litigation . Several amended and consolidated complaints have been filed on behalf of each putative class. The currently operative complaints allege, among other things, that beginning in January 2008 the defendants conspired and combined to fix, raise, maintain, and stabilize the price of broiler chickens in violation of United States antitrust laws. The complaints on behalf of the putative classes of indirect purchasers also include causes of action under various state unfair competition laws, consumer protection laws, and unjust enrichment common laws. The complaints also allege that defendants “manipulated and artificially inflated a widely used Broiler price index, the Georgia Dock.” It is further alleged that the defendants concealed this conduct from the plaintiffs and the members of the putative classes. The plaintiffs are seeking treble damages, injunctive relief, pre- and post-judgment interest, costs, and attorneys’ fees on behalf of the putative classes. We filed motions to dismiss these complaints; the court has yet to rule on our motions. 86 On October 17, 2016, William Huser, acting on behalf of himself and a putative class of persons who purchased shares of Tyson Foods' stock between November 23, 2015, and October 7, 2016, filed a class action complaint against Tyson Foods, Inc., Donnie Smith and Dennis Leatherby in the Central District of California. The complaint alleged, among other things, that our periodic filings contained materially false and misleading statements by failing to disclose that the Company has colluded with other producers to manipulate the supply of broiler chickens in order to keep supply artificially low, as alleged in In re Broiler Chicken Antitrust Litigation . Subsequent to the filing of this initial complaint, additional lawsuits making similar claims were filed in the United States District Courts for the Southern District of New York, the Western District of Arkansas, and the Southern District of Ohio. Each of those cases have now been transferred to the United States District Court for the Western District of Arkansas and consolidated, and lead plaintiffs have been appointed. A consolidated complaint was filed on March 22, 2017, (which also named additional individual defendants). The consolidated complaint seeks damages, pre- and post-judgment interest, costs, and attorneys’ fees. We filed a motion to dismiss this complaint, which the court granted on July 26, 2017. The plaintiffs filed a motion to amend or alter the judgment and to submit an amended complaint. That motion is pending. On January 20, 2017, the Company received a subpoena from the Securities and Exchange Commission (the "SEC") in connection with an investigation related to the Company. On August 23, 2017, we received written notification that the SEC staff had concluded the investigation and did not intend to recommend an enforcement action against the Company based on the information available to the agency as of that date. Based upon the information we have, we believe the investigation was based upon the allegations in In re Broiler Chicken Antitrust Litigation . On March 1, 2017, we received a civil investigative demand (CID) from the Office of the Attorney General, Department of Legal Affairs, of the State of Florida. The CID requests information primarily related to possible anticompetitive conduct in connection with the Georgia Dock, a chicken products pricing index formerly published by the Georgia Department of Agriculture. We are cooperating with the Attorney General’s office. Our subsidiary, The Hillshire Brands Company (formerly named Sara Lee Corporation), is a party to a consolidation of cases filed by individual complainants with the Republic of the Philippines, Department of Labor and Employment and the National Labor Relations Commission (NLRC) from 1998 through July 1999. The complaint is filed against Aris Philippines, Inc., Sara Lee Corporation, Sara Lee Philippines, Inc., Fashion Accessories Philippines, Inc., and Attorney Cesar C. Cruz (collectively, the “respondents”). The complaint alleges, among other things, that the respondents engaged in unfair labor practices in connection with the termination of manufacturing operations in the Philippines by Aris Philippines, Inc., a former subsidiary of The Hillshire Brands Company. In 2006, a labor arbiter ruled against the respondents and awarded the complainants PHP 3,453,664,710 (approximately US $67 million ) in damages and fees. The respondents appealed the labor arbiter's ruling, and it was subsequently set aside by the NLRC in December 2006. Subsequent to the NLRC’s decision, the parties filed numerous appeals, motions for reconsideration and petitions for review, certain of which remained outstanding for several years. While various of those appeals, motions and/or petitions were pending, The Hillshire Brands Company, on June 23, 2014, without admitting liability, filed a settlement motion requesting that the Supreme Court of the Philippines order dismissal with prejudice of all claims against it and certain other respondents in exchange for payments allocated by the court among the complainants in an amount not to exceed PHP 342,287,800 (approximately US $6.7 million ). Based in part on its finding that the consideration to be paid to the complainants as part of such settlement was insufficient, the Supreme Court of the Philippines denied the respondents’ settlement motion and all motions for reconsideration thereof. The Supreme Court of the Philippines also set aside as premature the NLRC’s December 2006 ruling. As a result, the cases are now back before the NLRC, which will once again rule on the respondents’ appeals regarding the labor arbiter’s 2006 ruling in favor of the complainants. In the meantime, the respondents reached a settlement with a group comprising approximately 18% of the class of 5,984 complainants, pursuant to which The Hillshire Brands Company would pay each settling complainant PHP 68,000 (approximately US $1,325 ). The settlement payment was made on December 21, 2016, to the NLRC, which is responsible for distributing the funds to each settling complainant. On December 27, 2016, the respondents filed motions for reconsideration with the NLRC asking that the award be set aside. The NLRC denied respondents' motions for reconsideration in a resolution received on May 5, 2017, and entered a judgment on the award on July 24, 2017. Previously, from May 10, 2017 to May 12, 2017, Aris Philippines, Inc., Sara Lee Corporation and Sara Lee Philippines each filed petitions for certiorari with requests for an immediate temporary restraining order and a writ of permanent injunction with the Philippines Court of Appeals. On August 18, 2017, the Court of Appeals granted a temporary restraining order precluding execution of the NLRC judgment against Aris Philippines, Inc., Sara Lee Corporation and Sara Lee Philippines, Inc. The temporary restraining order will expire on November 21, 2017 unless further extended by a preliminary injunction. We have recorded an accrual for this matter for the amount of loss that, at this time, we deem probable and enforceable. This accrual is reflected in the Company’s consolidated financial statements and reflects an amount significantly less than the amount awarded by the labor arbiter in 2004 (i.e., PHP 3,453,664,710 (approximately US $67 million )). The ultimate enforceable loss is uncertain, and if our accrual is not adequate, an adverse outcome could have a material effect on the consolidated financial condition or results of operations. 87 NOTE 21: QUARTERLY FINANCIAL DATA (UNAUDITED) | | | in millions, except per share data | --------------------------------------------+--------------+-------+------------------------------------+-------------- | FirstQuarter | | | SecondQuarter | | | ThirdQuarter | | FourthQuarter --------------------------------------------+--------------+-------+------------------------------------+---------------+---+-------+--------------+---+-------------- 2017 | | | | | | | --------------------------------------------+--------------+-------+------------------------------------+---------------+---+-------+------------- Sales | $ | 9,182 | | | $ | 9,083 | | $ | 9,850 | $ | 10,145 --------------------------------------------+--------------+-------+------------------------------------+---------------+---+-------+--------------+---+---------------+---+------- Gross profit | 1,483 | | | 1,047 | | | 1,202 | | 1,351 --------------------------------------------+--------------+-------+------------------------------------+---------------+---+-------+--------------+---+-------------- Operating income | 982 | | | 571 | | | 697 | | 681 --------------------------------------------+--------------+-------+------------------------------------+---------------+---+-------+--------------+---+-------------- Net income | 594 | | | 341 | | | 448 | | 395 --------------------------------------------+--------------+-------+------------------------------------+---------------+---+-------+--------------+---+-------------- Net income attributable to Tyson | 593 | | | 340 | | | 447 | | 394 --------------------------------------------+--------------+-------+------------------------------------+---------------+---+-------+--------------+---+-------------- Net income per share attributable to Tyson: | | | | | | | --------------------------------------------+--------------+-------+------------------------------------+---------------+---+-------+------------- Class A Basic | $ | 1.64 | | | $ | 0.95 | | $ | 1.24 | $ | 1.10 --------------------------------------------+--------------+-------+------------------------------------+---------------+---+-------+--------------+---+---------------+---+------- Class B Basic | $ | 1.49 | | | $ | 0.86 | | $ | 1.12 | $ | 0.98 --------------------------------------------+--------------+-------+------------------------------------+---------------+---+-------+--------------+---+---------------+---+------- Diluted | $ | 1.59 | | | $ | 0.92 | | $ | 1.21 | $ | 1.07 --------------------------------------------+--------------+-------+------------------------------------+---------------+---+-------+--------------+---+---------------+---+------- 2016 | | | | | | | --------------------------------------------+--------------+-------+------------------------------------+---------------+---+-------+------------- Sales | $ | 9,152 | | | $ | 9,170 | | $ | 9,403 | $ | 9,156 --------------------------------------------+--------------+-------+------------------------------------+---------------+---+-------+--------------+---+---------------+---+------- Gross profit | 1,201 | | | 1,183 | | | 1,224 | | 1,089 --------------------------------------------+--------------+-------+------------------------------------+---------------+---+-------+--------------+---+-------------- Operating income | 776 | | | 704 | | | 767 | | 586 --------------------------------------------+--------------+-------+------------------------------------+---------------+---+-------+--------------+---+-------------- Net income | 461 | | | 434 | | | 485 | | 392 --------------------------------------------+--------------+-------+------------------------------------+---------------+---+-------+--------------+---+-------------- Net income attributable to Tyson | 461 | | | 432 | | | 484 | | 391 --------------------------------------------+--------------+-------+------------------------------------+---------------+---+-------+--------------+---+-------------- Net income per share attributable to Tyson: | | | | | | | --------------------------------------------+--------------+-------+------------------------------------+---------------+---+-------+------------- Class A Basic | $ | 1.18 | | | $ | 1.14 | | $ | 1.29 | $ | 1.06 --------------------------------------------+--------------+-------+------------------------------------+---------------+---+-------+--------------+---+---------------+---+------- Class B Basic | $ | 1.09 | | | $ | 1.02 | | $ | 1.17 | $ | 0.96 --------------------------------------------+--------------+-------+------------------------------------+---------------+---+-------+--------------+---+---------------+---+------- Diluted | $ | 1.15 | | | $ | 1.10 | | $ | 1.25 | $ | 1.03 --------------------------------------------+--------------+-------+------------------------------------+---------------+---+-------+--------------+---+---------------+---+------- Second quarter fiscal 2017 net income included a $52 million pretax impairment charge related to our San Diego Prepared Foods operation. Third quarter fiscal 2017 net income included $77 million pretax expense from AdvancePierre purchase accounting and acquisition related costs, which included a $24 million purchase accounting adjustment for the amortization of the fair value step-up of inventory related to AdvancePierre, $35 million of acquisition related costs and $18 million of acquisition bridge financing fees. Third quarter fiscal 2017 net income included a post tax $26 million recognition of tax benefit related to the expected sale of a non-protein business. Fourth quarter fiscal 2017, net income included $150 million pretax restructuring and related charges, $45 million pretax impairment related to the expected sale of a non-protein business and $26 million pretax expense from AdvancePierre purchase accounting and acquisition related costs, which included $12 million purchase accounting adjustment for the amortization of the fair value step-up of inventory related to AdvancePierre and $14 million of acquisition related costs. Second quarter fiscal 2016 net income included a post tax $12 million recognition of previously unrecognized tax benefits. Third quarter fiscal 2016 net income included a post tax $15 million recognition of previously unrecognized tax benefits and audit settlement. Fourth quarter fiscal 2016 net income included a post tax $26 million recognition of previously unrecognized tax benefits. 88 Report of Independent Registered Public Accounting Firm To the Board of Directors and Shareholders of Tyson Foods, Inc. In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, comprehensive income, shareholders’ equity and cash flows present fairly, in all material respects, the financial position of Tyson Foods, Inc. and its subsidiaries as of September 30, 2017 and October 1, 2016, and the results of their operations and their cash flows for each of the three years in the period ended September 30, 2017 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of September 30, 2017, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for these financial statements and financial statement schedule, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management's Annual Report on Internal Control Over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedule, and on the Company's internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. As described in Management’s Annual Report on Internal Control Over Financial Reporting, management has excluded AdvancePierre Foods Holdings, Inc. from its assessment of internal control over financial reporting as of September 30, 2017 because it was acquired by the Company in a purchase business combination during fiscal 2017. We have also excluded AdvancePierre Foods Holdings, Inc. from our audit of internal control over financial reporting. AdvancePierre Foods Holdings, Inc. is a wholly-owned subsidiary whose total assets and total revenues excluded from management’s assessment and our audit of internal control over financial reporting represent 2.4% and 1.3% , respectively, of the related consolidated financial statement amounts as of and for the year ended September 30, 2017. /s/ PricewaterhouseCoopers LLP Fayetteville, Arkansas November 13, 2017 89 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. ITEM 9A. CONTROLS AND PROCEDURES Evaluation of Disclosure Controls and Procedures An evaluation was performed, under the supervision and with the participation of management, including the Chief Executive Officer (CEO) and the Chief Financial Officer (CFO), of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the 1934 Act)). Based on that evaluation, the CEO and CFO concluded that, as of September 30, 2017 , our disclosure controls and procedures were effective. Changes in Internal Control Over Financial Reporting In the quarter ended September 30, 2017 , there have been no changes in the Company’s internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. Management’s Annual Report on Internal Control Over Financial Reporting Management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rule 13a-15(f) of the 1934 Act. Our internal control over financial reporting was designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Management conducted an evaluation of the effectiveness of our internal control over financial reporting as of September 30, 2017 . In making this assessment, we used criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control - Integrated Framework (2013). Based on this evaluation under the framework in Internal Control - Integrated Framework (2013) issued by COSO, management concluded the Company’s internal control over financial reporting was effective as of September 30, 2017 . Management excluded AdvancePierre Food Holdings, Inc. from our assessment of internal control over financial reporting as of September 30, 2017 because it was acquired by the Company in a purchase business combination in June 2017. AdvancePierre Food Holdings, Inc. is a wholly-owned subsidiary whose total assets and total revenues represent 2.4% and 1.3% , respectively, of the related consolidated financial statement amounts as of and for the year ended September 30, 2017 . The Company’s independent registered public accounting firm, PricewaterhouseCoopers LLP, who has audited the fiscal 2017 financial statements included in this Annual Report on Form 10-K, has also audited the effectiveness of the Company’s internal control over financial reporting as of September 30, 2017 as stated in its report which appears in Part II, Item 8 of this Annual Report on Form 10-K. ITEM 9B. OTHER INFORMATION Second Amended and Restated Employment Agreement On November 9, 2017, we entered into a Second Amended and Restated Employment Agreement with Mr. John Tyson, Chairman of the Board of Directors. This agreement replaces Mr. Tyson’s previous employment agreement dated May 1, 2014. The agreement provides for an annual base salary of $1,050,000 and eligibility for participation in the Company’s annual performance incentive plan, as well as any benefit programs generally applicable to employees of the Company. In addition, Mr. Tyson is eligible to receive, on such dates specified by the Company consistent with the Company’s treatment of similarly-situated employees, performance and stock incentive awards under the Company’s incentive plans then in effect (if any), subject to the discretion of the Compensation and Leadership Development Committee of our Board of Directors. Mr. Tyson is also entitled to the use of certain Company-owned assets, including aircraft for up to 275 hours annually. Mr. Tyson is also entitled to personal security services provided by the Company, provided that such services do not exceed the value of $50,000 annually. The Company has also agreed to reimburse Mr. Tyson for the annual premium on a $7,500,000 life insurance policy. The Company will reimburse and gross-up any and all income tax liability of Mr. Tyson in connection with the use or acceptance of such Company-owned or -provided assets. 90 Mr. Tyson may terminate his employment under the agreement, subject to confidentiality and non-compete obligations contained therein, upon 30 days’ prior written notice to the Company. The Company’s Board of Directors has the right to terminate the agreement at any time upon written notice to Mr. Tyson. Any such termination without cause is subject to the Company’s obligation to pay, in a lump sum, an amount equal to two years of his base salary and two times his target annual cash bonus, plus continued medical coverage for life. Such termination will also trigger vesting of stock options, restricted stock and performance stock awards earlier than stated in the applicable award agreements. Upon the occurrence of a change in control (as defined in the agreement), all previously granted restricted stock, performance stock and stock option awards will be treated in accordance with the applicable award agreement. A copy of this agreement is filed as Exhibit 10.76 to this Form 10-K. PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE See information set forth under the captions “Election of Directors”, "Information Regarding the Board and its Committees" and "Report of the Audit Committee" in the Company’s definitive Proxy Statement for the Company’s Annual Meeting of Shareholders to be held February 8, 2018 (the “Proxy Statement”), which information is incorporated herein by reference. Pursuant to general instruction G(3) of Annual Report on Form 10-K, certain information concerning our executive officers is included under the caption “Executive Officers of the Company” in Part I of this Annual Report on Form 10-K. We have a code of ethics as defined in Item 406 of Regulation S-K, which code applies to all of our directors and employees, including our principal executive officers, principal financial officer, principal accounting officer or controller, and persons performing similar functions. This code of ethics, titled “Tyson Foods, Inc. Code of Conduct,” is available, free of charge on our website at http://ir.tyson.com. We will post any amendments to the Code of Conduct, and any waivers that are required to be disclosed by the rules of either the Securities and Exchange Commission or the New York Stock Exchange, on our website. ITEM 11. EXECUTIVE COMPENSATION See the information set forth under the captions “Executive Compensation,” “Director Compensation For Fiscal Year 2017 ,” “Compensation Discussion and Analysis,” “Report of the Compensation and Leadership Development Committee,” “Compensation Committee Interlocks and Insider Participation”, and "Section 16(a) Beneficial Ownership Reporting Compliance" in the Proxy Statement, which information is incorporated herein by reference. However, pursuant to instructions to Item 407(e)(5) of Regulation S-K, the material appearing under the sub-heading “Report of the Compensation and Leadership Development Committee” shall be deemed "furnished" and not be deemed to be “filed” with the Securities and Exchange Commission, other than as provided in this Item 11. 91 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS See the information included under the captions “Security Ownership of Certain Beneficial Owners” and “Security Ownership of Management” in the Proxy Statement, which information is incorporated herein by reference. Securities Authorized for Issuance Under Equity Compensation Plans The following information reflects certain information about our equity compensation plans as of September 30, 2017 : | Equity Compensation Plan Information -----------------------------------------------------------+------------------------------------------------------------------ | Number ofSecurities to beissued uponexercise ofoutstandingoptions | Weightedaverageexercise priceof outstandingoptions | | Number of Securities remaining available forfuture issuance underequity compensation plans(excluding Securitiesreflected in the first column (a) (b)) | -----------------------------------------------------------+-------------------------------------------------------------------+----------------------------------------------------+-------+-------------------------------------------------------------------------------------------------------------------------------------------------------+----------- Equity compensation plans approved by security holders | 7,547,518 | $ | 40.54 | | 40,279,989 -----------------------------------------------------------+-------------------------------------------------------------------+----------------------------------------------------+-------+-------------------------------------------------------------------------------------------------------------------------------------------------------+----------- Equity compensation plans not approved by security holders | — | — | | — | -----------------------------------------------------------+-------------------------------------------------------------------+----------------------------------------------------+-------+-------------------------------------------------------------------------------------------------------------------------------------------------------+----------- Total | 7,547,518 | $ | 40.54 | | 40,279,989 -----------------------------------------------------------+-------------------------------------------------------------------+----------------------------------------------------+-------+-------------------------------------------------------------------------------------------------------------------------------------------------------+----------- (a) | Shares available for future issuance as of September 30, 2017, under the Stock Incentive Plan (18,094,438), the Employee Stock Purchase Plan (14,537,943) and the Retirement Savings Plan (7,647,608) ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ (b) | "Securities" and "shares" refer to the Company's Class A common stock. ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE See the information included under the captions “Election of Directors”, "Information Regarding the Board and its Committees" and “Certain Transactions” in the Proxy Statement, which information is incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES See the information included under the captions “Audit Fees,” “Audit-Related Fees,” “Tax Fees,” “All Other Fees,” and “Audit Committee Pre-Approval Policy” in the Proxy Statement, which information is incorporated herein by reference. 92 PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES (a) | The following documents are filed as a part of this report: ----+------------------------------------------------------------ (1) Consolidated Financial Statements Consolidated Statements of Income for the three years ended September 30, 2017 Consolidated Statements of Comprehensive Income for the three years ended September 30, 2017 Consolidated Balance Sheets at September 30, 2017 , and October 1, 2016 Consolidated Statements of Shareholders’ Equity for the three years ended September 30, 2017 Consolidated Statements of Cash Flows for the three years ended September 30, 2017 Notes to Consolidated Financial Statements Report of Independent Registered Public Accounting Firm (2) Consolidated Financial Statement Schedules Financial Statement Schedule - Schedule II Valuation and Qualifying Accounts for the three years ended September 30, 2017 All other schedules are omitted because they are neither applicable nor required. (3) Exhibits required by Item 601 of Regulation S-K The exhibits filed with this report are listed in the Exhibit Index preceding the signature pages to this Annual Report on Form 10-K and incorporated herein by reference. 93 FINANCIAL STATEMENT SCHEDULE TYSON FOODS, INC. SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS Three Years Ended September 30, 2017 | | | | | | | | in millions | ---------------------------------------------+------------------------------+----+-----------+-----------------------------+---+----+--------------------------+-------------+------------- | | | Additions | | | | ---------------------------------------------+------------------------------+----+-----------+-----------------------------+---+----+------------------------- | Balance atBeginningof Period | | | Charged toCosts andExpenses | | | Charged toOther Accounts | | (Deductions) | | Balance at Endof Period | ---------------------------------------------+------------------------------+----+-----------+-----------------------------+---+----+--------------------------+-------------+--------------+---+-------------------------+---- Allowance for Doubtful Accounts: | | | | | | | | ---------------------------------------------+------------------------------+----+-----------+-----------------------------+---+----+--------------------------+------------ 2017 | $ | 33 | | | $ | 10 | | $ | — | | $ | (9 | ) | $ | 34 ---------------------------------------------+------------------------------+----+-----------+-----------------------------+---+----+--------------------------+-------------+--------------+---+-------------------------+-----+---+---+--- 2016 | 27 | | | 10 | | | — | | (4 | ) | 33 | ---------------------------------------------+------------------------------+----+-----------+-----------------------------+---+----+--------------------------+-------------+--------------+---+-------------------------+---- 2015 | 34 | | | 1 | | | — | | (8 | ) | 27 | ---------------------------------------------+------------------------------+----+-----------+-----------------------------+---+----+--------------------------+-------------+--------------+---+-------------------------+---- Inventory Lower of Cost or Market Allowance: | | | | | | | | ---------------------------------------------+------------------------------+----+-----------+-----------------------------+---+----+--------------------------+------------ 2017 | $ | 39 | | | $ | 5 | | $ | — | | $ | (41 | ) | $ | 3 ---------------------------------------------+------------------------------+----+-----------+-----------------------------+---+----+--------------------------+-------------+--------------+---+-------------------------+-----+---+---+--- 2016 | 58 | | | 70 | | | — | | (89 | ) | 39 | ---------------------------------------------+------------------------------+----+-----------+-----------------------------+---+----+--------------------------+-------------+--------------+---+-------------------------+---- 2015 | 7 | | | 99 | | | — | | (48 | ) | 58 | ---------------------------------------------+------------------------------+----+-----------+-----------------------------+---+----+--------------------------+-------------+--------------+---+-------------------------+---- Valuation Allowance on Deferred Tax Assets: | | | | | | | | ---------------------------------------------+------------------------------+----+-----------+-----------------------------+---+----+--------------------------+------------ 2017 | $ | 72 | | | $ | 4 | | $ | — | | $ | (1 | ) | $ | 75 ---------------------------------------------+------------------------------+----+-----------+-----------------------------+---+----+--------------------------+-------------+--------------+---+-------------------------+-----+---+---+--- 2016 | 68 | | | 10 | | | — | | (6 | ) | 72 | ---------------------------------------------+------------------------------+----+-----------+-----------------------------+---+----+--------------------------+-------------+--------------+---+-------------------------+---- 2015 | 51 | | | 21 | | | — | | (4 | ) | 68 | ---------------------------------------------+------------------------------+----+-----------+-----------------------------+---+----+--------------------------+-------------+--------------+---+-------------------------+---- 94 EXHIBIT INDEX Exhibit No. 2.1 | Agreement and Plan of Merger, dated as of July 1, 2014, by and between the Company and Hillshire Brands (previously filed as Exhibit 2.1 to the Company's Current Report on Form 8-K filed July 2, 2014, Commission File No. 001-14704, and incorporated herein by reference). Exhibits and schedules have been omitted pursuant to Item 601(b)(2) of Regulation S-K, but a copy will be furnished supplementally to the Securities and Exchange Commission upon request. ----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 2.2 | Share Purchase Agreement dated November 9, 2010, by and among BBU, Inc., Grupo Bimbo, S.A.B. DE C.V. and Hillshire Brands Corporation (previously filed as Exhibit 2.1 to the Company's Quarterly Report on Form 10-Q for the period ended January 1, 2011, by The Hillshire Brands Company, Commission File No. 001-03344, and incorporated herein by reference). Exhibits and schedules have been omitted pursuant to Item 601(b)(2) of Regulation S-K, but a copy will be furnished supplementally to the Securities and Exchange Commission upon request. ----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 2.3 | Master Separation Agreement by and between Sara Lee Corporation, D.E MASTER BLENDERS 1753 B.V. and DE US, Inc., dated as of June 15, 2012 (previously filed as Exhibit 2.1 to the Company's Current Report on Form 8-K filed June 18, 2012 by The Hillshire Brands Company, Commission File No. 001-03344, and incorporated herein by reference). Exhibits and schedules have been omitted pursuant to Item 601(b)(2) of Regulation S-K, but a copy will be furnished supplementally to the Securities and Exchange Commission upon request. ----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 2.4 | Agreement and Plan of Merger dated as of April 25, 2017 among Tyson Foods, Inc., AdvancePierre Foods Holdings, Inc. and DVB Merger Sub, Inc. (previously filed as Exhibit 2.1 to the Company's Current Report on Form 8-K filed on April 28, 2017, Commission File No. 001-14704, and incorporated herein by reference). Exhibits and schedules have been omitted pursuant to Item 601(b)(2) of Regulation S-K, but a copy will be furnished supplementally to the Securities and Exchange Commission upon request. ----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3.1 | Restated Certificate of Incorporation of the Company (previously filed as Exhibit 3.1 to the Company’s Annual Report on Form 10-K for the fiscal year ended October 3, 1998, Commission File No. 001-14704, and incorporated herein by reference). ----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3.2 | Fifth Amended and Restated By-laws of the Company (previously filed as Exhibit 3.2 to the Company’s Quarterly Report on Form 10-Q filed for the period ended June 29, 2013, Commission File No. 001-14704, and incorporated herein by reference). ----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.1 | Indenture dated June 1, 1995, by and between the Company and The Chase Manhattan Bank, N.A., as Trustee (the “Company Indenture”) (previously filed as Exhibit 4 to Registration Statement on Form S-3, filed with the Commission on December 18, 1997, Registration No. 333-42525, and incorporated herein by reference). ----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.2 | Form of 7.0% Note due January 15, 2028, issued under the Company Indenture (previously filed as Exhibit 4.2 to the Company’s Quarterly Report on Form 10-Q for the period ended December 27, 1997, Commission File No. 001-14704, and incorporated herein by reference). ----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.3 | Form of 7.0% Note due May 1, 2018, issued under the Company Indenture (previously filed as Exhibit 4.1 to the Company’s Quarterly Report on Form 10-Q for the period ended March 28, 1998, Commission File No. 001-14704, and incorporated herein by reference). ----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.4 | Supplemental Indenture, dated as of September 18, 2006, by and among the Company, Tyson Fresh Meats, Inc. and JPMorgan Chase Bank, National Association, supplementing the Company Indenture (previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed September 19, 2006, Commission File No. 001-14704, and incorporated herein by reference). ----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.5 | Supplemental Indenture dated as of September 15, 2008, by and between the Company and The Bank of New York Mellon Trust Company, National Association (as successor to JPMorgan Chase Bank, N.A. (formerly The Chase Manhattan Bank, N.A.)), as Trustee (including the form of 3.25% Convertible Senior Notes due 2013), supplementing the Company Indenture (previously filed as Exhibit 4.2 to the Company’s Current Report on Form 8-K filed September 15, 2008, Commission File No. 001-14704, and incorporated herein by reference). ----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.6 | Supplemental Indenture dated as of June 13, 2012, by and between the Company and The Bank of New York Mellon Trust Company, National Association (as successor to JPMorgan Chase Bank, N.A. (formerly The Chase Manhattan Bank, N.A.)), as Trustee, supplementing the Company Indenture (previously filed as Exhibit 4.1 to the Company's Current Report on Form 8-K filed June 13, 2012, Commission File No. 001-14704, and incorporated herein by reference). ----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.7 | Form of 4.50% Senior Note due 2022 (previously filed as Exhibit 4.2 and included in Exhibit 4.1 to the Company's Current Report on Form 8‑K filed June 13, 2012, Commission File No. 001‑14704, and incorporated herein by reference). ----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 95 4.8 | Supplemental Indenture dated as of August 8, 2014, by and between the Company and The Bank of New York Mellon Trust Company, National Association (as successor to JPMorgan Chase Bank, N.A. (formerly The Chase Manhattan Bank, N.A.)), as Trustee, supplementing the Company Indenture (previously filed as Exhibit 4.2 to the Company's Current Report on Form 8-K filed August 8, 2014, Commission File No. 001-14704, and incorporated herein by reference). -----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 4.9 | Form of 2.65% Senior Note due 2019 (previously filed as Exhibit 4.2 to the Company's Current Report on Form 8‑K filed August 8, 2014, Commission File No. 001‑14704, and incorporated herein by reference). -----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 4.10 | Supplemental Indenture dated as of August 8, 2014, by and between the Company and The Bank of New York Mellon Trust Company, National Association (as successor to JPMorgan Chase Bank, N.A. (formerly The Chase Manhattan Bank, N.A.)), as Trustee, supplementing the Company Indenture (previously filed as Exhibit 4.4 to the Company's Current Report on Form 8-K filed August 8, 2014, Commission File No. 001-14704, and incorporated herein by reference). -----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 4.11 | Form of 3.95% Senior Note due 2024 (included in Exhibit 4.4 to the Company's Current Report on Form 8‑K filed August 8, 2014, Commission File No. 001‑14704, and incorporated herein by reference). -----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 4.12 | Supplemental Indenture dated as of August 8, 2014, by and between the Company and The Bank of New York Mellon Trust Company, National Association (as successor to JPMorgan Chase Bank, N.A. (formerly The Chase Manhattan Bank, N.A.)), as Trustee, supplementing the Company Indenture (previously filed as Exhibit 4.6 to the Company's Current Report on Form 8-K filed August 8, 2014, Commission File No. 001-14704, and incorporated herein by reference). -----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 4.13 | Form of 4.875% Senior Note due 2034 (included in Exhibit 4.6 to the Company's Current Report on Form 8‑K filed August 8, 2014, Commission File No. 001‑14704, and incorporated herein by reference). -----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 4.14 | Supplemental Indenture dated as of August 8, 2014, by and between the Company and The Bank of New York Mellon Trust Company, National Association (as successor to JPMorgan Chase Bank, N.A. (formerly The Chase Manhattan Bank, N.A.)), as Trustee, supplementing the Company Indenture (previously filed as Exhibit 4.8 to the Company's Current Report on Form 8-K filed August 8, 2014, Commission File No. 001-14704, and incorporated herein by reference). -----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 4.15 | Form of 5.15% Senior Note due 2044 (previously filed as Exhibit 4.8 to the Company's Current Report on Form 8‑K filed August 8, 2014, Commission File No. 001‑14704, and incorporated herein by reference). -----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 4.16 | Purchase Contract Agreement dated as of August 5, 2014, by and between the Company and The Bank of New York Mellon Trust Company, N.A., as Purchase Contract Agent (previously filed as Exhibit 4.1 of the Company’s Current Report on Form 8-K filed August 5, 2014, Commission File No. 001-14704, and incorporated herein by reference). -----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 4.17 | Form of Unit (previously filed as Exhibit 4.1 to the Company’s Current Report on Form 8-K filed August 5, 2014, Commission File No. 001-14704, and incorporated herein by reference). -----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 4.18 | Form of Purchase Contract (previously filed as Exhibit 4.1 to the Company’s Current Report on Form 8-K filed August 5, 2014, Commission File No. 001-14704, and incorporated herein by reference). -----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 4.19 | Supplemental Indenture dated as of August 5, 2014, by and between the Company and The Bank of New York Mellon Trust Company, N.A., as Trustee, supplementing the Company Indenture (previously filed as Exhibit 4.5 of the Company’s Current Report on Form 8-K filed August 5, 2014, Commission File No. 001-14704, and incorporated herein by reference). -----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 4.20 | Form of Amortizing Note (previously filed as Exhibit 4.5 to the Company’s Current Report on Form 8-K filed August 5, 2014, Commission File No. 001-14704, and incorporated herein by reference). -----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 4.21 | Indenture dated October 2, 1990, between Sara Lee Corporation and Continental Bank, N.A., as Trustee (the “Sara Lee Indenture”) (previously filed as Exhibit 4.1 to Amendment No. 1 to Registration Statement No. 33-33603 on Form S-3 by Sara Lee Corporation, predecessor in interest to The Hillshire Brands Company, filed with the Commission on October 5, 1990, Commission File No. 001-03344, and incorporated herein by reference). -----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 4.22 | Form of 4.10% Notes due 2020 issued pursuant to the Sara Lee Indenture (previously filed as Exhibit 4.2 to the Company's Current Report on Form 8-K dated September 7, 2010 by The Hillshire Brands Company, Commission File No. 001-03344, and incorporated herein by reference). -----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 4.23 | Form of 6.13% Notes due 2032 issued pursuant to the Sara Lee Indenture (previously filed as Exhibit 4.25 to the Company’s Annual Report on Form 10-K for the fiscal year ended September 27, 2014, Commission File No. 001-14704, and incorporated herein by reference). -----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 96 4.24 | Supplemental Indenture dated June 2, 2017, by and between the Company and The Bank of New York Mellon Trust Company, N.A. (as successor to JPMorgan Chase Bank, N.A. (formerly The Chase Manhattan Bank, N.A.)), as Trustee, supplementing the Company Indenture (previously filed as Exhibit 4.2 to the Company's Current Report on Form 8-k filed on June 2, 2017, Commission File No. 001-14704, and incorporated herein by reference). -----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.25 | Form of Floating Rate Senior Notes due 2019 (previously filed as Exhibit 4.2 to the Company's Current Report on Form 8-K filed on June 2, 2017, Commission File No. 001-14704, and incorporated herein by reference). -----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.26 | Supplemental Indenture dated June 2, 2017, by and between the Company and The Bank of New York Mellon Trust Company, N.A. (as successor to JPMorgan Chase Bank, N.A. (formerly The Chase Manhattan Bank, N.A.)), as Trustee, supplementing the Company Indenture (previously filed as Exhibit 4.4 to the Company's Current Report on Form 8-K filed on June 2, 2017, Commission File No. 001-14704, and incorporated herein by reference). -----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.27 | Form of Floating Rate Senior Notes due 2020 (previously filed as Exhibit 4.4 to the Company's Current Report on Form 8-K filed on June 2, 2017, Commission File No. 001-14704, and incorporated herein by reference). -----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.28 | Supplemental Indenture dated June 2, 2017, by and between the Company and The Bank of New York Mellon Trust Company, N.A. (as successor to JPMorgan Chase Bank, N.A. (formerly The Chase Manhattan Bank, N.A.)), as Trustee, supplementing the Company Indenture (previously filed as Exhibit 4.6 on the Company's Current Report on Form 8-K filed on June 2, 2017, Commission File No. 001-14704, and incorporated herein by reference). -----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.29 | Form of 3.55% Senior Notes due 2027 (previously filed as Exhibit 4.6 to the Company's Current Report on Form 8-K filed on June 2, 2017, Commission File No. 001-14704, and incorporated herein by reference). -----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.30 | Supplemental Indenture dated June 2, 2017, by and between the Company and The Bank of New York Mellon Trust Company, N.A. (as successor to JPMorgan Chase Bank, N.A. (formerly The Chase Manhattan Bank, N.A.)), as Trustee, supplementing the Company Indenture (previously filed as Exhibit 4.8 to the Company's Current Report on Form 8-K filed on June 2, 2017, Commission File No. 001-14704, and incorporated herein by reference). -----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.31 | Form of 4.55% Senior Notes due 2047 (previously filed as Exhibit 4.8 to the Company's Current Report on Form 8-K filed on June 2, 2017, Commission File No. 001-14704, and incorporated herein by reference). -----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.32 | Supplemental Indenture dated August 23, 2017, by and between the Company and The Bank of New York Mellon Trust Company, N.A.(as successor to JPMorgan Chase Bank, N.A. (formerly The Chase Manhattan Bank, N.A.)), as Trustee, supplementing the Company Indenture (previously filed as Exhibit 4.2 to the Company's Current Report on Form 8-K filed on August 23, 2017, Commission File No. 001-14704, and incorporated herein by reference). -----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.33 | Form of Floating Rate Senior Notes due 2020 (previously filed as Exhibit 4.2 to the Company's Current Report on Form 8-K filed on August 23, 2017, Commission File No. 001-14704, and incorporated herein by reference). -----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.34 | Supplemental Indenture dated August 23, 2017, by and between the Company and The Bank of New York Mellon Trust Company, N.A.. (as successor to JPMorgan Chase Bank, N.A. (formerly The Chase Manhattan Bank, N.A.)), as Trustee, supplementing the Company Indenture (previously filed as Exhibit 4.4 to the Company's Current Report on Form 8-K filed on August 23, 2017, Commission File No. 001-14704, and incorporated herein by reference). -----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.35 | Form of 2.250% Senior Notes due 2021 (previously filed as Exhibit 4.4 to the Company's Current Report on Form 8-K filed on August 23, 2017, Commission File No. 001-14704, and incorporated herein by reference). -----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.1 | Term Loan Agreement, dated as of July 15, 2014, by and among the Company, Morgan Stanley Senior Funding, Inc., as the Administrative Agent, and certain other lenders party thereto (previously filed as Exhibit 10.2 to the Company’s Current Report on Form 8-K filed July 17, 2014, Commission File No. 001-14704, and incorporated herein by reference). -----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.2 | Term Loan Agreement, dated as of April 7, 2015, by and among the Company, Bank of America, N.A. as lender, and Merill Lynch, Pierce, Fenner & Smith Incorporated, as sole lead arranger and sole bookrunner (previously filed as Exhibit 10.1 to the Company's Current Report on Form 8-K filed April 8, 2015, Commission File No. 001-14704, and incorporated herein by reference). -----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.3 | Amendment No. 1 to Term Loan Agreement, dated as of May 5, 2016, by and between the Company and Bank of America, N.A. as lender (previously filed as Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the period ended April 2, 2016, Commission File No. 001-14704, and incorporated herein by reference). -----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.4 | Amendment No. 2 to Term Loan Agreement, dated as of August 18, 2017, by and between Tyson Foods, Inc., and Bank of America, N.A. (previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed August 18, 2017, Commission File No. 001-14704, and incorporated herein by reference). -----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 97 10.5 | | Term Loan Agreement, dated as of May 12, 2017, by and among the Company, Morgan Stanley Senior Funding, Inc., as Administrative Agent, and certain other lenders party thereto (previously filed as Exhibit 10.1 to the Company's Current Report on Form 8-K filed May 17, 2017, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.6 | | Amended and Restated Credit Agreement, dated as of May 12, 2017, among the Company, the subsidiary, borrowers party thereto, and lenders party thereto and JPMorgan Chase Bank, N.A., as the Administrative Agent, and certain other lenders thereto (previously filed as Exhibit 10.2 to the Company's Current Report on Form 8-K filed May 17, 2017, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.7 | * | Amended and Restated Employment Agreement, dated as of May 1, 2014, by and between the Company and John Tyson (previously filed as Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the period ended March 29, 2014, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.8 | * | Second Amended and Restated Employment Agreement, dated as of November 17, 2016, by and between the Company and Thomas Hayes (previously filed as Exhibit 10.1 to the Company's Current Report on Form 8-K filed November 22, 2016, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.9 | * | Employment Agreement, dated November 14, 2012, by and between the Company and David Van Bebber (previously filed as Exhibit 10.14 to the Company's Annual Report on Form 10-K for the fiscal year ended September 29, 2012, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.10 | * | Employment Agreement, dated November 14, 2012, by and between the Company and Dennis Leatherby (previously filed as Exhibit 10.15 to the Company's Annual Report on Form 10-K for the fiscal year ended September 29, 2012, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.11 | * | Employment Agreement, dated November 15, 2013, by and between the Company and Noel W. White (previously filed as Exhibit 10.19 to the Company's Annual Report on Form 10-K for the fiscal year ended September 28, 2013, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.12 | * | Employment Agreement, dated November 15, 2013, by and between the Company and Howell P. Carper(previously filed as Exhibit 10.20 to the Company's Annual Report on Form 10-K for the fiscal year ended September 28, 2013, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.13 | * | Employment Agreement, dated November 12, 2013, by and between the Company and Stephen R. Stouffer(previously filed as Exhibit 10.21 to the Company's Annual Report on Form 10-K for the fiscal year ended September 28, 2013, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.14 | * | Employment Agreement, dated August 29, 2014, by and between the Company and Andrew P. Callahan(previously filed as Exhibit 10.19 to the Company’s Annual Report on Form 10-K for the fiscal year ended September 27, 2014, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.15 | * | Employment Agreement, dated August 29, 2014, by and between the Company and Sobhana (Sally) Grimes (previously filed as Exhibit 10.20 to the Company’s Annual Report on Form 10-K for the fiscal year ended September 27, 2014, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.16 | * | Employment Agreement, dated August 29, 2014, by and between the Company and Mary Oleksiuk (previously filed as Exhibit 10.22 to the Company’s Annual Report on Form 10-K for the fiscal year ended September 27, 2014, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.17 | * | Employment Agreement, dated August 28, 2015, by and between the Company and Curt T. Calaway (previously filed as Exhibit 10.19 to the Company’s Annual Report on Form 10-K for the fiscal year ended October 3, 2015, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.18 | * | Employment Agreement, dated April 25, 2016, by and between the Company and Monica McGurk (previously filed as Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the period ended April 2, 2016, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.19 | * | Employment Agreement, dated November 1, 2012, by and between the Company and Scott E. Rouse (previously filed as Exhibit 10.2 to the Company's Current Report on Form 10-Q for the period ended April 1, 2017, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.20 | * | Employment Agreement, dated October 5, 2014, by and between the Company and Douglas W. Ramsey (previously filed as Exhibit 10.3 to the Company's Current Report on Form 10-Q for the period ended April 1, 2017, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.21 | * | Transition, Non-Compete and Consulting Agreement dated November 17, 2016, between the Company and Donald J. Smith (previously filed as Exhibit 10.2 to the Company's Current Report on Form 8-K filed November 22, 2016, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 98 10.22 | * | Form of Retention Award Letter Agreement, dated August 29, 2014, by and between the Company and Andrew Callahan, Sobhana (Sally) Grimes, Thomas Hayes and Mary Oleksiuk (previously filed as Exhibit 10.23 to the Company’s Annual Report on Form 10-K for the fiscal year ended September 27, 2014, Commission File No. 001-14704, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.23 | * | Indemnity Agreement, dated as of September 28, 2007, between the Company and John Tyson (previously filed as Exhibit 10.2 to the Company’s Current Report on Form 8-K filed September 28, 2007, Commission File No. 001-14704, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.24 | * | Form of Indemnity Agreement between Tyson Foods, Inc. and its directors and certain executive officers (previously filed as Exhibit 10(t) to the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 1995, Commission File No. 0-3400, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.25 | * | Tyson Foods, Inc. Annual Incentive Compensation Plan for Senior Executives adopted February 4, 2005, and reapproved February 5, 2010 (previously filed as Exhibit 10.34 to the Company’s Annual Report on Form 10-K for the fiscal year ended October 1, 2005, Commission File No. 001-14704, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.26 | * | Amended and Restated Tyson Foods, Inc. Employee Stock Purchase Plan, effective as of February 1, 2013 (previously filed as Exhibit 99.2 to Registration Statement on Form S-8 on February 22, 2013, Registration No. 333-186797, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.27 | * | First Amendment to the Tyson Foods, Inc. Employee Stock Purchase Plan, effective February 1, 2013 (previously filed as Exhibit 10.26 to the Company’s Annual Report on Form 10-K for the fiscal year ended September 28, 2013, Commission File No. 001-14704, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.28 | * | Amended and Restated Executive Savings Plan of Tyson Foods, Inc. effective January 1, 2013 (previously filed as Exhibit 10.27 to the Company’s Annual Report on Form 10-K for the fiscal year ended September 28, 2013, Commission File No. 001-14704, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.29 | * | Amended and Restated Tyson Foods, Inc. 2000 Stock Incentive Plan effective February 1, 2013 (previously filed as Exhibit 99.1 to Registration Statement on Form S-8 on February 22, 2013, Registration No. 333-186797, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.30 | * | First Amendment to the Tyson Foods, Inc. 2000 Stock Incentive Plan effective May 1, 2013 (previously filed as Exhibit 10.29 to the Company’s Annual Report on Form 10-K for the fiscal year ended September 28, 2013, Commission File No. 001-14704, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.31 | * | Amended and Restated Tyson Foods, Inc. Supplemental Executive Retirement and Life Insurance Premium Plan effective November 14, 2013 (previously filed as Exhibit 10.30 to the Company’s Annual Report on Form 10-K for the fiscal year ended September 28, 2013, Commission File No. 001-147-4, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.32 | * | Retirement Savings Plan of Tyson Foods, Inc. effective January 1, 2011 (previously filed as Exhibit 10.33 to the Company's Annual Report on Form 10-K for the fiscal year ended October 1, 2011, Commission File No. 001-14704, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.33 | * | First Amendment to the Retirement Savings Plan of Tyson Foods, Inc., as Amended and Restated as of January 1, 2011 (previously filed as Exhibit 10.32 to the Company’s Annual Report on Form 10-K for the fiscal year ended September 28, 2013, Commission File No. 001-14704, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.34 | * | Amended and Restated Retirement Income Plan of IBP, inc. effective August 1, 2000, and Amendment to Freeze the Retirement Income Plan of IBP, inc. effective December 31, 2002 (previously filed as Exhibit 10.46 to the Company’s Annual Report on Form 10-K for the fiscal year ended September 27, 2008, Commission File No. 001-14704, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.35 | * | Form of Performance Shares Relative Total Shareholder Return Stock Incentive Award Agreement pursuant to which performance stock awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective November 28, 2016 (previously filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended December 31, 2016, Commission File No. 001-14704, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.36 | * | Form of Performance Shares EBIT Stock Incentive Award Agreement pursuant to which performance stock awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective November 28, 2016 (previously filed as Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the period ended December 31, 2016, Commission File No. 001-14704, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.37 | * | Form of Restricted Stock Agreement pursuant to which restricted stock awards were granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan prior to July 31, 2009 (previously filed as Exhibit 10.48 to the Company’s Annual Report on Form 10-K for the fiscal year ended October 2, 2004, Commission File No. 001-14704, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 99 10.38 | * | Form of Restricted Stock Agreement pursuant to which restricted stock awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective July 31, 2009 (previously filed as Exhibit 10.41 to the Company’s Annual Report on Form 10-K for the fiscal year ended October 3, 2009, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.39 | * | Form of Restricted Stock Agreement pursuant to which restricted stock awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective January 1, 2010 (previously filed as Exhibit 10.41 to the Company’s Annual Report on Form 10-K for the fiscal year ended October 2, 2010, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.40 | * | Form of Restricted Stock Subject to Performance Criteria Stock Incentive Award Agreement pursuant to which restricted stock awards subject to performance criteria are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective November 28, 2016 (previously filed as Exhibit 10.3 to the Company's Quarterly Report on Form 10-Q for the period ending December 31, 2016, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.41 | * | Form of Restricted Stock Incentive Award Agreement with contracted employees pursuant to which restricted stock awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective November 28, 2016 (previously filed as Exhibit 10.4 to the Company's Quarterly Report on Form 10-Q for the period ending December 31, 2016, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.42 | * | Form of Restricted Stock Incentive Award Agreement with non-contracted employees pursuant to which restricted stock awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective November 28, 2016 (previously filed as Exhibit 10.5 to the Company's Quarterly Report on Form 10-Q for the period ending December 31, 2016, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.43 | * | Form of Stock Incentive Agreement with key employees and contracted employees at band level 3-9 pursuant to which restricted stock awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective October 26, 2012 (previously filed as Exhibit 10.38 to the Company's Annual Report on Form 10-K for the fiscal year ended September 29, 2012, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.44 | * | Form of Stock Incentive Agreement with the remaining contracted employees pursuant to which restricted stock awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective October 26, 2012 (previously filed as Exhibit 10.39 to the Company's Annual Report on Form 10-K for the fiscal year ended September 29, 2012, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.45 | * | Form of Stock Options Incentive Award Agreement with contracted employees pursuant to which stock options awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective November 28, 2016 (previously filed as Exhibit 10.6 to the Company's Quarterly Report on Form 10-Q for the period ending December 31, 2016, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.46 | * | Form of Stock Options Incentive Award Agreement with non-contracted employees pursuant to which stock options awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective November 28, 2016 (previously filed as Exhibit 10.7 to the Company's Quarterly Report on Form 10-Q for the period ending December 31, 2016, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.47 | * | Form of Stock Option Grant Agreement pursuant to which stock option awards were granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan prior to July 31, 2009 (previously filed as Exhibit 10.49 to the Company’s Annual Report on Form 10-K for the fiscal year ended October 2, 2004, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.48 | * | Form of Stock Option Grant Agreement pursuant to which stock option awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective July 31, 2009, through February 3, 2010 (previously filed as Exhibit 10.43 to the Company’s Annual Report on Form 10-K for the fiscal year ended October 2, 2010, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.49 | * | Form of Stock Option Grant Agreement pursuant to which stock option awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective February 4, 2010 (previously filed as Exhibit 10.44 to the Company’s Annual Report on Form 10-K for the fiscal year ended October 2, 2010, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.50 | * | Form of Stock Option Grant Agreement with non-contracted employees pursuant to which stock option awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective November 29, 2010 (previously filed as Exhibit 10.40 to the Company's Annual Report on Form 10-K for the fiscal year ended October 1, 2011, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.51 | * | Form of Stock Option Grant Agreement with contracted employees at band level 1-5 pursuant to which stock option awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective November 29, 2010 (previously filed as Exhibit 10.41 to the Company's Annual Report on Form 10-K for the fiscal year ended October 1, 2011, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 100 10.52 | * | Form of Stock Option Grant Agreement with key employees and contracted employees at band level 6-9 pursuant to which stock option awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective November 29, 2010 (previously filed as Exhibit 10.42 to the Company's Annual Report on Form 10-K for the fiscal year ended October 1, 2011, Commission File No. 001-14704, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.53 | * | Form of Stock Option Grant Agreement with non-contracted employees pursuant to which stock option awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective November 28, 2011 (previously filed as Exhibit 10.46 to the Company's Annual Report on Form 10-K for the fiscal year ended September 29, 2012, Commission File No. 001-14704, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.54 | * | Form of Stock Option Grant Agreement with contracted employees at band level 1-5 pursuant to which stock option awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective November 28, 2011 (previously filed as Exhibit 10.47 to the Company's Annual Report on Form 10-K for the fiscal year ended September 29, 2012, Commission File No. 001-14704, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.55 | * | Form of Stock Option Grant Agreement with key employees and contracted employees at band level 6-9 pursuant to which stock option awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective November 28, 2011 (previously filed as Exhibit 10.48 to the Company's Annual Report on Form 10-K for the fiscal year ended September 29, 2012, Commission File No. 001-14704, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.56 | * | Form of Stock Incentive Agreement pursuant to which stock options are granted to contracted employees under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective October 26, 2012 (previously filed as Exhibit 10.49 to the Company's Annual Report on Form 10-K for the fiscal year ended September 29, 2012, Commission File No. 001-14704, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.57 | * | Form of Stock Incentive Agreement pursuant to which stock options are granted to non-contracted employees under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective October 26, 2012 (previously filed as Exhibit 10.50 to the Company's Annual Report on Form 10-K for the fiscal year ended September 29, 2012, Commission File No. 001-14704, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.58 | * | Form of Performance Stock Award Agreement pursuant to which performance stock awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective October 4, 2010 (previously filed as Exhibit 10.44 to the Company's Annual Report on Form 10-K for the fiscal year ended October 1, 2011, Commission File No. 001-14704, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.59 | * | Form of Performance Stock Award Agreement pursuant to which performance stock awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective October 3, 2011 (previously filed as Exhibit 10.52 to the Company's Annual Report on Form 10-K for the fiscal year ended September 29, 2012, Commission File No. 001-14704, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.60 | * | Form of Stock Incentive Agreement pursuant to which performance stock awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective October 26, 2012 (previously filed as Exhibit 10.53 to the Company's Annual Report on Form 10-K for the fiscal year ended September 29, 2012, Commission File No. 001-14704, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.61 | * | Form of Stock Incentive Award Agreement with non-contracted officers pursuant to which performance stock awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective November 30, 2015. 2000 Stock Incentive Plan effective November 30, 2015 (previously filed as Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the period ended January 2, 2016, Commission File No. 001-14704, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.62 | * | Form of Stock Incentive Award Agreement with contracted officers pursuant to which performance stock awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective November 30, 2015 (previously filed as Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the period ended January 2, 2016, Commission File No. 001-14704, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.63 | * | Form of Stock Incentive Award Agreement with contracted employees pursuant to which restricted stock awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective November 30, 2015 (previously filed as Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q for the period ended January 2, 2016, Commission File No. 001-14704, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.64 | * | Form of Stock Incentive Award Agreement with non-contracted employees which include non-competition, non-solicitation and confidentiality agreements, pursuant to which restricted stock awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective November 30, 2015 (previously filed as Exhibit 10.4 to the Company’s Quarterly Report on Form 10-Q for the period ended January 2, 2016, Commission File No. 001-14704, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.65 | * | Form of Stock Incentive Award Agreement with non-contracted employees pursuant to which restricted stock awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective November 30, 2015 (previously filed as Exhibit 10.5 to the Company’s Quarterly Report on Form 10-Q for the period ended January 2, 2016, Commission File No. 001-14704, and incorporated herein by reference). ------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101 10.66 | * | Form of Stock Incentive Award Agreement pursuant to which restricted stock awards subject to performance criteria are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective November 30, 2015 (previously filed as Exhibit 10.6 to the Company’s Quarterly Report on Form 10-Q for the period ended January 2, 2016, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.67 | * | Form of Stock Incentive Plan Stock Agreement pursuant to which restricted stock units awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective November 30, 2015 (previously filed as Exhibit 10.7 to the Company’s Quarterly Report on Form 10-Q for the period ended January 2, 2016, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.68 | * | Form of Stock Incentive Agreement pursuant to which stock appreciation rights awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective November 30, 2015 (previously filed as Exhibit 10.8 to the Company’s Quarterly Report on Form 10-Q for the period ended January 2, 2016, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.69 | * | Form of Stock Incentive Award Agreement with contracted employees pursuant to which stock options awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective November 30, 2015 (previously filed as Exhibit 10.9 to the Company’s Quarterly Report on Form 10-Q for the period ended January 2, 2016, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.70 | * | Form of Stock Incentive Award Agreement with non-contracted employees which include non-competition, non-solicitation and confidentiality agreements, pursuant to which stock options awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective November 30, 2015 (previously filed as Exhibit 10.10 to the Company’s Quarterly Report on Form 10-Q for the period ended January 2, 2016, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.71 | * | Form of Stock Incentive Award Agreement with non-contracted employees pursuant to which stock options awards are granted under the Tyson Foods, Inc. 2000 Stock Incentive Plan effective November 30, 2015 (previously filed as Exhibit 10.11 to the Company’s Quarterly Report on Form 10-Q for the period ended January 2, 2016, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.72 | * | Tyson Foods, Inc. Severance Pay Plan for Contracted Employees, effective October 31, 2012 (previously filed as Exhibit 10.54 to the Company's Annual Report on Form 10-K for the fiscal year ended September 29, 2012, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.73 | | Tax Sharing Agreement, dated as of June 15, 2012, by and among Sara Lee Corporation, D.E MASTER BLENDERS 1753 B.V. and DE US, Inc. (previously filed as Exhibit 10.1 to the Current Report on Form 8-K dated June 18, 2012 by The Hillshire Brands Company, Commission File No. 001-03344, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.74 | * | First Amendment to the Company's Supplemental Executive Retirement and Life Insurance Premium Plan as Amended and Restated as of November 14, 2014 (previously filed as Exhibit 10.57 to the Company's Annual Report on Form 10-K for the fiscal year ended September 27, 2014, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.75 | * | Amended and Restated Tyson Foods, Inc. Supplemental Executive Retirement and Life Insurance Premium Plan effective January 1, 2017 (previously filed as Exhibit 10.68 to the Company's Annual report on Form 10-K for the fiscal year ended October 1, 2016, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.76 | * | Second Amended and Restated Employment Agreement, dated November 9, 2017, by and between the Company and John Tyson. ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 12.1 | | Calculation of Ratio of Earnings to Fixed Charges. ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 14.1 | | Code of Conduct of the Company (previously filed as Exhibit 14.1 to the Company's Annual Report on Form 10-K for the fiscal year ended September 28, 2013, Commission File No. 001-14704, and incorporated herein by reference). ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 21 | | Subsidiaries of the Company. ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 23 | | Consent of PricewaterhouseCoopers LLP. ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.1 | | Certification of Chief Executive Officer pursuant to SEC Rule 13a-14(a)/15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.2 | | Certification of Chief Financial Officer pursuant to SEC Rule 13a-14(a)/15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 32.1 | | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. ------+---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 102 32.2 | | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. -----+---+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101 | | The following financial information from our Annual Report on Form 10-K for the year ended September 30, 2017, formatted in XBRL (eXtensible Business Reporting Language): (i) Consolidated Statements of Income, (ii) Consolidated Statements of Comprehensive Income, (iii) Consolidated Balance Sheets, (iv) Consolidated Statements of Shareholders' Equity, (v) Consolidated Statements of Cash Flows, (vi) the Notes to Consolidated Financial Statements, and (vii) Financial Statement Schedule. -----+---+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | * | Indicates a management contract or compensatory plan or arrangement. -----+---+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ITEM 16. Form 10-K Summary None. 103 SIGNATURES Pursuant to requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. TYSON FOODS, INC. | ------------------+---------------------------------------------------------------------------------- By: | /s/ Dennis Leatherby | November 13, 2017 ------------------+-----------------------------------------------------------------------------------+------------------ | Dennis Leatherby | ------------------+-----------------------------------------------------------------------------------+------------------ | Executive Vice President and ChiefFinancial Officer (Principal Financial Officer) | ------------------+-----------------------------------------------------------------------------------+------------------ 104 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. /s/ Gaurdie E. Banister Jr. | Director | November 13, 2017 ----------------------------+------------------------------------------------------+------------------ Gaurdie E. Banister Jr. | | ----------------------------+------------------------------------------------------+------------------ /s/ Mike Beebe | Director | November 13, 2017 ----------------------------+------------------------------------------------------+------------------ Mike Beebe | | ----------------------------+------------------------------------------------------+------------------ /s/ Curt T. Calaway | Senior Vice President, Controller and | November 13, 2017 ----------------------------+------------------------------------------------------+------------------ Curt T. Calaway | Chief Accounting Officer | ----------------------------+------------------------------------------------------+------------------ | (Principal Accounting Officer) | ----------------------------+------------------------------------------------------+------------------ /s/ Mikel A. Durham | Director | November 13, 2017 ----------------------------+------------------------------------------------------+------------------ Mikel A. Durham | | ----------------------------+------------------------------------------------------+------------------ /s/ Thomas P. Hayes | President and Chief Executive Officer | November 13, 2017 ----------------------------+------------------------------------------------------+------------------ Thomas P. Hayes | (Principal Executive Officer) | ----------------------------+------------------------------------------------------+------------------ /s/ Dennis Leatherby | Executive Vice President and Chief Financial Officer | November 13, 2017 ----------------------------+------------------------------------------------------+------------------ Dennis Leatherby | (Principal Financial Officer) | ----------------------------+------------------------------------------------------+------------------ /s/ Kevin M. McNamara | Director | November 13, 2017 ----------------------------+------------------------------------------------------+------------------ Kevin M. McNamara | | ----------------------------+------------------------------------------------------+------------------ /s/ Cheryl S. Miller | Director | November 13, 2017 ----------------------------+------------------------------------------------------+------------------ Cheryl S. Miller | | ----------------------------+------------------------------------------------------+------------------ /s/ Jeffrey K. Schomburger | Director | November 13, 2017 ----------------------------+------------------------------------------------------+------------------ Jeffrey K. Schomburger | | ----------------------------+------------------------------------------------------+------------------ /s/ Robert C. Thurber | Director | November 13, 2017 ----------------------------+------------------------------------------------------+------------------ Robert C. Thurber | | ----------------------------+------------------------------------------------------+------------------ /s/ Barbara A. Tyson | Director | November 13, 2017 ----------------------------+------------------------------------------------------+------------------ Barbara A. Tyson | | ----------------------------+------------------------------------------------------+------------------ /s/ John Tyson | Chairman of the Board of Directors | November 13, 2017 ----------------------------+------------------------------------------------------+------------------ John Tyson | | ----------------------------+------------------------------------------------------+------------------ 105

TransDigm Group INC

1260221

10-K

0001260221-17-000060

Document UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K --------- x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 --+------------------------------------------------------------------------------------- For the fiscal year ended September 30, 2017 ¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 --+----------------------------------------------------------------------------------------- For the transition period from to Commission File Number 001-32833 TransDigm Group Incorporated(Exact name of registrant as specified in its charter) ---------------------------------------------------------------------------------- Delaware (State or other jurisdiction of incorporation or organization) 41-2101738 (I.R.S. Employer Identification No.) 1301 East 9th Street, Suite 3000, Cleveland, Ohio | 44114 --------------------------------------------------+----------- (Address of principal executive offices) | (Zip Code) --------------------------------------------------+----------- (216) 706-2960 (Registrants’ telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: Common Stock | New York Stock Exchange -------------+--------------------------------------- (Title) | (Name of exchange on which registered) -------------+--------------------------------------- Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. LARGE ACCELERATED FILER | ý | ACCELERATED FILER | ¨ -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---+---------------------------+-- NON-ACCELERATED FILER | ¨ | SMALLER REPORTING COMPANY | ¨ -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---+---------------------------+-- EMERGING GROWTH COMPANY | ¨ | | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---+---------------------------+-- If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. | ¨ -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-- Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x The aggregate market value of the voting and non-voting common stock held by non-affiliates of the registrant as of March 31, 2017 , based upon the last sale price of such voting and non-voting common stock on that date, was $10,561,787,638 . The number of shares outstanding of TransDigm Group Incorporated’s common stock, par value $.01 per share, was 51,959,702 as of November 6, 2017 . Documents incorporated by reference: The registrant incorporates by reference in Part III hereof portions of its definitive Proxy Statement for its 2018 Annual Meeting of Stockholders. TABLE OF CONTENTS | | Page ---------+--------------------------------------------------------------------------------------------------------------+----- PART I | | ---------+--------------------------------------------------------------------------------------------------------------+----- ITEM 1 | BUSINESS | 1 ---------+--------------------------------------------------------------------------------------------------------------+----- ITEM 1A | RISK FACTORS | 6 ---------+--------------------------------------------------------------------------------------------------------------+----- ITEM 1B | UNRESOLVED STAFF COMMENTS | 14 ---------+--------------------------------------------------------------------------------------------------------------+----- ITEM 2 | PROPERTIES | 14 ---------+--------------------------------------------------------------------------------------------------------------+----- ITEM 3 | LEGAL PROCEEDINGS | 15 ---------+--------------------------------------------------------------------------------------------------------------+----- PART II | | ---------+--------------------------------------------------------------------------------------------------------------+----- ITEM 5 | MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES | 16 ---------+--------------------------------------------------------------------------------------------------------------+----- ITEM 6 | SELECTED FINANCIAL DATA | 19 ---------+--------------------------------------------------------------------------------------------------------------+----- ITEM 7 | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS | 25 ---------+--------------------------------------------------------------------------------------------------------------+----- ITEM 7A | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK | 40 ---------+--------------------------------------------------------------------------------------------------------------+----- ITEM 8 | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA | 40 ---------+--------------------------------------------------------------------------------------------------------------+----- ITEM 9 | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE | 40 ---------+--------------------------------------------------------------------------------------------------------------+----- ITEM 9A | CONTROLS AND PROCEDURES | 40 ---------+--------------------------------------------------------------------------------------------------------------+----- ITEM 9B | OTHER INFORMATION | 43 ---------+--------------------------------------------------------------------------------------------------------------+----- PART III | | ---------+--------------------------------------------------------------------------------------------------------------+----- ITEM 10 | DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE | 43 ---------+--------------------------------------------------------------------------------------------------------------+----- ITEM 11 | EXECUTIVE COMPENSATION | 44 ---------+--------------------------------------------------------------------------------------------------------------+----- ITEM 12 | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS | 45 ---------+--------------------------------------------------------------------------------------------------------------+----- ITEM 13 | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE | 45 ---------+--------------------------------------------------------------------------------------------------------------+----- ITEM 14 | PRINCIPAL ACCOUNTING FEES AND SERVICES | 45 ---------+--------------------------------------------------------------------------------------------------------------+----- PART IV | | ---------+--------------------------------------------------------------------------------------------------------------+----- ITEM 15 | EXHIBITS AND FINANCIAL STATEMENT SCHEDULES | 46 ---------+--------------------------------------------------------------------------------------------------------------+----- | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA | 66 ---------+--------------------------------------------------------------------------------------------------------------+----- Special Note Regarding Forward-Looking Statements This report on Form 10-K contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and 27A of the Securities Act of 1933, as amended. Discussions containing such forward-looking statements may be found in Items 1, 1A, 2, 3, 5, 7 and 7A hereof and elsewhere within this Report generally. In addition, when used in this Report, the words “believe,” “may,” “will,” “should,” “expect,” “intend,” “plan,” “predict,” “anticipate,” “estimate” or “continue” and other words and terms of similar meaning are intended to identify forward-looking statements. Although the Company (as defined below) believes that its plans, intentions and expectations reflected in or suggested by such forward-looking statements are reasonable, such forward-looking statements are subject to a number of risks and uncertainties that could cause actual results to differ materially from the forward-looking statements made in this Report. The more important of such risks and uncertainties are set forth under the caption “Risk Factors” and elsewhere in this Report. Many such factors are outside the control of the Company. Consequently, such forward-looking statements should be regarded solely as our current plans, estimates and beliefs. We do not undertake, and specifically decline, any obligation, to publicly release the results of any revisions to these forward-looking statements that may be made to reflect any future events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events. All forward-looking statements attributable to the Company or persons acting on its behalf are expressly qualified in their entirety by these cautionary statements. Important factors that could cause actual results to differ materially from the forward-looking statements made in this Annual Report on Form 10-K include but are not limited to: the sensitivity of our business to the number of flight hours that our customers’ planes spend aloft and our customers’ profitability, both of which are affected by general economic conditions; future geopolitical or other worldwide events; cyber-security threats and natural disasters; our reliance on certain customers; the U.S. defense budget and risks associated with being a government supplier; failure to maintain government or industry approvals; failure to complete or successfully integrate acquisitions; our indebtedness; potential environmental liabilities; increases in raw material costs, taxes and labor costs that cannot be recovered in product pricing; risks and costs associated with our international sales and operations; and other factors. In this report, the term “TD Group” refers to TransDigm Group Incorporated, which holds all of the outstanding capital stock of TransDigm Inc. The terms “Company,” “TransDigm,” “we,” “us,” “our” and similar terms refer to TD Group, together with TransDigm Inc. and its direct and indirect subsidiaries. References to “fiscal year” mean the year ending or ended September 30. For example, “fiscal year 2017 ” or “fiscal 2017 ” means the period from October 1, 2016 to September 30, 2017 . PART I ITEM 1. BUSINESS The Company TransDigm Inc. was formed in 1993 in connection with a leveraged buyout transaction. TD Group was formed in 2003 to facilitate a leveraged buyout of TransDigm Inc. The Company was owned by private equity funds until its initial public offering in 2006. TD Group’s common stock is publicly traded on the New York Stock Exchange, or NYSE, under the ticker symbol “TDG.” We believe we are a leading global designer, producer and supplier of highly engineered aircraft components for use on nearly all commercial and military aircraft in service today. Our business is well diversified due to the broad range of products we offer to our customers. We estimate that about 90% of our net sales for fiscal year 2017 were generated by proprietary products. In addition, for fiscal year 2017 , we estimate that we generated about 80% of our net sales from products for which we are the sole source provider. Most of our products generate significant aftermarket revenue. Once our parts are designed into and sold on a new aircraft, we generate net sales from aftermarket consumption over the life of that aircraft, which is generally estimated to be approximately 25 to 30 years. A typical platform can be produced for 20 to 30 years, giving us an estimated product life cycle in excess of 50 years. We estimate that approximately 55% of our net sales in fiscal year 2017 were generated from aftermarket sales, the vast majority of which come from the commercial and military aftermarkets. These aftermarket revenues have historically produced a higher gross margin and been more stable than sales to original equipment manufacturers, or OEMs. Products We primarily design, produce and supply highly engineered proprietary aerospace components (and certain systems/subsystems) with significant aftermarket content. We seek to develop highly customized products to solve specific needs for aircraft operators and manufacturers. We attempt to differentiate ourselves based on engineering, service and manufacturing capabilities. We typically choose not to compete for non-proprietary “build to print” business because it frequently offers lower margins than proprietary products. We believe that our products have strong brand names within the industry and that we have a reputation for high quality, reliability and customer support. 1 Our business is well diversified due to the broad range of products that we offer to our customers. Some of our more significant product offerings, substantially all of which are ultimately provided to end-users in the aerospace industry, include mechanical/electro-mechanical actuators and controls, ignition systems and engine technology, specialized pumps and valves, power conditioning devices, specialized AC/DC electric motors and generators, NiCad batteries and chargers, engineered latching and locking devices, rods and locking devices, engineered connectors and elastomers, databus and power controls, cockpit security components and systems, specialized cockpit displays, aircraft audio systems, specialized lavatory components, seat belts and safety restraints, engineered interior surfaces and related components, lighting and control technology, military personnel parachutes, high performance hoists, winches and lifting devices and cargo loading, handling and delivery systems. Segments The Company’s businesses are organized and managed in three reporting segments: Power & Control, Airframe and Non-aviation. The Power & Control segment includes operations that primarily develop, produce and market systems and components that predominately provide power to or control power of the aircraft utilizing electronic, fluid, power and mechanical motion control technologies. Major product offerings include mechanical/electro-mechanical actuators and controls, ignition systems and engine technology, specialized pumps and valves, power conditioning devices, specialized AC/DC electric motors and generators, databus and power controls, high performance hoists, winches and lifting devices and cargo loading and handling systems. Primary customers of this segment are engine and power system and subsystem suppliers, airlines, third party maintenance suppliers, military buying agencies and repair depots. Products are sold in the OEM and aftermarket market channels. The Airframe segment includes operations that primarily develop, produce and market systems and components that are used in non-power airframe applications utilizing airframe and cabin structure technologies. Major product offerings include engineered latching and locking devices, rods and locking devices, engineered connectors and elastomers, cockpit security components and systems, aircraft audio systems, specialized lavatory components, seat belts and safety restraints, engineered interior surfaces and related components, lighting and control technology, military personnel parachutes and cargo delivery systems. Primary customers of this segment are airframe manufacturers and cabin system suppliers and subsystem suppliers, airlines, third party maintenance suppliers, military buying agencies and repair depots. Products are sold in the OEM and aftermarket market channels. The Non-aviation segment includes operations that primarily develop, produce and market products for non-aviation markets. Major product offerings include seat belts and safety restraints for ground transportation applications, mechanical/electro-mechanical actuators and controls for space applications, and refueling systems for heavy equipment used in mining, construction and other industries. Primary customers of this segment are off-road vehicle suppliers and subsystem suppliers, child restraint system suppliers, satellite and space system suppliers and manufacturers of heavy equipment used in mining, construction and other industries. For financial information about our segments, see Note 16, “Segments,” to our consolidated financial statements included herein. Sales and Marketing Consistent with our overall strategy, our sales and marketing organization is structured to continually develop technical solutions that meet customer needs. In particular, we attempt to focus on products and programs that will lead to high-margin, repeatable sales in the aftermarket. We have structured our sales efforts along our major product offerings, assigning a business unit manager to certain products. Each business unit manager is expected to grow the sales and profitability of the products for which he or she is responsible and to achieve the targeted annual level of bookings, sales, new business and profitability for such products. The business unit managers are assisted by account managers and sales engineers who are responsible for covering major OEM and aftermarket accounts. Account managers and sales engineers are expected to be familiar with the personnel, organization and needs of specific customers to achieve total bookings and new business goals at each account and, together with the business unit managers, to determine when additional resources are required at customer locations. Most of our sales personnel are evaluated, in part, on their bookings and their ability to identify and obtain new business opportunities. Though typically performed by employees, the account manager function may be performed by independent representatives depending on the specific customer, product and geographic location. We also use a number of distributors to provide logistical support as well as serve as a primary customer contact with certain smaller accounts. Our major distributors are Aviall, Inc. (a subsidiary of The Boeing Company) and Satair A/S (a subsidiary of Airbus S.A.S.). Manufacturing and Engineering We maintain approximately 60 principal manufacturing facilities. Most of our manufacturing facilities are comprised of manufacturing, distribution and engineering functions, and most facilities have certain administrative functions, including 2 management, sales and finance. We continually strive to improve productivity and reduce costs, including rationalization of operations, developing improved control systems that allow for accurate accounting and reporting, investing in equipment, tooling, information systems and implementing broad-based employee training programs. Management believes that our manufacturing systems and equipment contribute to our ability to compete by permitting us to meet the rigorous tolerances and cost sensitive price structure of aircraft component customers. We attempt to differentiate ourselves from our competitors by producing uniquely engineered products with high quality and timely delivery. Our engineering costs are recorded in cost of sales and in selling and administrative expenses and research and development costs are recorded in selling and administrative expenses in our consolidated statements of income. The aggregate of engineering expense and research and development expense represents approximately 8% of our operating units’ aggregate costs, or approximately 4% of our consolidated net sales. Our proprietary products, and particularly our new product initiatives, are designed by our engineers and are intended to serve the needs of the aircraft component industry. These proprietary designs must withstand the extraordinary conditions and stresses that will be endured by products during use and meet the rigorous demands of our customers’ tolerance and quality requirements. We use sophisticated equipment and procedures to comply with quality requirements, specifications and Federal Aviation Administration (“FAA”) and OEM requirements. We perform a variety of testing procedures as required by our customers, such as testing under different temperature, humidity and altitude levels, shock and vibration testing and X-ray fluorescent measurement. These procedures, together with other customer approved techniques for document, process and quality control, are used throughout our manufacturing facilities. Refer to Note 3, “Summary of Significant Accounting Policies,” to the consolidated financial statements included herein with respect to total costs of research and development, which is incorporated herein by reference. Customers We predominantly serve customers in the commercial, regional, business jet and general aviation aftermarket, which accounts for approximately 35% of total sales; the commercial aerospace OEM market, comprising large commercial transport manufacturers and regional and business jet manufacturers, which accounts for approximately 26% of total sales; and the defense market, which accounts for approximately 34% of total sales. Non-aerospace sales comprise approximately 5% of our total sales. Our customers include: (1) distributors of aerospace components; (2) worldwide commercial airlines, including national and regional airlines; (3) large commercial transport and regional and business aircraft OEMs; (4) various armed forces of the United States and friendly foreign governments; (5) defense OEMs; (6) system suppliers; and (7) various other industrial customers. For the year ended September 30, 2017 , Airbus S.A.S. (which includes Satair A/S, a distributor of commercial aftermarket parts to airlines throughout the world) accounted for approximately 13% of our net sales and The Boeing Company (which includes Aviall, Inc., also a distributor of commercial aftermarket parts to airlines throughout the world) accounted for approximately 11% of our net sales. Our top ten customers for fiscal year 2017 accounted for approximately 46% of our net sales. Products supplied to many of our customers are used on multiple platforms. Active commercial production programs include the Boeing 737 (including the 737MAX), 747, 767 and 787, the Airbus A320 family (including neo), A330, A350 and A380, the Bombardier CSeries, CRJ’s, Q400/Dash-8 aircraft, Challenger and Learjets, the Embraer Regional and business jets, the Cessna Citation family, the Gulfstream aircraft family, the Dassault aircraft family, the HondaJet and the ATR42/72 turboprop. Military platforms include aircraft such as the Boeing AH-64 Apache, CH-47, C17 Chinook, F-15, F-18, KC46 Tanker, P-8 and V-22, the Airbus A400M, the Lockheed Martin C-130J, F-16 and F-35 Joint Strike Fighter, UH-60 Blackhawk helicopter, the Northrop Grumman E-2C Hawkeye, the General Atomics Predator Drone and the Raytheon Patriot Missile. We have been awarded numerous contracts for the development of engineered products for production on the Airbus A330neo, the Boeing 777x, the Bombardier Global 7000/8000, the Embraer E2, the Mitsubishi Regional Jet and the Sikorsky S-97 and JMR helicopter. The markets in which we sell our products are, to varying degrees, cyclical and have experienced upswings and downturns. The demand for our commercial aftermarket parts and services depends on, among other things, the breadth of our installed OEM base, revenue passenger miles (“RPMs”), the size and age of the worldwide aircraft fleet, the percentage of the worldwide fleet that is in warranty, and airline profitability. The demand for defense products is specifically dependent on government budget trends, military campaigns and political pressures. Competition The niche markets within the aerospace industry that we serve are relatively fragmented and we face several competitors for many of the products and services we provide. Due to the global nature of the commercial aircraft industry, competition in these categories comes from both U.S. and foreign companies. Competitors in our product offerings range in size from divisions of large public corporations to small privately-held entities with only one or two components in their entire product portfolios. We compete on the basis of engineering, manufacturing and marketing high quality products, which we believe meet or exceed the performance and maintenance requirements of our customers, consistent and timely delivery, and superior customer service and support. The industry’s stringent regulatory, certification and technical requirements and the investments necessary 3 in the development and certification of products may create disincentives for potential new competitors for certain products. If customers receive products that meet or exceed expectations and performance standards, we believe that they will have a reduced incentive to certify another supplier because of the cost and time of the technical design and testing certification process. In addition, we believe that the availability, dependability and safety of our products are reasons for our customers to continue long-term supplier relationships. Government Contracts Companies engaged in supplying defense-related equipment and services to U.S. Government agencies are subject to business risks specific to the defense industry. These risks include the ability of the U.S. Government to unilaterally: (1) suspend us from receiving new contracts and impose criminal penalties based on alleged violations of procurement laws or regulations; (2) terminate existing contracts; (3) reduce the value of existing contracts; (4) audit our contract-related costs and fees, including allocated indirect costs; (5) control and potentially prohibit the export of our products; and (6) seek repayment of contract related payments under certain circumstances. Governmental Regulation The commercial aircraft component industry is highly regulated by the FAA in the United States and by the Joint Aviation Authorities in Europe and other agencies throughout the world, while the military aircraft component industry is governed by military quality specifications. We, and the components we manufacture, are required to be certified by one or more of these entities or agencies, and, in many cases, by individual OEMs, in order to engineer and service parts and components used in specific aircraft models. We must also satisfy the requirements of our customers, including OEMs and airlines that are subject to FAA regulations, and provide these customers with products and services that comply with the government regulations applicable to commercial flight operations. In addition, the FAA requires that various maintenance routines be performed on aircraft components. We believe that we currently satisfy or exceed these maintenance standards in our repair and overhaul services. We also maintain several FAA approved repair stations. In addition, our businesses are subject to many other laws and requirements typically applicable to manufacturers and exporters. Without limiting the foregoing, sales of many of our products that will be used on aircraft owned by foreign entities are subject to compliance with export control laws and the manufacture of our products and the operations of our businesses, including the disposal of hazardous wastes, are subject to compliance with applicable environmental laws. Market Channels The commercial aerospace industry, including the aftermarket and OEM market, is impacted by the health of the global economy and geo-political events around the world. The commercial aerospace industry had shown strength with increases in revenue passenger miles, or RPMs, between 2003 and 2008, as well as increases in OEM production and backlog. However, in 2009, the global economic downturn negatively impacted the commercial aerospace industry causing RPMs to decline slightly. This market sector began to rebound in 2010 and positive growth has continued through 2017 with increases in RPMs, as well as the growth in the large commercial OEM sector (aircraft with 100 or more seats) with order announcements by The Boeing Company and Airbus S.A.S. leading to planned increases in production. The 2018 leading indicators and industry consensus suggest a continuation of current trends in the commercial transport market sector supported by continued RPM growth and increases in production at the OEM level. The defense aerospace market is dependent on government budget constraints, the timing of orders, political pressures and the extent of global conflicts. It is not necessarily affected by general economic conditions that affect the commercial aerospace industry. Our presence in both the commercial aerospace and military sectors of the aerospace industry may mitigate the impact on our business of any specific industry risk. We service a diversified customer base in the commercial and military aerospace industry, and we provide components to a diverse installed base of aircraft, which mitigates our exposure to any individual airframe platform. At times, declines in sales in one channel have been offset by increased sales in another. However, due to differences between the profitability of our products sold to OEM and aftermarket customers, variation in product mix can cause variation in gross margin. There are many short-term factors (including inventory corrections, unannounced changes in order patterns, strikes and mergers and acquisitions) that can cause short-term disruptions in our quarterly shipment patterns as compared to previous quarters and the same periods in prior years. As such, it can be difficult to determine longer-term trends in our business based on quarterly comparisons. To normalize for short-term fluctuations, we tend to look at our performance over several quarters or years of activity rather than discrete short-term periods. There are also fluctuations in OEM and aftermarket ordering and delivery requests from quarter-to-quarter, as well as variations in product mix from quarter-to-quarter, that may cause positive or negative variations in gross profit margins since 4 commercial aftermarket sales have historically produced a higher gross margin than sales to commercial OEMs. Again, in many instances these are timing events between quarters and must be balanced with macro aerospace industry indicators. Commercial Aftermarket The key growth factors in the commercial aftermarket include worldwide RPMs and the size and activity level of the worldwide fleet of aircraft and the percentage of the fleet that is in warranty. Commercial OEM Market The commercial transport market sector, the largest sector in the commercial OEM market, grew modestly during 2017. Our commercial transport OEM shipments and revenues generally run ahead of the Boeing and Airbus airframe delivery schedules. As a result and consistent with prior years, our fiscal 2018 shipments will be a function of, among other things, the estimated 2018 and 2019 commercial airframe production rates. We have been experiencing increased sales in the large commercial OEM sector (aircraft with 100 or more seats) driven by an increase in production by The Boeing Company and Airbus S.A.S tied to previous order announcements. Industry consensus indicates this production increase will continue in 2018 and 2019, though the growth may continue to moderate and begin to flatten. Defense Our military business fluctuates from year to year, and is dependent, to a degree, on government budget constraints, the timing of orders and the extent of global conflicts. For a variety of reasons, the military spending outlook is very uncertain. For planning purposes we assume that military related sales of our types of products to be flat in future years over the recent high levels. Raw Materials We require the use of various raw materials in our manufacturing processes. We also purchase a variety of manufactured component parts from various suppliers. At times, we concentrate our orders among a few suppliers in order to strengthen our supplier relationships. Most of our raw materials and component parts are generally available from multiple suppliers at competitive prices. Intellectual Property We have various trade secrets, proprietary information, trademarks, trade names, patents, copyrights and other intellectual property rights, which we believe, in the aggregate but not individually, are important to our business. Backlog As of September 30, 2017 , the Company estimated its sales order backlog at $1,669 million compared to an estimated sales order backlog of $1,554 million as of September 30, 2016 . The increase in estimated sales order backlog is primarily due to acquisitions. The majority of the purchase orders outstanding as of September 30, 2017 are scheduled for delivery within the next twelve months. Purchase orders may be subject to cancellation or deferral by the customer prior to shipment. The level of unfilled purchase orders at any given date during the year will be materially affected by the timing of the Company’s receipt of purchase orders and the speed with which those orders are filled. Accordingly, the Company’s backlog as of September 30, 2017 may not necessarily represent the actual amount of shipments or sales for any future period. Foreign Operations Although we manufacture a significant portion of our products in the United States, we manufacture some products in Belgium, China, Germany, Hungary, Malaysia, Mexico, Norway, Sri Lanka, Sweden, and the United Kingdom. Although the majority of sales of our products are made to customers (including distributors) located in the United States, our products are ultimately sold to and used by customers (including airlines and other end users of aircraft) throughout the world. A number of risks inherent in international operations could have a material adverse effect on our results of operations, including currency fluctuations, difficulties in staffing and managing multi-national operations, general economic and political uncertainties and potential for social unrest in countries in which we operate, limitations on our ability to enforce legal rights and remedies, restrictions on the repatriation of funds, change in trade policies, tariff regulation, difficulties in obtaining export and import licenses and the risk of government financed competition. Environmental Matters Our operations and facilities are subject to a number of federal, state, local and foreign environmental laws and regulations that govern, among other things, discharges of pollutants into the air and water, the generation, handling, storage and disposal of hazardous materials and wastes, the remediation of contamination and the health and safety of our employees. Environmental laws and regulations may require that the Company investigate and remediate the effects of the release or disposal of materials at sites associated with past and present operations. Certain facilities and third-party sites utilized by the Company have been identified 5 as potentially responsible parties under the federal superfund laws and comparable state laws. The Company is currently involved in the investigation and remediation of a number of sites under applicable laws. Employees As of September 30, 2017 , we had approximately 9,200 full-time, part-time and temporary employees. Approximately 11% of our full-time and part-time employees were represented by labor unions. Collective bargaining agreements between us and these labor unions expire at various dates ranging from February 2018 to November 2020. We consider our relationship with our employees generally to be satisfactory. Available Information TD Group’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, including any amendments, will be made available free of charge on the Company’s website, www.transdigm.com , as soon as reasonably practicable, following the filing of the reports with the Securities and Exchange Commission. ITEM 1A. RISK FACTORS Set forth below are important risks and uncertainties that could negatively affect our business and financial condition and could cause our actual results to differ materially from those expressed in forward-looking statements contained in this report. Our commercial business is sensitive to the number of flight hours that our customers’ planes spend aloft, the size and age of the worldwide aircraft fleet and our customers’ profitability. These items are, in turn, affected by general economic and geopolitical and other worldwide conditions. Our commercial business is directly affected by, among other factors, changes in revenue passenger miles (RPMs), the size and age of the worldwide aircraft fleet, the percentage of the fleet that is out-of-warranty and changes in the profitability of the commercial airline industry. RPMs and airline profitability have historically been correlated with the general economic environment, although national and international events also play a key role. For example, in the past, the airline industry has been severely affected by the downturn in the global economy, higher fuel prices, the increased security concerns among airline customers following the events of September 11, 2001, the Severe Acute Respiratory Syndrome (SARS) epidemic, and the conflicts abroad, and could be impacted by future geopolitical or other worldwide events, such as war, terrorist acts, or a worldwide infectious disease outbreak. In addition, global market and economic conditions have been challenging with turbulence in the U.S. and international markets and economies and have prolonged declines in business and consumer spending. As a result of the substantial reduction in airline traffic resulting from these events, the airline industry incurred large losses and financial difficulties. Some carriers have also parked or retired a portion of their fleets and have reduced workforces and flights. During periods of reduced airline profitability, some airlines may delay purchases of spare parts, preferring instead to deplete existing inventories, and delay refurbishments and discretionary spending. If demand for spare parts decreases, there would be a decrease in demand for certain of our products. An adverse change in demand could impact our results of operations, collection of accounts receivable and our expected cash flow generation from current and acquired businesses which may adversely impact our financial condition and access to capital markets. Our sales to manufacturers of aircraft are cyclical, and a downturn in sales to these manufacturers may adversely affect us. Our sales to manufacturers of large commercial aircraft, such as The Boeing Company, Airbus S.A.S, and related OEM suppliers, as well as manufacturers of business jets (which collectively accounted for approximately 25% of our net sales in fiscal year 2017 ) have historically experienced periodic downturns. In the past, these sales have been affected by airline profitability, which is impacted by, among other things, fuel and labor costs, price competition, interest rates, downturns in the global economy and national and international events. In addition, sales of our products to manufacturers of business jets are impacted by, among other things, downturns in the global economy. Downturns adversely affect our net sales, gross margin and net income. We rely heavily on certain customers for much of our sales. Our two largest customers for fiscal year 2017 were Airbus S.A.S. (which includes Satair A/S) and The Boeing Company (which includes Aviall, Inc.). Airbus S.A.S. accounted for approximately13% of our net sales and The Boeing Company accounted for approximately 11% of our net sales in fiscal year 2017 . Our top ten customers for fiscal year 2017 accounted for approximately 46% of our net sales. A material reduction in purchasing by one of our larger customers for any reason, including but not limited to economic downturn, decreased production, strike or resourcing, could have a material adverse effect on our net sales, gross margin and net income. 6 We generally do not have guaranteed future sales of our products. Further, when we enter into fixed price contracts with some of our customers, we take the risk for cost overruns. As is customary in our business, we do not generally have long-term contracts with most of our aftermarket customers and, therefore, do not have guaranteed future sales. Although we have long-term contracts with many of our OEM customers, many of those customers may terminate the contracts on short notice and, in most cases, our customers have not committed to buy any minimum quantity of our products. In addition, in certain cases, we must anticipate the future volume of orders based upon the historic purchasing patterns of customers and upon our discussions with customers as to their anticipated future requirements, and this anticipated future volume of orders may not materialize. We also have entered into multi-year, fixed-price contracts with some of our customers, pursuant to which we have agreed to perform the work for a fixed price and, accordingly, realize all the benefit or detriment resulting from any decreases or increases in the costs of making these products. Sometimes we accept a fixed-price contract for a product that we have not yet produced, and this increases the risk of cost overruns or delays in the completion of the design and manufacturing of the product. Most of our contracts do not permit us to recover increases in raw material prices, taxes or labor costs. U.S. military spending is dependent upon the U.S. defense budget. The military and defense market is significantly dependent upon government budget trends, particularly the U.S. Department of Defense (the “DOD”) budget. In addition to normal business risks, our supply of products to the United States Government is subject to unique risks largely beyond our control. DOD budgets could be negatively impacted by several factors, including, but not limited to, a change in defense spending policy by the current presidential administration, the U.S. Government’s budget deficits, spending priorities, the cost of sustaining the U.S. military presence internationally and possible political pressure to reduce U.S. Government military spending, each of which could cause the DOD budget to remain unchanged or to decline. A significant decline in U.S. military expenditures could result in a reduction in the amount of our products sold to the various agencies and buying organizations of the U.S. Government. We intend to pursue acquisitions. Our business may be adversely affected if we cannot consummate acquisitions on satisfactory terms, or if we cannot effectively integrate acquired operations. A significant portion of our growth has occurred through acquisitions. Any future growth through acquisitions will be partially dependent upon the continued availability of suitable acquisition candidates at favorable prices and upon advantageous terms and conditions. We intend to pursue acquisitions that we believe will present opportunities consistent with our overall business strategy. However, we may not be able to find suitable acquisition candidates to purchase or may be unable to acquire desired businesses or assets on economically acceptable terms or may be unable to receive necessary regulatory approvals or support. In addition, we may not be able to raise the capital necessary to fund future acquisitions. Because we may actively pursue a number of opportunities simultaneously, we may encounter unforeseen expenses, complications and delays, including regulatory complications or difficulties in employing sufficient staff and maintaining operational and management oversight. We regularly engage in discussions with respect to potential acquisition and investment opportunities. If we consummate an acquisition, our capitalization and results of operations may change significantly. Future acquisitions could result in margin dilution and further likely result in the incurrence of additional debt and contingent liabilities and an increase in interest and amortization expenses or periodic impairment charges related to goodwill and other intangible assets as well as significant charges relating to integration costs. Acquisitions involve risks that the businesses acquired will not perform in accordance with expectations and that business judgments concerning the value, strengths and weaknesses of businesses acquired will prove incorrect. In addition, we may not be able to successfully integrate any business we acquire into our existing business. The successful integration of new businesses depends on our ability to manage these new businesses and cut excess costs. The successful integration of future acquisitions may also require substantial attention from our senior management and the management of the acquired business, which could decrease the time that they have to service, attract customers and develop new products and services or attend to other acquisition opportunities. We are subject to certain unique business risks as a result of supplying equipment and services to the U.S. Government. Companies engaged in supplying defense-related equipment and services to U.S. Government agencies are subject to business risks specific to the defense industry. These risks include the ability of the U.S. Government to unilaterally: • | suspend us from receiving new contracts based on alleged violations of procurement laws or regulations; --+-------------------------------------------------------------------------------------------------------- • | terminate existing contracts; --+------------------------------ • | reduce the value of existing contracts; and --+-------------------------------------------- • | audit our contract-related costs and fees, including allocated indirect costs. --+------------------------------------------------------------------------------- 7 Most of our U.S. Government contracts can be terminated by the U.S. Government for its convenience without significant notice. Termination for convenience provisions provide only for our recovery of costs incurred or committed, settlement expenses and profit on the work completed prior to termination. On contracts for which the price is based on cost, the U.S. Government may review our costs and performance, as well as our accounting and general business practices. Based on the results of such audits, the U.S. Government may adjust our contract-related costs and fees, including allocated indirect costs. In addition, under U.S. Government purchasing regulations, some of our costs, including most financing costs, amortization of intangible assets, portions of research and development costs, and certain marketing expenses may not be subject to reimbursement. Furthermore, even where the price is not based on cost, the U.S. Government may seek to review our costs to determine whether our pricing is “fair and reasonable.” Our subsidiaries are periodically subject to a pricing review and in fact, government buying agencies that purchase some of our subsidiaries’ products are currently the subject of a DOD Office of Inspector General audit with respect to prices paid for such products. Pricing reviews and government audits, including the one underway, could be costly and time consuming for our management and could distract from our ability to effectively manage the business. As a result of such a review, we could be subject to providing a refund to the U.S. Government or we could be asked to enter into an arrangement whereby our prices would be based on cost or the DOD could seek to pursue alternative sources of supply for our parts. Any of those occurrences could lead to a reduction in our revenue from, or the profitability of certain of our supply arrangements with, certain agencies and buying organizations of the U.S. Government. Moreover, U.S. Government purchasing regulations contain a number of additional operation requirements, which do not apply to entities not engaged in government contracting. Failure to comply with such government contracting requirements could result in civil and criminal penalties that could have a material adverse effect on the Company’s results of operations. Our business may be adversely affected if we would lose our government or industry approvals or if more stringent government regulations are enacted or if industry oversight is increased. The aerospace industry is highly regulated in the United States and in other countries. In order to sell our components, we and the components we manufacture must be certified by the FAA, the DOD and similar agencies in foreign countries and by individual manufacturers. If new and more stringent government regulations are adopted or if industry oversight increases, we might incur significant expenses to comply with any new regulations or heightened industry oversight. In addition, if material authorizations or approvals were revoked or suspended, our business would be adversely affected. In addition to the aviation approvals, we are at times required to obtain approval from U.S. Government agencies to export our products. Failure to obtain approval to export or determination by the U.S. Government that we failed to receive required approvals or licenses could eliminate or restrict our ability to sell our products outside the United States, and the penalties that could be imposed by the U.S. Government for failure to comply with these laws could be significant. Our indebtedness could adversely affect our financial health and could harm our ability to react to changes to our business and prevent us from fulfilling our obligations under our indebtedness. We have a significant amount of indebtedness. As of September 30, 2017 , our total indebtedness, excluding approximately $16 million of letters of credit outstanding, was approximately $11.8 billion , which was 133.5% of our total book capitalization as a result of our dividends being funded, in part, with indebtedness and the addition of approximately $1.6 billion in net new incremental borrowings during fiscal 2017 . In addition, we may be able to incur substantial additional indebtedness in the future. For example, as of September 30, 2017 , we had approximately $584 million of unused commitments under our revolving loan facility. Although our senior secured credit facility and the indentures governing the various senior subordinated notes outstanding (the “Indentures”) contain restrictions on the incurrence of additional indebtedness, these restrictions are subject to a number of significant qualifications and exceptions, and the indebtedness incurred in compliance with these qualifications and exceptions could be substantial. For example, if the usage of the revolving loan facility exceeds 25% of the total revolving commitments, the Company will be required to maintain a maximum consolidated net leverage ratio of net debt, as defined, to trailing four-quarter EBITDA As Defined. A breach of any of the covenants or an inability to comply with the required leverage ratio could result in a default under the senior secured credit facility or the Indentures. Our substantial debt could also have other important consequences to investors. For example, it could: • | increase our vulnerability to general economic downturns and adverse competitive and industry conditions; --+---------------------------------------------------------------------------------------------------------- • | increase the risk we are subjected to downgrade or put on a negative watch by the ratings agencies; --+---------------------------------------------------------------------------------------------------- • | require us to dedicate a substantial portion of our cash flow from operations to payments on our indebtedness, thereby reducing the availability of our cash flow to fund working capital requirements, capital expenditures, acquisitions, research and development efforts and other general corporate requirements; --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 8 • | limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate; --+--------------------------------------------------------------------------------------------------------------------- • | place us at a competitive disadvantage compared to competitors that have less debt; and --+---------------------------------------------------------------------------------------- • | limit, along with the financial and other restrictive covenants contained in the documents governing our indebtedness, among other things, our ability to borrow additional funds, make investments and incur liens. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- In addition, all of our debt under the senior secured credit facility, which includes $7.0 billion in term loans and a revolving loan facility of $600 million, bears interest at floating rates. Accordingly, if interest rates increase, our debt service expense will also increase. Interest rate swap and cap agreements are used to manage interest rate risk associated with floating-rate borrowings under our credit facilities. For information about our interest rate swap and cap agreements, see Note 20, “Derivatives and Hedging Instruments,” in the notes to the consolidated financial statements included herein. Our substantial level of indebtedness increases the possibility that we may be unable to generate cash sufficient to pay, when due, the principal of, interest on or other amounts due in respect of our indebtedness, including the Indentures. We cannot assure that our business will generate sufficient cash flow from operations or that future borrowings will be available to us under the senior secured credit facility or otherwise in amounts sufficient to enable us to service our indebtedness. If we cannot service our debt, we will have to take actions such as reducing or delaying capital investments, selling assets, restructuring or refinancing our debt or seeking additional equity capital. To service our indebtedness, we will require a significant amount of cash. Our ability to generate cash depends on many factors beyond our control and any failure to meet our debt service obligations could harm our business, financial condition and results of operations. Our ability to make payments on and to refinance our indebtedness, including the Indentures, amounts borrowed under the senior secured credit facility, amounts due under our Securitization Facility, and to fund our operations, will depend on our ability to generate cash in the future, which, to a certain extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. We cannot assure that our business will generate sufficient cash flow from operations, that currently anticipated cost savings and operating improvements will be realized on schedule, or at all, or that future borrowings will be available to us under the senior secured credit facility or otherwise in amounts sufficient to enable us to service our indebtedness, including the amounts borrowed under the senior secured credit facility, amounts borrowed under our Securitization Facility and the Indentures, or to fund our other liquidity needs. If we cannot service our debt, we will have to take actions such as reducing or delaying capital investments, selling assets, restructuring or refinancing our debt or seeking additional equity capital. We cannot assure that any of these remedies could, if necessary, be effected on commercially reasonable terms, or at all. Our ability to restructure or refinance our debt will depend on the condition of the capital markets and our financial condition at such time. Any refinancing of our debt could be at higher interest rates and may require us to comply with more onerous covenants, which could further restrict our business operations. The terms of existing or future debt instruments, the Securitization Facility, the Indentures and the senior secured credit facility may restrict us from adopting any of these alternatives. In addition, any failure to make payments of interest and principal on our outstanding indebtedness on a timely basis would likely result in a reduction of our credit rating, which could harm our ability to incur additional indebtedness on acceptable terms and would otherwise adversely affect the Indentures. The terms of the senior secured credit facility and Indentures may restrict our current and future operations, particularly our ability to respond to changes or to take certain actions. Our senior secured credit facility and the Indentures contain a number of restrictive covenants that impose significant operating and financial restrictions on TD Group, TransDigm Inc. and its subsidiaries (in the case of the senior secured credit facility) and TransDigm Inc. and its subsidiaries (in the case of the Indentures) and may limit their ability to engage in acts that may be in our long-term best interests. The senior secured credit facility and Indentures include covenants restricting, among other things, the ability of TD Group, TransDigm Inc. and its subsidiaries (in the case of the senior secured credit facility) and TransDigm Inc. and its subsidiaries (in the case of the Indentures) to: • | incur or guarantee additional indebtedness or issue preferred stock; --+--------------------------------------------------------------------- • | pay distributions on, redeem or repurchase our capital stock or redeem or repurchase our subordinated debt; --+------------------------------------------------------------------------------------------------------------ • | make investments; --+------------------ • | sell assets; --+------------- • | enter into agreements that restrict distributions or other payments from our restricted subsidiaries to us; --+------------------------------------------------------------------------------------------------------------ • | incur or allow to exist liens; --+------------------------------- • | consolidate, merge or transfer all or substantially all of our assets; --+----------------------------------------------------------------------- 9 • | engage in transactions with affiliates; --+---------------------------------------- • | create unrestricted subsidiaries; and --+-------------------------------------- • | engage in certain business activities. --+--------------------------------------- A breach of any of these covenants could result in a default under the senior secured credit facility or the Indentures. If any such default occurs, the lenders under the senior secured credit facility and the holders of the senior subordinated notes may elect to declare all outstanding borrowings, together with accrued interest and other amounts payable thereunder, to be immediately due and payable. The lenders under the senior secured credit facility also have the right in these circumstances to terminate any commitments they have to provide further borrowings. In addition, following an event of default under the senior secured credit facility, the lenders under that facility will have the right to proceed against the collateral granted to them to secure the debt, which includes our available cash, and they will also have the right to prevent us from making debt service payments on the senior subordinated notes. If the debt under the senior secured credit facility or the senior subordinated notes were to be accelerated, we cannot assure that our assets would be sufficient to repay in full our debt. We could incur substantial costs as a result of violations of or liabilities under environmental laws and regulations. Our operations and facilities are subject to a number of federal, state, local and foreign environmental laws and regulations that govern, among other things, discharges of pollutants into the air and water, the generation, handling, storage and disposal of hazardous materials and wastes, the remediation of contamination and the health and safety of our employees. Environmental laws and regulations may require that the Company investigate and remediate the effects of the release or disposal of materials at sites associated with past and present operations. Certain facilities and third-party sites utilized by subsidiaries of the Company have been identified as potentially responsible parties under the federal superfund laws and comparable state laws. The Company is currently involved in the investigation and remediation of a number of sites under applicable laws. Estimates of the Company’s environmental liabilities are based on current facts, laws, regulations and technology. These estimates take into consideration the Company’s prior experience and professional judgment of the Company’s environmental advisors. Estimates of the Company’s environmental liabilities are further subject to uncertainties regarding the nature and extent of site contamination, the range of remediation alternatives available, evolving remediation standards, imprecise engineering evaluations and cost estimates, the extent of corrective actions that may be required and the number and financial condition of other potentially responsible parties, as well as the extent of their responsibility for the remediation. Accordingly, as investigation and remediation proceed, it is likely that adjustments in the Company’s accruals will be necessary to reflect new information. The amounts of any such adjustments could have a material adverse effect on the Company’s results of operations or cash flows in a given period. Based on currently available information, however, the Company does not believe that future environmental costs in excess of those accrued with respect to sites for which the Company has been identified as a potentially responsible party are likely to have a material adverse effect on the Company’s financial condition. We are dependent on our senior management team and highly trained employees and any work stoppage or difficulty hiring similar employees could adversely affect our business. Because our products are complicated and highly engineered, we depend on an educated and trained workforce. There is substantial competition for skilled personnel in the aircraft component industry, and we could be adversely affected by a shortage of skilled employees. We may not be able to fill new positions or vacancies created by expansion or turnover or attract and retain qualified personnel. Although we believe that our relations with our employees are satisfactory, we cannot assure that we will be able to negotiate a satisfactory renewal of collective bargaining agreements or that our employee relations will remain stable. Because we maintain a relatively small inventory of finished goods, any work stoppage could materially and adversely affect our ability to provide products to our customers. In addition, our success depends in part on our ability to attract and motivate our senior management and key employees. Achieving this objective may be difficult due to a variety of factors, including fluctuations in economic and industry conditions, competitors’ hiring practices, and the effectiveness of our compensation programs. Competition for qualified personnel can be intense. A loss of senior management and key personnel, or failure to attract qualified new talent could prevent us from capitalizing on business opportunities, and our operating results and/or market value could be adversely affected. The Board continually monitors this risk and we believe that the Board’s succession plan, together with our straightforward strategy, clear value drivers, decentralized nature and the quality of managers running our operating units helps to mitigate this risk. Our business is dependent on the availability of certain components and raw materials from suppliers. Our business is affected by the price and availability of the raw materials and component parts that we use to manufacture our components. Our business, therefore, could be adversely impacted by factors affecting our suppliers (such as the destruction of our suppliers’ facilities or their distribution infrastructure, a work stoppage or strike by our suppliers’ employees or the failure 10 of our suppliers to provide materials of the requisite quality), or by increased costs of such raw materials or components if we were unable to pass along such price increases to our customers. Because we maintain a relatively small inventory of raw materials and component parts, our business could be adversely affected if we were unable to obtain these raw materials and components from our suppliers in the quantities we require or on favorable terms. Although we believe in most cases that we could identify alternative suppliers, or alternative raw materials or component parts, the lengthy and expensive FAA and OEM certification processes associated with aerospace products could prevent efficient replacement of a supplier, raw material or component part. Our operations depend on our manufacturing facilities, which are subject to physical and other risks that could disrupt production. A number of our manufacturing facilities are located in the greater Los Angeles area, an area known for earthquakes, and are thus vulnerable to damage. In addition, a number of our manufacturing facilities are located along the Eastern seaboard area susceptible to hurricanes. We are also vulnerable to damage from other types of disasters, including power loss, fire, explosions, floods, communications failures, terrorist attacks and similar events. Disruptions could also occur due to cyber-attacks, computer or equipment malfunction (accidental or intentional), operator error or process failures. Any disruption of our ability to operate our business could result in a material decrease in our revenues or significant additional costs to replace, repair or insure our assets, which could have a material adverse impact on our financial condition and results of operations. Operations and sales outside of the United States may be subject to additional risks. A number of risks inherent in international operations could have a material adverse effect on our results of operations, including currency fluctuations, difficulties in staffing and managing multi-national operations, general economic and political uncertainties and potential for social unrest in countries in which we operate, limitations on our ability to enforce legal rights and remedies, restrictions on the repatriation of funds, change in trade policies, tariff regulation, difficulties in obtaining export and import licenses and the risk of government financed competition. Furthermore, the Company is subject to laws and regulations, such as the Foreign Corrupt Practices Act, UK Bribery Act and similar local anti-bribery laws, which generally prohibit companies and their employees, agents and contractors from making improper payments for the purpose of obtaining or retaining business. Failure to comply with these laws could subject the Company to civil and criminal penalties that could materially adversely affect the Company’s results of operations. We face significant competition. We operate in a highly competitive global industry and compete against a number of companies. Competitors in our product lines are both U.S. and foreign companies and range in size from divisions of large public corporations to small privately held entities. We believe that our ability to compete depends on high product performance, consistent high quality, short lead-time and timely delivery, competitive pricing, superior customer service and support and continued certification under customer quality requirements and assurance programs. We may have to adjust the prices of some of our products to stay competitive. We could be adversely affected if one of our components causes an aircraft to crash. Our operations expose us to potential liabilities for personal injury or death as a result of the failure of an aircraft component that we have designed, manufactured or serviced. While we maintain liability insurance to protect us from future product liability claims, in the event of product liability claims our insurers may attempt to deny coverage or any coverage we have may not be adequate. We also may not be able to maintain insurance coverage in the future at an acceptable cost. Any liability not covered by insurance or for which third party indemnification is not available could result in significant liability to us. In addition, a crash caused by one of our components could damage our reputation for quality products. We believe our customers consider safety and reliability as key criteria in selecting a provider of aircraft components. If a crash were to be caused by one of our components, or if we were to otherwise fail to maintain a satisfactory record of safety and reliability, our ability to retain and attract customers may be materially adversely affected. We could incur substantial costs as a result of data protection concerns. The interpretation and application of data protection laws in the U.S., Europe and elsewhere are uncertain and evolving. It is possible that these laws may be interpreted and applied in a manner that is inconsistent with our data practices. Compliance could cause us to incur substantial costs or require us to change our business practices in a manner adverse to our business. In addition, despite our efforts to protect confidential information, our facilities and systems may be vulnerable to data loss, including cyber-attacks. This could lead to negative publicity, legal claims, theft, modification or destruction of proprietary or key information, damage to or inaccessibility of critical systems, manufacture of defective products, production downtimes, operational disruptions and other significant costs, which could adversely affect our reputation, financial condition and results of operations. 11 We have recorded a significant amount of intangible assets, which may never generate the returns we expect. Mergers and acquisitions have resulted in significant increases in identifiable intangible assets and goodwill. Identifiable intangible assets, which primarily include trademarks, trade names, trade secrets, and technology, were approximately $1.7 billion at September 30, 2017 , representing approximately 17% of our total assets. Goodwill recognized in accounting for the mergers and acquisitions was approximately $5.7 billion at September 30, 2017 , representing approximately 58% of our total assets. We may never realize the full value of our identifiable intangible assets and goodwill, and to the extent we were to determine that our identifiable intangible assets or our goodwill were impaired within the meaning of applicable accounting standards, we would be required to write-off the amount of any impairment. The Company may be subject to risks relating to changes in its tax rates or exposure to additional income tax liabilities. The Company is subject to income taxes in the United States and various non-U.S. jurisdictions. The Company’s domestic and international tax liabilities are dependent upon the location of earnings among these different jurisdictions. The Company’s future results of operations could be adversely affected by changes in the Company’s effective tax rate as a result of changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets, challenges by tax authorities or changes in tax laws or regulations. In addition, the amount of income taxes paid by the Company is subject to ongoing audits by U.S. federal, state and local tax authorities and by non-U.S. tax authorities. If these audits result in assessments different from amounts reserved, future financial results may include unfavorable adjustments to the Company’s tax liabilities, which could have a material adverse effect on the Company’s results of operations. Our stock price may be volatile, and an investment in our common stock could suffer a decline in value. There has been significant volatility in the market price and trading volume of equity securities, which is unrelated to the operating performance of the companies issuing the securities. These market fluctuations may negatively affect the market price of our common stock. Shareholders may not be able to sell their shares at or above the purchase price due to fluctuations in the market price of our common stock. Such changes could be caused by changes in our operating performance or prospects, including possible changes due to the cyclical nature of the aerospace industry and other factors such as fluctuations in OEM and aftermarket ordering, which could cause short-term swings in profit margins. Or such changes could be unrelated to our operating performance, such as changes in market conditions affecting the stock market generally or the stocks of aerospace companies or changes in the outlook for our common stock, such as changes to or the confidence in our business strategy, changes to or confidence in our management, or expectations for future growth of the Company. Future sales of our common stock in the public market could lower our share price. We may sell additional shares of common stock into the public markets or issue convertible debt securities to raise capital in the future. The market price of our common stock could decline as a result of sales of a large number of shares of our common stock in the public markets or the perception that these sales could occur. These sales, or the possibility that these sales may occur, also might make it more difficult for us to sell equity securities to raise capital at a time and price that we deem appropriate. Our corporate documents and Delaware law contain certain provisions that could discourage, delay or prevent a change in control of our company. Provisions in our amended and restated certificate of incorporation and bylaws may discourage, delay or prevent a merger or acquisition involving us that our stockholders may consider favorable. For example, our amended and restated certificate of incorporation authorizes our Board of Directors to issue up to 149,600,000 shares of “blank check” preferred stock. Without stockholder approval, the Board of Directors has the authority to attach special rights, including voting and dividend rights, to this preferred stock. With these rights, holders of preferred stock could make it more difficult for a third party to acquire us. Our amended and restated certificate of incorporation also provides that the affirmative vote of the holders of at least 75% of the voting power of our issued and outstanding capital stock, voting together as a single class, is required for the alteration, amendment or repeal of certain provisions of our amended and restated certificate of incorporation and certain provisions of our amended and restated bylaws, including the provisions relating to our stockholders’ ability to call special meetings, notice provisions for stockholder business to be conducted at an annual meeting, requests for stockholder lists and corporate records, nomination and removal of directors, and filling of vacancies on our Board of Directors. We are also subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law. Under these provisions, if anyone becomes an “interested stockholder,” we may not enter into a “business combination” with that person for three years without special approval, which could discourage a third party from making a takeover offer and could delay or prevent a change of control. For purposes of Section 203, “interested stockholder” means, generally, someone owning 15% or more of our outstanding voting stock or an affiliate of ours that owned 15% or more of our outstanding voting stock during the past three years, subject to certain exceptions as described in Section 203. 12 We do not regularly declare and pay quarterly or annual cash dividends on our stock. On July 3, 2013, June 4, 2014, October 14, 2016 and August 23, 2017, the Company’s Board of Directors authorized and declared special cash dividends of $22.00, $25.00, $24.00 and $22.00, respectively, on each outstanding share of common stock and cash dividend equivalent payments to holders of options under its stock option plans. Notwithstanding the special cash dividends, we do not anticipate declaring regular quarterly or annual cash dividends on our common stock or any other equity security in the foreseeable future. The amounts that may be available to us to pay future special cash dividends are restricted under our debt and other agreements. Any payment of special cash dividends on our common stock in the future will be at the discretion of our Board of Directors and will depend on our results of operations, earnings, capital requirements, financial condition, future prospects, contractual restrictions and other factors deemed relevant by our Board of Directors. Therefore, shareholders should not rely on regular quarterly or annual dividend income from shares of our common stock and should not rely on special dividends with any regularity or at all. 13 ITEM 1B. UNRESOLVED STAFF COMMENTS None. ITEM 2. PROPERTIES TransDigm’s principal owned properties as of September 30, 2017 are as follows: Location | Reporting Segment | SquareFootage ----------------------------+-------------------+-------------- Miesbach, Germany | Power & Control | 242,000 ----------------------------+-------------------+-------------- Liberty, SC | Power & Control | 219,000 ----------------------------+-------------------+-------------- Waco, TX | Power & Control | 218,800 ----------------------------+-------------------+-------------- Ingolstadt, Germany | Airframe | 191,900 ----------------------------+-------------------+-------------- Kent, OH | Airframe | 185,000 ----------------------------+-------------------+-------------- Bridport, United Kingdom | Airframe | 174,700 ----------------------------+-------------------+-------------- Liverpool, NY | Power & Control | 169,900 ----------------------------+-------------------+-------------- Union Gap, WA | Airframe | 142,000 ----------------------------+-------------------+-------------- Phoenix, AZ | Airframe | 138,700 ----------------------------+-------------------+-------------- Paks, Hungary | Airframe | 137,800 ----------------------------+-------------------+-------------- Los Angeles, CA | Power & Control | 131,000 ----------------------------+-------------------+-------------- Bohemia, NY | Power & Control | 124,000 ----------------------------+-------------------+-------------- Llangeinor, United Kingdom | Airframe | 110,000 ----------------------------+-------------------+-------------- Westbury, NY | Power & Control | 106,800 ----------------------------+-------------------+-------------- Letchworth, United Kingdom | Airframe | 88,200 ----------------------------+-------------------+-------------- Placentia, CA | Airframe | 86,600 ----------------------------+-------------------+-------------- Addison, IL | Power & Control | 83,300 ----------------------------+-------------------+-------------- Painesville, OH | Power & Control | 63,900 ----------------------------+-------------------+-------------- Clearwater, FL | Power & Control | 61,000 ----------------------------+-------------------+-------------- South Euclid, OH | Power & Control | 60,000 ----------------------------+-------------------+-------------- Wichita, KS | Power & Control | 57,000 ----------------------------+-------------------+-------------- Branford, CT | Airframe | 52,000 ----------------------------+-------------------+-------------- Avenel, NJ | Power & Control | 48,500 ----------------------------+-------------------+-------------- Rancho Cucamonga, CA | Power & Control | 47,000 ----------------------------+-------------------+-------------- Herstal, Belgium | Airframe | 45,700 ----------------------------+-------------------+-------------- Valencia, CA | Airframe | 38,000 ----------------------------+-------------------+-------------- Pennsauken, NJ | Airframe | 38,000 ----------------------------+-------------------+-------------- Ryde, United Kingdom | Power & Control | 33,200 ----------------------------+-------------------+-------------- Rancho Cucamonga, CA | Airframe | 32,700 ----------------------------+-------------------+-------------- Arnsberg, Germany (Schroth) | Airframe | 26,800 ----------------------------+-------------------+-------------- Melaka, Malaysia | Power & Control | 24,800 ----------------------------+-------------------+-------------- Deerfield Beach, FL | Non-aviation | 20,000 ----------------------------+-------------------+-------------- The Liberty, Kent, Union Gap, Bohemia, Addison, and 47,000 square feet Rancho Cucamonga property is subject to mortgage liens under our senior secured credit facility. TransDigm’s principal leased properties as of September 30, 2017 are as follows: Location | Reporting Segment | SquareFootage ----------------------+-------------------+-------------- Santa Ana, CA | Airframe | 159,200 ----------------------+-------------------+-------------- Holmestrand, Norway | Airframe | 149,300 ----------------------+-------------------+-------------- Dayton, NV | Airframe | 144,000 ----------------------+-------------------+-------------- Everett, WA | Airframe | 121,000 ----------------------+-------------------+-------------- Whippany, NJ | Power & Control | 115,300 ----------------------+-------------------+-------------- Whippany, NJ | Power & Control | 114,300 ----------------------+-------------------+-------------- Nittambuwa, Sri Lanka | Airframe | 113,000 ----------------------+-------------------+-------------- 14 Location | Reporting Segment | SquareFootage ----------------------------+-------------------+-------------- Fullerton, CA | Airframe | 100,000 ----------------------------+-------------------+-------------- Anaheim, CA | Airframe | 99,900 ----------------------------+-------------------+-------------- Elkhart, IN | Non-aviation | 91,500 ----------------------------+-------------------+-------------- Collegeville, PA | Airframe | 90,000 ----------------------------+-------------------+-------------- Goldsboro, NC | Power & Control | 87,600 ----------------------------+-------------------+-------------- Arnsberg, Germany (Schroth) | Airframe | 86,000 ----------------------------+-------------------+-------------- Miesbach, Germany | Power & Control | 80,800 ----------------------------+-------------------+-------------- Kunshan, China | Non-aviation | 75,300 ----------------------------+-------------------+-------------- Camarillo, CA | Power & Control | 70,000 ----------------------------+-------------------+-------------- Matamoros, Mexico | Power & Control | 60,500 ----------------------------+-------------------+-------------- Tempe, AZ | Power & Control | 40,200 ----------------------------+-------------------+-------------- Chongqing, China | Airframe | 37,700 ----------------------------+-------------------+-------------- Northridge, CA | Power & Control | 35,000 ----------------------------+-------------------+-------------- Erie, PA | Airframe | 30,500 ----------------------------+-------------------+-------------- Ashford, United Kingdom | Power & Control | 28,000 ----------------------------+-------------------+-------------- London, United Kingdom | Airframe | 27,400 ----------------------------+-------------------+-------------- Nogales, Mexico | Airframe | 27,000 ----------------------------+-------------------+-------------- Kunshan, China | Airframe | 25,600 ----------------------------+-------------------+-------------- Pompano Beach, FL (Schroth) | Airframe | 25,000 ----------------------------+-------------------+-------------- Bridgend, United Kingdom | Airframe | 24,800 ----------------------------+-------------------+-------------- Memphis, TN | Power & Control | 20,800 ----------------------------+-------------------+-------------- Pennsauken, NJ | Airframe | 20,500 ----------------------------+-------------------+-------------- Poway, CA | Power & Control | 12,800 ----------------------------+-------------------+-------------- Lund, Sweden | Power & Control | 17,600 ----------------------------+-------------------+-------------- Cleveland, OH | Power & Control | 13,100 ----------------------------+-------------------+-------------- Our Cleveland, OH and Pasadena, CA corporate facilities house our principal executive offices, and we currently lease approximately 20,100 square feet and 5,300 square feet, respectively, for those purposes. TransDigm also leases certain of its other non-material facilities. Management believes that our machinery, plants and offices are in satisfactory operating condition and that it will have sufficient capacity to meet foreseeable future needs without incurring significant additional capital expenditures. ITEM 3. LEGAL PROCEEDINGS During the ordinary course of business, TransDigm is from time to time a party to legal actions and other proceedings related to its businesses, products or operations. While TransDigm is currently involved in some legal proceedings, management believes the results of these proceedings will not have a material effect on its financial condition, results of operations, or cash flows. 15 PART II ITEM 5. | MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES --------+------------------------------------------------------------------------------------------------------------- Market Information Our common stock is traded on the New York Stock Exchange, or NYSE, under the ticker symbol “TDG.” The following chart sets forth, for the periods indicated, the high and low sales prices of the common stock on the NYSE. Quarterly Stock Prices ------------------------------------ | High | | Low -------------------------------------+--------+--------+---- Fiscal 2016 | | | -------------------------------------+--------+--------+---- For Quarter ended January 2, 2016 | $ | 238.51 | | | $ | 210.22 -------------------------------------+--------+--------+-----+--------+---+------- For Quarter ended April 2, 2016 | 232.42 | | | 180.76 | -------------------------------------+--------+--------+-----+--------+-- For Quarter ended July 2, 2016 | 268.00 | | | 218.56 | -------------------------------------+--------+--------+-----+--------+-- For Quarter ended September 30, 2016 | 294.38 | | | 257.28 | -------------------------------------+--------+--------+-----+--------+-- Fiscal 2017 | | | -------------------------------------+--------+--------+---- For Quarter ended December 31, 2016 | $ | 293.19 | | | $ | 235.14 -------------------------------------+--------+--------+-----+--------+---+------- For Quarter ended April 1, 2017 | 259.57 | | | 203.72 | -------------------------------------+--------+--------+-----+--------+-- For Quarter ended July 1, 2017 | 274.99 | | | 217.41 | -------------------------------------+--------+--------+-----+--------+-- For Quarter ended September 30, 2017 | 295.00 | | | 249.57 | -------------------------------------+--------+--------+-----+--------+-- Holders On November 3, 2017, there were 30 stockholders of record of our common stock. We estimate that there were approximately 62,000 beneficial stockholders as of November 3, 2017, which includes an estimated amount of stockholders who have their shares held in their accounts by banks and brokers. Dividends On October 14, 2016, TD Group’s Board of Directors authorized and declared a special cash dividend of $24.00 on each outstanding share of common stock and cash dividend equivalent payments under options granted under its stock option plans. The record date for the special dividend was October 24, 2016, and the payment date for the dividend was November 1, 2016. On August 23, 2017, TD Group’s Board of Directors authorized and declared a special cash dividend of $22.00 on each outstanding share of common stock and cash dividend equivalent payments under options granted under its stock option plans. The record date for the special dividend was September 5, 2017, and the payment date for the dividend was September 12, 2017. No dividends were declared in fiscal 2015 or fiscal 2016. We do not anticipate declaring regular quarterly or annual cash dividends on our common stock in the near future. Any declaration of special cash dividends on our common stock in the future will be at the discretion of our Board of Directors and will depend upon our results of operations, earnings, capital requirements, financial condition, future prospects, contractual restrictions under the senior secured credit facility and Indentures, the availability of surplus under Delaware law and other factors deemed relevant by our Board of Directors. TD Group is a holding company and conducts all of its operations through direct and indirect subsidiaries. Unless TD Group receives dividends, distributions, advances, transfers of funds or other payments from our subsidiaries, TD Group will be unable to pay any dividends on our common stock in the future. The ability of any subsidiaries to take any of the foregoing actions is limited by the terms of our senior secured credit facility and Indentures and may be limited by future debt or other agreements that we may enter into. 16 Performance Graph Set forth below is a line graph comparing the cumulative total return of a hypothetical investment in the shares of common stock of TD Group with the cumulative total return of a hypothetical investment in each of the S&P 500 Index (“S&P 500”) and the S&P MidCap 400 S&P Aerospace & Defense Index based on the respective market prices of each such investment on the dates shown below, assuming an initial investment of $100 on September 30, 2012. The following performance graph and related information shall not be deemed “soliciting material” nor to be “filed” with the SEC, nor shall such information be incorporated by reference into any future filings under the Securities Act of 1933 or the Securities Exchange Act of 1934, each as amended, except to the extent we specifically incorporate it by reference into such filing. COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN* Among TransDigm Group Inc., the S&P 500 and S&P MidCap 400 S&P Aerospace & Defense Index *$100 invested on 9/30/12 in stock or index, including reinvestment of dividends. Fiscal year ending September 30. Copyright 2017 S&P, a division of The McGraw-Hill Companies Inc. All rights reserved. | 9/30/12 | 9/30/13 | | 9/30/14 | | 9/30/15 | | 9/30/16 | 9/30/17 ---------------------------------------------+---------+---------+--------+---------+--------+---------+--------+---------+-------- TransDigm Group Inc. | 100.00 | | 124.01 | | 189.37 | | 218.22 | | 297.03 | 311.08 ---------------------------------------------+---------+---------+--------+---------+--------+---------+--------+---------+---------+------- S&P 500 | 100.00 | | 119.34 | | 142.89 | | 142.02 | | 163.93 | 194.44 ---------------------------------------------+---------+---------+--------+---------+--------+---------+--------+---------+---------+------- S&P MidCap 400 S&P Aerospace & Defense Index | 100.00 | | 154.70 | | 209.81 | | 205.33 | | 254.85 | 371.15 ---------------------------------------------+---------+---------+--------+---------+--------+---------+--------+---------+---------+------- 17 Purchases of Equity Securities by the Issuer or Affiliated Purchaser On October 22, 2014, our Board of Directors authorized a stock repurchase program permitting us to repurchase a portion of our outstanding shares not to exceed $300 million in the aggregate. No shares were repurchased under the program in fiscal 2015. On January 21, 2016, our Board of Directors authorized a stock repurchase program replacing the $300 million program with a repurchase program permitting us to repurchase a portion of our outstanding shares not to exceed $450 million in the aggregate, subject to any restrictions specified in the Credit Agreement and/or Indentures. During fiscal 2016, under the aforementioned authorized programs, the Company repurchased 1,015,387 shares of its common stock at a gross cost of approximately $207.8 million at the weighted-average price per share of $204.61 . On January 26, 2017, our Board of Directors increased the authorized amount of repurchases allowable under the stock program from $450 million to $472 million . The increase in the allowable repurchases aligned the program with the restricted payments allowable under the Credit Agreement. During January 2017, the Company repurchased 666,755 shares of its common stock at a gross cost of approximately $150 million at the weighted average cost of $224.97 under the $472 million stock repurchase program. On March 7, 2017, our Board of Directors authorized a new stock repurchase program replacing the $472 million program permitting repurchases of outstanding shares not to exceed $600 million in the aggregate, subject to any restrictions specified in the Credit Agreement and/or Indentures governing the existing Notes. During March 2017, the Company repurchased 851,069 shares of its common stock at a gross cost of approximately $189.8 million at the weighted average cost of $223.05 under the new $600 million stock repurchase program. Additionally, during May 2017, the Company repurchased 205,800 shares of its common stock at a gross cost of approximately $50 million at the weighted average cost of $242.90 under the new $600 million stock repurchase program. As of September 30, 2017, the remaining amount of repurchases allowable under the $600 million program was $360.2 million subject to any restrictions specified in the Credit Agreement and/or Indentures governing the existing Notes as described within the Liquidity and Capital Resources section of Item 7. - “Management’s Discussion and Analysis of Financial Conditions and Results of Operations.” On November 8, 2017, our Board of Directors, authorized a new stock repurchase program replacing the $600 million program permitting repurchases of our outstanding shares not to exceed $650 million in the aggregate, subject to any restrictions specified in the Credit Agreement and/or Indentures governing the existing Notes. During the fiscal years ended September 30, 2017 and 2016, the Company received 2,548 shares in each period as forfeitures in lieu of payment for withholding taxes on the vesting of restricted stock. The deemed gross cost of the shares was approximately $0.6 million in each period at a weighted-average price per share of $247.33 and $225.58, respectively. 18 ITEM 6. SELECTED FINANCIAL DATA The following table sets forth selected historical consolidated financial and other data of TD Group for the fiscal years ended September 30, 2013 to 2017, which have been derived from TD Group’s audited consolidated financial statements. Separate historical financial information of TransDigm Inc. is not presented since the 5.50% Senior Subordinated Notes issued in October 2012 (the “2020 Notes”), the 6.00% Senior Subordinated Notes issued in June 2014 (the “2022 Notes”), the 6.50% Senior Subordinated Notes issued June 2014 (the “2024 Notes”), the 6.50% Senior Subordinated Notes issued May 2015 (the “2025 Notes”) and the 6.375% Senior Subordinated Notes issued June 2016 (the “2026 Notes”) (also together with the 2020 Notes, the 2022 Notes, the 2024 Notes, the 2025 Notes, and the 2026 Notes, the “Notes”) are guaranteed by TD Group and all direct and indirect domestic restricted subsidiaries of TransDigm Inc. and since TD Group has no operations or significant assets separate from its investment in TransDigm Inc. Acquisitions of businesses and product lines completed by TD Group during the last five fiscal years are as follows: Date | Acquisition -------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------------------- June 5, 2013 | Aerosonic Corporation -------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------------------- June 5, 2013 | Arkwin Industries, Inc. -------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------------------- June 28, 2013 | Whippany Actuation -------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------------------- December 19, 2013 | Airborne Global Inc. (“Airborne”) -------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------------------- March 6, 2014 | Elektro-Metall Export GmbH (“EME”) -------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------------------- March 26, 2015 | Telair Cargo Group (comprised of Telair International GmbH (“Telair Europe”), Telair US LLC and Nordisk Aviation Products) -------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------------------- March 31, 2015 | Franke Aquarotter GmbH (“Adams Rite Aerospace GmbH”) -------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------------------- May 14, 2015 | Pexco LLC (“Pexco Aerospace”) -------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------------------- August 19, 2015 | PneuDraulics, Inc. (“PneuDraulics”) -------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------------------- January 4, 2016 | Breeze-Eastern Corporation (“Breeze-Eastern”) -------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------------------- June 23, 2016 | Data Device Corporation (“DDC”) -------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------------------- September 23, 2016 | Young & Franklin Inc. / Tactair Fluid Controls Inc. (“Y&F/Tactair”) -------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------------------- February 22, 2017 | Schroth Safety Products Group (“Schroth”) -------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------------------- May 5, 2017, May 31, 2017 and June 1, 2017 | North Hills Signal Processing Corp, Cablecraft Motion Controls LLC and Preece Incorporated (together, the “Third Quarter 2017 Acquisitions”) -------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------------------- All of the acquisitions were accounted for using the acquisition method. The results of operations of the acquired businesses and product lines are included in TD Group’s consolidated financial statements from the effective date of each acquisition. During the fourth quarter of 2017, the Company committed to disposing of Schroth in connection with the settlement of a Department of Justice investigation into the competitive effects of the acquisition. Therefore, Schroth was classified as held-for-sale and as discontinued operations as of September 30, 2017. 19 The information presented below should be read together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and accompanying notes included elsewhere herein. | Fiscal Years EndedSeptember 30, ---------------------------------------------------------------------------------+------------------------------------------ | 2017 | | 2016 | | 2015 | | 2014 | 2013 ---------------------------------------------------------------------------------+-------------------------------------------+-----------+------+-----------+------+-----------+-----------+----- | (in thousands, except per share amounts ) ---------------------------------------------------------------------------------+------------------------------------------ Statement of Income Data: | | | | | | | | ---------------------------------------------------------------------------------+-------------------------------------------+-----------+------+-----------+------+-----------+-----------+----- Net sales | $ | 3,504,286 | | | $ | 3,171,411 | | $ | 2,707,115 | $ | 2,372,906 | $ | 1,924,400 ---------------------------------------------------------------------------------+-------------------------------------------+-----------+------+-----------+------+-----------+-----------+------+-----------+-----------+-----------+---+---------- Gross profit(1) | 1,984,627 | | | 1,728,063 | | | 1,449,845 | | 1,267,874 | 1,049,562 | ---------------------------------------------------------------------------------+-------------------------------------------+-----------+------+-----------+------+-----------+-----------+------+-----------+-----------+---------- Selling and administrative expenses | 415,575 | | | 382,858 | | | 321,624 | | 276,446 | 254,468 | ---------------------------------------------------------------------------------+-------------------------------------------+-----------+------+-----------+------+-----------+-----------+------+-----------+-----------+---------- Amortization of intangible assets | 89,226 | | | 77,445 | | | 54,219 | | 63,608 | 45,639 | ---------------------------------------------------------------------------------+-------------------------------------------+-----------+------+-----------+------+-----------+-----------+------+-----------+-----------+---------- Income from operations(1) | 1,479,826 | | | 1,267,760 | | | 1,074,002 | | 927,820 | 749,455 | ---------------------------------------------------------------------------------+-------------------------------------------+-----------+------+-----------+------+-----------+-----------+------+-----------+-----------+---------- Interest expense—net | 602,589 | | | 483,850 | | | 418,785 | | 347,688 | 270,685 | ---------------------------------------------------------------------------------+-------------------------------------------+-----------+------+-----------+------+-----------+-----------+------+-----------+-----------+---------- Refinancing costs | 39,807 | | | 15,794 | | | 18,393 | | 131,622 | 30,281 | ---------------------------------------------------------------------------------+-------------------------------------------+-----------+------+-----------+------+-----------+-----------+------+-----------+-----------+---------- Income from continuing operations before income taxes | 837,430 | | | 768,116 | | | 636,824 | | 448,510 | 448,489 | ---------------------------------------------------------------------------------+-------------------------------------------+-----------+------+-----------+------+-----------+-----------+------+-----------+-----------+---------- Income tax provision | 208,889 | | | 181,702 | | | 189,612 | | 141,600 | 145,700 | ---------------------------------------------------------------------------------+-------------------------------------------+-----------+------+-----------+------+-----------+-----------+------+-----------+-----------+---------- Income from continuing operations | 628,541 | | | 586,414 | | | 447,212 | | 306,910 | 302,789 | ---------------------------------------------------------------------------------+-------------------------------------------+-----------+------+-----------+------+-----------+-----------+------+-----------+-----------+---------- Loss from discontinued operations, net of tax (5) | (31,654 | ) | | — | | | — | | — | — | ---------------------------------------------------------------------------------+-------------------------------------------+-----------+------+-----------+------+-----------+-----------+------+-----------+-----------+---------- Net income | $ | 596,887 | | | $ | 586,414 | | $ | 447,212 | $ | 306,910 | $ | 302,789 ---------------------------------------------------------------------------------+-------------------------------------------+-----------+------+-----------+------+-----------+-----------+------+-----------+-----------+-----------+---+---------- Net income applicable to common stock | $ | 437,630 | | | $ | 583,414 | | $ | 443,847 | $ | 180,284 | $ | 131,546 ---------------------------------------------------------------------------------+-------------------------------------------+-----------+------+-----------+------+-----------+-----------+------+-----------+-----------+-----------+---+---------- Denominator for basic and diluted earnings per share under the two-class method: | | | | | | | | ---------------------------------------------------------------------------------+-------------------------------------------+-----------+------+-----------+------+-----------+-----------+----- Weighted-average common shares outstanding | 52,517 | | | 53,326 | | | 53,112 | | 52,748 | 52,258 | ---------------------------------------------------------------------------------+-------------------------------------------+-----------+------+-----------+------+-----------+-----------+------+-----------+-----------+---------- Vested options deemed participating securities | 3,013 | | | 2,831 | | | 3,494 | | 4,245 | 2,822 | ---------------------------------------------------------------------------------+-------------------------------------------+-----------+------+-----------+------+-----------+-----------+------+-----------+-----------+---------- Total shares for basic and diluted earnings per share | 55,530 | | | 56,157 | | | 56,606 | | 56,993 | 55,080 | ---------------------------------------------------------------------------------+-------------------------------------------+-----------+------+-----------+------+-----------+-----------+------+-----------+-----------+---------- Net earnings per share: | | | | | | | | ---------------------------------------------------------------------------------+-------------------------------------------+-----------+------+-----------+------+-----------+-----------+----- Net earnings per share from continuing operations—basic and diluted | $ | 8.45 | | | $ | 10.39 | | $ | 7.84 | $ | 3.16 | $ | 2.39 ---------------------------------------------------------------------------------+-------------------------------------------+-----------+------+-----------+------+-----------+-----------+------+-----------+-----------+-----------+---+---------- Net loss per share from discontinued operations—basic and diluted | (0.57 | ) | | — | | | — | | — | — | ---------------------------------------------------------------------------------+-------------------------------------------+-----------+------+-----------+------+-----------+-----------+------+-----------+-----------+---------- Net earnings per share(2) | $ | 7.88 | | | $ | 10.39 | | $ | 7.84 | $ | 3.16 | $ | 2.39 ---------------------------------------------------------------------------------+-------------------------------------------+-----------+------+-----------+------+-----------+-----------+------+-----------+-----------+-----------+---+---------- Cash dividends paid per common share | $ | 46.00 | | | $ | — | | $ | — | $ | 25.00 | $ | 34.85 ---------------------------------------------------------------------------------+-------------------------------------------+-----------+------+-----------+------+-----------+-----------+------+-----------+-----------+-----------+---+---------- 20 | As of September 30, ---------------------------------------------+-------------------- | 2017 | | 2016 | | 2015 | | 2014 | | 2013 ---------------------------------------------+---------------------+---------+------+------------+------+-----------+------------+---+----- | (in thousands) ---------------------------------------------+-------------------- Balance Sheet Data: | | | | | | | | | ---------------------------------------------+---------------------+---------+------+------------+------+-----------+------------+---+----- Cash and cash equivalents | $ | 650,561 | | | $ | 1,586,994 | | | $ | 714,033 | | $ | 819,548 | $ | 564,740 ---------------------------------------------+---------------------+---------+------+------------+------+-----------+------------+---+------+------------+---+-----------+---------+---+-------- Working capital(3,4) | 1,262,558 | | | 2,178,094 | | | 1,128,993 | | | 1,066,735 | | 968,207 | ---------------------------------------------+---------------------+---------+------+------------+------+-----------+------------+---+------+------------+---+-----------+-------- Total assets(3,4) | 9,975,661 | | | 10,726,277 | | | 8,303,935 | | | 6,626,786 | | 6,046,029 | ---------------------------------------------+---------------------+---------+------+------------+------+-----------+------------+---+------+------------+---+-----------+-------- Long-term debt, including current portion(4) | 11,762,661 | | | 10,195,607 | | | 8,349,602 | | | 7,380,738 | | 5,658,570 | ---------------------------------------------+---------------------+---------+------+------------+------+-----------+------------+---+------+------------+---+-----------+-------- Stockholders’ deficit | (2,951,204 | ) | | (651,490 | ) | | (1,038,306 | ) | | (1,556,099 | ) | (336,381 | ) ---------------------------------------------+---------------------+---------+------+------------+------+-----------+------------+---+------+------------+---+-----------+-------- (1) | Gross profit and income from operations include the effect of charges relating to purchase accounting adjustments to inventory associated with the acquisition of various businesses and product lines for the fiscal years ended September 30, 2017, 2016, 2015, 2014 and 2013 of $20,621, $23,449, $11,362, $10,441 and $7,352, respectively. ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ (2) | Net earnings per share is calculated by dividing net income applicable to common stock by the basic and diluted weighted average common shares outstanding. ----+------------------------------------------------------------------------------------------------------------------------------------------------------------ (3) | In connection with adopting ASU 2015-17, “Balance Sheet Classification of Deferred Taxes,” for reporting periods ended after October 1, 2015, the Company reclassified $45,375, $37,669, and $30,182 from current deferred income tax assets in our consolidated balance sheets as of September 2015, 2014, and 2013, respectively, to non-current deferred income tax liabilities. ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ (4) | In connection with adopting ASU 2015-03, “Simplifying the Presentation of Debt Issuance Costs,” for reporting periods ended after October 1, 2015, the Company reclassified $77,740, $92,393, and $72,668 from debt issuance costs in our consolidated balance sheets as of September 2015, 2014, and 2013, respectively, to the current portion of long-term and long-term-term debt. ----+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (5) | During the fourth quarter of 2017, the Company committed to disposing of Schroth in connection with the settlement of a Department of Justice investigation into the competitive effects of the acquisition. Therefore, Schroth was classified as held-for-sale and as discontinued operations as of September 30, 2017. The Company acquired Schroth in February 2017 (refer to Note 2, “Acquisitions”). The loss from discontinued operations in the consolidated statements of income for the year ended September 30, 2017 includes a $32.0 million impairment charge to write down the assets to fair value. Refer to Note 22, “Discontinued Operations,” for further information. ----+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Non-GAAP Financial Measures We present below certain financial information based on our EBITDA and EBITDA As Defined. References to “EBITDA” mean earnings before interest, taxes, depreciation and amortization, and references to “EBITDA As Defined” mean EBITDA plus, as applicable for each relevant period, certain adjustments as set forth in the reconciliations of net income to EBITDA and EBITDA As Defined and the reconciliations of net cash provided by operating activities to EBITDA and EBITDA As Defined presented below. Neither EBITDA nor EBITDA As Defined is a measurement of financial performance under accounting principles generally accepted in the United States of America (“GAAP”). We present EBITDA and EBITDA As Defined because we believe they are useful indicators for evaluating operating performance and liquidity. Our management believes that EBITDA and EBITDA As Defined are useful as indicators of liquidity because securities analysts, investors, rating agencies and others use EBITDA to evaluate a company’s ability to incur and service debt. In addition, EBITDA As Defined is useful to investors because the revolving commitments under our senior secured credit facility requires compliance under certain circumstances, on a pro forma basis, with a financial covenant that measures the ratio of the amount of our secured indebtedness to the amount of our Consolidated EBITDA defined in the same manner as we define EBITDA As Defined herein. In addition to the above, our management uses EBITDA As Defined to review and assess the performance of the management team in connection with employee incentive programs and to prepare its annual budget and financial projections. Moreover, our management uses EBITDA As Defined to evaluate acquisitions. Although we use EBITDA and EBITDA As Defined as measures to assess the performance of our business and for the other purposes set forth above, the use of these non-GAAP financial measures as analytical tools has limitations, and you should not consider any of them in isolation, or as a substitute for analysis of our results of operations as reported in accordance with GAAP. Some of these limitations are: 21 • | neither EBITDA nor EBITDA As Defined reflects the significant interest expense, or the cash requirements necessary to service interest payments, on our indebtedness; --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | although depreciation and amortization are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future, and neither EBITDA nor EBITDA As Defined reflects any cash requirements for such replacements; --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | the omission of the substantial amortization expense associated with our intangible assets further limits the usefulness of EBITDA and EBITDA As Defined; --+---------------------------------------------------------------------------------------------------------------------------------------------------------- • | neither EBITDA nor EBITDA As Defined includes the payment of taxes, which is a necessary element of our operations; and --+------------------------------------------------------------------------------------------------------------------------ • | EBITDA As Defined excludes the cash expense we have incurred to integrate acquired businesses into our operations, which is a necessary element of certain of our acquisitions. --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Because of these limitations, EBITDA and EBITDA As Defined should not be considered as measures of discretionary cash available to us to invest in the growth of our business. Management compensates for these limitations by not viewing EBITDA or EBITDA As Defined in isolation and specifically by using other GAAP measures, such as net income, net sales and operating profit, to measure our operating performance. Neither EBITDA nor EBITDA As Defined is a measurement of financial performance under GAAP, and neither should be considered as an alternative to net income or cash flow from operations determined in accordance with GAAP. Our calculation of EBITDA and EBITDA As Defined may not be comparable to the calculation of similarly titled measures reported by other companies. | Fiscal Years Ended September 30, --------------------------------------+--------------------------------- | 2017 | | 2016 | | 2015 | | 2014 | | 2013 --------------------------------------+----------------------------------+-----------+------+------------+------+-----------+------------+---+----- | (in thousands) --------------------------------------+--------------------------------- Other Financial Data: | | | | | | | | | --------------------------------------+----------------------------------+-----------+------+------------+------+-----------+------------+---+----- Cash flows provided by (used in): | | | | | | | | | --------------------------------------+----------------------------------+-----------+------+------------+------+-----------+------------+---+----- Operating activities | $ | 788,733 | | | $ | 683,298 | | | $ | 520,938 | | $ | 541,222 | $ | 470,205 --------------------------------------+----------------------------------+-----------+------+------------+------+-----------+------------+---+------+-----------+---+----------+-----------+---+-------- Investing activities | (287,003 | ) | | (1,443,046 | ) | | (1,679,149 | ) | | (329,638 | ) | (502,442 | ) --------------------------------------+----------------------------------+-----------+------+------------+------+-----------+------------+---+------+-----------+---+----------+---------- Financing activities | (1,443,682 | ) | | 1,632,467 | | | 1,054,947 | | | 43,973 | | 156,195 | --------------------------------------+----------------------------------+-----------+------+------------+------+-----------+------------+---+------+-----------+---+----------+---------- Depreciation and amortization | 141,025 | | | 121,670 | | | 93,663 | | | 96,385 | | 73,515 | --------------------------------------+----------------------------------+-----------+------+------------+------+-----------+------------+---+------+-----------+---+----------+---------- Capital expenditures | 71,013 | | | 43,982 | | | 54,871 | | | 34,146 | | 35,535 | --------------------------------------+----------------------------------+-----------+------+------------+------+-----------+------------+---+------+-----------+---+----------+---------- Ratio of earnings to fixed charges(1) | 2.4x | | | 2.6x | | | 2.5x | | | 2.3x | | 2.6x | --------------------------------------+----------------------------------+-----------+------+------------+------+-----------+------------+---+------+-----------+---+----------+---------- Other Data: | | | | | | | | | --------------------------------------+----------------------------------+-----------+------+------------+------+-----------+------------+---+----- EBITDA(2) | $ | 1,581,044 | | | $ | 1,373,636 | | | $ | 1,149,272 | | $ | 892,583 | $ | 792,689 --------------------------------------+----------------------------------+-----------+------+------------+------+-----------+------------+---+------+-----------+---+----------+-----------+---+-------- EBITDA As Defined(2) | $ | 1,710,563 | | | $ | 1,495,196 | | | $ | 1,233,654 | | $ | 1,073,207 | $ | 900,278 --------------------------------------+----------------------------------+-----------+------+------------+------+-----------+------------+---+------+-----------+---+----------+-----------+---+-------- (1) | For purposes of computing the ratio of earnings to fixed charges, earnings consist of earnings from continuing operations before income taxes plus fixed charges. Fixed charges consist of interest expense, amortization of debt issuance costs, original issue discount and premium and the portion (approximately 33%) of rental expense that management believes is representative of the interest component of rental expense. ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ (2) | EBITDA represents earnings from continuing operations before interest, taxes, depreciation and amortization. EBITDA As Defined represents EBITDA plus, as applicable for each relevant period, certain adjustments as set forth in the reconciliation of net income to EBITDA and EBITDA As Defined and the reconciliation of net cash provided by operating activities to EBITDA and EBITDA As Defined presented below. See “Non-GAAP Financial Measures” for additional information and limitations regarding these non-GAAP financial measures. ----+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 22 The following table sets forth a reconciliation of net income to EBITDA and EBITDA As Defined: | Fiscal Years Ended September 30, ----------------------------------------------------+--------------------------------- | 2017 | | 2016 | | 2015 | | 2014 | | 2013 ----------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+----- | (in thousands) ----------------------------------------------------+--------------------------------- Net income | $ | 596,887 | | | $ | 586,414 | | | $ | 447,212 | $ | 306,910 | $ | 302,789 ----------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---------+-----------+---+-------- Loss from discontinued operations, net of tax(1) | (31,654 | ) | | — | | | — | | | — | — | ----------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---------+---------- Income from continuing operations | 628,541 | | | 586,414 | | | 447,212 | | | 306,910 | 302,789 | ----------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---------+---------- Adjustments: | | | | | | | | | ----------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+----- Depreciation and amortization expense | 141,025 | | | 121,670 | | | 93,663 | | | 96,385 | 73,515 | ----------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---------+---------- Interest expense, net | 602,589 | | | 483,850 | | | 418,785 | | | 347,688 | 270,685 | ----------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---------+---------- Income tax provision | 208,889 | | | 181,702 | | | 189,612 | | | 141,600 | 145,700 | ----------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---------+---------- EBITDA | 1,581,044 | | | 1,373,636 | | | 1,149,272 | | | 892,583 | 792,689 | ----------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---------+---------- Adjustments: | | | | | | | | | ----------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+----- Inventory purchase accounting adjustments(2) | 20,621 | | | 23,449 | | | 11,362 | | | 10,441 | 7,352 | ----------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---------+---------- Acquisition integration costs(3) | 6,341 | | | 18,539 | | | 12,554 | | | 7,239 | 10,942 | ----------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---------+---------- Acquisition transaction-related expenses(4) | 4,229 | | | 15,711 | | | 12,289 | | | 3,480 | 8,139 | ----------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---------+---------- Non-cash stock and deferred compensation expense(5) | 45,524 | | | 48,306 | | | 31,500 | | | 26,332 | 48,884 | ----------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---------+---------- Refinancing costs(6) | 39,807 | | | 15,794 | | | 18,393 | | | 131,622 | 30,281 | ----------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---------+---------- Other, net (7) | 12,997 | | | (239 | ) | | (1,716 | ) | | 1,510 | 1,991 | ----------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---------+---------- EBITDA As Defined | $ | 1,710,563 | | | $ | 1,495,196 | | | $ | 1,233,654 | $ | 1,073,207 | $ | 900,278 ----------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---------+-----------+---+-------- (1) | During the fourth quarter of 2017, the Company committed to disposing of Schroth in connection with the settlement of a Department of Justice investigation into the competitive effects of the acquisition. Therefore, Schroth was classified as held-for-sale and as discontinued operations as of September 30, 2017. The Company acquired Schroth in February 2017 (refer to Note 2, “Acquisitions”). The loss from discontinued operations in the consolidated statements of income for the year ended September 30, 2017 includes a $32.0 million impairment charge to write down the assets to fair value. Refer to Note 22, “Discontinued Operations,” for further information. ----+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (2) | Represents accounting adjustments to inventory associated with acquisitions of businesses and product lines that were charged to cost of sales when the inventory was sold. ----+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (3) | Represents costs incurred to integrate acquired businesses and product lines into TD Group’s operations, facility relocation costs and other acquisition-related costs. ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------ (4) | Represents transaction-related costs comprising deal fees; legal, financial and tax due diligence expenses; and valuation costs that are required to be expensed as incurred. ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ (5) | Represents the compensation expense recognized by TD Group under our stock incentive plans. ----+-------------------------------------------------------------------------------------------- (6) | Represents costs expensed related to debt financing activities, including new issuances, extinguishments, refinancings and amendments to existing agreements. ----+-------------------------------------------------------------------------------------------------------------------------------------------------------------- (7) | Primarily represents gain or loss on sale of fixed assets, foreign currency transaction gain or loss and employer withholding taxes on dividend equivalent payments. In the periods prior to fiscal 2017, foreign currency transaction gain or loss other than related to intercompany loans is not included in the adjustments to EBITDA, as the foreign currency transaction gain or loss was immaterial during those periods. ----+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 23 The following table sets forth a reconciliation of net cash provided by operating activities to EBITDA and EBITDA As Defined: | Fiscal Years Ended September 30, ----------------------------------------------------------------------------------+--------------------------------- | 2017 | | 2016 | | 2015 | | 2014 | | 2013 ----------------------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+----- | (in thousands) ----------------------------------------------------------------------------------+--------------------------------- Net cash provided by operating activities | $ | 788,733 | | | $ | 683,298 | | | $ | 520,938 | | $ | 541,222 | $ | 470,205 ----------------------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---+---------+-----------+---+-------- Adjustments: | | | | | | | | | ----------------------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+----- Changes in assets and liabilities, net of effects from acquisitions of businesses | 83,753 | | | 110,905 | | | 24,322 | | | (27,967 | ) | (71,618 | ) ----------------------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---+---------+---------- Net gain on sale of real estate | — | | | — | | | — | | | 804 | | — | ----------------------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---+---------+---------- Interest expense, net(1) | 581,483 | | | 467,639 | | | 402,988 | | | 333,753 | | 258,752 | ----------------------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---+---------+---------- Income tax provision—current(2) | 215,385 | | | 175,894 | | | 188,952 | | | 151,016 | | 148,314 | ----------------------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---+---------+---------- Non-cash stock and deferred compensation expense(3) | (45,524 | ) | | (48,306 | ) | | (31,500 | ) | | (26,332 | ) | (48,884 | ) ----------------------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---+---------+---------- Excess tax benefit from exercise of stock options(2) | — | | | — | | | 61,965 | | | 51,709 | | 66,201 | ----------------------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---+---------+---------- Refinancing costs(4) | (39,807 | ) | | (15,794 | ) | | (18,393 | ) | | (131,622 | ) | (30,281 | ) ----------------------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---+---------+---------- EBITDA from discontinued operations(9) | (2,979 | ) | | — | | | — | | | — | | — | ----------------------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---+---------+---------- EBITDA | 1,581,044 | | | 1,373,636 | | | 1,149,272 | | | 892,583 | | 792,689 | ----------------------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---+---------+---------- Adjustments: | | | | | | | | | ----------------------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+----- Inventory purchase accounting adjustments(5) | 20,621 | | | 23,449 | | | 11,362 | | | 10,441 | | 7,352 | ----------------------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---+---------+---------- Acquisition integration costs(6) | 6,341 | | | 18,539 | | | 12,554 | | | 7,239 | | 10,942 | ----------------------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---+---------+---------- Acquisition transaction-related expenses(7) | 4,229 | | | 15,711 | | | 12,289 | | | 3,480 | | 8,139 | ----------------------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---+---------+---------- Non-cash stock and deferred compensation expense(3) | 45,524 | | | 48,306 | | | 31,500 | | | 26,332 | | 48,884 | ----------------------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---+---------+---------- Refinancing costs(4) | 39,807 | | | 15,794 | | | 18,393 | | | 131,622 | | 30,281 | ----------------------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---+---------+---------- Other, net(8) | 12,997 | | | (239 | ) | | (1,716 | ) | | 1,510 | | 1,991 | ----------------------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---+---------+---------- EBITDA As Defined | $ | 1,710,563 | | | $ | 1,495,196 | | | $ | 1,233,654 | | $ | 1,073,207 | $ | 900,278 ----------------------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+------+-----------+---+---------+-----------+---+-------- (1) | Represents interest expense excluding the amortization of debt issuance costs, original issue discount and premium. ----+-------------------------------------------------------------------------------------------------------------------- (2) | For the period ended September 30, 2016, the income tax provision and excess tax benefit from exercise of stock options were impacted by the adoption of ASU 2016-09, “Improvements to Employee Share-Based Payment Accounting.” Refer to Note 4, “Recent Accounting Pronouncements,” in the notes to the consolidated financial statements included herein for additional information. ----+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (3) | Represents the compensation expense recognized by TD Group under our stock incentive plans. ----+-------------------------------------------------------------------------------------------- (4) | Represents costs expensed related to debt financing activities, including new issuances, extinguishments, refinancings and amendments to existing agreements. ----+-------------------------------------------------------------------------------------------------------------------------------------------------------------- (5) | Represents accounting adjustments to inventory associated with acquisitions of businesses and product lines that were charged to cost of sales when the inventory was sold. ----+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (6) | Represents costs incurred to integrate acquired businesses and product lines into TD Group’s operations, facility relocation costs and other acquisition-related costs. ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------ (7) | Represents transaction-related costs comprising deal fees; legal, financial and tax due diligence expenses; and valuation costs that are required to be expensed as incurred. ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ (8) | Primarily represents gain or loss on sale of fixed assets, foreign currency transaction gain or loss and employer withholding taxes on dividend equivalent payments. In the periods prior to fiscal 2017, foreign currency transaction gain or loss other than related to intercompany loans is not included in the adjustments to EBITDA, as the foreign currency transaction gain or loss was immaterial during those periods. ----+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (9) | During the fourth quarter of 2017, the Company committed to disposing of Schroth in connection with the settlement of a Department of Justice investigation into the competitive effects of the acquisition. Therefore, Schroth was classified as held-for-sale and as discontinued operations as of September 30, 2017. Refer to Note 22, “Discontinued Operations,” for further information. ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 24 ITEM 7. | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS --------+-------------------------------------------------------------------------------------- The following discussion of our financial condition and results of operations should be read together with “Selected Financial Data” and TD Group’s consolidated financial statements and the related notes included elsewhere in this report. The following discussion may contain predictions, estimates and other forward-looking statements that involve a number of risks and uncertainties, including those discussed under the heading entitled “Risk Factors” included elsewhere in this report. These risks could cause our actual results to differ materially from any future performance suggested below. Overview For fiscal year 2017 , we generated net sales of $3,504.3 million , gross profit of $1,984.6 million or 56.6% of sales, and net income of $596.9 million . We believe we have achieved steady, long-term growth in sales and improvements in operating performance since our formation in 1993 due to our competitive strengths and through execution of our value-driven operating strategy. More specifically, focusing our businesses on our value-driven operating strategy of obtaining profitable new business, carefully controlling the cost structure and pricing our highly engineered value-added products to fairly reflect the value we provide and the resources required to do so has historically resulted in improvements in gross profit and income from operations over the long term. Our selective acquisition strategy has also contributed to the growth of our business. The integration of certain acquisitions into our existing businesses combined with implementing our proven operating strategy has historically resulted in improvements of the financial performance of the acquired business. We believe our key competitive strengths include: Large and Growing Installed Product Base with Aftermarket Revenue Stream. We provide components to a large and growing installed base of aircraft to which we supply aftermarket products. We estimate that our products are installed on approximately 95,000 commercial transport, regional transport, military and general aviation fixed wing turbine aircraft and rotary wing aircraft. Diversified Revenue Base. We believe that our diversified revenue base reduces our dependence on any particular product, platform or market channel and has been a significant factor in maintaining our financial performance. Our products are installed on almost all of the major commercial aircraft platforms now in production. We expect to continue to develop new products for military and commercial applications. Barriers to Entry . We believe that the niche nature of our markets, the industry’s stringent regulatory and certification requirements, the large number of products that we sell and the investments necessary to develop and certify products create potential disincentives to competition for certain products. Our business strategy is made up of two key elements: (1) a value-driven operating strategy focused around our three core value drivers and (2) a selective acquisition strategy. Value-Driven Operating Strategy. Our three core value drivers are: • | Obtaining Profitable New Business. We attempt to obtain profitable new business by using our technical expertise and application skill and our detailed knowledge of our customer base and the individual niche markets in which we operate. We have regularly been successful in identifying and developing both aftermarket and OEM products to drive our growth. --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Improving Our Cost Structure. We are committed to maintaining and continuously improving our lean cost structure through detailed attention to the cost of each of the products that we offer and our organizational structure, with a focus on reducing the cost of each. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Providing Highly Engineered Value-Added Products to Customers. We focus on the engineering, manufacturing and marketing of a broad range of highly engineered niche products that we believe provide value to our customers. We believe we have been consistently successful in communicating to our customers the value of our products. This has generally enabled us to price our products to fairly reflect the value we provide and the resources required to do so. --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Selective Acquisition Strategy. We selectively pursue the acquisition of proprietary aerospace component businesses when we see an opportunity to create value through the application of our three core value-driven operating strategies. The aerospace industry, in particular, remains highly fragmented, with many of the companies in the industry being small private businesses or small non-core operations of larger businesses. We have significant experience among our management team in executing acquisitions and integrating acquired businesses into our company and culture. As of the date of this report, we have successfully acquired approximately 60 businesses and/or product lines since our formation in 1993. Many of these acquisitions have been integrated into an existing TransDigm production facility, which enables a higher production capacity utilization, which in turn improves gross profit levels due to the ability to spread the fixed manufacturing overhead costs over higher production volume. 25 Acquisitions during the previous three fiscal years are more fully described in Note 2, “Acquisitions,” in the notes to the consolidated financial statements included herein. Critical Accounting Policies Our consolidated financial statements have been prepared in conformity with GAAP, which often requires the judgment of management in the selection and application of certain accounting principles and methods. Management believes that the quality and reasonableness of our most critical policies enable the fair presentation of our financial position and results of operations. However, investors are cautioned that the sensitivity of financial statements to these methods, assumptions and estimates could create materially different results under different conditions or using different assumptions. Below are those policies applied in preparing our financial statements that management believes are the most dependent on the application of estimates and assumptions. For additional accounting policies, see Note 3, “Summary of Significant Accounting Policies,” in the notes to the consolidated financial statements included herein. Revenue Recognition and Related Allowances : Revenue is recognized from the sale of products when title and risk of loss passes to the customer, which is generally at the time of shipment. Substantially all product sales are made pursuant to firm, fixed-price purchase orders received from customers. Collectibility of amounts recorded as revenue is reasonably assured at the time of sale. Provisions for returns, uncollectible accounts and the cost of repairs under contract warranty provisions are provided for in the same period as the related revenues are recorded and are principally based on historical results modified, as appropriate, by the most current information available. We have a history of making reasonably dependable estimates of such allowances; however, due to uncertainties inherent in the estimation process, it is possible that actual results may vary from the estimates and the differences could be material. Allowance for Doubtful Accounts: Management estimates the allowance for doubtful accounts based on the aging of the accounts receivable and customer creditworthiness. The allowance also incorporates a provision for the estimated impact of disputes with customers. Management’s estimate of the allowance amounts that are necessary includes amounts for specifically identified credit losses and estimated credit losses based on historical information. The determination of the amount of the allowance for doubtful accounts is subject to significant levels of judgment and estimation by management. Depending on the resolution of potential credit and other collection issues, or if the financial condition of any of the Company’s customers were to deteriorate and their ability to make required payments were to become impaired, increases in these allowances may be required. Historically, changes in estimates in the allowance for doubtful accounts have not been significant. Inventories : Inventories are stated at the lower of cost or market. Cost of inventories is generally determined by the average cost and the first-in, first-out (FIFO) methods and includes material, labor and overhead related to the manufacturing process. Because the Company sells products that are installed on airframes that can be in-service for 25 or more years, it must keep a supply of such products on hand while the airframes are in use. Where management estimated that the current market value was below cost or determined that future demand was lower than current inventory levels, based on historical experience, current and projected market demand, current and projected volume trends and other relevant current and projected factors associated with the current economic conditions, a reduction in inventory cost to estimated net realizable value was made by recording a provision included in cost of sales. Although management believes that the Company’s estimates of excess and obsolete inventory are reasonable, actual results may differ materially from the estimates and additional provisions may be required in the future. In addition, in accordance with industry practice, all inventories are classified as current assets as all inventories are available and necessary to support current sales, even though a portion of the inventories may not be sold within one year. Historically, changes in estimates in the net realizable value of inventories have not been significant. Goodwill and Other Intangible Assets : In accordance with ASC 805, “Business Combinations,” the Company uses the acquisition method of accounting to allocate costs of acquired businesses to the assets acquired and liabilities assumed based on their estimated fair values at the dates of acquisition. The excess costs of acquired businesses over the fair values of the assets acquired and liabilities assumed were recognized as goodwill. The valuations of the acquired assets and liabilities will impact the determination of future operating results. In addition to using management estimates and negotiated amounts, the Company used a variety of information sources to determine the estimated fair values of acquired assets and liabilities including third-party appraisals for the estimated value and lives of identifiable intangible assets. Fair value adjustments to the Company’s assets and liabilities are recognized and the results of operations of the acquired business are included in our consolidated financial statements from the effective date of the merger or acquisition . Intangible assets other than goodwill are recognized if the benefit of the intangible asset is obtained through contractual or other legal rights, or if the intangible asset can be sold, transferred, licensed or exchanged, regardless of the Company’s intent to do so. Goodwill and identifiable intangible assets are recorded at their estimated fair value on the date of acquisition and are reviewed at least annually for impairment based on cash flow projections and fair value estimates. GAAP requires that the annual, and any interim, impairment assessment be performed at the reporting unit level. The reporting unit level is one level below an operating segment. Substantially all goodwill was determined and recognized for each reporting 26 unit pursuant to the accounting for the merger or acquisition as of the date of each transaction. With respect to acquisitions integrated into an existing reporting unit, any acquired goodwill is combined with the goodwill of the reporting unit. At the time of goodwill impairment testing, the Company first assesses qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, and whether it is necessary to perform the quantitative goodwill impairment test. The quantitative test is required only if the Company concludes that it is more likely than not that a reporting unit’s fair value is less than its carrying amount, or if the Company elects not to perform a qualitative assessment of a reporting unit. For the quantitative test, management determines the estimated fair value through the use of a discounted cash flow valuation model incorporating discount rates commensurate with the risks involved for each reporting unit. If the calculated estimated fair value is less than the current carrying value, impairment of goodwill of the reporting unit may exist. The use of a discounted cash flow valuation model to determine estimated fair value is common practice in impairment testing. The key assumptions used in the discounted cash flow valuation model for impairment testing includes discount rates, growth rates, cash flow projections and terminal value rates. Discount rates are set by using the Weighted Average Cost of Capital (“WACC”) methodology. The WACC methodology considers market and industry data as well as company specific risk factors for each reporting unit in determining the appropriate discount rates to be used. The discount rate utilized for each reporting unit is indicative of the return an investor would expect to receive for investing in such a business. Management, considering industry and company-specific historical and projected data, develops growth rates, sales projections and cash flow projections for each reporting unit. Terminal value rate determination follows common methodology of capturing the present value of perpetual cash flow estimates beyond the last projected period assuming a constant WACC and low long-term growth rates. As an indicator that each reporting unit has been valued appropriately through the use of the discounted cash flow valuation model, the aggregate of all reporting unit’s estimated fair value is reconciled to the total market capitalization of the Company. The Company had 34 reporting units with goodwill as of the first day of the fourth quarter of fiscal 2017, the date of the last annual impairment test. The estimated fair values of each of the reporting units was substantially in excess of their respective carrying values, and therefore, no goodwill impairment was recorded. The Company performed a sensitivity analysis on the discount rate, which is a significant assumption in the calculation of fair values. With a one percentage point increase in the discount rate, nearly all of the reporting units would continue to have fair values substantially in excess of their respective carrying values. Management tests indefinite-lived intangible assets for impairment at the asset level, as determined by appropriate asset valuation at the time of acquisition. The impairment test for indefinite-lived intangible assets consists of a comparison between the estimated fair values and carrying values. If the carrying amounts of intangible assets that have indefinite useful lives exceed their estimated fair values, an impairment loss will be recognized in an amount equal to the difference. Management utilizes the royalty savings valuation method to determine the estimated fair value for each indefinite-lived intangible asset. In this method, management estimates the royalty savings arising from the ownership of the intangible asset. The key assumptions used in estimating the royalty savings for impairment testing include discount rates, royalty rates, growth rates, sales projections and terminal value rates. Discount rates used are similar to the rates developed by the WACC methodology considering any differences in company-specific risk factors between reporting units and the indefinite-lived intangible assets. Royalty rates are established by management with the advice of valuation experts and periodically substantiated by valuation experts. Management, considering industry and company-specific historical and projected data, develops growth rates and sales projections for each significant intangible asset. Terminal value rate determination follows common methodology of capturing the present value of perpetual sales estimates beyond the last projected period assuming a constant WACC and low long-term growth rates. The discounted cash flow and royalty savings valuation methodologies require management to make certain assumptions based upon information available at the time the valuations are performed. Actual results could differ from these assumptions. Management believes the assumptions used are reflective of what a market participant would have used in calculating fair value considering the current economic conditions. Stock-Based Compensation : The cost of the Company’s stock-based compensation is recorded in accordance with ASC 718, “Stock Compensation.” The Company uses a Black-Scholes-Merton option pricing model to estimate the grant-date fair value of the stock options awarded. The Black-Scholes-Merton model requires assumptions regarding the expected volatility of the Company’s common shares, the risk-free interest rate, the expected life of the stock options award and the Company’s dividend yield. The Company utilizes historical data in determining these assumptions. An increase or decrease in the assumptions or economic events outside of management’s control could have an impact on the Black-Scholes-Merton model. Income Taxes : The Company estimates income taxes in each jurisdiction in which it operates. This involves estimating taxable earnings, specific taxable and deductible items, the likelihood of generating sufficient future taxable income to utilize deferred tax assets and possible exposures related to future tax audits. To the extent these estimates change, adjustments to deferred and accrued income taxes are made in the period in which the changes occur. Historically, such adjustments have not been significant. 27 Results of Operations The following table sets forth, for the periods indicated, certain operating data of the Company, including presentation of the amounts as a percentage of net sales (amounts in thousands): | Fiscal Years Ended September 30, ----------------------------------------------+--------------------------------- | 2017 | | 2017 % ofSales | | 2016 | | 2016 % ofSales | | 2015 | | 2015 % ofSales ----------------------------------------------+----------------------------------+-----------+----------------+------+-------+---+----------------+---+-----------+------+--------------- Net sales | $ | 3,504,286 | | | 100.0 | % | | $ | 3,171,411 | | | 100.0 | % | $ | 2,707,115 | 100.0 | % ----------------------------------------------+----------------------------------+-----------+----------------+------+-------+---+----------------+---+-----------+------+----------------+-------+-----------+---+-----------+-------+-- Cost of sales | 1,519,659 | | | 43.4 | | | 1,443,348 | | | 45.5 | | | 1,257,270 | | 46.4 ----------------------------------------------+----------------------------------+-----------+----------------+------+-------+---+----------------+---+-----------+------+----------------+-------+-----------+---+---------- Selling and administrative expenses | 415,575 | | | 11.9 | | | 382,858 | | | 12.1 | | | 321,624 | | 11.9 ----------------------------------------------+----------------------------------+-----------+----------------+------+-------+---+----------------+---+-----------+------+----------------+-------+-----------+---+---------- Amortization of intangible assets | 89,226 | | | 2.5 | | | 77,445 | | | 2.4 | | | 54,219 | | 2.0 ----------------------------------------------+----------------------------------+-----------+----------------+------+-------+---+----------------+---+-----------+------+----------------+-------+-----------+---+---------- Income from operations | 1,479,826 | | | 42.2 | | | 1,267,760 | | | 40.0 | | | 1,074,002 | | 39.7 ----------------------------------------------+----------------------------------+-----------+----------------+------+-------+---+----------------+---+-----------+------+----------------+-------+-----------+---+---------- Interest expense, net | 602,589 | | | 17.2 | | | 483,850 | | | 15.3 | | | 418,785 | | 15.5 ----------------------------------------------+----------------------------------+-----------+----------------+------+-------+---+----------------+---+-----------+------+----------------+-------+-----------+---+---------- Refinancing costs | 39,807 | | | 1.1 | | | 15,794 | | | 0.5 | | | 18,393 | | 0.7 ----------------------------------------------+----------------------------------+-----------+----------------+------+-------+---+----------------+---+-----------+------+----------------+-------+-----------+---+---------- Income tax provision | 208,889 | | | 6.0 | | | 181,702 | | | 5.7 | | | 189,612 | | 7.0 ----------------------------------------------+----------------------------------+-----------+----------------+------+-------+---+----------------+---+-----------+------+----------------+-------+-----------+---+---------- Income from continuing operations | 628,541 | | | 17.9 | | | 586,414 | | | 18.5 | | | 447,212 | | 16.5 ----------------------------------------------+----------------------------------+-----------+----------------+------+-------+---+----------------+---+-----------+------+----------------+-------+-----------+---+---------- Loss from discontinued operations, net of tax | (31,654 | ) | | (0.9 | ) | | — | | | — | | | — | | — ----------------------------------------------+----------------------------------+-----------+----------------+------+-------+---+----------------+---+-----------+------+----------------+-------+-----------+---+---------- Net income | $ | 596,887 | | | 17.0 | % | | $ | 586,414 | | | 18.5 | % | $ | 447,212 | 16.5 | % ----------------------------------------------+----------------------------------+-----------+----------------+------+-------+---+----------------+---+-----------+------+----------------+-------+-----------+---+-----------+-------+-- Fiscal year ended September 30, 2017 compared with fiscal year ended September 30, 2016 Total Company Net Sales . Net organic sales and acquisition sales and the related dollar and percentage changes for the fiscal years ended September 30, 2017 and 2016 were as follows (amounts in millions): | Fiscal Years Ended | | Change | | % ChangeTotal Sales ------------------+--------------------+---------+--------------------+---+-------------------- | September 30, 2017 | | September 30, 2016 | ------------------+--------------------+---------+--------------------+-- Organic sales | $ | 3,248.6 | | | $ | 3,171.4 | | $ | 77.2 | | 2.4 | % ------------------+--------------------+---------+--------------------+---+---------------------+---------+-------+---+-------+---+------+-- Acquisition sales | 255.7 | | | — | | | 255.7 | | 8.1 | % ------------------+--------------------+---------+--------------------+---+---------------------+---------+-------+---+-------+-- | $ | 3,504.3 | | | $ | 3,171.4 | | $ | 332.9 | | 10.5 | % ------------------+--------------------+---------+--------------------+---+---------------------+---------+-------+---+-------+---+------+-- Acquisition sales represent sales of acquired businesses for the period up to one year subsequent to their acquisition date. The amount of acquisition sales shown in the table above was attributable to the Third Quarter 2017 Acquisitions in fiscal year 2017 and the acquisitions of Y&F/Tactair, DDC and Breeze-Eastern in fiscal year 2016. The increase in organic sales was primarily driven by commercial aftermarket organic sales increasing by $34.8 million , or 3.0% and defense organic sales increasing by $41.5 million , or 4.4% . Slightly offsetting the increases was commercial OEM organic sales decreasing by $2.8 million , or 0.3% . Cost of Sales and Gross Profit . Cost of sales increased by $76.4 million , or 5.3% , to $1,519.7 million for the fiscal year ended September 30, 2017 compared to $1,443.3 million for the fiscal year ended September 30, 2016 . Cost of sales and the related percentage of total sales for the fiscal years ended September 30, 2017 and 2016 were as follows (amounts in millions): | Fiscal Years Ended | | Change | | % Change ------------------------------------------+--------------------+---------+--------------------+---------+--------- | September 30, 2017 | | September 30, 2016 | ------------------------------------------+--------------------+---------+--------------------+-------- Cost of sales—excluding costs below | $ | 1,490.5 | | | $ | 1,405.6 | | | $ | 84.9 | | | 6.0 | % ------------------------------------------+--------------------+---------+--------------------+---------+----------+---------+------+------+---+-------+-----+---+------+-- % of total sales | 42.5 | % | | 44.3 | % | | | | ------------------------------------------+--------------------+---------+--------------------+---------+----------+---------+------+------+-- Inventory purchase accounting adjustments | 20.6 | | | 23.4 | | | (2.8 | ) | | (12.0 | )% ------------------------------------------+--------------------+---------+--------------------+---------+----------+---------+------+------+---+-------+---- % of total sales | 0.6 | % | | 0.7 | % | | | | ------------------------------------------+--------------------+---------+--------------------+---------+----------+---------+------+------+-- Acquisition integration costs | 4.0 | | | 8.3 | | | (4.3 | ) | | (51.8 | )% ------------------------------------------+--------------------+---------+--------------------+---------+----------+---------+------+------+---+-------+---- % of total sales | 0.1 | % | | 0.3 | % | | | | ------------------------------------------+--------------------+---------+--------------------+---------+----------+---------+------+------+-- Stock compensation expense | 4.6 | | | 6.0 | | | (1.4 | ) | | (23.3 | )% ------------------------------------------+--------------------+---------+--------------------+---------+----------+---------+------+------+---+-------+---- % of total sales | 0.1 | % | | 0.2 | % | | | | ------------------------------------------+--------------------+---------+--------------------+---------+----------+---------+------+------+-- Total cost of sales | 1,519.7 | | | 1,443.3 | | | $ | 76.4 | | | 5.3 | % ------------------------------------------+--------------------+---------+--------------------+---------+----------+---------+------+------+---+-------+-----+-- % of total sales | 43.4 | % | | 45.5 | % | | | | ------------------------------------------+--------------------+---------+--------------------+---------+----------+---------+------+------+-- Gross profit | $ | 1,984.6 | | | $ | 1,728.1 | | | $ | 256.5 | | | 14.8 | % ------------------------------------------+--------------------+---------+--------------------+---------+----------+---------+------+------+---+-------+-----+---+------+-- Gross profit percentage | 56.6 | % | | 54.5 | % | | 2.1 | % | | ------------------------------------------+--------------------+---------+--------------------+---------+----------+---------+------+------+---+------ 28 The increase in the dollar amount of cost of sales during the fiscal year ended September 30, 2017 was primarily due to increased volume associated with the sales from acquisitions and organic sales growth. Gross profit as a percentage of sales increased by 2.1 percentage points to 56.6% for the fiscal year ended September 30, 2017 from 54.5% for the fiscal year ended September 30, 2016 . The dollar amount of gross profit increased by $256.5 million , or 14.8% , for the fiscal year ended September 30, 2017 compared to the comparable period last year due to the following items: • | Gross profit on the sales from the acquisitions indicated above (excluding acquisition-related costs) was approximately $153.6 million for the fiscal year ended September 30, 2017, which represented gross profit of approximately 60% of the acquisition sales. The higher gross profit margin on the acquisition sales increased gross profit as a percentage of consolidated sales by approximately 1 percentage point. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Organic sales growth described above, application of our three core value-driven operating strategies (obtaining profitable new business, continually improving our cost structure, and providing highly engineered value-added products to customers), and positive leverage on our fixed overhead costs spread over a higher production volume, resulted in a net increase in gross profit of approximately $94.4 million for the fiscal year ended September 30, 2017. --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Gross profit was also improved by the reduction of the impact of inventory purchase accounting adjustments, acquisition integration costs and stock compensation expense charged to cost of sales of approximately $8.5 million. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Selling and Administrative Expenses. Selling and administrative expenses increased by $32.7 million to $415.6 million , or 11.9% of sales, for the fiscal year ended September 30, 2017 from $382.9 million , or 12.1% of sales, for the comparable period last year. Selling and administrative expenses and the related percentage of total sales for the fiscal years ended September 30, 2017 and 2016 were as follows (amounts in millions): | Fiscal Years Ended | | Change | | % Change ----------------------------------------------------------+--------------------+-------+--------------------+------+--------- | September 30, 2017 | | September 30, 2016 | ----------------------------------------------------------+--------------------+-------+--------------------+----- Selling and administrative expenses—excluding costs below | $ | 368.1 | | | $ | 314.5 | | | $ | 53.6 | | 17.0 | % ----------------------------------------------------------+--------------------+-------+--------------------+------+----------+-------+-------+---+---+-------+----+------+-- % of total sales | 10.5 | % | | 9.9 | % | | | | ----------------------------------------------------------+--------------------+-------+--------------------+------+----------+-------+-------+---+-- Stock compensation expense | 41.0 | | | 42.4 | | | (1.4 | ) | | (3.3 | )% ----------------------------------------------------------+--------------------+-------+--------------------+------+----------+-------+-------+---+---+-------+--- % of total sales | 1.2 | % | | 1.3 | % | | | | ----------------------------------------------------------+--------------------+-------+--------------------+------+----------+-------+-------+---+-- Acquisition-related expenses | 6.5 | | | 26.0 | | | (19.5 | ) | | (75.0 | )% ----------------------------------------------------------+--------------------+-------+--------------------+------+----------+-------+-------+---+---+-------+--- % of total sales | 0.2 | % | | 0.8 | % | | | | ----------------------------------------------------------+--------------------+-------+--------------------+------+----------+-------+-------+---+-- Total selling and administrative expenses | $ | 415.6 | | | $ | 382.9 | | | $ | 32.7 | | 8.5 | % ----------------------------------------------------------+--------------------+-------+--------------------+------+----------+-------+-------+---+---+-------+----+------+-- % of total sales | 11.9 | % | | 12.1 | % | | | | ----------------------------------------------------------+--------------------+-------+--------------------+------+----------+-------+-------+---+-- The increase in the dollar amount of selling and administrative expenses during the fiscal year ended September 30, 2017 is primarily due to higher selling and administrative expenses relating to recent acquisitions of approximately $47.7 million, which was approximately 19% of acquisition sales. The increase is partially offset by lower acquisition-related and stock compensation expenses of $19.5 million and $1.4 million , respectively. Amortization of Intangible Assets. Amortization of intangible assets increased to $89.2 million for the fiscal year ended September 30, 2017 from $77.4 million for the comparable period last year. The net increase of $11.8 million was primarily due to the Third Quarter 2017 Acquisitions and full year amortization recorded from the fiscal 2016 acquisitions of Breeze-Eastern, DDC and Y&F/Tactair. Refinancing Costs. Refinancing costs of $39.8 million were recorded during the year ended September 30, 2017 representing debt issuance costs expensed in connection with the debt financing activity as disclosed in Note 11, "Debt," to the consolidated financial statements. Included within the $39.8 million was approximately $31.9 million in debt issuance costs and premium related to the repurchase of the 2021 Notes. Refinancing costs of $15.8 million were recorded during the fiscal year ended September 30, 2016 representing debt issuance costs expensed in connection with the debt financing activity in June 2016. Interest Expense-net. Interest expense-net includes interest on borrowings outstanding, amortization of debt issuance costs, original issue discount and premium, and revolving credit facility fees offset by interest income. Interest expense-net increased $ 118.7 million , or 24.5% , to $602.6 million for the fiscal year ended September 30, 2017 from $483.9 million for the comparable period last year. The net increase in interest expense-net was primarily due to an increase in the weighted average level of outstanding borrowings, which was approximately $10,993 million for the fiscal year ended September 30, 2017 and approximately $8,834 million for the fiscal year ended September 30, 2016 . The weighted average cash interest rate was consistent at 5.3% during the fiscal years ended September 30, 2017 and 2016. The increase in weighted average level of borrowings was due to the issuance of the 2026 Notes for $950 million in June 2016, the incremental term loans of $950 million in June 2016, the additional net debt financing of $641 million in the first fiscal quarter of 2017, the additional 2025 Notes offering of $300 million in the second fiscal 29 quarter of 2017, the additional $100 million drawn on the trade receivable securitization facility in the fourth quarter of fiscal 2017 and the additional net debt financing of $575 million in the fourth quarter of fiscal 2017. The weighted average interest rate for cash interest payments on total borrowings outstanding at September 30, 2017 was 5.2%. Income Taxes. Income tax expense as a percentage of income before income taxes was approximately 24.9% for the fiscal year ended September 30, 2017 compared to 23.7% for the fiscal year ended September 30, 2016 . The Company’s effective tax rate for these periods was less than the Federal statutory tax rate due primarily to excess tax benefits on equity compensation, foreign earnings taxed at rates lower than the U.S. statutory rates, and the domestic manufacturing deduction. The increase in the effective tax rate for the fiscal year ended September 30, 2017 compared to the fiscal year ended September 30, 2016 was primarily due to foreign earnings taxed at higher rates versus the prior year foreign earnings. Loss from Discontinued Operations . Loss from discontinued operations is comprised of the operating loss from the Schroth operations that were classified as held-for-sale as of September 30, 2017. The loss includes a $32 million impairment charge to write-down Schroth’s assets to fair value. More detailed information can be found in Note 22, “Discontinued Operations.” Net Income . Net income increased $10.5 million , or 1.8% , to $596.9 million for the fiscal year ended September 30, 2017 compared to net income of $586.4 million for the year ended September 30, 2016 , primarily as a result of the factors referred to above. Earnings per Share . The basic and diluted earnings per share were $7.88 for the fiscal year ended September 30, 2017 and $10.39 per share for the fiscal year ended September 30, 2016 . For the fiscal year ended September 30, 2017, basic and diluted earnings per share from continuing operations were $8.45 and basic and diluted loss per share from discontinued operations were $(0.57). Net income for the fiscal year ended September 30, 2017 of $596.9 million was decreased by dividend equivalent payments of $159.3 million resulting in net income available to common shareholders of $437.6 million . Net income for the fiscal year ended September 30, 2016 of $586.4 million was decreased by dividend equivalent payments of $3.0 million resulting in net income available to common shareholders of $583.4 million . The decrease in earnings per share of $2.51 per share to $7.88 per share is a result of the factors referred to above. Business Segments Segment Net Sales . Net sales by segment for the fiscal years ended September 30, 2017 and 2016 were as follows (amounts in millions): | Fiscal Years Ended September 30, | | Change | | % Change ----------------+----------------------------------+---------+------------+------+--------- | 2017 | | % of Sales | | 2016 | | % of Sales | ----------------+----------------------------------+---------+------------+------+----------+---+------------+-- Power & Control | $ | 1,948.2 | | | 55.6 | % | | $ | 1,621.7 | | | 51.1 | % | | $ | 326.5 | | 20.1 | % ----------------+----------------------------------+---------+------------+------+----------+---+------------+---+---------+------+---+-------+------+---+---+-------+----+------+-- Airframe | 1,442.1 | | | 41.2 | % | | 1,447.9 | | | 45.7 | % | | (5.8 | ) | | (0.4 | )% ----------------+----------------------------------+---------+------------+------+----------+---+------------+---+---------+------+---+-------+------+---+---+-------+--- Non-aviation | 114.0 | | | 3.2 | % | | 101.8 | | | 3.2 | % | | 12.2 | | | 12.0 | % ----------------+----------------------------------+---------+------------+------+----------+---+------------+---+---------+------+---+-------+------+---+---+-------+--- | $ | 3,504.3 | | | 100.0 | % | | $ | 3,171.4 | | | 100.0 | % | | $ | 332.9 | | 10.5 | % ----------------+----------------------------------+---------+------------+------+----------+---+------------+---+---------+------+---+-------+------+---+---+-------+----+------+-- Organic sales for the Power & Control segment increased $70.8 million , or an increase of 4.3% , when compared to the fiscal year ended September 30, 2016 . The organic sales increase resulted from increases in commercial aftermarket sales ( $40.9 million , an increase of 7.5% ), defense sales ( $28.2 million , an increase of 4.4% ), and commercial OEM sales ( $1.0 million , an increase of 0.3% ). Acquisition sales for the Power & Control segment totaled $255.7 million , or an increase of 15.8% , resulting from the Third Quarter 2017 Acquisitions and the acquisitions of Y&F/Tactair, DDC and Breeze-Eastern in fiscal year 2016. Organic sales for the Airframe segment decreased $5.8 million , or a decrease of 0.4% , when compared to the fiscal year ended September 30, 2016 . The organic sales decrease primarily resulted from decreases in commercial aftermarket sales ( $6.1 million , a decrease of 1.0% ), commercial OEM sales ( $5.3 million , a decrease of 1.1% ) and non-aerospace sales ( $6.9 million , a decrease of 39.4% ) offset by an increase in defense sales ( $12.5 million , an increase of 4.2% ). There was no impact from acquisitions in the results of the Airframe segment. Organic sales for the Non-aviation segment increased $12.2 million , or an increase of 12.0%, when compared to the fiscal year ended September 30, 2016 . The sales increase was primarily due to an increase in non-aerospace sales of $9.9 million , an increase of 11.5%. There was no impact from acquisitions in the results of the Non-aviation segment. 30 EBITDA As Defined . EBITDA As Defined by segment for the fiscal years ended September 30, 2017 and 2016 were as follows (amounts in millions): | Fiscal Years Ended September 30, | | Change | | % Change ----------------+----------------------------------+---------+-------------------+------+--------- | 2017 | | % of SegmentSales | | 2016 | | % of SegmentSales | ----------------+----------------------------------+---------+-------------------+------+----------+---+-------------------+-- Power & Control | $ | 981.0 | | | 50.4 | % | | $ | 787.4 | | | 48.6 | % | $ | 193.6 | | 24.6 | % ----------------+----------------------------------+---------+-------------------+------+----------+---+-------------------+---+---------+------+---+------+------+---+-------+---+------+-- Airframe | 726.6 | | | 50.4 | % | | 709.9 | | | 49.0 | % | | 16.7 | | 2.4 | % ----------------+----------------------------------+---------+-------------------+------+----------+---+-------------------+---+---------+------+---+------+------+---+-------+-- Non-aviation | 41.5 | | | 36.4 | % | | 28.2 | | | 27.7 | % | | 13.3 | | 47.2 | % ----------------+----------------------------------+---------+-------------------+------+----------+---+-------------------+---+---------+------+---+------+------+---+-------+-- | $ | 1,749.1 | | | 49.9 | % | | $ | 1,525.5 | | | 48.1 | % | $ | 223.6 | | 14.7 | % ----------------+----------------------------------+---------+-------------------+------+----------+---+-------------------+---+---------+------+---+------+------+---+-------+---+------+-- Organic EBITDA As Defined for the Power & Control segment increased approximately $82.7 million for the fiscal year ended September 30, 2017 compared to the fiscal year ended September 30, 2016 . EBITDA As Defined from the Third Quarter 2017 Acquisitions and the acquisitions of Y&F/Tactair, DDC and Breeze-Eastern in fiscal year 2016 was approximately $110.9 million for the fiscal year ended September 30, 2017 . Organic EBITDA As Defined for the Airframe segment increased approximately $16.7 million for the fiscal year ended September 30, 2017 compared to the fiscal year ended September 30, 2016 . There was no impact from acquisitions in the results of the Airframe segment. Organic EBITDA As Defined for the Non-aviation segment increased approximately $13.3 million for the fiscal year ended September 30, 2017 compared to the fiscal year ended September 30, 2016 . There was no impact from acquisitions in the results of the Non-aviation segment. Fiscal year ended September 30, 2016 compared with fiscal year ended September 30, 2015 Total Company Net Sales . Net organic sales and acquisition sales and the related dollar and percentage changes for the fiscal years ended September 30, 2016 and 2015 were as follows (amounts in millions): | Fiscal Years Ended | | Change | | % ChangeTotal Sales ------------------+--------------------+---------+--------------------+---+--------------------- | September 30, 2016 | | September 30, 2015 | ------------------+--------------------+---------+--------------------+-- Organic sales | $ | 2,762.2 | | | $ | 2,707.1 | | $ | 55.1 | | 2.0 | % ------------------+--------------------+---------+--------------------+---+----------------------+---------+-------+---+-------+---+------+-- Acquisition sales | 409.2 | | | — | | | 409.2 | | 15.1 | % ------------------+--------------------+---------+--------------------+---+----------------------+---------+-------+---+-------+-- | $ | 3,171.4 | | | $ | 2,707.1 | | $ | 464.3 | | 17.1 | % ------------------+--------------------+---------+--------------------+---+----------------------+---------+-------+---+-------+---+------+-- Acquisition sales represent sales of acquired businesses for the period up to one year subsequent to their acquisition date. The amount of acquisition sales shown in the table above was attributable to the acquisitions of Breeze-Eastern and DDC in fiscal year 2016 and and the acquisitions of PneuDraulics, Pexco Aerospace, Adams Rite Aerospace Gmbh and Telair Cargo Group in fiscal year 2015 . Commercial aftermarket organic sales increased $61.3 million, or 6.1%, commercial OEM organic sales decreased by $8.8 million, or an increase of 1.1%, and defense organic sales were flat when comparing the fiscal year ended September 30, 2016 compared to fiscal year ended September 30, 2015 . 31 Cost of Sales and Gross Profit . Cost of sales increased by $186.0 million , or 14.8% , to $1,443.3 million for the fiscal year ended September 30, 2016 compared to $1,257.3 million for the fiscal year ended September 30, 2015 . Cost of sales and the related percentage of total sales for the fiscal years ended September 30, 2016 and 2015 were as follows (amounts in millions): | Fiscal Years Ended | | Change | | % Change --------------------------------------------------------+--------------------+---------+--------------------+------+--------- | September 30, 2016 | | September 30, 2015 | --------------------------------------------------------+--------------------+---------+--------------------+----- Cost of sales—excluding acquisition-related costs below | $ | 1,405.6 | | | $ | 1,235.1 | | | $ | 170.5 | | 13.8 | % --------------------------------------------------------+--------------------+---------+--------------------+------+----------+---------+------+---+---+-------+---+------+-- % of total sales | 44.3 | % | | 45.6 | % | | | | --------------------------------------------------------+--------------------+---------+--------------------+------+----------+---------+------+---+-- Inventory purchase accounting adjustments | 23.4 | | | 11.4 | | | 12.0 | | | 105.3 | % --------------------------------------------------------+--------------------+---------+--------------------+------+----------+---------+------+---+---+-------+-- % of total sales | 0.7 | % | | 0.4 | % | | | | --------------------------------------------------------+--------------------+---------+--------------------+------+----------+---------+------+---+-- Acquisition integration costs | 8.3 | | | 6.1 | | | 2.2 | | | 36.1 | % --------------------------------------------------------+--------------------+---------+--------------------+------+----------+---------+------+---+---+-------+-- % of total sales | 0.3 | % | | 0.2 | % | | | | --------------------------------------------------------+--------------------+---------+--------------------+------+----------+---------+------+---+-- Stock compensation expense | 6.0 | | | 4.7 | | | 1.3 | | | 27.7 | % --------------------------------------------------------+--------------------+---------+--------------------+------+----------+---------+------+---+---+-------+-- % of total sales | 0.2 | % | | 0.2 | % | | | | --------------------------------------------------------+--------------------+---------+--------------------+------+----------+---------+------+---+-- Total cost of sales | $ | 1,443.3 | | | $ | 1,257.3 | | | $ | 186.0 | | 14.8 | % --------------------------------------------------------+--------------------+---------+--------------------+------+----------+---------+------+---+---+-------+---+------+-- % of total sales | 45.5 | % | | 46.4 | % | | | | --------------------------------------------------------+--------------------+---------+--------------------+------+----------+---------+------+---+-- Gross profit | $ | 1,728.1 | | | $ | 1,449.8 | | | $ | 278.3 | | 19.2 | % --------------------------------------------------------+--------------------+---------+--------------------+------+----------+---------+------+---+---+-------+---+------+-- Gross profit percentage | 54.5 | % | | 53.6 | % | | 0.9 | % | | --------------------------------------------------------+--------------------+---------+--------------------+------+----------+---------+------+---+---+------ The increase in the dollar amount of cost of sales during the fiscal year ended September 30, 2016 was primarily due to increased volume associated with the sales from acquisitions and organic sales growth. Gross profit as a percentage of sales increased by 0.9 percentage points to 54.5% for the fiscal year ended September 30, 2016 from 53.6% for the fiscal year ended September 30, 2015 . The dollar amount of gross profit increased by $278.3 million , or 19.2% , for the fiscal year ended September 30, 2016 compared to the comparable period last year due to the following items: • | Gross profit on the sales from the acquisitions indicated above (excluding acquisition-related costs) was approximately $171.2 million for the fiscal year ended September 30, 2016, which represented gross profit of approximately 42% of the acquisition sales. The lower gross profit margin on the acquisition sales reduced gross profit as a percentage of consolidated sales by approximately 2 percentage points. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Organic sales growth described above, application of our three core value-driven operating strategies (obtaining profitable new business, continually improving our cost structure, and providing highly engineered value-added products to customers), and positive leverage on our fixed overhead costs spread over a higher production volume, resulted in a net increase in gross profit of approximately $122.6 million for the fiscal year ended September 30, 2016. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Slightly offsetting the increases in gross profit was the impact of higher inventory purchase accounting adjustments acquisition integration costs and stock compensation expense charged to cost of sales of approximately $15.5 million. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Selling and Administrative Expenses. Selling and administrative expenses increased by $61.3 million to $382.9 million , or 12.1% of sales, for the fiscal year ended September 30, 2016 from $321.6 million , or 11.9% of sales, for the comparable period last year. Selling and administrative expenses and the related percentage of total sales for the fiscal years ended September 30, 2016 and 2015 were as follows (amounts in millions): | Fiscal Years Ended | | Change | | % Change ----------------------------------------------------------+--------------------+-------+--------------------+------+--------- | September 30, 2016 | | September 30, 2015 | ----------------------------------------------------------+--------------------+-------+--------------------+----- Selling and administrative expenses—excluding costs below | $ | 314.5 | | | $ | 276.1 | | $ | 38.4 | | 13.9 | % ----------------------------------------------------------+--------------------+-------+--------------------+------+----------+-------+------+---+------+---+------+-- % of total sales | 9.9 | % | | 10.2 | % | | | ----------------------------------------------------------+--------------------+-------+--------------------+------+----------+-------+------+-- Stock compensation expense | 42.4 | | | 26.8 | | | 15.6 | | 58.2 | % ----------------------------------------------------------+--------------------+-------+--------------------+------+----------+-------+------+---+------+-- % of total sales | 1.3 | % | | 1.0 | % | | | ----------------------------------------------------------+--------------------+-------+--------------------+------+----------+-------+------+-- Acquisition-related expenses | 26.0 | | | 18.7 | | | 7.3 | | 39.0 | % ----------------------------------------------------------+--------------------+-------+--------------------+------+----------+-------+------+---+------+-- % of total sales | 0.8 | % | | 0.7 | % | | | ----------------------------------------------------------+--------------------+-------+--------------------+------+----------+-------+------+-- Total selling and administrative expenses | $ | 382.9 | | | $ | 321.6 | | $ | 61.3 | | 19.1 | % ----------------------------------------------------------+--------------------+-------+--------------------+------+----------+-------+------+---+------+---+------+-- % of total sales | 12.1 | % | | 11.9 | % | | | ----------------------------------------------------------+--------------------+-------+--------------------+------+----------+-------+------+-- The increase in the dollar amount of selling and administrative expenses during the fiscal year ended September 30, 2016 is primarily due to higher selling and administrative expenses relating to recent acquisitions of approximately $44.8 million, which 32 was approximately 11% of acquisition sales, and higher acquisition-related and stock compensation expenses of $7.3 million and $15.6 million, respectively. Amortization of Intangible Assets. Amortization of intangible assets decreased to $77.4 million for the fiscal year ended September 30, 2016 from $54.2 million for the comparable period last year. The net increase of $23.2 million was primarily due to the acquisitions of Breeze-Eastern and DDC in fiscal 2016 and full year amortization recorded on the acquisitions made in 2015. Refinancing Costs. Refinancing costs of $15.8 million were recorded during the fiscal year ended September 30, 2016 representing debt issuance costs expensed in connection with the debt financing activity in June 2016. Included within the $15.8 million was approximately $1.4 million of unamortized debt issuance costs written off. Refinancing costs of $18.4 million were recorded during the fiscal year ended September 30, 2015 representing debt issuance costs expensed in conjunction with the debt financing activity in May 2015. Included within the $18.4 million was approximately $10.2 million of unamortized debt issuance costs written off. Interest Expense-net. Interest expense-net includes interest on borrowings outstanding, amortization of debt issuance costs and revolving credit facility fees offset by interest income. Interest expense-net increased $65.1 million, or 15.5%, to $483.9 million for the fiscal year ended September 30, 2016 from $418.8 million for the comparable period last year. The net increase in interest expense-net was primarily due to an increase in the weighted average level of outstanding borrowings, which was approximately $8,834 million for the fiscal year ended September 30, 2016 and approximately $7,827 million for the fiscal year ended September 30, 2015 in addition to a slight increase in the weighted average cash interest rate during the fiscal year ended September 30, 2016 of 5.3% compared to the weighted average cash interest rate during the comparable prior period of 5.2%. The increase in weighted average level of borrowings was primarily due to the issuance of the 2026 Notes for $950.0 million in June 2016, the additional incremental term loans of $950 million in June 2016, the issuance of the 2025 Notes for $450 million in May 2015, and the additional incremental term loan of $1.0 billion in May 2015. The weighted average interest rate for cash interest payments on total borrowings outstanding at September 30, 2016 was 5.2%. Income Taxes. Income tax expense as a percentage of income before income taxes was approximately 24.9% for the fiscal year ended September 30, 2017 compared to 23.7% for the fiscal year ended September 30, 2016 . The Company’s effective tax rate for these periods was less than the Federal statutory tax rate due primarily to excess tax benefits on equity compensation, foreign earning taxed at rates lower than the U.S. statutory rates, and the domestic manufacturing deduction. The decrease in the effective tax rate for the fiscal year ended September 30, 2017 compared to the fiscal year ended September 30, 2016 was primarily due to excess tax benefits on equity compensation and foreign earning taxed at rates lower than the U.S. statutory rates. Net Income . Net income increased $139.2 million, or 31.1%, to $586.4 million for the fiscal year ended September 30, 2016 compared to net income of $447.2 million for the year ended September 30, 2015 , primarily as a result of the factors referred to above. Earnings per Share . The basic and diluted earnings per share were $10.39 for the fiscal year ended September 30, 2016 and $7.84 per share for the fiscal year ended September 30, 2015 . Net income for the fiscal year ended September 30, 2016 of $586.4 million was decreased by dividend equivalent payments of $3.0 million resulting in net income available to common shareholders of $583.4 million . Net income for the fiscal year ended September 30, 2015 of $447.2 million was decreased by dividend equivalent payments of $3.4 million resulting in net income available to common shareholders of $443.8 million . The increase in earnings per share of $2.55 per share to $10.39 per share is a result of the factors referred to above. Business Segments Segment Net Sales . Net sales by segment for the fiscal years ended September 30, 2016 and 2015 were as follows (amounts in millions): | Fiscal Years Ended September 30, | | Change | | % Change ----------------+----------------------------------+---------+------------+------+--------- | 2016 | | % of Sales | | 2015 | | % of Sales | ----------------+----------------------------------+---------+------------+------+----------+---+------------+-- Power & Control | $ | 1,621.7 | | | 51.1 | % | | $ | 1,330.1 | | | 49.1 | % | $ | 291.6 | | 21.9 | % ----------------+----------------------------------+---------+------------+------+----------+---+------------+---+---------+------+---+-------+-------+---+-------+---+------+-- Airframe | 1,447.9 | | | 45.7 | % | | 1,280.7 | | | 47.3 | % | | 167.2 | | 13.1 | % ----------------+----------------------------------+---------+------------+------+----------+---+------------+---+---------+------+---+-------+-------+---+-------+-- Non-aviation | 101.8 | | | 3.2 | % | | 96.3 | | | 3.6 | % | | 5.5 | | 5.7 | % ----------------+----------------------------------+---------+------------+------+----------+---+------------+---+---------+------+---+-------+-------+---+-------+-- | $ | 3,171.4 | | | 100.0 | % | | $ | 2,707.1 | | | 100.0 | % | $ | 464.3 | | 17.2 | % ----------------+----------------------------------+---------+------------+------+----------+---+------------+---+---------+------+---+-------+-------+---+-------+---+------+-- Organic sales for the Power & Control segment decreased approximately $21.2 million, or a decrease of 1.6%, when compared to the fiscal year ended September 30, 2015 . The organic sales decrease resulted primarily from decrease in commercial OEM sales ($31.4 million, a decrease of 9.3%) and in defense sales ($20.6 million, a decrease of 4.0%) partially offset by an increase in commercial aftermarket sales ($32.1 million, an increase of 7.1%). Acquisition sales for the Power & Control segment totaled 33 $312.8 million, or an increase of 23.5%, resulting from the acquisitions of Breeze-Eastern and DDC in fiscal year 2016 and the acquisitions of PneuDraulics, Telair Europe, Telair US in fiscal year 2015. Organic sales for the Airframe segment, increased approximately $70.7 million, or an increase of 5.5% when compared to the fiscal year ended September 30, 2015 . The organic sales increase primarily resulted from increases in commercial aftermarket ($23.9 million, an increase of 5.3%), commercial OEM sale ($19.6 million, an increase of 4.5%) and defense sales ($21.6 million, an increase of 77%). Acquisition sales for the Airframe segment totaled $96.5 million, or an increase of 7.5%, resulting from the acquisitions of Pexco Aerospace, Adams Rite Aerospace GmbH and Nordisk Aviation Products in fiscal year 2015. Sales for the Non-aviation segment increased $5.5 million when compared to the fiscal year ended September 30, 2015 . The sales increase was primarily due to an increase in commercial OEM sales of approximately $3.0 million. There was no impact from acquisitions in the results of the Non-aviation segment. EBITDA As Defined . EBITDA As Defined by segment for the fiscal years ended September 30, 2016 and 2015 were as follows (amounts in millions): | Fiscal Years Ended September 30, | | Change | | % Change ----------------+----------------------------------+---------+-------------------+------+--------- | 2016 | | % of SegmentSales | | 2015 | | % of SegmentSales | ----------------+----------------------------------+---------+-------------------+------+----------+---+-------------------+-- Power & Control | $ | 787.4 | | | 48.6 | % | | $ | 653.1 | | | 49.1 | % | $ | 134.3 | | 20.6 | % ----------------+----------------------------------+---------+-------------------+------+----------+---+-------------------+---+---------+------+---+------+-------+---+-------+---+------+-- Airframe | 709.9 | | | 49.0 | % | | 585.5 | | | 45.7 | % | | 124.4 | | 21.2 | % ----------------+----------------------------------+---------+-------------------+------+----------+---+-------------------+---+---------+------+---+------+-------+---+-------+-- Non-aviation | 28.2 | | | 27.7 | % | | 22.4 | | | 23.3 | % | | 5.8 | | 25.9 | % ----------------+----------------------------------+---------+-------------------+------+----------+---+-------------------+---+---------+------+---+------+-------+---+-------+-- | $ | 1,525.5 | | | 48.1 | % | | $ | 1,261.0 | | | 46.6 | % | $ | 264.5 | | 21.0 | % ----------------+----------------------------------+---------+-------------------+------+----------+---+-------------------+---+---------+------+---+------+-------+---+-------+---+------+-- Organic EBITDA As Defined for the Power & Control segment increased approximately $22.9 million for the fiscal year ended September 30, 2016 compared to the fiscal year ended September 30, 2015 . EBITDA As Defined from the acquisitions of Breeze-Eastern and DDC in fiscal year 2016 and the acquisitions of PneuDraulics, Telair Europe and Telair US in fiscal year 2015 was approximately $111.5 for th year ended September 30, 2016 . Organic EBITDA As Defined for the Airframe segment increased approximately $76.9 million for the fiscal year ended September 30, 2016 compared to the fiscal year ended September 30, 2015 . EBITDA As Defined from the fiscal year 2015 acquisitions of Pexco Aerospace, Adams Rite Aerospace GmbH and Nordisk Aviation Products was approximately $47.5 million for the fiscal year ended September 30, 2016 . EBITDA As Defined for the Non-aviation segment increased approximately $5.8 million for the fiscal year ended September 30, 2016 compared to the fiscal year ended September 30, 2015 . There was no impact from acquisitions in the results of the Non-aviation segment. Backlog For information about our backlog, see Item 1. - “Business.” Foreign Operations Our direct sales to foreign customers were approximately $1,318.9 million , $1,169.5 million , and $881.1 million for fiscal years 2017 , 2016 and 2015 , respectively. Sales to foreign customers are subject to numerous additional risks, including foreign currency fluctuations, the impact of foreign government regulations, political uncertainties and differences in business practices. There can be no assurance that foreign governments will not adopt regulations or take other action that would have a direct or indirect adverse impact on the business or market opportunities of the Company within such governments’ countries. Furthermore, there can be no assurance that the political, cultural and economic climate outside the United States will be favorable to our operations and growth strategy. Inflation Many of the Company’s raw materials and operating expenses are sensitive to the effects of inflation, which could result in changing operating costs. The effects of inflation on the Company’s businesses during the fiscal years 2017 , 2016 and 2015 were immaterial. 34 Liquidity and Capital Resources We have historically maintained a capital structure comprising a mix of equity and debt financing. We vary our leverage both to optimize our equity return and to pursue acquisitions. We expect to meet our current debt obligations as they come due through internally generated funds from current levels of operations and/or through refinancing in the debt markets prior to the maturity dates of our debt. We continually evaluate our debt facilities to assess whether they most efficiently and effectively meet the current and future needs of our business. The Company evaluates from time to time the appropriateness of its current leverage, taking into consideration the Company’s debt holders, equity holders, credit ratings, acquisition opportunities and other factors. The Company’s debt leverage ratio, which is computed as total debt divided by EBITDA As Defined for the applicable twelve-month period, has varied widely during the Company’s history, ranging from approximately 3.5 to 7.2. Our debt leverage ratio at September 30, 2017 was approximately 6.9 . If the Company has excess cash, it generally prioritizes allocating the excess cash in the following manner: (1) capital spending at existing businesses, (2) acquisitions of businesses, (3) payment of a special dividend and/or repurchases of our common stock and (4) prepayment of indebtedness or repurchase of debt. Whether the Company undertakes additional common stock repurchases or other aforementioned activities will depend on prevailing market conditions, the Company’s liquidity requirements, contractual restrictions and other factors. The amounts involved may be material. In addition, the Company may issue additional debt if prevailing market conditions are favorable to doing so. The Company’s ability to make scheduled interest payments on, or to refinance, the Company’s indebtedness, or to fund non-acquisition related capital expenditures and research and development efforts, will depend on the Company’s ability to generate cash in the future. This is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond its control. As a result of the additional debt financing during the fiscal year ended September 30, 2017, interest payments will increase going forward in accordance with the terms of the related debt agreements. However, in connection with the continued application of our three core value-driven operating strategies (obtaining profitable new business, continually improving our cost structure and providing highly engineered value-added products to customers), we expect our efforts will continue to generate strong margins and provide more than sufficient cash from operating activities to meet our interest obligations and liquidity needs. We believe our cash from operations and available borrowing capacity will enable us to make opportunistic investments in our own stock, make strategic business combinations and/or pay dividends to our shareholders. In the future, the Company may increase its borrowings in connection with acquisitions, if cash flow from operating activities becomes insufficient to fund current operations or for other short-term cash needs or for stock repurchases or dividends. Our future leverage will also be impacted by the then current conditions of the credit markets. Operating Activities . The Company generated $788.7 million of net cash from operating activities during fiscal 2017 compared to $683.3 million during fiscal 2016 , a net increase of $105.4 million . The net increase is primarily attributable to an increase in income from continuing operations and items adjusting net income for non-cash expenses and income of $38.8 million , and favorable changes in trade accounts receivable, inventories, and accounts payable of $28.9 million , net. The change in trade accounts receivable during fiscal 2017 was a use of $54.7 million in cash compared to a use of cash of $80.1 million in fiscal 2016, which is a reduction to the use of cash of $25.4 million year over year. The lower use of cash in fiscal 2017 compared to fiscal 2016 is attributable to the timing of sales and collections on trade accounts receivable. The change in inventories was a source of cash of $5.1 million in fiscal 2017 compared to a use of cash of $2.1 million in fiscal 2016, which is attributable to increased monitoring of inventory management. The change in accounts payable during fiscal 2017 was a use of cash of $10.4 million compared to a use of cash of $6.7 million in fiscal 2016. The increase in the use of cash was primarily attributable the timing of payments to vendors. The Company generated $683.3 million of net cash from operating activities during fiscal 2016 compared to $520.9 million during fiscal 2015 . The net increase of $162.4 million was due primarily to an increase in income from continuing operations. Investing Activities. Net cash used in investing activities was $287.0 million during fiscal 2017 primarily consisting of capital expenditures of $71.0 million , cash paid in connection with the Third Quarter 2017 Acquisitions of $106.3 million, the Schroth acquisition of $79.7 million and the cash settlement of the Breeze-Eastern dissenting shares litigation of $28.7 million. The Company expects its capital expenditures in fiscal year 2018 to be between $85 million and $95 million. The Company’s capital expenditures incurred from year to year are primarily for projects that are consistent with our three core value-driven operating strategies (obtaining profitable new business, continually improve our cost structure and providing highly engineered value-added products to customers). 35 Net cash used in investing activities was $1,443.0 million during fiscal 2016 consisting primarily of the acquisitions of Breeze-Eastern, DDC and Y&F/Tactair for a total of $1,399.1 million and capital expenditures of $44.0 million . Net cash used in investing activities was $1,679.1 million during fiscal 2015 consisting primarily of the acquisitions of Telair Cargo Group, Adams Rite Aerospace GmbH, Pexco Aerospace and PneuDraulics for a total of $1,624.3 million and capital expenditures of $54.9 million . Financing Activities . Net cash used in financing activities during the fiscal year ended September 30, 2017 was $1,443.7 million . The use of cash was primarily related to the aggregate payment of $2,581.6 million for a $24.00 per share special dividend declared and paid during the first quarter of fiscal 2017 and a $22.00 per share special dividend declared and paid in the fourth quarter of fiscal 2017 and dividend equivalent payments. Also contributing to the use of cash was $1,284.7 million in debt service payments on the existing term loans and the remaining principal on the Tranche C Term Loans, redemption and related premium paid on the 2021 Notes aggregating to $528.8 million and $389.8 million related to treasury stock purchases under the Company's share repurchase program. Slightly offsetting the uses of cash were net proceeds from the 2017 term loans (Tranche F and Tranche G Term Loans) of $2,937.7 million and the additional 2025 Notes offering of $300.4 million , $99.5 million in net proceeds from an additional A/R Securitization draw in the fourth quarter of fiscal 2017 and $21.2 million in proceeds from stock option exercises. Net cash provided by financing activities during the fiscal year ended September 30, 2016 was $1,632.5 million , which primarily comprised of net proceeds from the 2016 term loans of $1,711.5 million , net proceeds from our 2026 Notes of $939.6 million , and $30.1 million of cash proceeds from the exercise of stock options. These increases were partially offset by $834.4 million of repayments on our existing term loans, $207.8 million in treasury stock purchases under the Company’s share repurchase programs, $3.0 million in dividend equivalent payments and the impact from the adoption of ASU 2016-09 which resulted in the excess tax benefits related to share-based payment arrangements being classified within operating activities beginning in fiscal 2016. Net cash provided by financing activities during the fiscal year ended September 30, 2015 was $1,054.9 million , which was comprised of $1,516.0 million in net proceeds under our Tranche E Term Loans, $445.3 million of net proceeds from our 2025 Notes, and $123.6 million of cash for tax benefits related to share-based payment arrangements and from the exercise of stock options slightly offset by $1,025.3 million of repayments on our term loans and $3.4 million in dividend equivalent payments. Description of Senior Secured Term Loans and Indentures Senior Secured Credit Facilities On October 14, 2016, the Company entered into the Assumption Agreement with Credit Suisse AG, as administrative agent and collateral agent, and as a lender, in connection with the 2016 term loans. The Assumption Agreement, among other things, provided for (i) additional tranche F term loans in an aggregate principal amount equal to $650 million, which were fully drawn on October 14, 2016, and (ii) additional delayed draw tranche F term loans in an aggregate principal amount not to exceed $500 million, which were fully drawn on October 27, 2016. The terms and conditions that apply to the additional tranche F term loans and the additional delayed draw tranche F term loans are substantially the same as the terms and conditions that apply to the tranche F term loans under the 2016 term loans immediately prior to the Assumption Agreement. On March 6, 2017, TD Group and certain subsidiaries of TransDigm entered into Amendment No. 2 to the Second Amended and Restated Credit Agreement (“Amendment No. 2”. Refer to Note 11, “Debt,” in the consolidated financial statements included within this Form 10-K for further information regarding the authorized dividends and share repurchases and the increase to the general investment basket established by Amendment No. 2. On August 22, 2017, the Company entered into Amendment No. 3 and Incremental Term Loan Assumption Agreement to the Second Amended and Restated Credit Agreement (“Amendment No. 3”). Pursuant to Amendment No. 3, TransDigm, among other things, incurred the new tranche G term loans (the “Tranche G Term Loans”) in an aggregate principal amount equal to approximately $1.8 billion and repaid in full all of the Tranche C term loans outstanding under the Restated Credit Agreement. The Tranche G Term Loans were fully drawn on August 22, 2017. The Tranche G Term Loans mature on August 22, 2024. The terms and conditions (other than maturity date) that apply to the Tranche G Term Loans, including pricing, are substantially the same as the terms and conditions that applied to the Tranche C term loans immediately prior to Amendment No. 3. Amendment No. 3 also permitted (a) payment of a special dividend, share repurchase, or combination thereof, in an aggregate amount up to approximately $1.3 billion within 60 days of the effective date of Amendment No. 3, and (b) certain additional restricted payments, including the ability of the Company to declare or pay dividends or repurchase stock, in an aggregate amount not to exceed $1.5 billion within twelve months of the effective date of Amendment No. 3 provided that, among other conditions, if such additional loans are to be used by the Company to repurchase shares of its capital stock, the consolidated secured net debt ratio would be no greater than 4.00 to 1.00 and if such additional terms loans are to be used by TD Group to pay dividends or other distributions on or in respect of its capital stock, the consolidated net leverage ratio would be no greater than 6.00 to 1.00, in each case, after giving effect to such incremental term loans. If any portion of the $1.5 billion is not used for dividends or share repurchases over such twelve month period, such amount (not to exceed $500 million) may be used to repurchase stock at any time thereafter. 36 TransDigm has $6,973.0 million in fully drawn term loans (the “Term Loans Facility”) and a $600 million revolving credit facility. The Term Loans Facility consists of four tranches of term loans as follows (aggregate principal amount disclosed is as of September 30, 2017 ): Term Loans Facility | Aggregate Principal | Maturity Date | Interest Rate --------------------+---------------------+-----------------+---------------------- Tranche D | $798 million | June 4, 2021 | LIBO rate (1) + 3.00% --------------------+---------------------+-----------------+---------------------- Tranche E | $1,503 million | May 14, 2022 | LIBO rate (1) + 3.00% --------------------+---------------------+-----------------+---------------------- Tranche F | $2,857 million | June 9, 2023 | LIBO rate (1) + 3.00% --------------------+---------------------+-----------------+---------------------- Tranche G | $1,815 million | August 22, 2024 | LIBO rate (1) + 3.00% --------------------+---------------------+-----------------+---------------------- (1) | LIBO rate is subject to a floor of 0.75%. ----+------------------------------------------ The Term Loans Facility requires quarterly aggregate principal payments of $17.5 million. The revolving commitments consist of two tranches which include up to $100 million of multicurrency revolving commitments. At September 30, 2017 , the Company had $15.7 million in letters of credit outstanding and $584.3 million in borrowings available under the revolving commitments. The interest rates per annum applicable to the loans under the Credit Agreement are, at TransDigm’s option, equal to either an alternate base rate or an adjusted LIBO rate for one, two, three or six-month (or to the extent agreed to by each relevant lender, nine or twelve-month) interest periods chosen by TransDigm, in each case plus an applicable margin percentage. The adjusted LIBO rate is subject to a floor of 0.75%. For the fiscal year 2017, the applicable interest rates ranged from approximately 3.75% to 4.26% on the existing term loans. Under the terms of the Credit Agreement, TransDigm is entitled, on one or more occasions, to request additional term loans or additional revolving commitments to the extent that the existing or new lenders agree to provide such incremental term loans or additional revolving commitments provided that, among other conditions, our consolidated net leverage ratio would be no greater than 7.25 to 1.00 and the consolidated secured net debt ratio would be no greater than 4.25 to 1.00, in each case, after giving effect to such incremental term loans or additional revolving commitments The Credit Agreement requires mandatory prepayments of principal based on certain percentages of Excess Cash Flow (as defined in the Credit Agreement), commencing 90 days after the end of each fiscal year, subject to certain exceptions. In addition, subject to certain exceptions (including, with respect to asset sales, the reinvestment in productive assets), TransDigm will be required to prepay the loans outstanding under the Credit Agreement at 100% of the principal amount thereof, plus accrued and unpaid interest, with the net cash proceeds of certain asset sales and issuance or incurrence of certain indebtedness. No matters mandating prepayments occurred during the year ended September 30, 2017 . Interest rate swaps and caps used to hedge and offset, respectively, the variable interest rates on the credit facility are described in Note 20, “Derivatives and Hedging Activities” to the consolidated financial statements included herein. Indentures Senior Subordinated Notes | Aggregate Principal | Maturity Date | Interest Rate --------------------------+---------------------+------------------+-------------- 2020 Notes | $550 million | October 15, 2020 | 5.50% --------------------------+---------------------+------------------+-------------- 2022 Notes | $1,150 million | July 15, 2022 | 6.00% --------------------------+---------------------+------------------+-------------- 2024 Notes | $1,200 million | July 15, 2024 | 6.50% --------------------------+---------------------+------------------+-------------- 2025 Notes | $750 million | May 15, 2025 | 6.50% --------------------------+---------------------+------------------+-------------- 2026 Notes | $950 million | June 15, 2026 | 6.375% --------------------------+---------------------+------------------+-------------- The 2020 Notes, the 2022 Notes, the 2024 Notes, and the 2026 Notes (the “Notes”) were issued at an issue price of 100% of the principal amount. The initial $450 million offering of the 2025 Notes (also considered to be part of the “Notes”) were issued at an issue price of 100% of the principal amount and the subsequent $300 million offering in the quarter ended April 1, 2017 of 2025 Notes (further described below) were issued at an issue price of 101.5% of the principal amount. Such Notes do not require principal payments prior to their maturity. Interest under the Notes is payable semi-annually. The Notes represent unsecured obligations of TransDigm Inc. ranking subordinate to TransDigm Inc.’s senior debt, as defined in the applicable Indentures. The Notes are subordinated to all of TransDigm’s existing and future senior debt, rank equally with all of its existing and future senior subordinated debt and rank senior to all of its future debt that is expressly subordinated to the Notes. The Notes are guaranteed on a senior subordinated unsecured basis by TD Group and its wholly-owned domestic subsidiaries named in the indentures. The guarantees of the Notes are subordinated to all of the guarantors’ existing and future senior debt, rank equally with 37 all of their existing and future senior subordinated debt and rank senior to all of their future debt that is expressly subordinated to the guarantees of the Notes. The Notes are structurally subordinated to all of the liabilities of TD Group’s non-guarantor subsidiaries. The Notes contain many of the restrictive covenants included in the Credit Agreement. TransDigm is in compliance with all the covenants contained in the Notes. During the first quarter of fiscal 2017, the Company offered to purchase in a cash tender offer all of its previously outstanding 2021 Notes with a portion of the proceeds received from the Incremental Term Loan Assumption Agreement. During the second quarter of fiscal 2017, the Company issued $300 million in aggregate principal of its 2025 Notes at a premium of 1.5%, resulting in gross proceeds of $304.5 million. The new notes offered were an additional issuance of our existing 2025 Notes and were issued under the same indenture as the original issuance of the $450 million of 2025 Notes. With these additional Notes, there is a total of $750 million in aggregate principal amount of 2025 Notes. Certain Restrictive Covenants in Our Debt Documents The Credit Agreement and the Indentures governing the Notes contain restrictive covenants that, among other things, limit the incurrence of additional indebtedness, the payment of dividends, transactions with affiliates, asset sales, acquisitions, mergers and consolidations, liens and encumbrances, and prepayments of certain other indebtedness. Pursuant to the Credit Agreement, prior to Amendment No. 2 and Amendment No. 3 as described below, and subject to certain conditions, TransDigm was permitted to make certain additional restricted payments, including to declare or pay dividends or repurchase stock, in an aggregate amount not to exceed $1,500 million on or prior to December 31, 2016. Subsequent to December 31, 2016, the aggregate amount of restricted payments remaining, not to exceed $500 million, were permissible solely to the extent that the proceeds were used to repurchase stock. The total restricted payments, as described above, made prior to December 31, 2016 totaled $1,326 million (all related to the special dividend payment and dividend equivalent payments). The remaining $50 million in dividend equivalent payments made in the quarter ended December 31, 2016 were applied against allowable restricted payments that carried over from previous years under our Credit Agreement. During January 2017, $150 million in stock repurchases were made (up to $174 million in stock repurchases were allowable) under this agreement. On March 6, 2017, TD Group and certain subsidiaries of TransDigm entered into Amendment No. 2. Amendment No. 2 permitted, among other things, up to $1.5 billion of dividends and share repurchases on or prior to March 6, 2018. If any portion of the $1.5 billion was not used for dividends or share repurchases by March 6, 2018, such amount (not to exceed $500 million) may be used to repurchase stock at any time thereafter. On August 22, 2017, the Company entered into Amendment No. 3. Pursuant to Amendment No. 3, TransDigm, among other things, incurred the Tranche G Term Loans in an aggregate principal amount equal to approximately $1.8 billion and repaid in full all of the Tranche C term loans outstanding under the Credit Agreement. The Tranche G Term Loans were fully drawn on August 22, 2017. The Tranche G Term Loans mature on August 22, 2024. The terms and conditions (other than maturity date) that applied to the Tranche G Term Loans, including pricing, are substantially the same as the terms and conditions that apply to the Tranche C term loans immediately prior to Amendment No. 3. Amendment No. 3 also permitted (a) payment of a special dividend, share repurchase, or combination thereof, in an aggregate amount up to approximately $1.3 billion within 60 days of the effective date of Amendment No. 3, and (b) certain additional restricted payments, including the ability of the Company to declare or pay dividends or repurchase stock, in an aggregate amount not to exceed $1.5 billion within twelve months of the effective date of Amendment No. 3. If any portion of such $1.5 billion is not used for dividends or share repurchases over such twelve month period, such amount (not to exceed $500 million) may be used to repurchase stock at any time thereafter. In addition, under the Credit Agreement, if the usage of the revolving credit facility exceeds 25% of the total revolving commitments, the Company will be required to maintain a maximum consolidated net leverage ratio of net debt, as defined, to trailing four-quarter EBITDA As Defined. A breach of any of the covenants or an inability to comply with the required leverage ratio could result in a default under the Credit Agreement or the Indentures. If any such default occurs, the lenders under the Credit Agreement and the holders of the Notes may elect to declare all outstanding borrowings, together with accrued interest and other amounts payable thereunder, to be immediately due and payable. The lenders under the Credit Agreement also have the right in these circumstances to terminate any commitments they have to provide further borrowings. In addition, following an event of default under the Credit Agreement, the lenders thereunder will have the right to proceed against the collateral granted to them to secure the debt, which includes our available cash, and they will also have the right to prevent us from making debt service payments on the Notes. As of September 30, 2017 , the Company was in compliance with all of its debt covenants. Trade Receivables Securitization For information about our trade receivables securitization, see Note 11, “Debt,” to our consolidated financial statements included herein. 38 Stock Repurchase Program For information about our stock repurchase programs, see Note 15, “Capital Stock,” to our consolidated financial statements included herein. Contractual Obligations The following is a summary of contractual cash obligations as of September 30, 2017 (in millions): | 2018 | | 2019 | | 2020 | | 2021 | 2022 | | 2023 andthereafter | Total -----------------------------------+-------+---------+------+-------+------+-------+-------+------+-------+--------------------+-------- Senior Secured Term Loans(1) | $ | 70.0 | | | $ | 70.0 | | $ | 70.0 | | $ | 835.2 | | $ | 1,491.8 | | $ | 4,435.9 | $ | 6,973.0 -----------------------------------+-------+---------+------+-------+------+-------+-------+------+-------+--------------------+---------+---------+---------+---+---------+---------+---+---------+---+--------- 2020 Notes | — | | | — | | | — | | 550.0 | | — | | — | | | 550.0 -----------------------------------+-------+---------+------+-------+------+-------+-------+------+-------+--------------------+---------+---------+---------+---+---------+-------- 2022 Notes | — | | | — | | | — | | — | | 1,150.0 | | — | | | 1,150.0 -----------------------------------+-------+---------+------+-------+------+-------+-------+------+-------+--------------------+---------+---------+---------+---+---------+-------- 2024 Notes | — | | | — | | | — | | — | | — | | 1,200.0 | | | 1,200.0 -----------------------------------+-------+---------+------+-------+------+-------+-------+------+-------+--------------------+---------+---------+---------+---+---------+-------- 2025 Notes | — | | | — | | | — | | — | | — | | 750.0 | | | 750.0 -----------------------------------+-------+---------+------+-------+------+-------+-------+------+-------+--------------------+---------+---------+---------+---+---------+-------- 2026 Notes | — | | | — | | | — | | — | | — | | 950.0 | | | 950.0 -----------------------------------+-------+---------+------+-------+------+-------+-------+------+-------+--------------------+---------+---------+---------+---+---------+-------- Securitization Facility | 300.0 | | | — | | | — | | — | | — | | — | | | 300.0 -----------------------------------+-------+---------+------+-------+------+-------+-------+------+-------+--------------------+---------+---------+---------+---+---------+-------- Scheduled Interest Payments(2) | 628.1 | | | 631.4 | | | 632.7 | | 594.0 | | 519.9 | | 762.7 | | | 3,768.8 -----------------------------------+-------+---------+------+-------+------+-------+-------+------+-------+--------------------+---------+---------+---------+---+---------+-------- Operating Leases | 18.0 | | | 17.5 | | | 14.6 | | 12.6 | | 11.5 | | 33.6 | | | 107.8 -----------------------------------+-------+---------+------+-------+------+-------+-------+------+-------+--------------------+---------+---------+---------+---+---------+-------- Purchase Obligations | 249.0 | | | 41.6 | | | 26.2 | | 33.6 | | 17.1 | | — | | | 367.5 -----------------------------------+-------+---------+------+-------+------+-------+-------+------+-------+--------------------+---------+---------+---------+---+---------+-------- Total Contractual Cash Obligations | $ | 1,265.1 | | | $ | 760.5 | | $ | 743.5 | | $ | 2,025.4 | | $ | 3,190.3 | | $ | 8,132.2 | $ | 16,117.1 -----------------------------------+-------+---------+------+-------+------+-------+-------+------+-------+--------------------+---------+---------+---------+---+---------+---------+---+---------+---+--------- (1) | The Tranche D Term Loans mature in June 2021, the Tranche E Term Loans mature in May 2022, the Tranche F Term Loans mature in June 2023, and the Tranche G Term Loans mature in August 2024. The term loans require quarterly principal payments totaling $17.5 million. ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (2) | Assumes that the variable interest rate on our Tranche D, Tranche E, Tranche F and Tranche G borrowings under our Senior Secured Term Loans range from approximately 4.37% to 4.92% based on anticipated movements in the LIBO rate. In addition, interest payments include the impact of the existing interest rate swap and cap agreements described in Note 20, “Derivatives and Hedging Activities” to the consolidated financial statements herein. ----+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- In addition to the contractual obligations set forth above, the Company incurs capital expenditures for the purpose of maintaining and replacing existing equipment and facilities and, from time to time, for facility expansion. Capital expenditures totaled approximately $71.0 million , $44.0 million , and $54.9 million during fiscal years 2017 , 2016 , and fiscal 2015 , respectively. The Company expects its capital expenditures in fiscal year 2018 to be between $85 million and $95 million. Off-Balance Sheet Arrangements The Company utilizes letters of credit to back certain payment and performance obligations. Letters of credit are subject to limits based on amounts outstanding under the Company’s revolving credit facility. New Accounting Standards For information about new accounting standards, see Note 4, “Recent Accounting Pronouncements,” to our consolidated financial statements included herein. Additional Disclosure Required by Indentures Separate financial statements of TransDigm Inc. are not presented since TD Group has no operations or significant assets separate from its investment in TransDigm Inc. and since the Notes are guaranteed by TD Group and all direct and indirect domestic restricted subsidiaries of TransDigm Inc. TransDigm Inc.’s immaterial wholly owned foreign subsidiaries are not obligated to guarantee the Notes. 39 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Interest Rate Risk Our main exposure to market risk relates to interest rates. Our financial instruments that are subject to interest rate risk principally include fixed-rate and floating-rate long-term debt. At September 30, 2017 , we had borrowings under our term loans of approximately $6,973 million that were subject to interest rate risk. Borrowings under our term loans bear interest, at our option, at a rate equal to either an alternate base rate or an adjusted LIBOR for a one-, two-, three- or six-month (or to the extent available to each lender, nine- or twelve-month) interest period chosen by us, in each case, plus an applicable margin percentage. Accordingly, the Company’s cash flows and earnings will be exposed to the market risk of interest rate changes resulting from variable rate borrowings under our term loans. The effect of a hypothetical one percentage point increase in interest rates would increase the annual interest costs under our term loans by approximately $67 million based on the amount of outstanding borrowings at September 30, 2017 . The weighted average interest rate on the $6,973 million of borrowings under our term loans on September 30, 2017 was 4.5%. Interest rate swaps and caps used to hedge and offset, respectively, the variable interest rates on the credit facility are described in Note 20, “Derivatives and Hedging Activities,” to our consolidated financial statements included herein. We do not hold or issue derivative instruments for speculative purposes. For information about the fair value of the aggregate principal amount of borrowings under our term loans and the fair value of the Notes, see Note 19, “Fair Value Measurements,” to our consolidated financial statements included herein. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this Item is contained on pages F-1 through F-42 of this Report. ITEM 9. | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE --------+------------------------------------------------------------------------------------- None. ITEM 9A. CONTROLS AND PROCEDURES Evaluation of Disclosure Controls and Procedures As of September 30, 2017 , TD Group carried out an evaluation, under the supervision and with the participation of TD Group’s management, including its Chief Executive Officer (Principal Executive Officer) and Chief Financial Officer (Principal Financial Officer), of the effectiveness of the design and operation of TD Group’s disclosure controls and procedures. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that TD Group’s disclosure controls and procedures are effective to ensure that information required to be disclosed by TD Group in the reports it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified by the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to TD Group’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, TD Group’s management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in designing and evaluating the controls and procedures. Management’s Report on Internal Control Over Financial Reporting The management of TD Group is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Exchange Act Rule 13a-15(f). Using criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (COSO) in Internal Control-Integrated Framework, TransDigm’s management assessed the effectiveness of the Company’s internal control over financial reporting as of September 30, 2017 . Based on our assessment, management concluded that the Company’s internal control over financial reporting was effective as of September 30, 2017 . During fiscal 2017 , we completed the acquisitions of Schroth and the Third Quarter 2017 Acquisitions. The results of operations are included in our consolidated financial statements from the date of acquisition. As permitted by the Securities and Exchange Commission, we have elected to exclude Schroth and the Third Quarter 2017 Acquisitions from our assessment of the effectiveness of our internal control over financial reporting as of September 30, 2017 . Total assets as of September 30, 2017 and revenues for the fiscal year ended September 30, 2017 for these fiscal 2017 acquisitions constituted 2% and 1%, respectively, of each of these key measures as reported in our consolidated financial statements. 40 The effectiveness of the Company’s internal control over financial reporting as of September 30, 2017 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report, which is included elsewhere in this Annual Report on Form 10-K and is incorporated herein by reference. Changes in Internal Control Over Financial Reporting There have been no changes in the Company’s internal control over financial reporting that occurred during the fourth quarter of fiscal 2017 that materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. 41 Report of Independent Registered Public Accounting Firm The Board of Directors and Shareholders of TransDigm Group Incorporated We have audited TransDigm Group Incorporated’s internal control over financial reporting as of September 30, 2017, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). TransDigm Group Incorporated’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with policies and procedures may deteriorate. As indicated in the accompanying Management’s Report on Internal Control Over Financial Reporting, management’s assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of Schroth and the Third Quarter 2017 Acquisitions, which are included in the 2017 consolidated financial statements of TransDigm Group Incorporated and constituted 2% of total assets as of September 30, 2017 and 1% of revenues for the year then ended. Our audit of internal control over financial reporting of TransDigm Group Incorporated also did not include an evaluation of the internal control over financial reporting of Schroth or the Third Quarter 2017 Acquisitions. In our opinion, TransDigm Group Incorporated maintained, in all material respects, effective internal control over financial reporting as of September 30, 2017, based on the COSO criteria . We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of TransDigm Group Incorporated as of September 30, 2017 and 2016, and the related consolidated statements of income, comprehensive income, changes in stockholders’ deficit and cash flows for each of the three years in the period ended September 30, 2017 of TransDigm Group Incorporated and our report dated November 13, 2017 expressed an unqualified opinion thereon . /s/ Ernst & Young LLP Cleveland, Ohio November 13, 2017 42 ITEM 9B. OTHER INFORMATION None. PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS, AND CORPORATE GOVERNANCE Directors and Executive Officers Information regarding TD Group’s directors will be set forth under the caption “Proposal One: Election of Directors” in our Proxy Statement, which is incorporated herein by reference. The following table sets forth certain information concerning TD Group’s executive officers: Name | Age | Position ---------------------+-----+------------------------------------------------------------------------- W. Nicholas Howley | 65 | Chief Executive Officer and Chairman of the Board of Directors ---------------------+-----+------------------------------------------------------------------------- Robert S. Henderson | 61 | Vice Chairman ---------------------+-----+------------------------------------------------------------------------- Kevin Stein | 51 | President and Chief Operating Officer ---------------------+-----+------------------------------------------------------------------------- Terrance M. Paradie | 49 | Executive Vice President and Chief Financial Officer ---------------------+-----+------------------------------------------------------------------------- Bernt G. Iversen II | 60 | Executive Vice President—Mergers & Acquisitions and Business Development ---------------------+-----+------------------------------------------------------------------------- James Skulina | 58 | Executive Vice President ---------------------+-----+------------------------------------------------------------------------- Peter Palmer | 53 | Executive Vice President ---------------------+-----+------------------------------------------------------------------------- Jorge Valladares III | 43 | Executive Vice President ---------------------+-----+------------------------------------------------------------------------- Roger V. Jones | 57 | Executive Vice President ---------------------+-----+------------------------------------------------------------------------- Joel Reiss | 47 | Executive Vice President ---------------------+-----+------------------------------------------------------------------------- Mr. Howley was named Chairman of the Board of Directors of TD Group in July 2003. He has served as Chief Executive Officer of TD Group since December 2005 and of TransDigm Inc. since December 2001. Mr. Howley served as President of TD Group from July 2003 through December 2015, as Chief Operating Officer of TransDigm Inc. from December 1998 through December 2001 and as President of TransDigm Inc. from December 1998 through September 2005. Mr. Howley was a director of Polypore International Inc., a NYSE-listed manufacturer of polymer-based membranes used in separation and filtration processes through October 2012. Mr. Howley was a director of Satair A/S, a Danish public company that is an aerospace distributor, including a distributor of the Company’s products through October 2011. Mr. Henderson was appointed Vice Chairman in January 2017. Prior to that, Mr. Henderson served as Chief Operating Officer—Airframe from October 2014 to December 2016. Mr. Henderson also previously served as Executive Vice President from December 2005 to October 2014, and as President of the AdelWiggins Group, a division of TransDigm Inc., from August 1999 to April 2008. Mr. Stein was appointed President and Chief Operating Officer in January 2017. Prior to that, Mr. Stein served as Chief Operating Officer—Power from October 2014 to December 2016. Prior to joining TransDigm, Mr. Stein served as Executive Vice President and President of the Structurals division of Precision Castparts Corp. from November 2011 to October 2014 and Executive Vice President and President of the Fasteners division of Precision Castparts Corp. from January 2009 through November 2011. Mr. Paradie was appointed Executive Vice President and Chief Financial Officer in April 2015. Prior to joining TransDigm, Mr. Paradie held various titles at Cliffs Natural Resources Inc., a NYSE-listed international mining company, including Chief Financial Officer (from October 2012 to April 2015) and Executive Vice President (from March 2013 to April 2015). Mr. Iversen was appointed Executive Vice President—Mergers & Acquisitions and Business Development in May 2012. Prior to that, Mr. Iversen served as Executive Vice President of TD Group from December 6, 2010 through May 2012 and as President of Champion Aerospace LLC, a wholly-owned subsidiary of TransDigm Inc., from June 2006 to December 2010. Mr. Skulina was appointed Executive Vice President in January 2012. Prior to that, Mr. Skulina served as President of the Aero Fluid Products division of AeroControlex Group, Inc., a wholly-owned subsidiary of TransDigm Inc., from September 2009 to December 2011, and as Controller of TransDigm Inc., from August 2007 to August 2009. Mr. Palmer was appointed Executive Vice President in February 2012. Prior to that, Mr. Palmer served as President of AdelWiggins Group, a division of TransDigm Inc., from April 2010 to February 2012, and as President of CEF Industries, LLC, a wholly-owned subsidiary of TransDigm Inc., from June 2008 to March 2010. Mr. Valladares was appointed Executive Vice President in October 2013. Prior to that, Mr. Valladares served as President of AvtechTyee, Inc. (formerly Avtech Corporation), a wholly-owned subsidiary of TransDigm Inc., from August 2009 to September 2013, and as President of AdelWiggins Group, a division of TransDigm Inc., from April 2008 to July 2009. 43 Mr. Jones was appointed Executive Vice President in October 2015. Prior to that, Mr. Jones served as President of AeroControlex, a wholly-owned subsidiary of TransDigm Inc., from September 2009 to October 2015. Mr. Reiss was appointed Executive Vice President in October 2015. Prior to that, Mr. Reiss served as President of Hartwell Corporation, a wholly-owned subsidiary of TransDigm Inc., from May 2012 to October 2015, and as President of Skurka Aerospace, also a wholly-owned subsidiary of TransDigm Inc., from July 2010 to May 2012. Section 16(a) Beneficial Ownership Reporting Compliance The information regarding compliance with Section 16 of the Securities Exchange Act of 1934 will be set forth under the caption entitled “Section 16(a) Beneficial Ownership Reporting Compliance” in our Proxy Statement, which is incorporated herein by reference. Code of Ethics We have adopted a Code of Business Conduct and Ethics, which applies to all of our directors, officers, and employees and a Code of Ethics for Senior Financial Officers which includes additional ethical obligations for our senior financial management (which includes our chief executive officer, president, chief financial officer, division presidents, controllers, treasurer, and chief internal auditor). Please refer to the information set forth under the caption “Corporate Governance—Codes of Ethics & Whistleblower Policy” in our Proxy Statement, which is incorporated herein by reference. Our Code of Business Conduct and Ethics and our Code of Ethics for Senior Financial Officers is available on our website at www.transdigm.com . Any person may receive a copy without charge by writing to us at TransDigm Group Incorporated, 1301 East 9 th Street, Suite 3000, Cleveland, Ohio 44114. We intend to disclose on our website any amendment to, or waiver from, a provision of our Code of Business Conduct and Ethics that applies to directors and executive officers and that is required to be disclosed pursuant to the rules of the Securities and Exchange Commission. Nominations of Directors The procedure by which stockholders may recommend nominees to our Board of Directors will be set forth under the caption “Corporate Governance-Board Committees—Nominating and Corporate Governance Committee” in our Proxy Statement, which is incorporated herein by reference. Audit Committee The information regarding the audit committee of our Board of Directors and audit committee financial experts will be set forth under the caption “Corporate Governance-Board Committees—Audit Committee” in our Proxy Statement, which is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION The information required by this item will be set forth under the captions “Executive Compensation”, “Compensation of Directors”, “Compensation Committee Interlocks and Insider Participation” and “Compensation Committee Report” in our Proxy Statement, which is incorporated herein by reference. 44 ITEM 12. | SECURITY OWNERSHIP OF BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS ---------+--------------------------------------------------------------------------------------- The information regarding security ownership of certain beneficial owners and management will be set forth under the caption “Security Ownership of Certain Beneficial Owners and Management” in our Proxy Statement, which is incorporated herein by reference. Equity Compensation Plan Information Plan category | Number of Securities to Be Issued upon Exercise of Outstanding Options, Warrants and Rights(a) | Weighted-Average Exercise Price of Outstanding Options, Warrants and Rights(b) | | Number of Securities Remaining Available for Future Issuance Under Equity Compensation Plans (excluding securities reflected in column (a))(c) ----------------------------------------------------------+------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------+---+----------------------------------------------------------------------------------------------------------------------------------------------- Equity compensation plans approved by security holders(1) | 5,726,002 | (2) | $ | 154.58 | 4,137,011 | (3) ----------------------------------------------------------+------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------+---+------------------------------------------------------------------------------------------------------------------------------------------------+-----------+---- (1) | Includes information related to the 2003 stock option plan, the 2006 stock incentive plan and the 2014 stock option plan. ----+-------------------------------------------------------------------------------------------------------------------------- (2) | This amount represents 77,829, 4,786,114 and 862,059 shares subject to outstanding stock options under our 2003 stock option plan, 2006 stock incentive plan and 2014 stock option plan, respectively. No further grants may be made under our 2003 stock option plan and 2006 stock incentive plan, although outstanding stock options continue in force in accordance with their terms. ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ (3) | This amount represents remaining shares available for award under our 2014 stock option plan. ----+---------------------------------------------------------------------------------------------- ITEM 13. | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE ---------+-------------------------------------------------------------------------- The information required by this item will be set forth under the captions entitled “Certain Relationships and Related Transactions,” “Compensation of Directors,” and “Independence of Directors” in our Proxy Statement, which is incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES The information required by this item will be set forth under the caption “Principal Accounting Fees and Services” in our Proxy Statement, which is incorporated herein by reference. 45 PART IV ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (a) Documents Filed with Report (a) (1) Financial Statements | Page ---------------------------------------------------------------------------------------------------------------------+------------------ Report of Independent Registered Public Accounting Firm | F-1 ---------------------------------------------------------------------------------------------------------------------+------------------ Consolidated Balance Sheets as of September 30, 2017 and 2016 | F-2 ---------------------------------------------------------------------------------------------------------------------+------------------ Consolidated Statements of Income for Fiscal Years Ended September 30, 2017, 2016 and 2015 | F-3 ---------------------------------------------------------------------------------------------------------------------+------------------ Consolidated Statements of Comprehensive Income for Fiscal Years Ended September 30, 2017, 2016 and 2015 | F-4 ---------------------------------------------------------------------------------------------------------------------+------------------ Consolidated Statements of Changes in Stockholders’ Deficit for Fiscal Years Ended September 30, 2017, 2016 and 2015 | F-5 ---------------------------------------------------------------------------------------------------------------------+------------------ Consolidated Statements of Cash Flows for Fiscal Years Ended September 30, 2017, 2016 and 2015 | F-6 ---------------------------------------------------------------------------------------------------------------------+------------------ Notes to Consolidated Financial Statements for Fiscal Years Ended September 30, 2017, 2016 and 2015 | pages F-7 to F-41 ---------------------------------------------------------------------------------------------------------------------+------------------ (a) (2) Financial Statement Schedules | ---------------------------------------------------------------------------------------------------------------------+------------------ Valuation and Qualifying Accounts for the Fiscal Years Ended September 30, 2017, 2016 and 2015 | F-42 ---------------------------------------------------------------------------------------------------------------------+------------------ 46 (a) (3) Exhibits Exhibit No. | Description | Filed Herewith or Incorporated by Reference From ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 2.1 | Purchase Agreement, dated February 20, 2015, among AAR International, Inc., AAR Manufacturing, Inc., TransDigm Inc. and TransDigm Germany GmbH | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed February 24, 2015 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 2.2 | Agreement and Plan of Merger dated as of May 23, 2016 among TransDigm Inc., Thunder Merger Sub Inc., ILC Holdings, Inc. and Behrman Capital PEP L.P. | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed May 26, 2016 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.1 | Second Amended and Restated Certificate of Incorporation, filed April 28, 2014, of TransDigm Group Incorporated | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed April 28, 2014 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.2 | Second Amended and Restated Bylaws of TransDigm Group Incorporated | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed April 28, 2014 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.3 | Certificate of Incorporation, filed July 2, 1993, of NovaDigm Acquisition, Inc. (now known as TransDigm Inc.) | Incorporated by reference to TransDigm Inc. and TransDigm Holding Company’s Form S-4 filed January 29, 1999 (File No. 333-71397) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.4 | Certificate of Amendment, filed July 22, 1993, of the Certificate of Incorporation of NovaDigm Acquisition, Inc. (now known as TransDigm Inc.) | Incorporated by reference to TransDigm Inc. and TransDigm Holding Company’s Form S-4 filed January 29, 1999 (File No. 333-71397) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.5 | Bylaws of NovaDigm Acquisition, Inc. (now known as TransDigm Inc.) | Incorporated by reference to TransDigm Inc. and TransDigm Holding Company’s Form S-4 filed January 29, 1999 (File No. 333-71397) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.6 | Certificate of Incorporation, filed July 10, 2009, of Acme Aerospace Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed August 5, 2009 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.7 | Bylaws of Acme Aerospace Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed August 5, 2009 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.8 | Articles of Incorporation, filed July 30, 1986, of ARP Acquisition Corporation (now known as Adams Rite Aerospace, Inc.) | Incorporated by reference to TransDigm Inc. and TransDigm Holding Company’s Form S-4 filed January 29, 1999 (File No. 333-71397) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.9 | Certificate of Amendment, filed September 12, 1986, of the Articles of Incorporation of ARP Acquisition Corporation (now known as Adams Rite Aerospace, Inc.) | Incorporated by reference to TransDigm Inc. and TransDigm Holding Company’s Form S-4 filed January 29, 1999 (File No. 333-71397) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.10 | Certificate of Amendment, filed January 27, 1992, of the Articles of Incorporation of Adams Rite Products, Inc. (now known as Adams Rite Aerospace, Inc.) | Incorporated by reference to TransDigm Inc. and TransDigm Holding Company’s Form S-4 filed January 29, 1999 (File No. 333-71397) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.11 | Certificate of Amendment, filed December 31, 1992, of the Articles of Incorporation of Adams Rite Products, Inc. (now known as Adams Rite Aerospace, Inc.) | Incorporated by reference to TransDigm Inc. and TransDigm Holding Company’s Form S-4 filed January 29, 1999 (File No. 333-71397) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.12 | Certificate of Amendment, filed August 11, 1997, of the Articles of Incorporation of Adams Rite Sabre International, Inc. (now known as Adams Rite Aerospace, Inc.) | Incorporated by reference to TransDigm Inc. and TransDigm Holding Company’s Form S-4 filed January 29, 1999 (File No. 333-71397) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.13 | Amended and Restated Bylaws of Adams Rite Aerospace, Inc. | Incorporated by reference to TransDigm Inc. and TransDigm Holding Company’s Form S-4 filed January 29, 1999 (File No. 333-71397) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.14 | Certificate of Incorporation, filed June 18, 2007, of AeroControlex Group, Inc. | Incorporated by reference to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed July 6, 2007 (File No. 333-144366) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.15 | Bylaws of AeroControlex Group, Inc. | Incorporated by reference to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed July 6, 2007 (File No. 333-144366) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.16 | Certificate of Formation, filed September 25, 2013, of Aerosonic LLC | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 47 Exhibit No. | Description | Filed Herewith or Incorporated by Reference From ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 3.17 | Limited Liability Company Agreement of Aerosonic LLC | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 3.18 | Certificate of Incorporation, filed November 13, 2009, of Airborne Acquisition, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 3.19 | Bylaws of Airborne Acquisition, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 3.20 | Amended and Restated Certificate of Incorporation, filed January 25, 2010, of HDT International Holdings, Inc. (now known as Airborne Global, Inc.) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 3.21 | Certificate of Amendment to Certificate of Incorporation, filed February 24, 2010, of HDT International Holdings, Inc. (now known as Airborne Global, Inc.) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 3.22 | Certificate of Amendment to Certificate of Incorporation, filed December 10, 2013, of HDT International Holdings, Inc. (now known as Airborne Global, Inc.) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 3.23 | Bylaws of HDT International Holdings, Inc. (now known as Airborne Global, Inc.) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 3.24 | Certificate of Incorporation, filed November 13, 2009, of Airborne Holdings, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 3.25 | Bylaws of Airborne Holdings, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 3.26 | Certificate of Incorporation, filed September 1, 1995, of Wardle Storeys Inc. (now known as Airborne Systems NA Inc.) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 3.27 | Certificate of Amendment to Certificate of Incorporation, filed May 28, 2002, of Wardle Storeys Inc. (now known as Airborne Systems NA Inc.) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 3.28 | Bylaws of Airborne Systems NA Inc., as amended | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 3.29 | Certificate of Incorporation, filed April 23, 2007, of Airborne Systems North America Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 3.30 | Bylaws of Airborne Systems North America Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 3.31 | Certificate of Incorporation, filed April 25, 1989, of Irvin Industries (Del), Inc. (now known as Airborne Systems North America of CA Inc.) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 3.32 | Certificate of Amendment to Certificate of Incorporation, filed June 2, 1989, of Irvin Industries (Del), Inc. (now known as Airborne Systems North America of CA Inc.) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 3.33 | Certificate of Amendment to Certificate of Incorporation, filed April 30, 1996, of Irvin Industries, Inc. (now known as Airborne Systems North America of CA Inc.) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 3.34 | Certificate of Amendment to Certificate of Incorporation, filed April 23, 1997, of Irvin Aerospace Inc. (now known as Airborne Systems North America of CA Inc.) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 48 Exhibit No. | Description | Filed Herewith or Incorporated by Reference From ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.35 | Bylaws of Airborne Systems North America of CA Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.36 | Certificate of Incorporation, Profit, filed October 28, 1994, of Wardle Storeys (Parachutes) Inc. (now known as Airborne Systems North America of NJ Inc.) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.37 | Certificate of Merger, filed February 9, 1995, of Para-Flite Inc. with and into Wardle Storeys (Parachutes) Inc. (now known as Airborne Systems North America of NJ Inc.) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.38 | Certificate of Amendment to Certificate of Incorporation, filed April 23, 1997, of Para-Flite Inc. (now known as Airborne Systems North America of NJ Inc.) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.39 | Certificate of Correction to Certificate of Incorporation, filed June 27, 2007, of Airborne Systems North America of NJ Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.40 | Bylaws of Airborne Systems North America of NJ Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.41 | Certificate of Incorporation, filed May 8, 1985, of Am-Safe, Inc. (now known as AmSafe, Inc.) | Incorporated by reference to Form TransDigm Group Incorporated’s 10-Q filed May 9, 2012 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.42 | Certificate of Amendment of Certificate of Incorporation, filed May 19, 2005, of Am-Safe, Inc. (now known as AmSafe, Inc.) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed May 9, 2012 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.43 | By-Laws of Am-Safe, Inc. (now known as AmSafe, Inc.) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed May 9, 2012 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.44 | Certificate of Incorporation, filed October 16, 2007, of AmSafe Global Holdings, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed May 9, 2012 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.45 | Amended and Restated By-Laws of AmSafe Global Holdings, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed May 9, 2012 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.46 | Restated Certificate of Incorporation, filed July 10, 1967, of Arkwin Industries, Inc. | Incorporated by reference to Amendment No. 3 to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed June 27, 2013 (File No. 333-186494) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.47 | Certificate of Amendment, filed November 4, 1981, of Arkwin Industries, Inc. | Incorporated by reference to Amendment No. 3 to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed June 27, 2013 (File No. 333-186494) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.48 | Certificate of Amendment, filed June 11, 1999, of Arkwin Industries, Inc. | Incorporated by reference to Amendment No. 3 to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed June 27, 2013 (File No. 333-186494) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.49 | Bylaws of Arkwin Industries, Inc. | Incorporated by reference to Amendment No. 3 to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed June 27, 2013 (File No. 333-186494) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.50 | Certificate of Incorporation, filed March 7, 2003, of Wings Holdings, Inc. (now known as Aviation Technologies, Inc.) | Incorporated by reference to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed July 6, 2007 (File No. 333-144366) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.51 | Certificate of Amendment of Certificate of Incorporation, filed May 12, 2003, of Wings Holdings, Inc. (now known as Aviation Technologies, Inc.) | Incorporated by reference to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed July 6, 2007 (File No. 333-144366) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.52 | Certificate of Amendment of Certificate of Incorporation, filed July 17, 2003, of Wings Holdings, Inc. (now known as Aviation Technologies, Inc.) | Incorporated by reference to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed July 6, 2007 (File No. 333-144366) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.53 | Bylaws of Wings Holdings, Inc. (now known as Aviation Technologies, Inc.) | Incorporated by reference to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed July 6, 2007 (File No. 333-144366) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 49 Exhibit No. | Description | Filed Herewith or Incorporated by Reference From ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------- 3.54 | Certificate of Formation, filed June 28, 2007, of Avionic Instruments LLC | Filed Herewith ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------- 3.55 | Limited Liability Company Agreement of Avionic Instruments LLC | Incorporated by reference to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed July 6, 2007 (File No.333-144366) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------- 3.56 | Certificate of Incorporation, filed December 29, 1992, of Avionic Specialties, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------- 3.57 | Bylaws of Avionic Specialties, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------- 3.58 | Articles of Incorporation, filed October 3, 1963, of Avtech Corporation (now known as AvtechTyee, Inc.) | Incorporated by reference to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed July 6, 2007 (File No. 333-144366) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------- 3.59 | Articles of Amendment of Articles of Incorporation, filed March 30, 1984, of Avtech Corporation (now known as AvtechTyee, Inc.) | Incorporated by reference to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed July 6, 2007 (File No. 333-144366) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------- 3.60 | Articles of Amendment of Articles of Incorporation, filed April 17, 1989, of Avtech Corporation (now known as AvtechTyee, Inc.) | Incorporated by reference to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed July 6, 2007 (File No. 333-144366) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------- 3.61 | Articles of Amendment of Articles of Incorporation, filed July 17, 1998, of Avtech Corporation (now known as AvtechTyee, Inc.) | Incorporated by reference to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed July 6, 2007 (File No. 333-144366) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------- 3.62 | Articles of Amendment of Articles of Incorporation, filed May 20, 2003, of Avtech Corporation (now known as Avtech Tyee, Inc.) | Incorporated by reference to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4, filed July 6, 2007 (File No. 333-144366) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------- 3.63 | Articles of Amendment of Articles of Incorporation, filed May 2, 2012, of AvtechTyee, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 16, 2012 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------- 3.64 | Bylaws of Avtech Corporation (now known as AvtechTyee, Inc.) | Incorporated by reference to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed July 6, 2007 (File No. 333-144366) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------- 3.65 | Certificate of Incorporation, filed October 24, 1977, of Transformer Technology Corporation (now known as Beta Transformer Technology Corporation) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------- 3.66 | Certificate of Amendment of Certificate of Incorporation, filed December 1, 1977, of Transformer Technology Corporation (now known as Beta Transformer Technology Corporation) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------- 3.67 | Bylaws of Transformer Technology Corporation (now known as Beta Transformer Technology Corporation) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------- 3.68 | Certificate of Formation, filed May 30, 2013, of Beta Transformer Technology LLC | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------- 3.69 | Amended and Restated Limited Liability Company Agreement, filed July 7, 2016, of Beta Transformer Technology LLC | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------- 3.70 | Certificate of Formation of Breeze-Eastern LLC | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed May 11, 2016 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------- 3.71 | Limited Liability Company Agreement of Breeze-Eastern LLC | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed May 11, 2016 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------- 50 Exhibit No. | Description | Filed Herewith or Incorporated by Reference From ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.72 | Articles of Incorporation, filed February 6, 1998, of Air Carrier Acquisition Corp. (now known as Bridport-Air Carrier, Inc.) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed May 9, 2012 (File No. 001-32833) ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.73 | Articles of Amendment, filed February 23, 1998, of Air Carrier Acquisition Corp. (now known as Bridport-Air Carrier, Inc.) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed May 9, 2012 (File No. 001-32833) ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.74 | Articles of Amendment, filed December 14, 1999, of Bridport-Air Carrier, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed May 9, 2012 (File No. 001-32833) ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.75 | Amended and Restated By-Laws of Bridport-Air Carrier, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed May 9, 2012 (File No. 001-32833) ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.76 | Certificate of Incorporation, filed May 9, 2000, of Erie Acquisition Corp. (now known as Bridport Erie Aviation, Inc.) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed May 9, 2012 (File No. 001-32833) ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.77 | Certificate of Amendment of Certificate of Incorporation, filed May 30, 2000, of Erie Acquisition Corp. (now known as Bridport Erie Aviation, Inc.) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed May 9, 2012 (File No. 001-32833) ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.78 | Certificate of Amendment of Certificate of Incorporation, filed June 19, 2000, of Bridport Erie Aviation, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed May 9, 2012 (File No. 001-32833) ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.79 | Amended and Restated By-Laws of Erie Acquisition Corp. (now known as Bridport Erie Aviation, Inc.) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed May 9, 2012 (File No. 001-32833) ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.80 | Certificate of Incorporation, filed July 2, 2004, of Bridport Holdings, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed May 9, 2012 (File No. 001-32833) ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.81 | Amended and Restated By-Laws of Bridport Holdings, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed May 9, 2012 (File No. 001-32833) ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.82 | Certificate of Incorporation filed August 6, 2007, of Bruce Aerospace, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 21, 2007 (File No. 001-32833) ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.83 | Bylaws of Bruce Aerospace, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 21, 2007 (File No. 001-32833) ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.84 | Certificate of Conversion, effective June 30, 2007, converting CDA InterCorp into CDA InterCorp LLC | Incorporated by reference to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed July 6, 2007 (File No. 333-144366) ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.85 | Operating Agreement of CDA InterCorp LLC | Incorporated by reference to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed July 6, 2007 (File No. 333-144366) ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.86 | Certificate of Formation, filed September 30, 2010, of CEF Industries, LLC | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 24, 2009 (File No. 001-32833) ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.87 | Limited Liability Company Agreement of CEF Industries, LLC | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 24, 2009 (File No. 001-32833) ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.88 | Certificate of Formation, effective June 30, 2007, of Champion Aerospace LLC | Incorporated by reference to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed July 6, 2007 (File No. 333-144366) ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.89 | Limited Liability Company Agreement of Champion Aerospace LLC | Incorporated by reference to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed July 6, 2007 (File No. 333-144366) ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.90 | Certificate of Incorporation, filed October 23, 1970, of ILC Data Devices Corporation (now known as Data Device Corporation) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 51 Exhibit No. | Description | Filed Herewith or Incorporated by Reference From ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 3.91 | Certificate of Amendment of Certificate of Incorporation, filed April 23, 1999, of ILC Data Devices Corporation (now known as Data Device Corporation) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 3.92 | Certificate of Amendment of Certificate of Incorporation, filed July 14, 2014, of Data Device Corporation | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 3.93 | Bylaws of ILC Data Devices Corporation (now known as Data Device Corporation) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 3.94 | Certificate of Incorporation, filed November 20, 2009, of Dukes Aerospace, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed December 4, 2009 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 3.95 | Bylaws of Dukes Aerospace, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed December 4, 2009 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 3.96 | Certificate of Formation, filed February 29, 2000, of Western Sky Industries, LLC (now known as Electromech Technologies LLC) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 8, 2011 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 3.97 | Certificate of Amendment, filed December 18, 2013, of Western Sky Industries, LLC (now known as Electromech Technologies LLC) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 3.98 | Second Amended and Restated Limited Liability Agreement of Western Sky Industries, LLC (now known as Electromech Technologies LLC) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 8, 2011 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 3.99 | Certificate of Conversion, effective March 31, 2014, of Harco LLC | Incorporated by reference to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed August 7, 2014 (File No. 333-197935) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 3.100 | Limited Liability Company Agreement of Harco LLC | Incorporated by reference to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed August 7, 2014 (File No. 333-197935) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 3.101 | Articles of Incorporation, filed May 10, 1957, of Hartwell Aviation Supply Company (now known as Hartwell Corporation) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 8, 2011 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 3.102 | Certificate of Amendment, filed June 9, 1960, of Articles of Incorporation of Hartwell Aviation Supply Company (now known as Hartwell Corporation) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 8, 2011 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 3.103 | Certification of Amendment, filed October 23, 1987, of Articles of Incorporation of Hartwell Corporation | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 8, 2011 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 3.104 | Certificate of Amendment, filed April 9, 1997, of Articles of Incorporation of Hartwell Corporation | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 8, 2011 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 3.105 | Bylaws of Hartwell Corporation | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 8, 2011 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 3.106 | Amended and Restated Certificate of Incorporation, filed June 23, 2016, of ILC Holdings, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 3.107 | Bylaws of ILC Holdings, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 3.108 | Certificate of Formation, filed August 12, 2008, of New ILC Mergeco, LLC (now known as ILC Industries, LLC) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 52 Exhibit No. | Description | Filed Herewith or Incorporated by Reference From ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.109 | Certificate of Amendment to Certificate of Formation, filed December 3, 2010, of New ILC Mergeco, LLC (now known as ILC Industries, LLC) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.110 | Limited Liability Company Agreement of ILC Industries, LLC | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.111 | Certificate of Formation, filed January 26, 2007, of Johnson Liverpool LLC | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.112 | Amended and Restated Limited Liability Company Agreement of Johnson Liverpool LLC | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.113 | Certificate of Incorporation, filed March 28, 1994, of MPT Acquisition Corp. (now known as MarathonNorco Aerospace, Inc.) | Incorporated by reference to TransDigm Inc. and TransDigm Holding Company’s Form S-4 filed January 29, 1999 (File No. 333-71397) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.114 | Certificate of Amendment, filed May 18, 1994, of the Certificate of Incorporation of MPT Acquisition Corp. (now known as MarathonNorco Aerospace, Inc.) | Incorporated by reference to TransDigm Inc. and TransDigm Holding Company’s Form S-4 filed January 29, 1999 (File No. 333-71397) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.115 | Certificate of Amendment, filed May 24, 1994, of the Certificate of Incorporation of MPT Acquisition Corp. (now known as MarathonNorco Aerospace, Inc.) | Incorporated by reference to TransDigm Inc. and TransDigm Holding Company’s Form S-4 filed January 29, 1999 (File No. 333-71397) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.116 | Certificate of Amendment, filed August 28, 2003, of the Certificate of Incorporation of Marathon Power Technology Company (now known as MarathonNorco Aerospace, Inc.) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 28, 2006 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.117 | Bylaws of MPT Acquisition Corp. (now known as MarathonNorco Aerospace, Inc.) | Incorporated by reference to TransDigm Inc. and TransDigm Holding Company’s Form S-4 filed January 29, 1999 (File No. 333-71397) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.118 | Certificate of Incorporation, filed April 13, 2007, of McKechnie Aerospace DE, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 8, 2011 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.119 | Bylaws of McKechnie Aerospace DE, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 8, 2011 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.120 | Certificate of Incorporation, filed April 25, 2007, of McKechnie Aerospace Holdings, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 8, 2011 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.121 | Bylaws of McKechnie Aerospace Holdings, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 8, 2011 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.122 | Certificate of Incorporation, filed December 11, 1998, of McKechnie US Holdings Inc. (now known as McKechnie Aerospace Investments, Inc.) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 8, 2011 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.123 | Certificate of Amendment, filed May 11, 2007, to the Certificate of Incorporation of McKechnie Investments, Inc. (now known as McKechnie Aerospace Investments, Inc.) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 8, 2011 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.124 | Amended and Restated Bylaws of McKechnie Aerospace Investments, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 8, 2011 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.125 | Certificate of Formation, filed May 11, 2005, of Melrose US 3 LLC (now known as McKechnie Aerospace US LLC) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 8, 2011 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 3.126 | Certificate of Amendment, filed May 11, 2007, to Certificate of Formation of Melrose US 3 LLC (now known as McKechnie Aerospace US LLC) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 8, 2011 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------------------------------------------- 53 Exhibit No. | Description | Filed Herewith or Incorporated by Reference From ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------- 3.127 | Limited Liability Company Agreement of McKechnie Aerospace US LLC | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 8, 2011 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------- 3.128 | Certificate of Incorporation, filed April 28, 2015, of PX Acquisition Co. (now known as Pexco Aerospace, Inc.) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed August 5, 2015 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------- 3.129 | Certificate of Amendment, filed May 14, 2015, of Certificate of Incorporation of PX Acquisition Co. (now known as Pexco Aerospace, Inc.) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed August 5, 2015 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------- 3.130 | Bylaws of Pexco Aerospace, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed August 5, 2015 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------- 3.131 | Articles of Incorporation, filed October 3, 1956, of Pneudraulics, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 13, 2015 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------- 3.132 | Certificate of Amendment, filed December 9, 1970, of Articles of Incorporation of Pneudraulics, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 13, 2015 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------- 3.133 | Restated Bylaws of Pneudraulics, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 13, 2015 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------- 3.134 | Certificate of Formation, filed May 30, 2007, of Schneller LLC | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 8, 2012 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------- 3.135 | Amended and Restated Limited Liability Company Agreement, dated August 31, 2011, of Schneller LLC | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 8, 2012 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------- 3.136 | Certificate of Incorporation of Semco Instruments, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed September 7, 2010 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------- 3.137 | Certificate of Amendment to Certificate of Incorporation, filed October 17, 2012, of Semco Instruments, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 16, 2012 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------- 3.138 | Amended and Restated Bylaws of Semco Instruments, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed September 7, 2010 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------- 3.139 | Certificate of Incorporation, filed September 16, 1994, of Am-Safe Commercial Products, Inc. (now known as Shield Restraint Systems, Inc.) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed May 9, 2012 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------- 3.140 | Certificate of Amendment of Certificate of Incorporation, filed May 19, 2005, of AmSafe Commercial Products, Inc. (now known as Shield Restraint Systems, Inc.) | Incorporated by reference to TransDigm GroupIncorporated’s Form 10-Q filed May 9, 2012 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------- 3.141 | Certificate of Amendment of Certificate of Incorporation, filed August 27, 2014 of AmSafe Commercial Products, Inc. (now known as Shield Restraint Systems, Inc.) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 14, 2014 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------- 3.142 | By Laws of Am-Safe Commercial Products, Inc. (now known as Shield Restraint Systems, Inc.) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed May 9, 2012 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------- 3.143 | Certificate of Incorporation, filed December 22, 2004, of Skurka Aerospace Inc. | Incorporated by reference to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed October 11, 2006 (File No. 333-137937) ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------- 3.144 | Bylaws of Skurka Aerospace Inc. | Incorporated by reference to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed October 11, 2006 (File No. 333-137937) ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------- 3.145 | Certificate of Incorporation, filed August 22, 1986, of Tactair Fluid Controls, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------- 54 Exhibit No. | Description | Filed Herewith or Incorporated by Reference From ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.146 | Certificate of Amendment of Certificate of Incorporation of Tactair Fluid Controls, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.147 | Bylaws of Tactair Fluid Controls, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.148 | Certificate of Formation, filed March 27, 2015, of Telair International LLC | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed May 5, 2015 (File No. 001-32833) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.149 | Limited Liability Company Agreement of Telair International LLC | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed May 5, 2015 (File No. 001-32833) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.150 | Certificate of Formation, filed February 23, 2015, of Telair US LLC | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed May 5, 2015 (File No. 001-32833) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.151 | Limited Liability Company Agreement of Telair US LLC | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed May 5, 2015 (File No. 001-32833) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.152 | Articles of Incorporation, filed August 6, 1999, of Texas Rotronics, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 8, 2011 (File No. 001-32833) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.153 | Bylaws of Texas Rotronics, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 8, 2011 (File No. 001-32833) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.154 | Certificate of Formation, effective June 30, 2007, of Transicoil LLC | Incorporated by reference to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed July 6, 2007 (File No. 333-144366) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.155 | Limited Liability Company Agreement of Transicoil LLC | Incorporated by reference to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed July 6, 2007 (File No. 333-144366) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.156 | Certificate of Formation, filed June 13, 2013, of Whippany Actuation Systems, LLC | Incorporated by reference to Amendment No. 3 to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed June 27, 2013 (File No. 333-186494) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.157 | Limited Liability Agreement of Whippany Actuation Systems, LLC | Incorporated by reference to Amendment No. 3 to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed June 27, 2013 (File No. 333-186494) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.158 | Restated Certificate of Incorporation, filed November 10, 2016, of Young & Franklin, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.159 | Bylaws of Young & Franklin, Inc. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.160 | Restated Certificate of Incorporation, filed June 27, 2014, of North Hills Processing Corp. | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed August 8, 2017 (File No. 001-32833) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.161 | Bylaws of Porta Systems Corp. (now known as North Hills Signal Processing Corp.) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed August 8, 2017 (File No. 001-32833) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.162 | Certificate of Incorporation, filed October 12, 1982, of Porta Systems Overseas Corp (now known as North Hills Signal Processing Overseas Corp) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed August 8, 2017 (File No. 001-32833) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 3.163 | Certificate of Amendment to Certificate of Incorporation, filed October 6, 2010, of Porta Systems Overseas Corp (now known as North Hills Signal Processing Overseas Corp) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed August 8, 2017 (File No. 001-32833) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------------------------- 55 Exhibit No. | Description | Filed Herewith or Incorporated by Reference From ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 3.164 | Bylaws of Porta Systems Overseas Corp. (now known as North Hills Signal Processing Overseas Corp) | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed August 8, 2017 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 3.165 | Certificate of Formation, filed December 13, 2016, of Wings Acquisition Sub LLC (now known as Interiors In Flight LLC) | Filed Herewith ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 3.166 | Limited Liability Agreement of Wings Acquisition Sub LLC (now known as Interiors in Flight LLC) | Filed Herewith ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 3.167 | Certificate of Formation, filed December 13, 2016, of Wings Acquisition Co LLC (now known as SCHROTH Safety Products LLC) | Filed Herewith ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 3.168 | Limited Liability Agreement of Wings Acquisition Co LLC (now known as SCHROTH Safety Products LLC) | Filed Herewith ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 4.1 | Form of Stock Certificate | Incorporated by reference to Amendment No. 3 to TransDigm Group Incorporated’s Form S-1 filed March 13, 2006 (File No. 333-130483) ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 4.2 | Indenture, dated as of October 15, 2012, among TransDigm Inc., as issuer, TransDigm Group Incorporated, as a guarantor, the subsidiary guarantors party thereto and The Bank of New York Mellon Trust Company, N.A., as trustee, relating to TransDigm Inc.’s 5.5% Senior Subordinated Notes due 2020 | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed October 15, 2012 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 4.3 | First Supplemental Indenture, dated as of June 5, 2013, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed June 11, 2013 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 4.4 | Second Supplemental Indenture, dated as of June 26, 2013, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed July 1, 2013 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 4.5 | Third Supplemental Indenture, dated as of December 19, 2013, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 4.6 | Fourth Supplemental Indenture, dated as of April 9, 2015, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed May 5, 2015 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 4.7 | Fifth Supplemental Indenture, dated as of June 12, 2015, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed August 5, 2015 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 4.8 | Sixth Supplemental Indenture, dated as of August 28, 2015, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 13, 2015 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 4.9 | Seventh Supplemental Indenture, dated as of April 1, 2016, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------------------- 56 Exhibit No. | Description | Filed Herewith or Incorporated by Reference From ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.10 | Eighth Supplemental Indenture, dated as of July 8, 2016, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.11 | Ninth Supplemental Indenture, dated as of October 28, 2016, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.12 | Tenth Supplemental Indenture, dated as of March 31, 2017, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed May 10, 2017 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.13 | Eleventh Supplemental Indenture, dated as of May 9, 2017, among TransDigm, Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed August 8, 2017 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.14 | Indenture, dated as of June 4, 2014, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee, relating to TransDigm Inc.’s 6.00% Senior Subordinated Notes due 2022 | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed June 6, 2014 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.15 | First Supplemental Indenture, dated as of April 9, 2015, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed May 5, 2015 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.16 | Second Supplemental Indenture, dated as of June 12, 2015, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed August 5, 2015 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.17 | Third Supplemental Indenture, dated as of August 28, 2015, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 13, 2015 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.18 | Fourth Supplemental Indenture, dated as of April 1, 2016, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.19 | Fifth Supplemental Indenture, dated as of July 8, 2016, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.20 | Sixth Supplemental Indenture, dated as of October 28, 2016, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.21 | Seventh Supplemental Indenture, dated as of March 31, 2017, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed May 10, 2017 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 57 Exhibit No. | Description | Filed Herewith or Incorporated by Reference From ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.22 | Eighth Supplemental Indenture, dated as of May 9, 2017, among TransDigm, Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed August 8, 2017 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.23 | Indenture, dated as of June 4, 2014, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee, relating to TransDigm Inc.’s 6.50% Senior Subordinated Notes due 2024 | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed June 6, 2014 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.24 | First Supplemental Indenture, dated as of April 9, 2015, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed May 5, 2015 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.25 | Second Supplemental Indenture, dated as of June 12, 2015, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed August 5, 2015 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.26 | Third Supplemental Indenture, dated as of August 28, 2015, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 13, 2015 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.27 | Fourth Supplemental Indenture, dated as of April 1, 2016, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.28 | Fifth Supplemental Indenture, dated as of July 8, 2016, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.29 | Sixth Supplemental Indenture, dated as of October 28, 2016, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.30 | Seventh Supplemental Indenture, dated as of March 31, 2017, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to 10-Q filed May 10, 2017 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.31 | Eighth Supplemental Indenture, dated as of May 9, 2017, among TransDigm, Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed August 8, 2017 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.32 | Indenture, dated as of May 14, 2015, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee, relating to TransDigm Inc.’s 6.50% Senior Subordinated Notes due 2025 | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed May 19, 2015 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.33 | First Supplemental Indenture, dated as of June 12, 2015, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed August 5, 2015 (File No. 001-32833) ------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 58 Exhibit No. | Description | Filed Herewith or Incorporated by Reference From ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.34 | Second Supplemental Indenture, dated as of August 28, 2015, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 13, 2015 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.35 | Third Supplemental Indenture, dated as of April 1, 2016, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.36 | Fourth Supplemental Indenture, dated as of July 8, 2016, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.37 | Fifth Supplemental Indenture, dated as of October 28, 2016, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.38 | Sixth Supplemental Indenture, dated as of March 31, 2017, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed May 10, 2017 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.39 | Seventh Supplemental Indenture, dated as of May 9, 2017, among TransDigm, Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed August 8, 2017 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.40 | Indenture, dated as of June 6, 2016, among TransDigm Inc., Transdigm Group Incorporated, the guarantors party thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee, relating to TransDigm Inc.’s 6.375% Senior Subordinated Notes due 2026 | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed June 14, 2016 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.41 | First Supplemental Indenture, dated as of July 8, 2016, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.42 | Second Supplemental Indenture, dated as of October 28, 2016, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 15, 2016 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.43 | Third Supplemental Indenture, dated as of March 31, 2017, among TransDigm Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed May 10, 2017 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.44 | Fourth Supplemental Indenture, dated as of May 9, 2017, among TransDigm, Inc., TransDigm Group Incorporated, the guarantors listed on the signature pages thereto and The Bank of New York Mellon Trust Company, N.A., as Trustee | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed August 8, 2017 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.45 | Form of 5.50% Senior Subordinated Notes due 2020 | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed October 15, 2012 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 4.46 | Form of 6.00% Senior Subordinated Notes due 2022 | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed June 6, 2014 (File No. 001-32833) ------------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 59 Exhibit No. | Description | Filed Herewith or Incorporated by Reference From ------------+-------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 4.47 | Form of 6.50% Senior Subordinated Notes due 2024 | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed June 6, 2014 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 4.48 | Form of 6.50% Senior Subordinated Notes due 2025 | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed May 19, 2015 ------------+-------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 4.49 | Form of 6.375% Senior Subordinated Notes due 2026 | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed June 14, 2016 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 4.50 | Form of Notation of Guarantee of 5.50% Senior Subordinated Notes due 2020 | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed October 15, 2012 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 4.51 | Form of Notation of Guarantee of 6.00% Senior Subordinated Notes due 2022 | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed June 6, 2014 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 4.52 | Form of Notation of Guarantee of 6.50% Senior Subordinated Notes due 2024 | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed June 6, 2014 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 4.53 | Form of Notation of Guarantee of 6.50% Senior Subordinated Notes due 2025 | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed May 19, 2015 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 4.54 | Form of Notation of Guarantee of 6.375% Senior Subordinated Notes due 2026 | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed June 14, 2016 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 10.1 | Fourth Amended and Restated Employment Agreement, dated December 10, 2015, between TransDigm Group Incorporated and W. Nicholas Howley* | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed Decmber 10, 2015 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 10.2 | Employment Agreement, dated April 27, 2015, between TransDigm Group Incorporated and Terrance Paradie | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed April 28, 2015 ------------+-------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 10.3 | Amended and Restated Employment Agreement, dated December 14, 2016, between TransDigm GroupIncorporated and Robert Henderson* | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed December 15, 2016 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 10.4 | Amended and Restated Employment Agreement, dated December 14, 2016, between TransDigm GroupIncorporated and Kevin Stein* | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed December 15, 2016 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 10.5 | Employment Agreement, Dated February 24, 2011, between TransDigm Group Incorporated and Bernt Iversen* | Incorporated by reference to TramsDigm Group Incorporated’s Form 8-K filed February 25, 2011 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 10.6 | Employment Agreement, dated April 20, 2012, between TransDigm Group Incorporated and James Skulina* | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed April 24, 2012 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 10.7 | Employment Agreement, dated April 20, 2012, between TransDigm Group Incorporated and Peter Palmer* | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed April 24, 2012 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 10.8 | Employment Agreement, dated October 23, 2013, between TransDigm Group Incorporated and Jorge Valladares* | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed October 29, 2013 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 10.9 | Form of Employment Agreement, dated October 2015, between TransDigm Group Incorporated and each of Joel Reiss and Roger Jones* | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed October 27, 2015 ------------+-------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 10.10 | First Amendment to Employment Agreement, dated April 20, 2012, between TransDigm Group Incorporated and Bernt Iversen* | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed April 24, 2012 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 10.11 | Form of Amendment to Employment Agreement between TransDigm Group Incorporated and each of Bernt Iversen, Peter Palmer and James Skulina* | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed October 25, 2012 (File No. 001-32833) ------------+-------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------ 60 Exhibit No. | Description | Filed Herewith or Incorporated by Reference From ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------- 10.12 | Form of Amendment to Employment Agreement, dated October 2015, between TransDigm Group Incorporated and each of Terrance Paradie, Bernt Iversen, James Skulina, Peter Palmer and Jorge Valladares* | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed October 27, 2015 (File No. 001-32833) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------- 10.13 | Fourth Amendment to Employment Agreement, dated November 11, 2016, between TransDigmGroup Incorporated and Bernt Iversen* | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed November 15, 2016 (File No. 001-32833) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------- 10.14 | Second Amendment to Employment Agreement, dated November 11, 2016, between TransDigmGroup Incorporated and Terrance Paradie* | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed November 15, 2016 (File No. 001-32833) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------- 10.15 | TransDigm Group Incorporated Fourth Amended and Restated 2003 Stock Option Plan* | Incorporated by reference to Amendment No. 1 to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed November 7, 2006 (File No. 333-137937) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------- 10.16 | Amendment No. 1 to TransDigm Group Incorporated Fourth Amended and Restated 2003 Stock Option Plan* | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 21, 2007 (File No. 001-32833) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------- 10.17 | Amendment No. 2 to TransDigm Group Incorporated Fourth Amended and Restated Stock Option Plan* | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed August 7, 2008 (File No. 001-32833) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------- 10.18 | Amendment No. 3 to TransDigm Group Incorporated Fourth Amended and Restated Stock Option Plan* | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed April 28, 2009 (File No. 001-32833) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------- 10.19 | TransDigm Group Incorporated 2006 Stock Incentive Plan* | Incorporated by reference to Amendment No. 3 to TransDigm Group Incorporated’s Form S-1 filed March 13, 2006 (File No. 333-130483) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------- 10.20 | Amendment No. 1, dated October 20, 2006, to the TransDigm Group Incorporated 2006 Stock Incentive Plan* | Incorporated by reference to Amendment No. 1 to TransDigm Inc. and TransDigm Group Incorporated’s Form S-4 filed November 7, 2006 (File No. 333-137937) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------- 10.21 | Second Amendment to TransDigm Group Incorporated 2006 Stock Incentive Plan, dated April 25, 2008* | Incorporated by reference to TransDigm Group Incorporated’s Schedule 14A filed June 6, 2008 (File No. 001-32833) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------- 10.22 | TransDigm Group Incorporated 2014 Stock Option Plan* | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed October 6, 2014 (File No. 001-32833) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------- 10.23 | Director Share Plan* | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 10, 2016 (File No. 001-32833) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------- 10.24 | Form of Option Agreements for options granted in fiscal 2013* | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 14, 2014 (File No. 001-32833) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------- 10.25 | Form of Option Agreements for options granted in fiscal 2014* | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 14, 2014 (File No. 001-32833) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------- 10.26 | Form of Option Agreements for options granted in fiscal 2015* | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed January 30, 2015 (File No. 001-32833) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------- 10.27 | Form of Option Agreements for options granted in fiscal 2016* | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 10, 2016 (File No. 001-32833) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------- 10.28 | Form of Stock Option Agreement for options awarded in fiscal 2017* | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 8, 2017 (File No. 001-32833) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------- 10.29 | Stock Option Grant Notice and Stock Option Agreement dated November 13, 2014 between TransDigm Group Incorporated and W. Nicholas Howley* | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed January 30, 2015 (File No. 001-32833) ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------- 61 Exhibit No. | Description | Filed Herewith or Incorporated by Reference From ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------- 10.30 | Stock Option Grant Notice and Stock Option Agreement dated November 10, 2016 between TransDigm Group Incorporated and W. Nicholas Howley (annual equity award)* | Incorporated by reference to TransDigm Group Incorporated’s Form10-Q filed February 8, 2017 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------- 10.31 | Stock Option Grant Notice and Stock Option Agreement dated November 10, 2016 between TransDigm Group Incorporated and W. Nicholas Howley (equity award in lieu of fiscal 2016 bonus and calendar 2017 salary)* | Incorporated by reference to TransDigm Group Incorporated’s Form10-Q filed February 8, 2017 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------- 10.32 | Fourth Amended and Restated TransDigm Group Incorporated 2003 Stock Option Plan Dividend Equivalent Plan* | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed August 2, 2013 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------- 10.33 | Third Amended and Restated TransDigm Group Incorporated 2006 Stock Incentive Plan Dividend Equivalent Plan* | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed August 2, 2013 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------- 10.34 | TransDigm Group Incorporated 2014 Stock Option Plan Dividend Equivalent Plan* | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed October 28, 2014 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------- 10.35 | Amendment and Restatement Agreement, and Second Amendment and Restated Credit Agreement, dated as of June 4, 2014, among TransDigm Inc., TransDigm Group Incorporated, the subsidiaries of TransDigm Inc. from time to time party thereto, the lenders party thereto, as lenders, and Credit Suisse AG, as administrative agent | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed June 6, 2014 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------- 10.36 | Incremental Assumption and Refinancing Facility Agreement, dated as of May 14, 2015, among TransDigm Inc., TransDigm Group Incorporated, the subsidiary guarantors party thereto, Credit Suisse AG, as administrative agent and collateral agent, and the other agents and lenders named therein | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed May 19, 2015 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------- 10.37 | Loan Modification Agreement, dated as of May 20, 2015, among TransDigm Inc., TransDigm Group Incorporated, the subsidiary guarantors party thereto, Credit Suisse AG, as administrative agent and collateral agent, and the other agents and lenders party thereto | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed May 27, 2015 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------- 10.38 | Incremental Revolving Credit Assumption and Refinancing Facility Agreement, dated as of May 20, 2015, among TransDigm Inc., TransDigm Group Incorporated, the subsidiary guarantors party thereto, Credit Suisse AG, as administrative agent and collateral agent and the other agents and lenders party thereto | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed May 27, 2015 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------- 10.39 | Incremental Term Loan Assumption Agreement dated October 14, 2016 among TransDigm Inc., TransDigm Group Incorporated, the subsidiaries of TransDigm Inc. party thereto, the lenders party thereto and Credit Suisse AG, as administrative and collateral agent | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed October 14, 2016 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------- 10.40 | Amendment No. 2 to the Second Amended and Restated Credit Agreement, dated as of March 6, 2017, among TransDigm Inc., as borrower, TransDigm Group Incorporated, as guarantor, the subsidiary guarantors party thereto, Credit Suisse AG, as administrative agent and collateral agent, and the other agents and lenders named therein | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed March 8, 2017 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------- 10.41 | Amendment No. 3 to the Second Amended and Restated Credit Agreement, dated as of August 22, 2017, among TransDigm Inc., as borrower, TransDigm Group Incorporated, as guarantor, the subsidiary guarantors party thereto, Credit Suisse AG, as administrative agent and collateral agent, and the other agents and lenders named therein | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed August 24, 2017 (File No. 001-32833) ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------- 62 Exhibit No. | Description | Filed Herewith or Incorporated by Reference From ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 10.42 | Guarantee and Collateral Agreement, dated as of June 23, 2006, as amended and restated as of December 6, 2010, as further amended and restated as of February 14, 2011 and February 28, 2013, among TransDigm Inc., TransDigm Group Incorporated, the subsidiaries of TransDigm Inc. named therein and Credit Suisse AG as administrative agent and collateral agent | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed March 6, 2013 (File No. 001-32833) ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 10.43 | Receivables Purchase Agreement, dated October 21, 2013, among TransDigm Receivables LLC, TransDigm Inc., PNC Bank, National Association as a Purchaser and a Purchaser Agent, the various other Purchasers and Purchaser Agents from time to time party thereto, and PNC National Association as Administrator | Incorporated by reference to TransDigm Group Incorporated’s Form 10-Q filed February 5, 2014 (File No. 001-32833) ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 10.44 | First Amendment to the Receivables Purchase Agreement, dated March 25, 2014, among TransDigm Receivables LLC, TransDigm Inc., PNC Bank, National Association as a Purchaser, Purchaser Agent for its Purchaser Group and as Administrator | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 13, 2015 (File No. 001-32833) ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 10.45 | Second Amendment to the Receivables Purchase Agreement, dated August 8, 2014, among TransDigm Receivables LLC, TransDigm Inc., PNC Bank, National Association, as a Committed Purchaser, as a Purchaser Agent for its Purchaser Group and Administrator, and Credit Agricole Corporate and Investment Bank, as a Committed Purchaser and as a Purchase Agent for its Purchaser Group | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 13, 2015 (File No. 001-32833) ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 10.46 | Third Amendment to the Receivables Purchase Agreement, dated March 20, 2015, among TransDigm Receivables LLC, TransDigm Inc., PNC Bank, National Association, as a Committed Purchaser, as a Purchaser Agent for its Purchaser Group and Administrator, Atlantic Asset Securitization LLC, as a Conduit Purchaser, and Credit Agricole Corporate and Investment Bank, as a Committed Purchaser and as a Purchase Agent for its and Atlantic’s Purchaser Group | Incorporated by reference to TransDigm Group Incorporated’s Form 10-K filed November 13, 2015 (File No. 001-32833) ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 10.47 | Fourth Amendment to the Receivables Purchase Agreement dated as of August 4, 2015, among TransDigm Receivables LLC, TransDigm Inc., PNC Bank, National Association, as a Committed Purchase, as a Purchaser Agent for its Purchaser Group and Administrator, Atlantic Asset Securitization LLC, as a Conduit Purchaser, and Credit Agricole Corporate and Investment Bank, as a Committed Purchaser and as a Purchaser Agent for its and Atlantic’s Purchaser Group | Incorporated by reference to TransDigm Group Incorporated’s Form 8-K filed August 7, 2015 (File No. 001-32833) ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 10.48 | Ninth Amendment to the Receivables Purchase Agreement dated as of August 1, 2017, among TransDigm Receivables LLC, TransDigm Inc., PNC Bank, National Association, as a Committed Purchaser, as Purchaser Agent for its Purchaser Group and as Administrator, Atlantic Asset Securitization LLC, as a Conduit Purchaser, Credit Agricole Corporate and Investment Bank, as a Committed Purchaser and as a Purchaser Agent for its and Atlantic's Purchaser Group, and Fifth Third Bank, as a Committed Purchaser and as Purchaser Agent for its Purchaser Group | Filed Herewith ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 12.1 | Statement of Computation of Ratio of Earnings to Fixed Charges | Filed Herewith ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 21.1 | Subsidiaries of TransDigm Group Incorporated | Filed Herewith ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 63 Exhibit No. | Description | Filed Herewith or Incorporated by Reference From ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------- 23.1 | Consent of Independent Registered Public Accounting Firm | Filed Herewith ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------- 31.1 | Certification by Principal Executive Officer of TransDigm Group Incorporated pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | Filed Herewith ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------- 31.2 | Certification by Principal Financial Officer of TransDigm Group Incorporated pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | Filed Herewith ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------- 32.1 | Certification by Principal Executive Officer of TransDigm Group Incorporated pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | Filed Herewith ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------- 32.2 | Certification by Principal Financial Officer of TransDigm Group Incorporated pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | Filed Herewith ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------- 101 | Financial Statements and Notes to Consolidated Financial Statements formatted in XBRL. | Filed Herewith ------------+-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------------------------- * | Indicates management contract or compensatory plan contract or arrangement. --+---------------------------------------------------------------------------- 64 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized on November 13, 2017 . TRANSDIGM GROUP INCORPORATED ---------------------------- By: | /s/ Terrance M. Paradie -----------------------------+----------------------------------------------------- Name: | Terrance M. Paradie -----------------------------+----------------------------------------------------- Title: | Executive Vice President and Chief Financial Officer -----------------------------+----------------------------------------------------- Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the registrant and in the capacities and as of the dates indicated. Signature | Title | Date ----------------------------+--------------------------------------------------------------------------------------------------+------------------ /s/ W. Nicholas Howley | Chairman of the Board of Directors and Chief Executive Officer (Principal Executive Officer) | November 13, 2017 ----------------------------+--------------------------------------------------------------------------------------------------+------------------ W. Nicholas Howley | ----------------------------+------------------------------------------------------------------------------------------------- /s/ Terrance M. Paradie | Executive Vice President and ChiefFinancial Officer (Principal Financial and Accounting Officer) | November 13, 2017 ----------------------------+--------------------------------------------------------------------------------------------------+------------------ Terrance M. Paradie | ----------------------------+------------------------------------------------------------------------------------------------- /s/ David Barr | Director | November 13, 2017 ----------------------------+--------------------------------------------------------------------------------------------------+------------------ David Barr | ----------------------------+------------------------------------------------------------------------------------------------- /s/ William Dries | Director | November 13, 2017 ----------------------------+--------------------------------------------------------------------------------------------------+------------------ William Dries | ----------------------------+------------------------------------------------------------------------------------------------- /s/ Mervin Dunn | Director | November 13, 2017 ----------------------------+--------------------------------------------------------------------------------------------------+------------------ Mervin Dunn | ----------------------------+------------------------------------------------------------------------------------------------- /s/ Michael Graff | Director | November 13, 2017 ----------------------------+--------------------------------------------------------------------------------------------------+------------------ Michael Graff | ----------------------------+------------------------------------------------------------------------------------------------- /s/ Sean P. Hennessy | Director | November 13, 2017 ----------------------------+--------------------------------------------------------------------------------------------------+------------------ Sean P. Hennessy | ----------------------------+------------------------------------------------------------------------------------------------- /s/ George E. McCullough | Director | November 13, 2017 ----------------------------+--------------------------------------------------------------------------------------------------+------------------ George E. McCullough | ----------------------------+------------------------------------------------------------------------------------------------- /s/ Douglas Peacock | Director | November 13, 2017 ----------------------------+--------------------------------------------------------------------------------------------------+------------------ Douglas Peacock | ----------------------------+------------------------------------------------------------------------------------------------- /s/ Robert J. Small | Director | November 13, 2017 ----------------------------+--------------------------------------------------------------------------------------------------+------------------ Robert J. Small | ----------------------------+------------------------------------------------------------------------------------------------- /s/ John Staer | Director | November 13, 2017 ----------------------------+--------------------------------------------------------------------------------------------------+------------------ John Staer | ----------------------------+------------------------------------------------------------------------------------------------- /s/ Raymond F. Laubenthal | Director | November 13, 2017 ----------------------------+--------------------------------------------------------------------------------------------------+------------------ Raymond F. Laubenthal | ----------------------------+------------------------------------------------------------------------------------------------- 65 TRANSDIGM GROUP INCORPORATED AND SUBSIDIARIES ANNUAL REPORT ON FORM 10-K: FISCAL YEAR ENDED SEPTEMBER 30, 2017 ITEM 8 AND ITEM 15(a) (1) FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX | Page ---------------------------------------------------------------------------------------------------------------------+----------- Financial Statements: | ---------------------------------------------------------------------------------------------------------------------+----------- Report of Independent Registered Public Accounting Firm | F-1 ---------------------------------------------------------------------------------------------------------------------+----------- Consolidated Balance Sheets as of September 30, 2017 and 2016 | F-2 ---------------------------------------------------------------------------------------------------------------------+----------- Consolidated Statements of Income for Fiscal Years Ended September 30, 2017, 2016 and 2015 | F-3 ---------------------------------------------------------------------------------------------------------------------+----------- Consolidated Statements of Comprehensive Income for Fiscal Years Ended September 30, 2017, 2016 and 2015 | F-4 ---------------------------------------------------------------------------------------------------------------------+----------- Consolidated Statements of Changes in Stockholders’ Deficit for Fiscal Years Ended September 30, 2017, 2016 and 2015 | F-5 ---------------------------------------------------------------------------------------------------------------------+----------- Consolidated Statements of Cash Flows for Fiscal Years Ended September 30, 2017, 2016 and 2015 | F-6 ---------------------------------------------------------------------------------------------------------------------+----------- Notes to Consolidated Financial Statements for Fiscal Years Ended September 30, 2017, 2016 and 2015 | F-7 – F-41 ---------------------------------------------------------------------------------------------------------------------+----------- Supplementary Data: | ---------------------------------------------------------------------------------------------------------------------+----------- Valuation and Qualifying Accounts for the Fiscal Years Ended September 30, 2017, 2016 and 2015 | F-42 ---------------------------------------------------------------------------------------------------------------------+----------- 66 Report of Independent Registered Public Accounting Firm The Board of Directors and Shareholders of TransDigm Group Incorporated We have audited the accompanying consolidated balance sheets of TransDigm Group Incorporated as of September 30, 2017 and 2016, and the related consolidated statements of income, comprehensive income, changes in stockholders’ deficit and cash flows for each of the three years in the period ended September 30, 2017. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of TransDigm Group Incorporated at September, 30, 2017 and 2016, and the consolidated results of its operations and its cash flows for each of the three years in the period ended September 30, 2017, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), TransDigm Group Incorporated’s internal control over financial reporting as of September 30, 2017, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated November 13, 2017, expressed an unqualified opinion thereon. /s/ Ernst & Young LLP Cleveland, Ohio November 13, 2017 F-1 TRANSDIGM GROUP INCORPORATED CONSOLIDATED BALANCE SHEETS AS OF SEPTEMBER 30, 2017 AND 2016 (Amounts in thousands, except share amounts) | 2017 | | 2016 -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+----- ASSETS | | | -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+----- CURRENT ASSETS: | | | -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+----- Cash and cash equivalents | $ | 650,561 | | | $ | 1,586,994 -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+------+------------+---+----------- Trade accounts receivable—Net | 636,127 | | | 576,339 | -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+------+------------+-- Inventories—Net | 730,681 | | | 724,011 | -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+------+------------+-- Assets held-for-sale | 77,500 | | | — | -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+------+------------+-- Prepaid expenses and other | 38,683 | | | 43,353 | -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+------+------------+-- Total current assets | 2,133,552 | | | 2,930,697 | -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+------+------------+-- PROPERTY, PLANT AND EQUIPMENT—Net | 324,924 | | | 310,580 | -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+------+------------+-- GOODWILL | 5,745,338 | | | 5,679,452 | -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+------+------------+-- OTHER INTANGIBLE ASSETS—Net | 1,717,862 | | | 1,764,343 | -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+------+------------+-- OTHER | 53,985 | | | 41,205 | -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+------+------------+-- TOTAL ASSETS | $ | 9,975,661 | | | $ | 10,726,277 -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+------+------------+---+----------- LIABILITIES AND STOCKHOLDERS’ DEFICIT | | | -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+----- CURRENT LIABILITIES: | | | -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+----- Current portion of long-term debt | $ | 69,454 | | | $ | 52,645 -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+------+------------+---+----------- Short-term borrowings—trade receivable securitization facility | 299,587 | | | 199,771 | -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+------+------------+-- Accounts payable | 148,761 | | | 156,075 | -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+------+------------+-- Accrued liabilities | 335,888 | | | 344,112 | -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+------+------------+-- Liabilities held-for-sale | 17,304 | | | — | -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+------+------------+-- Total current liabilities | 870,994 | | | 752,603 | -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+------+------------+-- LONG-TERM DEBT | 11,393,620 | | | 9,943,191 | -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+------+------------+-- DEFERRED INCOME TAXES | 500,949 | | | 492,255 | -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+------+------------+-- OTHER NON-CURRENT LIABILITIES | 161,302 | | | 189,718 | -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+------+------------+-- Total liabilities | 12,926,865 | | | 11,377,767 | -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+------+------------+-- STOCKHOLDERS’ DEFICIT: | | | -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+----- Common stock—$.01 par value; authorized 224,400,000 shares; issued 56,093,659 and 55,767,767 shares at September 30, 2017 and 2016, respectively | 561 | | | 558 | -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+------+------------+-- Additional paid-in capital | 1,095,319 | | | 1,028,972 | -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+------+------------+-- Accumulated deficit | (3,187,220 | ) | | (1,146,963 | ) -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+------+------------+-- Accumulated other comprehensive loss | (85,143 | ) | | (149,787 | ) -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+------+------------+-- Treasury stock, at cost; 4,159,207 and 2,433,035 shares at September 30, 2017 and 2016, respectively | (774,721 | ) | | (384,270 | ) -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+------+------------+-- Total stockholders’ deficit | (2,951,204 | ) | | (651,490 | ) -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+------+------------+-- TOTAL LIABILITIES AND STOCKHOLDERS’ DEFICIT | $ | 9,975,661 | | | $ | 10,726,277 -------------------------------------------------------------------------------------------------------------------------------------------------+------------+-----------+------+------------+---+----------- See Notes to Consolidated Financial Statements F-2 TRANSDIGM GROUP INCORPORATED CONSOLIDATED STATEMENTS OF INCOME (Amounts in thousands, except per share amounts) | Fiscal Years Ended September 30, --------------------------------------------------------------------+--------------------------------- | 2017 | | 2016 | | 2015 --------------------------------------------------------------------+----------------------------------+-----------+------+-----------+----- NET SALES | $ | 3,504,286 | | | $ | 3,171,411 | | | $ | 2,707,115 --------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+---+---------- COST OF SALES | 1,519,659 | | | 1,443,348 | | | 1,257,270 | --------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+-- GROSS PROFIT | 1,984,627 | | | 1,728,063 | | | 1,449,845 | --------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+-- SELLING AND ADMINISTRATIVE EXPENSES | 415,575 | | | 382,858 | | | 321,624 | --------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+-- AMORTIZATION OF INTANGIBLE ASSETS | 89,226 | | | 77,445 | | | 54,219 | --------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+-- INCOME FROM OPERATIONS | 1,479,826 | | | 1,267,760 | | | 1,074,002 | --------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+-- INTEREST EXPENSE—Net | 602,589 | | | 483,850 | | | 418,785 | --------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+-- REFINANCING COSTS | 39,807 | | | 15,794 | | | 18,393 | --------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+-- INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES | 837,430 | | | 768,116 | | | 636,824 | --------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+-- INCOME TAX PROVISION | 208,889 | | | 181,702 | | | 189,612 | --------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+-- INCOME FROM CONTINUING OPERATIONS | 628,541 | | | 586,414 | | | 447,212 | --------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+-- LOSS FROM DISCONTINUED OPERATIONS, NET OF TAX | (31,654 | ) | | — | | | — | --------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+-- NET INCOME | 596,887 | | | 586,414 | | | 447,212 | --------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+-- NET INCOME APPLICABLE TO COMMON STOCK | $ | 437,630 | | | $ | 583,414 | | | $ | 443,847 --------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+---+---------- Net earnings per share: | | | | | --------------------------------------------------------------------+----------------------------------+-----------+------+-----------+----- Net earnings per share from continuing operations—basic and diluted | $ | 8.45 | | | $ | 10.39 | | | $ | 7.84 --------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+---+---------- Net loss per share from discontinued operations—basic and diluted | (0.57 | ) | | $ | — | | | $ | — | --------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+---+---------- Net earnings per share | $ | 7.88 | | | $ | 10.39 | | | $ | 7.84 --------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+---+---------- Cash dividends paid per common share | $ | 46.00 | | | $ | — | | | $ | — --------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+---+---------- Weighted-average shares outstanding: | | | | | --------------------------------------------------------------------+----------------------------------+-----------+------+-----------+----- Basic and diluted | 55,530 | | | 56,157 | | | 56,606 | --------------------------------------------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+-- See Notes to Consolidated Financial Statements. F-3 TRANSDIGM GROUP INCORPORATED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Amounts in thousands) | Fiscal Years Ended September 30, -----------------------------------------------+--------------------------------- | 2017 | | 2016 | | 2015 -----------------------------------------------+----------------------------------+---------+------+---------+----- Net income | $ | 596,887 | | | $ | 586,414 | | | $ | 447,212 -----------------------------------------------+----------------------------------+---------+------+---------+------+---------+---------+---+---+-------- Other comprehensive income (loss), net of tax: | | | | | -----------------------------------------------+----------------------------------+---------+------+---------+----- Foreign currency translation adjustments | 22,241 | | | (31,846 | ) | | (29,448 | ) -----------------------------------------------+----------------------------------+---------+------+---------+------+---------+---------+-- Interest rate swap and cap agreements | 34,471 | | | (9,648 | ) | | (35,604 | ) -----------------------------------------------+----------------------------------+---------+------+---------+------+---------+---------+-- Pension liability adjustments | 7,932 | | | (12,284 | ) | | (5,786 | ) -----------------------------------------------+----------------------------------+---------+------+---------+------+---------+---------+-- Other comprehensive income (loss), net of tax | 64,644 | | | (53,778 | ) | | (70,838 | ) -----------------------------------------------+----------------------------------+---------+------+---------+------+---------+---------+-- TOTAL COMPREHENSIVE INCOME | $ | 661,531 | | | $ | 532,636 | | | $ | 376,374 -----------------------------------------------+----------------------------------+---------+------+---------+------+---------+---------+---+---+-------- See Notes to Consolidated Financial Statements. F-4 TRANSDIGM GROUP INCORPORATED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ DEFICIT (Amounts in thousands, except share and per share amounts) | Common Stock | AdditionalPaid-InCapital | | AccumulatedDeficit | AccumulatedOtherComprehensiveLoss | | Treasury Stock | | --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+-- | NumberofShares | CommonStock | | NumberofShares | Value | | Total --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+--------------- BALANCE—September 30, 2014 | 53,832,246 | | $ | 538 | | $ | 794,767 | | | $ | (2,150,293 | ) | $ | (25,171 | ) | | (1,415,100 | ) | | $ | (175,940 | ) | $ | (1,556,099 | ) --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+---+----------+---+---+------------+-- Unvested dividend equivalent payments | — | | — | | — | | | (14,151 | ) | | — | | — | | | — | | | (14,151 | ) --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- Compensation expense recognized for employee stock options and restricted stock | — | | — | | 31,500 | | | — | | | — | | — | | | — | | | 31,500 | --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- Excess tax benefits related to share-based payment arrangements | — | | — | | 61,965 | | | — | | | — | | — | | | — | | | 61,965 | --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- Exercise of employee stock options | 1,248,175 | | 13 | | 61,674 | | | — | | | — | | — | | | — | | | 61,687 | --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- Common stock issued | 19,673 | | — | | 418 | | | — | | | — | | — | | | — | | | 418 | --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- Net income | — | | — | | — | | | 447,212 | | | — | | — | | | — | | | 447,212 | --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- Interest rate swaps, net of tax | — | | — | | — | | | — | | | (35,604 | ) | — | | | — | | | (35,604 | ) --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- Foreign currency translation adjustments | — | | — | | — | | | — | | | (29,448 | ) | — | | | — | | | (29,448 | ) --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- Pension liability adjustments, net of tax | — | | — | | — | | | — | | | (5,786 | ) | — | | | — | | | (5,786 | ) --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- BALANCE—September 30, 2015 | 55,100,094 | | 551 | | 950,324 | | | (1,717,232 | ) | | (96,009 | ) | (1,415,100 | ) | | (175,940 | ) | | (1,038,306 | ) --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- Unvested dividend equivalent payments and other | — | | — | | — | | | (16,145 | ) | | — | | — | | | — | | | (16,145 | ) --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- Compensation expense recognized for employee stock options and restricted stock | — | | — | | 48,306 | | | — | | | — | | — | | | — | | | 48,306 | --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- Exercise of employee stock options and restricted stock activity, net | 666,709 | | 7 | | 30,112 | | | — | | | — | | (2,548 | ) | | (575 | ) | | 29,544 | --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- Treasury stock purchased | — | | — | | — | | | — | | | — | | (1,015,387 | ) | | (207,755 | ) | | (207,755 | ) --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- Common stock issued | 964 | | — | | 230 | | | — | | | — | | — | | | — | | | 230 | --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- Net income | — | | — | | — | | | 586,414 | | | — | | — | | | — | | | 586,414 | --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- Interest rate swaps and caps, net of tax | — | | — | | — | | | — | | | (9,648 | ) | — | | | — | | | (9,648 | ) --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- Foreign currency translation adjustments | — | | — | | — | | | — | | | (31,846 | ) | — | | | — | | | (31,846 | ) --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- Pension liability adjustments, net of tax | — | | — | | — | | | — | | | (12,284 | ) | — | | | — | | | (12,284 | ) --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- BALANCE—September 30, 2016 | 55,767,767 | | 558 | | 1,028,972 | | | (1,146,963 | ) | | (149,787 | ) | (2,433,035 | ) | | (384,270 | ) | | (651,490 | ) --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- Dividends paid | — | | — | | — | | | (2,422,295 | ) | | — | | — | | | — | | | (2,422,295 | ) --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- Unvested dividend equivalent payments and other | — | | — | | — | | | (214,849 | ) | | — | | — | | | — | | | (214,849 | ) --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- Compensation expense recognized for employee stock options and restricted stock | — | | — | | 44,931 | | | — | | | — | | — | | | — | | | 44,931 | --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- Exercise of employee stock options, restricted stock activity and other, net | 324,908 | | 3 | | 21,177 | | | — | | | — | | (2,548 | ) | | (630 | ) | | 20,550 | --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- Treasury stock purchased | — | | — | | — | | | — | | | — | | (1,723,624 | ) | | (389,821 | ) | | (389,821 | ) --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- Common stock issued | 984 | | — | | 239 | | | — | | | — | | — | | | — | | | 239 | --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- Net income | — | | — | | — | | | 596,887 | | | — | | — | | | — | | | 596,887 | --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- Interest rate swaps and caps, net of tax | — | | — | | — | | | — | | | 34,471 | | — | | | — | | | 34,471 | --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- Foreign currency translation adjustments | — | | — | | — | | | — | | | 22,241 | | — | | | — | | | 22,241 | --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- Pension liability adjustments, net of tax | — | | — | | — | | | — | | | 7,932 | | — | | | — | | | 7,932 | --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+-- BALANCE—September 30, 2017 | 56,093,659 | | $ | 561 | | $ | 1,095,319 | | | $ | (3,187,220 | ) | $ | (85,143 | ) | | (4,159,207 | ) | | $ | (774,721 | ) | $ | (2,951,204 | ) --------------------------------------------------------------------------------+----------------+--------------------------+-----+--------------------+-----------------------------------+---+----------------+------------+---+---+------------+---+------------+---------+---+----------+------------+---+------------+---+----------+---+---+------------+-- See Notes to Consolidated Financial Statements. F-5 TRANSDIGM GROUP INCORPORATED CONSOLIDATED STATEMENTS OF CASH FLOWS (Amounts in thousands) | Fiscal Years Ended September 30, ------------------------------------------------------------------------------------+--------------------------------- | 2017 | | 2016 | | 2015 ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+----- OPERATING ACTIVITIES: | | | | | ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+----- Net income | $ | 596,887 | | | $ | 586,414 | | | $ | 447,212 ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+---+---+-------- Net loss from discontinued operations | 31,654 | | | — | | | — | ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- Adjustments to reconcile net income to net cash provided by operating activities: | | | | | ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+----- Depreciation | 50,937 | | | 43,455 | | | 35,939 | ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- Amortization of intangible assets and product certification costs | 90,088 | | | 78,215 | | | 57,724 | ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- Amortization of debt issuance costs, original issue discount and premium | 21,106 | | | 16,211 | | | 15,797 | ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- Refinancing costs | 39,807 | | | 15,794 | | | 18,393 | ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- Non-cash equity compensation | 45,524 | | | 48,306 | | | 31,500 | ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- Excess tax benefits related to share-based payment arrangements | — | | | — | | | (61,965 | ) ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- Deferred income taxes | (918 | ) | | 5,808 | | | 660 | ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- Changes in assets/liabilities, net of effects from acquisitions of businesses: | | | | | ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+----- Trade accounts receivable | (54,669 | ) | | (80,114 | ) | | (25,418 | ) ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- Inventories | 5,127 | | | (2,073 | ) | | (25,974 | ) ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- Income taxes receivable/payable | 18,219 | | | (12,299 | ) | | 65,418 | ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- Other assets | (10,564 | ) | | (4,919 | ) | | (12,392 | ) ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- Accounts payable | (10,354 | ) | | (6,657 | ) | | 13,480 | ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- Accrued interest | (958 | ) | | 17,933 | | | (3,934 | ) ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- Accrued and other liabilities | (33,153 | ) | | (22,776 | ) | | (35,502 | ) ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- Net cash provided by operating activities | 788,733 | | | 683,298 | | | 520,938 | ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- INVESTING ACTIVITIES: | | | | | ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+----- Capital expenditures, net of disposals | (71,013 | ) | | (43,982 | ) | | (54,871 | ) ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- Payments made in connection with acquisitions | (136,295 | ) | | (1,399,064 | ) | | (1,624,278 | ) ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- Acquisition of Schroth, net of cash acquired | (79,695 | ) | | — | | | — | ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- Net cash used in investing activities | (287,003 | ) | | (1,443,046 | ) | | (1,679,149 | ) ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- FINANCING ACTIVITIES: | | | | | ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+----- Excess tax benefits related to share-based payment arrangements | — | | | — | | | 61,965 | ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- Proceeds from exercise of stock options | 21,177 | | | 30,112 | | | 61,674 | ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- Dividends paid | (2,581,552 | ) | | (3,000 | ) | | (3,365 | ) ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- Treasury stock purchased | (389,821 | ) | | (207,755 | ) | | — | ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- Proceeds from term loans, net | 2,937,773 | | | 1,711,515 | | | 1,515,954 | ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- Repayment on term loans | (1,284,698 | ) | | (834,409 | ) | | (1,025,318 | ) ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- Proceeds from senior subordinated notes, net | 300,386 | | | 939,584 | | | 445,303 | ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- Cash tender and redemption of senior subordinated notes due 2021, including premium | (528,847 | ) | | — | | | — | ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- Proceeds from trade receivable securitization facility, net | 99,471 | | | — | | | — | ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- Financing fees and other | (17,571 | ) | | (3,580 | ) | | (1,266 | ) ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- Net cash (used in) provided by financing activities | (1,443,682 | ) | | 1,632,467 | | | 1,054,947 | ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS | 5,519 | | | 242 | | | (2,251 | ) ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS | (936,433 | ) | | 872,961 | | | (105,515 | ) ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD | 1,586,994 | | | 714,033 | | | 819,548 | ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+-- CASH AND CASH EQUIVALENTS, END OF PERIOD | $ | 650,561 | | | $ | 1,586,994 | | | $ | 714,033 ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+---+---+-------- SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: | | | | | ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+----- Cash paid during the period for interest | $ | 587,718 | | | $ | 448,608 | | | $ | 398,939 ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+---+---+-------- Cash paid during the period for income taxes | $ | 185,295 | | | $ | 183,291 | | | $ | 127,363 ------------------------------------------------------------------------------------+----------------------------------+---------+------+------------+------+-----------+------------+---+---+-------- See Notes to Consolidated Financial Statements. F-6 TRANSDIGM GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. DESCRIPTION OF THE BUSINESS Description of the Business —TransDigm Group Incorporated (“TD Group”), through its wholly-owned subsidiary, TransDigm Inc., is a leading global designer, producer and supplier of highly engineered aircraft components for use on nearly all commercial and military aircraft in service today. TransDigm Inc., along with TransDigm Inc.’s direct and indirect wholly-owned operating subsidiaries (collectively, with TD Group, the “Company” or “TransDigm”), offers a broad range of proprietary aerospace components. TD Group has no significant assets or operations other than its 100% ownership of TransDigm Inc. TD Group’s common stock is listed on the New York Stock Exchange, or the NYSE, under the trading symbol “TDG.” Major product offerings, substantially all of which are ultimately provided to end-users in the aerospace industry, include mechanical/electro-mechanical actuators and controls, ignition systems and engine technology, specialized pumps and valves, power conditioning devices, specialized AC/DC electric motors and generators, NiCad batteries and chargers, engineered latching and locking devices, rods and locking devices, engineered connectors and elastomers, databus and power controls, cockpit security components and systems, specialized cockpit displays, aircraft audio systems, specialized lavatory components, seat belts and safety restraints, engineered interior surfaces and related components, lighting and control technology, military personnel parachutes, high performance hoists, winches and lifting devices, and cargo loading, handling and delivery systems. 2. ACQUISITIONS During the last three fiscal years, the Company completed the acquisitions of Schroth, Y&F/Tactair, DDC, Breeze-Eastern, PneuDraulics, Pexco Aerospace, Adams Rite Aerospace GmbH and Telair Cargo Group. Additionally, during the third quarter of fiscal 2017, the Company acquired three separate aerospace product lines (collectively, the “Third Quarter 2017 Acquisitions”). The Company accounted for the acquisitions using the acquisition method and included the results of operations of the acquisitions in its consolidated financial statements from the effective date of each acquisition. As of September 30, 2017 , the one-year measurement period is open for Schroth and the Third Quarter 2017 Acquisitions and therefore the assets acquired and liabilities assumed related to these acquisitions are subject to adjustment until the end of the respective one-year measurement period. The Company is in the process of obtaining a third-party valuation of certain tangible and intangible assets of the Third Quarter 2017 Acquisitions; therefore, the values attributed to those acquired assets and liabilities in the consolidated financial statements are subject to adjustment. Pro forma net sales and results of operations for the acquisitions, had they occurred at the beginning of the applicable fiscal year ended September 30, 2017 or 2016 , are not material and, accordingly, are not provided. The acquisitions strengthen and expand the Company’s position to design, produce and supply highly engineered proprietary aerospace components in niche markets with significant aftermarket content and provide opportunities to create value through the application of our three core value-driven operating strategies (obtaining profitable new business, improving our cost structure, and providing highly engineered value-added products to customers). The purchase price paid for each acquisition reflects the current earnings before interest, taxes, depreciation and amortization (EBITDA) and cash flows, as well as the future EBITDA and cash flows expected to be generated by the business, which are driven in most cases by the recurring aftermarket consumption over the life of a particular aircraft, estimated to be approximately 25 to 30 years . Third Quarter 2017 Acquisitions – During the third quarter of fiscal 2017, the Company acquired the Third Quarter 2017 Acquisitions for a total purchase price of approximately $106.3 million in cash, which includes working capital settlements totaling $1.0 million paid in the third and fourth quarter of 2017. All three product lines consist primarily of proprietary, sole source products with significant aftermarket content. The products include highly engineered aerospace controls, quick disconnect couplings, and communication electronics. Each product line acquired was consolidated into an existing TransDigm reporting unit within TransDigm's Power & Control segment. The Company expects that approximately $62 million of goodwill recognized for the acquisitions will be deductible for tax purposes over 15 years and approximately $9 million of goodwill recognized for the acquisitions will not be deductible for tax purposes. Schroth – On February 22, 2017, the Company acquired all of the outstanding stock of Schroth Safety Products GmbH and certain aviation and defense assets and liabilities from subsidiaries of Takata Corporation (collectively, "Schroth"), for a total purchase price of approximately $89.7 million , of which $79.7 million was paid in cash (including a working capital settlement of $0.8 million paid in the third quarter of 2017) and the remaining approximately $10.0 million of which is accrued primarily related to an indemnity holdback to be settled within the one-year measurement period. In connection with the settlement of a Department of Justice investigation into the competitive effects of the acquisition, during the fourth quarter of 2017, the Company committed to dispose of the Schroth business. Therefore, Schroth was classified as held-for-sale as of September 30, 2017. The results of operations of Schroth are reflected as discontinued operations in the accompanying consolidated financial statements. Schroth designs and manufactures proprietary, highly engineered, advanced F-7 safety systems for aviation, racing and military ground vehicles around the world. Prior to being classified as discontinued operations, Schroth was included in TransDigm's Airframe segment. The loss from discontinued operations in the consolidated statements of income includes a $32.0 million impairment charge to write down Schroth’s assets to estimated fair value. The impairment charge recorded in the fourth quarter of 2017 was based on an internal assessment around the recovery of the Schroth assets. Schroth’s assets have been recorded at fair value in the consolidated balance sheet as of September 30, 2017. Further disclosure related to Schroth’s discontinued operations is included in Note 22. Y&F/Tactair – On September 23, 2016, the Company acquired all of the outstanding stock of Young & Franklin, Inc., the parent company of Tactair Fluid Controls, Inc., for approximately $258.8 million in cash, which includes a working capital settlement of $2.7 million paid in the first quarter of 2017. Y&F/Tactair manufactures proprietary, highly engineered valves and actuators. Y&F/Tactair is included in TransDigm’s Power & Control segment. The purchase price includes approximately $74.5 million of tax benefits being realized by the Company over a 15 -year period that began in the first quarter of fiscal 2017. The Company expects that approximately $124 million of goodwill recognized for the acquisition will be deductible for tax purposes over 15 years and approximately $8 million of goodwill recognized for the acquisition will not be deductible for tax purposes. Data Device Corporation – On June 23, 2016, the Company acquired all of the outstanding stock of ILC Holdings, Inc., the parent company of Data Device Corporation, for a total purchase price of approximately $997.7 million in cash, which includes a working capital settlement of $1.4 million received in the first quarter of fiscal 2017. TransDigm financed the acquisition of DDC with cash proceeds from the issuance of senior subordinated notes due in June 2026 and term loans. DDC is a supplier of databus and power controls and related products that are used primarily in military avionics, commercial aerospace and space applications. DDC is included in TransDigm’s Power & Control segment. The total purchase price of DDC was allocated to the underlying assets acquired and liabilities assumed based upon management’s estimated fair values at the date of acquisition. To the extent the purchase price exceeded the estimated fair value of the net identifiable tangible and intangible assets acquired, such excess was allocated to goodwill. The following table summarizes the final purchase price allocation of the estimated fair values of the assets acquired and liabilities assumed at the transaction date (in thousands). Assets acquired: | ----------------------------------------+---------- Current assets, excluding cash acquired | $ | 107,728 ----------------------------------------+-----------+-------- Property, plant, and equipment | 20,818 | ----------------------------------------+-----------+-------- Intangible assets | 229,300 | ----------------------------------------+-----------+-------- Goodwill | 750,935 | ----------------------------------------+-----------+-------- Other | 2,036 | ----------------------------------------+-----------+-------- Total assets acquired | 1,110,817 | ----------------------------------------+-----------+-------- Liabilities assumed: | ----------------------------------------+---------- Current liabilities | 26,520 | ----------------------------------------+-----------+-------- Other noncurrent liabilities | 86,642 | ----------------------------------------+-----------+-------- Total liabilities assumed | 113,162 | ----------------------------------------+-----------+-------- Net assets acquired | $ | 997,655 ----------------------------------------+-----------+-------- Approximately $740 million of goodwill recognized for the acquisition is not deductible for tax purposes and approximately $11 million of goodwill recognized for the acquisition is deductible for tax purposes over 15 years. Breeze-Eastern – On January 4, 2016, the Company completed the tender offer for all of the outstanding stock of Breeze-Eastern for $19.61 per share in cash. The purchase price was approximately $205.9 million , of which $146.4 million (net of cash acquired of $ 30.8 million ) was paid at closing and $34.9 million was paid to dissenting shareholders during the first fiscal quarter of 2017. Of the $34.9 million payment, $28.7 million related to the original merger consideration and $6.2 million represented the settlement reached with the dissenting shareholders resolving the dispute over the dissenting shareholders’ statutory appraisal action. Of the $6.2 million settlement, $4.9 million was recorded as selling and administrative expense and $1.3 million was recorded as interest expense for statutory interest arising under Delaware General Corporate Law. Once the Company paid the $34.9 million settlement to the dissenting shareholders on October 20, 2016, the dissenting stockholders fully released their claims against the Company. Breeze-Eastern manufactures high performance lifting and pulling devices for military and civilian aircraft, including rescue hoists, winches and cargo hooks, and weapons-lifting systems. Breeze-Eastern is included in TransDigm’s Power & Control segment. All of the approximately $115 million of goodwill recognized for the acquisition is not deductible for tax purposes. F-8 PneuDraulics – On August 19, 2015, the Company acquired all of the outstanding stock of PneuDraulics, Inc. for approximately $321.5 million in cash, which is net of a working capital settlement received in fiscal 2016 of $2.0 million . PneuDraulics manufactures proprietary, highly engineered aerospace pneumatic and hydraulic components and subsystems for commercial transport, regional, business jet and military applications. PneuDraulics is included in TransDigm’s Power & Control segment. The purchase price includes approximately $108.1 million of tax benefits being realized by the Company over a 15 -year period that began in the fourth quarter of fiscal 2015. All of the approximately $223 million of goodwill recognized for the acquisition is deductible for tax purposes. Pexco Aerospace – On May 14, 2015, the Company acquired the assets of the aerospace business of Pexco LLC (“Pexco Aerospace”) for a total purchase price of approximately $496.4 million in cash. Pexco Aerospace manufactures extruded plastic interior parts for use in the commercial aerospace industry. Pexco Aerospace is included in TransDigm’s Airframe segment. The purchase price includes approximately $166.4 million of tax benefits being realized by TransDigm over a 15 -year period that began in the third quarter of fiscal 2015. All of the approximately $406 million of goodwill recognized for the acquisition is deductible for tax purposes. Adams Rite Aerospace GmbH – On March 31, 2015, the Company acquired the aerospace business of Franke Aquarotter GmbH (now known as Adams Rite Aerospace GmbH) for approximately $75.3 million in cash. Adams Rite Aerospace GmbH manufactures proprietary faucets and related products for use on commercial transports and regional jets. Adams Rite Aerospace GmbH is included in TransDigm’s Airframe segment. All of the approximately $64 million of goodwill recognized for the acquisition is not deductible for tax purposes. Telair Cargo Group – On March 26, 2015, the Company acquired all of the outstanding stock of Telair International GmbH (“Telair Europe”), all of the outstanding stock of Nordisk Aviation Products (“Nordisk”) and the assets of the AAR Cargo business (collectively, “Telair Cargo Group”). The total purchase price was approximately $730.9 million in cash. Telair Cargo Group manufactures aerospace on-board cargo loading and handling, restraint systems and unit load devices for a variety of commercial and military platforms with positions on a wide range of new and existing aircraft. The business consists of three reporting units: Telair Europe, Nordisk and Telair US. Telair Europe and Telair US are included in TransDigm’s Power & Control segment and Nordisk is included in TransDigm’s Airframe segment. Approximately $33 million of goodwill recognized for the acquisition is deductible for tax purposes and approximately $450 million of goodwill recognized for the acquisition is not deductible for tax purposes. 3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation and Consolidation —The accompanying consolidated financial statements were prepared in conformity with generally accepted accounting principles in the United States (“GAAP”) and include the accounts of TD Group and subsidiaries. All significant intercompany balances and transactions have been eliminated. Certain reclassifications have been made to the current period annual and interim final statements as during the fourth quarter of 2017, the Company committed to disposing of Schroth. As of September 30, 2017, Schroth was classified as held-for-sale and the results of operations for Schroth are reflected as discontinued operations in the accompanying consolidated financial statements. Refer to Note 22, “Discontinued Operations,” for further information. Revenue Recognition and Related Allowances —Revenue is recognized from the sale of products when title and risk of loss passes to the customer, which is generally at the time of shipment. Substantially all product sales are made pursuant to firm, fixed-price purchase orders received from customers. Provisions for estimated returns, uncollectible accounts and the cost of repairs under contract warranty provisions are provided for in the same period as the related revenues are recorded and are principally based on historical results modified, as appropriate, by the most current information available. Due to uncertainties in the estimation process, it is possible that actual results may vary from the estimates. Shipping and Handling Costs —Shipping and handling costs are included in cost of sales in the consolidated statements of income. Research and Development Costs —The Company expenses research and development costs as incurred and classifies such amounts in selling and administrative expenses. The expense recognized for research and development costs for the years ended September 30, 2017 , 2016 and 2015 was approximately $73.8 million , $58.6 million , and $48.3 million , respectively. Cash Equivalents —The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Allowance for Uncollectible Accounts —The Company reserves for amounts determined to be uncollectible based on specific identification of losses and estimated losses based on historical experience. The allowance also incorporates a provision for the estimated impact of disputes with customers. The determination of the amount of the allowance for doubtful accounts is subject to significant levels of judgment and estimation by management. If circumstances change or economic conditions deteriorate or improve, the allowance for doubtful accounts could increase or decrease. F-9 Inventories —Inventories are stated at the lower of cost or market. Cost of inventories is generally determined by the average cost and the first-in, first-out (FIFO) methods and includes material, labor and overhead related to the manufacturing process. Provision for potentially obsolete or slow-moving inventory is made based on management’s analysis of inventory levels and future sales forecasts. Property, Plant and Equipment —Property, plant and equipment are stated at cost and include improvements which significantly increase capacities or extend the useful lives of existing plant and equipment. Depreciation is computed using the straight-line method over the following estimated useful lives: land improvements from 10 to 20 years, buildings and improvements from 5 to 30 years, machinery and equipment from 2 to 10 years and furniture and fixtures from 3 to 10 years. Net gains or losses related to asset dispositions are recognized in earnings in the period in which dispositions occur. Routine maintenance, repairs and replacements are expensed as incurred. Property, plant and equipment is assessed for potential impairment whenever indicators of impairment are present by determining whether the carrying value of the property can be recovered through projected, undiscounted cash flows from future operations over the property’s remaining estimated useful life. Any impairment recognized is the amount by which the carrying amount exceeds the fair value of the asset. Fair value is measured based on quoted market prices in active markets, if available. If quoted market prices are not available, the estimate of fair value is based on various valuation techniques, including the discounted value of estimated future cash flows. Debt Issuance Costs, Premiums and Discounts —The cost of obtaining financing as well as premiums and discounts are amortized using the effective interest method over the terms of the respective obligations as a component of interest expense within the consolidated statements of income. Debt issuance costs are presented in the consolidated balance sheets as a direct reduction from the carrying amount of the related debt liabilities. Intangible Assets —Intangible assets consist of identifiable intangibles acquired or recognized in accounting for the acquisitions (trademarks, trade names, technology, order backlog and other intangible assets) and goodwill. Goodwill and intangible assets that have indefinite useful lives (i.e., trademarks and trade names) are subject to annual impairment testing. Management determines fair value using a discounted future cash flow analysis or other accepted valuation techniques. The Company performs an annual impairment test for goodwill and other intangible assets as of the first day of the fourth fiscal quarter of each year, or more frequently, if an event occurs or circumstances change that would more likely than not reduce fair value below current value. At the time of goodwill impairment testing, the Company first assesses qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, and whether it is therefore necessary to perform the quantitative goodwill impairment test. The quantitative goodwill impairment test consists of two steps. The first step of the goodwill impairment test, used to identify potential impairment, compares the fair value of a reporting unit (as defined) with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, goodwill is not considered impaired, and the second step of the goodwill impairment test is unnecessary. The second step measures the amount of impairment, if any, by comparing the carrying value of the goodwill associated with a reporting unit to the implied fair value of the goodwill derived from the estimated overall fair value of the reporting unit and the individual fair values of the other assets and liabilities of the reporting unit. GAAP requires that the annual, and any interim, impairment assessment be performed at the reporting unit level. The reporting unit level is one level below an operating segment. Substantially all goodwill was determined and recognized for each reporting unit pursuant to the accounting for the merger or acquisition as of the date of each transaction. With respect to acquisitions integrated into an existing reporting unit, any acquired goodwill is combined with the goodwill of the reporting unit. The impairment test for indefinite lived intangible assets consists of a comparison between their fair values and carrying values. If the carrying amounts of intangible assets that have indefinite useful lives exceed their fair values, an impairment loss will be recognized in an amount equal to the sum of any such excesses. The Company assesses the recoverability of its amortizable intangible assets only when indicators of impairment are present by determining whether the amortization over their remaining lives can be recovered through projected, undiscounted cash flows from future operations. Amortization of amortizable intangible assets is computed using the straight-line method over the following estimated useful lives: technology from 20 to 22 years, order backlog over one year , and other intangible assets over 20 years. Stock-Based Compensation —The Company records stock-based compensation expense using the fair value method of accounting. Compensation expense is recorded over the vesting periods of the stock options, restricted stock and other stock-based incentives. No expense is recognized for any stock options, restricted stock and other stock-based incentives ultimately forfeited because the recipients fail to meet vesting requirements. Income Taxes —The Company accounts for income taxes using an asset and liability approach. Deferred taxes are recorded for the difference between the book and tax basis of various assets and liabilities. A valuation allowance is provided when it is more likely than not that some or all of a deferred tax asset will not be realized. F-10 Contingencies —During the ordinary course of business, the Company is from time to time threatened with, or may become a party to, legal actions and other proceedings. While the Company is currently involved in certain legal proceedings, it believes the results of these proceedings will not have a material adverse effect on its financial condition, results of operations, or cash flows. Estimates —The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Comprehensive Income (Loss) —The term “comprehensive income (loss)” represents the change in stockholders’ equity (deficit) from transactions and other events and circumstances resulting from non-stockholder sources. The Company’s accumulated other comprehensive income or loss, consisting principally of fair value adjustments to its interest rate swap and cap agreements (net of tax), cumulative foreign currency translation adjustments and pension liability adjustments (net of tax), is reported separately in the accompanying consolidated statements of comprehensive income. Foreign Currency Translation and Transactions —The assets and liabilities of subsidiaries located outside the United States are translated into U.S. dollars at the rates of exchange in effect at the balance sheet dates. Revenue and expense items are translated at the average monthly exchange rates prevailing during the period. Gains and losses resulting from foreign currency transactions are recognized currently in income, and those resulting from translation of financial statements are accumulated as a separate component of other comprehensive income (loss) for the period. Foreign currency gains or losses recognized currently in income from changes in exchange rates were immaterial to our results of operations. Earnings per Share —Earnings per share information is determined using the two-class method, which includes the weighted-average number of common shares outstanding during the period and other securities that participate in dividends (“participating securities”). Our vested stock options are considered “participating securities” because they include non-forfeitable rights to dividends. In applying the two-class method, earnings are allocated to both common stock shares and participating securities based on their respective weighted-average shares outstanding for the period. Diluted earnings per share information may include the additional effect of other securities, if dilutive, in which case the dilutive effect of such securities is calculated using the treasury stock method. Contingently issuable shares are not included in earnings per share until the period in which the contingency is satisfied; therefore, basic and diluted earnings per share are the same. 4. RECENT ACCOUNTING PRONOUNCEMENTS In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-09, which creates a new topic in the Accounting Standards Codification (“ASC”) 606, “Revenue From Contracts With Customers .” In addition to superseding and replacing nearly all existing U.S. GAAP revenue recognition guidance, including industry-specific guidance, ASC 606 establishes a new control-based revenue recognition model; changes the basis for deciding when revenue is recognized over time or at a point in time; provides new and more detailed guidance on specific topics; and expands and improves disclosures about revenue. The new revenue standards may be applied retrospectively to each prior period presented or retrospectively with the cumulative effect recognized as of the date of adoption. The guidance is effective for the Company for annual reporting periods, including interim periods therein, beginning October 1, 2018, which is the Company’s planned date of adoption. The Company preliminarily expects to use the full retrospective method. The Company is continuing to evaluate the impact of the standard, and the planned adoption method is subject to change. For each reporting unit, we have evaluated a representative sample of contracts and other agreements with our customers and evaluated the provisions contained within these contracts and agreements in consideration of the five step model specified within ASC 606. We are in the process of documenting the impact of the standard on our current accounting policies and practices in order to identify material differences, if any, that would result from applying the new requirements to our revenue contracts. We continue to make progress on our assessment of ASC 606 and are also in the process of evaluating the impact, if any, on changes to our business processes, systems, and controls to support recognition and disclosure requirements under ASC 606. In September 2015, the FASB issued ASU 2015-16, "Simplifying the Accounting for Measurement-Period Adjustments," a new standard intended to simplify the accounting for measurement period adjustments in a business combination. Measurement period adjustments are changes to provisional amounts recorded when the accounting for a business combination is incomplete as of the end of a reporting period. The measurement period can extend for up to a year following the transaction date. During the measurement period, companies may make adjustments to provisional amounts when information necessary to complete the measurement is received. The new guidance requires companies to recognize these adjustments, including any related impacts to net income, in the reporting period in which the adjustments are determined. Companies are no longer required to retroactively apply measurement period adjustments to all periods presented. The guidance was effective for the Company on October 1, 2016. However, as early adoption was permissible, the Company adopted the pronouncement beginning October 1, 2015. The adoption of this standard did not have a significant impact on its consolidated financial statements and disclosures. F-11 In February 2016, the FASB issued ASU 2016-02, “Leases (ASC 842),” which will require that a lessee recognize assets and liabilities on the balance sheet for all leases with a lease term of more than twelve months, with the result being the recognition of a right of use asset and a lease liability. The guidance is effective for the Company for annual reporting periods, including interim periods therein, beginning October 1, 2019, with early adoption permitted. The Company is currently evaluating the impact of adopting this standard on its consolidated financial statements and disclosures. In March 2016, the FASB issued ASU 2016-09, “Improvements to Employee Share-Based Payment Accounting.” The guidance requires the recognition of the income tax effects of awards in the income statement when the awards vest or are settled, thus eliminating additional paid in capital pools. The guidance also allows for the employer to repurchase more of an employee’s shares for tax withholding purposes without triggering liability accounting. In addition, the guidance allows for a policy election to account for forfeitures as they occur rather than on an estimated basis. ASU 2016-09 was effective for the Company for annual reporting periods, including interim periods therein, beginning October 1, 2017, with early adoption permitted. As early adoption is permissible, the Company adopted this standard in the fourth quarter of fiscal 2016. Changes were applied prospectively in accordance with the standard and prior periods were not adjusted. In addition, the Company continued to account for forfeitures on an estimated basis. In June 2016, the FASB issued ASU 2016-13, "Financial Instruments—Credit Losses: Measurement of Credit Losses on Financial Instruments (ASU 2016-13)," which changes the impairment model for most financial assets. The new model uses a forward-looking expected loss method, which will generally result in earlier recognition of allowances for losses. ASU 2016-13 is effective for annual and interim periods beginning after December 15, 2019 and early adoption is permitted for annual and interim periods beginning after December 15, 2018. The Company is currently evaluating the impact of adopting this standard on its consolidated financial statements and disclosures. In August 2016, the FASB issued ASU 2016-15, "Statement of Cash Flows—Classification of Certain Cash Receipts and Cash Payments," which clarifies existing guidance related to accounting for cash receipts and cash payments and classification on the statement of cash flows. This guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2017, with early adoption permitted. The Company elected to early adopt this standard in the fourth quarter of fiscal 2017. The adoption of this standard did not have a significant impact on its consolidated statement of cash flows. In January 2017, the FASB issued ASU 2017-04, “Simplifying the Test for Goodwill Impairment,” to eliminate Step 2 from the goodwill impairment test in order to simplify the subsequent measurement of goodwill. The guidance is effective for fiscal years beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The adoption of this standard is not expected to have a material impact on its consolidated financial statements and disclosures. In May 2017, the FASB issued ASU 2017-09, "Compensation—Stock Compensation (ASC 718): Scope of Modification Accounting," which provides clarity on which changes to the terms or conditions of share-based payment awards require an entity to apply the modification accounting provisions required in ASC 718. The standard is effective for all entities for annual periods beginning after December 15, 2017, with early adoption permitted, including adoption in any interim period for which financial statements have not yet been issued. The adoption of this standard is not expected to have a material impact on its consolidated financial statements and disclosures. In August 2017, the FASB issued ASU 2017-12, “Derivatives and Hedging (ASC 815): Targeted Improvements to Accounting for Hedging Activities,” which amends the FASB’s hedge accounting model to enable entities to better portray their risk management activities in financial statements. The guidance eliminates the requirement to separately measure and report hedge ineffectiveness and generally requires the entire change in the fair value of a hedging instrument to be presented in the same income statement line as the hedged item. The guidance also eases certain documentation and assessment requirements and modifies the accounting for components excluded from the assessment of hedge effectiveness. This guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2018, and early adoption is permitted. The Company is currently evaluating the impact of adopting this standard on its consolidated financial statements and disclosures. F-12 5. EARNINGS PER SHARE (TWO-CLASS METHOD) The following table sets forth the computation of basic and diluted earnings per share (in thousands, except per share data): | Fiscal Years Ended September 30, ---------------------------------------------------------------------------------+--------------------------------- | 2017 | | 2016 | | 2015 ---------------------------------------------------------------------------------+----------------------------------+---------+------+--------+----- Numerator for earnings per share: | | | | | ---------------------------------------------------------------------------------+----------------------------------+---------+------+--------+----- Net income from continuing operations | $ | 628,541 | | | $ | 586,414 | | | $ | 447,212 ---------------------------------------------------------------------------------+----------------------------------+---------+------+--------+------+---------+--------+---+---+-------- Less dividends paid on participating securities | (159,257 | ) | | (3,000 | ) | | (3,365 | ) ---------------------------------------------------------------------------------+----------------------------------+---------+------+--------+------+---------+--------+-- | $ | 469,284 | | | $ | 583,414 | | | $ | 443,847 ---------------------------------------------------------------------------------+----------------------------------+---------+------+--------+------+---------+--------+---+---+-------- Net loss from discontinued operations | (31,654 | ) | | — | | | — | ---------------------------------------------------------------------------------+----------------------------------+---------+------+--------+------+---------+--------+-- Net income applicable to common stock—basic and diluted | $ | 437,630 | | | $ | 583,414 | | | $ | 443,847 ---------------------------------------------------------------------------------+----------------------------------+---------+------+--------+------+---------+--------+---+---+-------- Denominator for basic and diluted earnings per share under the two-class method: | | | | | ---------------------------------------------------------------------------------+----------------------------------+---------+------+--------+----- Weighted average common shares outstanding | 52,517 | | | 53,326 | | | 53,112 | ---------------------------------------------------------------------------------+----------------------------------+---------+------+--------+------+---------+--------+-- Vested options deemed participating securities | 3,013 | | | 2,831 | | | 3,494 | ---------------------------------------------------------------------------------+----------------------------------+---------+------+--------+------+---------+--------+-- Total shares for basic and diluted earnings per share | 55,530 | | | 56,157 | | | 56,606 | ---------------------------------------------------------------------------------+----------------------------------+---------+------+--------+------+---------+--------+-- Net earnings per share from continuing operations—basic and diluted | $ | 8.45 | | | $ | 10.39 | | | $ | 7.84 ---------------------------------------------------------------------------------+----------------------------------+---------+------+--------+------+---------+--------+---+---+-------- Net loss per share from discontinued operations—basic and diluted | (0.57 | ) | | — | | | — | ---------------------------------------------------------------------------------+----------------------------------+---------+------+--------+------+---------+--------+-- Net earnings per share | $ | 7.88 | | | $ | 10.39 | | | $ | 7.84 ---------------------------------------------------------------------------------+----------------------------------+---------+------+--------+------+---------+--------+---+---+-------- 6. SALES AND TRADE ACCOUNTS RECEIVABLE Sales —The Company’s sales and receivables are concentrated in the aerospace industry. TransDigm’s customers include: distributors of aerospace components; commercial airlines, large commercial transport and regional and business aircraft OEMs; various armed forces of the United States and friendly foreign governments; defense OEMs; system suppliers; and various other industrial customers. Two customers accounted for approximately 13% , 13% and 11% and 11% , 12% and 12% of the Company’s net sales for fiscal years ended 2017 , 2016 and 2015 , respectively. Sales to these customers were split approximately evenly between the Power & Control and Airframe segments. Sales to foreign customers, primarily in Western Europe, Canada and Asia, were $1,318.9 million , $1,169.5 million and $881.1 million during fiscal years ended 2017 , 2016 and 2015 . Trade Accounts Receivable —Trade accounts receivable consist of the following at September 30 (in thousands): | 2017 | | 2016 -------------------------------------+--------+---------+----- Trade accounts receivable—gross | $ | 639,946 | | | $ | 580,753 -------------------------------------+--------+---------+------+--------+---+-------- Allowance for uncollectible accounts | (3,819 | ) | | (4,414 | ) -------------------------------------+--------+---------+------+--------+-- Trade accounts receivable—net | $ | 636,127 | | | $ | 576,339 -------------------------------------+--------+---------+------+--------+---+-------- At September 30, 2017 , approximately 12% of the Company’s trade accounts receivable was due from one customer. In addition, approximately 42% of the Company’s trade accounts receivable was due from entities that principally operate outside of the United States. Credit is extended based on an evaluation of each customer’s financial condition and collateral is generally not required. F-13 7. INVENTORIES Inventories consist of the following at September 30 (in thousands): | 2017 | | 2016 --------------------------------------------+---------+---------+----- Raw materials and purchased component parts | $ | 496,899 | | | $ | 464,410 --------------------------------------------+---------+---------+------+---------+---+-------- Work-in-progress | 187,009 | | | 188,417 | --------------------------------------------+---------+---------+------+---------+-- Finished Goods | 131,548 | | | 153,253 | --------------------------------------------+---------+---------+------+---------+-- Total | 815,456 | | | 806,080 | --------------------------------------------+---------+---------+------+---------+-- Reserves for excess and obsolete inventory | (84,775 | ) | | (82,069 | ) --------------------------------------------+---------+---------+------+---------+-- Inventories—net | $ | 730,681 | | | $ | 724,011 --------------------------------------------+---------+---------+------+---------+---+-------- 8. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment consist of the following at September 30 (in thousands): | 2017 | | 2016 ----------------------------------+----------+---------+----- Land and improvements | $ | 56,554 | | | $ | 57,510 ----------------------------------+----------+---------+------+----------+---+-------- Buildings and improvements | 161,990 | | | 153,691 | ----------------------------------+----------+---------+------+----------+-- Machinery, equipment and other | 376,659 | | | 338,527 | ----------------------------------+----------+---------+------+----------+-- Construction in progress | 22,037 | | | 15,958 | ----------------------------------+----------+---------+------+----------+-- Total | 617,240 | | | 565,686 | ----------------------------------+----------+---------+------+----------+-- Accumulated depreciation | (292,316 | ) | | (255,106 | ) ----------------------------------+----------+---------+------+----------+-- Property, plant and equipment—net | $ | 324,924 | | | $ | 310,580 ----------------------------------+----------+---------+------+----------+---+-------- 9. INTANGIBLE ASSETS Other intangible assets - net in the consolidated balance sheets consist of the following at September 30 (in thousands): | 2017 | | 2016 ---------------------------+----------------------+-----------+------------------------ | Gross CarryingAmount | | AccumulatedAmortization | | Net | | Gross CarryingAmount | AccumulatedAmortization | | Net ---------------------------+----------------------+-----------+-------------------------+---------+-----+---------+----------------------+-------------------------+-----------+---- Trademarks and trade names | $ | 729,931 | | | $ | — | | $ | 729,931 | | $ | 720,263 | | $ | — | $ | 720,263 ---------------------------+----------------------+-----------+-------------------------+---------+-----+---------+----------------------+-------------------------+-----------+-----+---------+-----------+---------+---+---------+---+---------- Technology | 1,292,719 | | | 351,638 | | | 941,081 | | 1,279,335 | | 288,429 | | 990,906 | ---------------------------+----------------------+-----------+-------------------------+---------+-----+---------+----------------------+-------------------------+-----------+-----+---------+-----------+---------+-- Order backlog | 29,000 | | | 26,668 | | | 2,332 | | 55,341 | | 29,641 | | 25,700 | ---------------------------+----------------------+-----------+-------------------------+---------+-----+---------+----------------------+-------------------------+-----------+-----+---------+-----------+---------+-- Other | 63,599 | | | 19,081 | | | 44,518 | | 43,331 | | 15,857 | | 27,474 | ---------------------------+----------------------+-----------+-------------------------+---------+-----+---------+----------------------+-------------------------+-----------+-----+---------+-----------+---------+-- Total | $ | 2,115,249 | | | $ | 397,387 | | $ | 1,717,862 | | $ | 2,098,270 | | $ | 333,927 | $ | 1,764,343 ---------------------------+----------------------+-----------+-------------------------+---------+-----+---------+----------------------+-------------------------+-----------+-----+---------+-----------+---------+---+---------+---+---------- Information regarding the amortization expense of amortizable intangible assets is detailed below (in thousands): Annual Amortization Expense: Years ended September 30, | --------------------------+------- 2017 | $ | 89,226 --------------------------+--------+------- 2016 | 77,445 | --------------------------+--------+------- 2015 | 54,219 | --------------------------+--------+------- F-14 Estimated Amortization Expense: Years ending September 30, | ---------------------------+------- 2018 | $ | 69,344 ---------------------------+--------+------- 2019 | 67,011 | ---------------------------+--------+------- 2020 | 67,011 | ---------------------------+--------+------- 2021 | 67,011 | ---------------------------+--------+------- 2022 | 67,011 | ---------------------------+--------+------- Intangible assets acquired during the year ended September 30, 2017 were as follows (in thousands): | Gross Amount | | AmortizationPeriod -----------------------------------------------+--------------+---------+------------------- Intangible assets not subject to amortization: | | | -----------------------------------------------+--------------+---------+------------------- Goodwill | $ | 129,152 | | -----------------------------------------------+--------------+---------+--------------------+--------- Trademarks and trade names | 12,100 | | | -----------------------------------------------+--------------+---------+--------------------+--------- | 141,252 | | | -----------------------------------------------+--------------+---------+--------------------+--------- Intangible assets subject to amortization: | | | -----------------------------------------------+--------------+---------+------------------- Technology | 33,800 | | | 20 years -----------------------------------------------+--------------+---------+--------------------+--------- Order backlog | 4,500 | | | 1 year -----------------------------------------------+--------------+---------+--------------------+--------- | 38,300 | | | 18 years -----------------------------------------------+--------------+---------+--------------------+--------- Total | $ | 179,552 | | -----------------------------------------------+--------------+---------+--------------------+--------- The changes in the carrying amount of goodwill by segment for the fiscal years ended September 30, 2016 and 2017 were as follows (in thousands): | Power &Control | | Airframe | | Non-aviation | | Total ---------------------------------------------------------------+----------------+-----------+----------+-----------+--------------+-----------+------- Balance at September 30, 2015 | $ | 2,238,443 | | | $ | 2,392,408 | | $ | 55,369 | | $ | 4,686,220 ---------------------------------------------------------------+----------------+-----------+----------+-----------+--------------+-----------+--------+---+-----------+---+---+---------- Goodwill acquired during the year (Note 2) | 1,008,510 | | | — | | | — | | 1,008,510 | ---------------------------------------------------------------+----------------+-----------+----------+-----------+--------------+-----------+--------+---+-----------+-- Purchase price allocation adjustments | 505 | | | (792 | ) | | — | | (287 | ) ---------------------------------------------------------------+----------------+-----------+----------+-----------+--------------+-----------+--------+---+-----------+-- Currency translation adjustment | 32 | | | (15,023 | ) | | — | | (14,991 | ) ---------------------------------------------------------------+----------------+-----------+----------+-----------+--------------+-----------+--------+---+-----------+-- Balance at September 30, 2016 | 3,247,490 | | | 2,376,593 | | | 55,369 | | 5,679,452 | ---------------------------------------------------------------+----------------+-----------+----------+-----------+--------------+-----------+--------+---+-----------+-- Goodwill acquired during the year (Note 2) | 70,369 | | | 58,783 | | | — | | 129,152 | ---------------------------------------------------------------+----------------+-----------+----------+-----------+--------------+-----------+--------+---+-----------+-- Write-down of discontinued operations (Note 22) | — | | | (32,000 | ) | | — | | (32,000 | ) ---------------------------------------------------------------+----------------+-----------+----------+-----------+--------------+-----------+--------+---+-----------+-- Reclass of goodwill acquired to assets held-for-sale (Note 22) | — | | | (26,783 | ) | | — | | (26,783 | ) ---------------------------------------------------------------+----------------+-----------+----------+-----------+--------------+-----------+--------+---+-----------+-- Purchase price allocation adjustments | (9,972 | ) | | — | | | — | | (9,972 | ) ---------------------------------------------------------------+----------------+-----------+----------+-----------+--------------+-----------+--------+---+-----------+-- Currency translation adjustment | — | | | 5,489 | | | — | | 5,489 | ---------------------------------------------------------------+----------------+-----------+----------+-----------+--------------+-----------+--------+---+-----------+-- Balance at September 30, 2017 | $ | 3,307,887 | | | $ | 2,382,082 | | $ | 55,369 | | $ | 5,745,338 ---------------------------------------------------------------+----------------+-----------+----------+-----------+--------------+-----------+--------+---+-----------+---+---+---------- F-15 10. ACCRUED LIABILITIES Accrued liabilities consist of the following at September 30 (in thousands): | 2017 | | 2016 ---------------------------------------------------+--------+---------+----- Compensation and related benefits | $ | 68,945 | | | $ | 69,323 ---------------------------------------------------+--------+---------+------+--------+---+-------- Interest | 82,222 | | | 83,180 | ---------------------------------------------------+--------+---------+------+--------+-- Breeze-Eastern dissenting shares (see Note 2) | — | | | 33,644 | ---------------------------------------------------+--------+---------+------+--------+-- Interest rate swap agreements | 20,740 | | | 29,191 | ---------------------------------------------------+--------+---------+------+--------+-- Product warranties | 22,971 | | | 24,334 | ---------------------------------------------------+--------+---------+------+--------+-- Dividend equivalent payments—current (see Note 17) | 56,506 | | | 19,503 | ---------------------------------------------------+--------+---------+------+--------+-- Other | 84,504 | | | 84,937 | ---------------------------------------------------+--------+---------+------+--------+-- Total | $ | 335,888 | | | $ | 344,112 ---------------------------------------------------+--------+---------+------+--------+---+-------- 11. DEBT The Company’s debt consists of the following at September 30 (in thousands): | 2017 ---------------------------------------------------------------+------------- | Gross Amount | | Debt Issuance Costs | | Original Issue Discount or Premium | | Net Amount ---------------------------------------------------------------+--------------+------------+---------------------+---------+------------------------------------+---------+----------- Short-term borrowings—trade receivable securitization facility | $ | 300,000 | | | $ | (413 | ) | | $ | — | | $ | 299,587 ---------------------------------------------------------------+--------------+------------+---------------------+---------+------------------------------------+---------+------------+---+---+------------+---+---+----------- Term loans | $ | 6,973,009 | | | $ | (64,104 | ) | | $ | (18,948 | ) | $ | 6,889,957 ---------------------------------------------------------------+--------------+------------+---------------------+---------+------------------------------------+---------+------------+---+---+------------+---+---+----------- 2020 Notes | 550,000 | | | (3,243 | ) | | — | | | 546,757 | ---------------------------------------------------------------+--------------+------------+---------------------+---------+------------------------------------+---------+------------+---+---+------------+-- 2022 Notes | 1,150,000 | | | (6,941 | ) | | — | | | 1,143,059 | ---------------------------------------------------------------+--------------+------------+---------------------+---------+------------------------------------+---------+------------+---+---+------------+-- 2024 Notes | 1,200,000 | | | (8,042 | ) | | — | | | 1,191,958 | ---------------------------------------------------------------+--------------+------------+---------------------+---------+------------------------------------+---------+------------+---+---+------------+-- 2025 Notes | 750,000 | | | (4,033 | ) | | 4,182 | | | 750,149 | ---------------------------------------------------------------+--------------+------------+---------------------+---------+------------------------------------+---------+------------+---+---+------------+-- 2026 Notes | 950,000 | | | (8,806 | ) | | — | | | 941,194 | ---------------------------------------------------------------+--------------+------------+---------------------+---------+------------------------------------+---------+------------+---+---+------------+-- | 11,573,009 | | | (95,169 | ) | | (14,766 | ) | | 11,463,074 | ---------------------------------------------------------------+--------------+------------+---------------------+---------+------------------------------------+---------+------------+---+---+------------+-- Less current portion | 70,031 | | | (577 | ) | | — | | | 69,454 | ---------------------------------------------------------------+--------------+------------+---------------------+---------+------------------------------------+---------+------------+---+---+------------+-- Long-term debt | $ | 11,502,978 | | | $ | (94,592 | ) | | $ | (14,766 | ) | $ | 11,393,620 ---------------------------------------------------------------+--------------+------------+---------------------+---------+------------------------------------+---------+------------+---+---+------------+---+---+----------- | 2016 ---------------------------------------------------------------+------------- | Gross Amount | | Debt Issuance Costs | | Original Issue Discount or Premium | | Net Amount ---------------------------------------------------------------+--------------+------------+---------------------+---------+------------------------------------+---------+----------- Short-term borrowings—trade receivable securitization facility | $ | 200,000 | | | $ | (229 | ) | | $ | — | | $ | 199,771 ---------------------------------------------------------------+--------------+------------+---------------------+---------+------------------------------------+---------+------------+---+---+-----------+---+---+---------- Term loans | $ | 5,288,708 | | | $ | (42,662 | ) | | $ | (11,439 | ) | $ | 5,234,607 ---------------------------------------------------------------+--------------+------------+---------------------+---------+------------------------------------+---------+------------+---+---+-----------+---+---+---------- 2020 Notes | 550,000 | | | (4,299 | ) | | — | | | 545,701 | ---------------------------------------------------------------+--------------+------------+---------------------+---------+------------------------------------+---------+------------+---+---+-----------+-- 2021 Notes | 500,000 | | | (3,141 | ) | | — | | | 496,859 | ---------------------------------------------------------------+--------------+------------+---------------------+---------+------------------------------------+---------+------------+---+---+-----------+-- 2022 Notes | 1,150,000 | | | (8,381 | ) | | — | | | 1,141,619 | ---------------------------------------------------------------+--------------+------------+---------------------+---------+------------------------------------+---------+------------+---+---+-----------+-- 2024 Notes | 1,200,000 | | | (9,218 | ) | | — | | | 1,190,782 | ---------------------------------------------------------------+--------------+------------+---------------------+---------+------------------------------------+---------+------------+---+---+-----------+-- 2025 Notes | 450,000 | | | (4,144 | ) | | — | | | 445,856 | ---------------------------------------------------------------+--------------+------------+---------------------+---------+------------------------------------+---------+------------+---+---+-----------+-- 2026 Notes | 950,000 | | | (9,588 | ) | | — | | | 940,412 | ---------------------------------------------------------------+--------------+------------+---------------------+---------+------------------------------------+---------+------------+---+---+-----------+-- | 10,088,708 | | | (81,433 | ) | | (11,439 | ) | | 9,995,836 | ---------------------------------------------------------------+--------------+------------+---------------------+---------+------------------------------------+---------+------------+---+---+-----------+-- Less current portion | 53,074 | | | (429 | ) | | — | | | 52,645 | ---------------------------------------------------------------+--------------+------------+---------------------+---------+------------------------------------+---------+------------+---+---+-----------+-- Long-term debt | $ | 10,035,634 | | | $ | (81,004 | ) | | $ | (11,439 | ) | $ | 9,943,191 ---------------------------------------------------------------+--------------+------------+---------------------+---------+------------------------------------+---------+------------+---+---+-----------+---+---+---------- F-16 Trade Receivable Securitization Facility During fiscal 2014, the Company established a trade receivable securitization facility (the “Securitization Facility”). The Securitization Facility effectively increases the Company’s borrowing capacity depending on the amount of the domestic operations’ trade accounts receivable. The Securitization Facility includes the right for the Company to exercise annual one year extensions as long as there have been no termination events as defined by the agreement. The Company uses the proceeds from the Securitization Facility as an alternative to other forms of debt, effectively reducing borrowing costs. In August 2017, the Company amended the Securitization Facility to increase the borrowing capacity to $300 million and extend the maturity date to August 1, 2018 . As of September 30, 2017 , the Company has borrowed $300 million under the Securitization Facility. The Securitization Facility is collateralized by substantially all of the Company’s domestic operations’ trade accounts receivable. Repurchase of Senior Subordinated Notes due 2021 On October 13, 2016, the Company announced a cash tender offer for any and all of its outstanding 2021 Notes. On October 27, 2016, the Company redeemed a principal amount of approximately $158 million in 2021 Notes outstanding for total consideration of $1,060.50 (plus accrued and unpaid interest) for each $1,000 aggregate principal amount. The total consideration included an early tender premium of $30.00 per $1,000 principal amount of 2021 Notes payable only with respect to each note validly tendered and not revoked on or before October 26, 2016. On November 28, 2016, pursuant to the terms of the indenture governing the 2021 Notes, the Company redeemed the remaining principal of $342 million in 2021 Notes outstanding at a redemption price of 105.625% of the principal amount (plus accrued and unpaid interest). The Company recorded refinancing costs of $31.9 million during the fiscal year ended September 30, 2017 representing debt issuance costs expensed in conjunction with the redemption of the 2021 Notes. The costs consisted of the premium of $28.8 million paid to redeem the $500 million of 2021 Notes and the write-off of $3.1 million in unamortized debt issuance costs. Incremental Term Loan Assumption Agreement On October 14, 2016, the Company entered into an Incremental Term Loan Assumption Agreement (the “Assumption Agreement”) with Credit Suisse AG, as administrative agent and collateral agent, and as a lender, in connection with the 2016 term loans. The Assumption Agreement, among other things, provides for (i) additional tranche F term loans in an aggregate principal amount equal to $650 million , which were fully drawn on October 14, 2016, and (ii) additional delayed draw tranche F term loans in an aggregate principal amount not to exceed $500 million , which were fully drawn on October 27, 2016, the proceeds of which were used to repurchase the Company's 2021 Notes. The terms and conditions that apply to the additional tranche F term loans and the additional delayed draw tranche F term loans are substantially the same as the terms and conditions that apply to the tranche F term loans under the 2016 term loans immediately prior to the Assumption Agreement. The Company capitalized $11.3 million and expensed $0.2 million in refinancing costs associated with the Assumption Agreement during the fiscal year ended September 30, 2017 . Issuance of Senior Subordinated Notes On March 1, 2017, TransDigm Inc. issued $300 million in aggregate principal amount of its 2025 Notes at an issue price of 101.5% of the principal amount. The new notes offered were an additional issuance to our existing $450 million of 2025 Notes. The new notes offered, together with the existing 2025 Notes, are treated as a single class for all purposes under the indenture. The 2025 Notes bear interest at the rate of 6.5% per annum, which accrues from November 15, 2016 and is payable semiannually in arrears on May 15 and November 15 of each year, commencing on May 15, 2017. The 2025 Notes mature on May 15, 2025, unless earlier redeemed or repurchased, and are subject to the terms and conditions set forth in the indentures governing the 2025 Notes. In addition to the premium of $4.5 million recorded upon the issuance of the additional $300 million of 2025 Notes, the Company capitalized $0.4 million and expensed $3.7 million in refinancing costs representing fees associated with the issuance of the additional $300 million of 2025 Notes during the fiscal year ended September 30, 2017 . Amendment No. 2 to the Second Amended and Restated Credit Agreement On March 6, 2017, TD Group and certain subsidiaries of TransDigm entered into Amendment No. 2 to the Second Amended and Restated Credit Agreement, dated June 4, 2014, with Credit Suisse AG, as administrative agent and collateral agent (the "Agent"), and the other agents and lenders named therein. Amendment No. 2 permits, among other things, up to $1.5 billion of dividends and share repurchases over twelve months. If any portion of the $1.5 billion is not used for dividends or share repurchases over the twelve month period, such amount (not to exceed $500 million ) may be used to repurchase stock at any time thereafter. Amendment No. 2 also increased the general investment basket to the greater of $400 million and 8% of consolidated total assets. The Company capitalized $10.3 million and expensed $0.3 million in refinancing costs representing fees associated with Amendment No. 2 during the fiscal year ended September 30, 2017 . F-17 Amendment No. 3 to the Second Amended and Restated Credit Agreement On August 22, 2017, the Company entered into Amendment No. 3 to the Second Amended and Restated Credit Agreement. Pursuant to Amendment No. 3, TransDigm, among other things, incurred new Tranche G Term Loans in an aggregate principal amount equal to approximately $1.8 billion and repaid in full all of the Tranche C term loans outstanding under the Credit Agreement. The Tranche G Term Loans were fully drawn on August 22, 2017. The Tranche G Term Loans mature on August 22, 2024. The terms and conditions (other than maturity date) that apply to the Tranche G Term Loans, including pricing, are substantially the same as the terms and conditions that apply to the Tranche C term loans immediately prior to Amendment No. 3. Amendment No. 3 also permitted (a) payment of a special dividend, share repurchase, or combination thereof, in an aggregate amount up to approximately $1.3 billion within 60 days of the effective date of Amendment No. 3, and (b) certain additional restricted payments, including the ability of the Company to declare or pay dividends or repurchase stock, in an aggregate amount not to exceed $1.5 billion within twelve months of the effective date of Amendment No. 3 and is subject to 6.0x consolidated net leverage ratio for dividends and 4.0x consolidated secured net debt ratio for share repurchases. If any portion of the $1.5 billion is not used for dividends or share repurchases over such twelve month period, such amount (not to exceed $500 million ) may be used to repurchase stock at any time thereafter. The Company capitalized $7.1 million representing fees associated with Amendment No. 3 during the fiscal year ended September 30, 2017 . The Company capitalized $16.5 million and expensed $2.2 million in refinancing costs representing debt issuances costs associated with the Tranche G Term Loans during the fiscal year ended September 30, 2017 . Additionally, the Company wrote-off $1.5 million in unamortized debt issuance costs related to the Tranche C Term Loans. Term Loans As of September 30, 2017 and 2016 , TransDigm had $6,973.0 million and $5,288.7 million in fully drawn term loans and $600.0 million in revolving commitments. The term loans consist of five tranches as follows (in millions): Term Loan Facility | Maturity Date | | Interest Rate | | Aggregate Principal as of September 30, -------------------+-------------------+------+-----------------------+------+---------------------------------------- | | 2017 | | 2016 -------------------+-------------------+------+-----------------------+----- Tranche C | February 28, 2020 | | LIBO rate (1) + 3.00% | | $ | — | $ | 1,228.3 -------------------+-------------------+------+-----------------------+------+-----------------------------------------+---------+---+-------- Tranche D | June 4, 2021 | | LIBO rate (1) + 3.00% | | $ | 798.1 | $ | 806.4 -------------------+-------------------+------+-----------------------+------+-----------------------------------------+---------+---+-------- Tranche E | May 14, 2022 | | LIBO rate (1) + 3.00% | | $ | 1,503.4 | $ | 1,518.0 -------------------+-------------------+------+-----------------------+------+-----------------------------------------+---------+---+-------- Tranche F | June 9, 2023 | | LIBO rate (1) + 3.00% | | $ | 2,857.0 | $ | 1,736.0 -------------------+-------------------+------+-----------------------+------+-----------------------------------------+---------+---+-------- Tranche G | August 22, 2024 | | LIBO rate (1) + 3.00% | | $ | 1,814.5 | $ | — -------------------+-------------------+------+-----------------------+------+-----------------------------------------+---------+---+-------- The interest rates per annum applicable to all of the existing tranches of term loans are, at TransDigm’s option, equal to either an alternate base rate or an adjusted LIBO rate for one, two, three or six-month (or to the extent agreed to by each relevant lender, nine or twelve-month) interest periods chosen by TransDigm, in each case plus an applicable margin percentage. The adjusted LIBO rate is subject to a floor of 0.75% . At September 30, 2017 and 2016 , the applicable interest rates were as follows: Term Loan Facility | | Interest Rate as of September 30, -------------------+------+---------------------------------- | 2017 | | 2016 -------------------+------+-----------------------------------+----- Tranche C | | — | % | 3.75 | % -------------------+------+-----------------------------------+------+------+-- Tranche D | | 4.24 | % | 3.75 | % -------------------+------+-----------------------------------+------+------+-- Tranche E | | 4.24 | % | 3.75 | % -------------------+------+-----------------------------------+------+------+-- Tranche F | | 4.24 | % | 3.75 | % -------------------+------+-----------------------------------+------+------+-- Tranche G | | 4.26 | % | — | % -------------------+------+-----------------------------------+------+------+-- Debt Issuance Costs, Premiums and Discounts During the year ended September 30, 2017 , the Company recorded refinancing costs of $39.8 million representing debt issuance costs and premium expensed in conjunction with the new Tranche G Term Loans, the refinancing of the Tranche C Term Loans, and additional $300 million tack-on to the 6.375% Senior Subordinated Notes. During the year ended September 30, 2016 , the Company recorded refinancing costs of $15.8 million representing debt issuance costs expensed in conjunction with the refinancing of the Tranche C Term Loans. During the year ended September 30, 2015 the Company recorded refinancing costs of $18.4 million representing debt issuance costs expensed in conjunction with the refinancing of the Tranche B Term Loans and Revolving B Commitments. F-18 Interest Rate Swap and Cap Agreements See Note 20, “Derivatives and Hedging Instruments” for information about how our interest rate swap and cap agreements are used to manage interest rate risk associated with floating-rate borrowings under our credit facilities. Senior Subordinated Notes Senior Subordinated Notes | Aggregate Principal | Maturity Date | Interest Rate --------------------------+---------------------+------------------+-------------- 2020 Notes | $550 million | October 15, 2020 | 5.50% --------------------------+---------------------+------------------+-------------- 2022 Notes | $1,150 million | July 15, 2022 | 6.00% --------------------------+---------------------+------------------+-------------- 2024 Notes | $1,200 million | July 15, 2024 | 6.50% --------------------------+---------------------+------------------+-------------- 2025 Notes | $750 million | May 15, 2025 | 6.50% --------------------------+---------------------+------------------+-------------- 2026 Notes | $950 million | June 15, 2026 | 6.375% --------------------------+---------------------+------------------+-------------- The Notes are subordinated to all of TransDigm’s existing and future senior debt, rank equally with all of its existing and future senior subordinated debt and rank senior to all of its future debt that is expressly subordinated to the Notes. The Notes are guaranteed on a senior subordinated unsecured basis by TD Group and its 100% -owned domestic subsidiaries named in the indentures. The guarantees of the Notes are subordinated to all of the guarantors’ existing and future senior debt, rank equally with all of their existing and future senior subordinated debt and rank senior to all of their future debt that is expressly subordinated to the guarantees of the Notes. See Note 25, “Supplemental Guarantor Information,” for further details. The Notes are structurally subordinated to all of the liabilities of TD Group’s non-guarantor subsidiaries. The Notes contain many of the restrictive covenants included in the Restated Credit Agreement. TransDigm is in compliance with all the covenants contained in the Notes. At September 30, 2017 , future maturities of long-term debt are as follows (in thousands): Years ended September 30, | --------------------------+---------- 2018 | $ | 70,031 --------------------------+-----------+----------- 2019 | 70,031 | --------------------------+-----------+----------- 2020 | 70,031 | --------------------------+-----------+----------- 2021 | 1,385,219 | --------------------------+-----------+----------- 2022 | 2,641,834 | --------------------------+-----------+----------- Thereafter | 7,335,863 | --------------------------+-----------+----------- | $ | 11,573,009 --------------------------+-----------+----------- 12. RETIREMENT PLANS Defined Contribution Plans — The Company sponsors certain defined contribution employee savings plans that cover substantially all of the Company’s non-union employees. Under certain plans, the Company contributes a percentage of employee compensation and matches a portion of employee contributions. The cost recognized for such contributions for the years ended September 30, 2017 , 2016 and 2015 was approximately $14.6 million , $12.7 million and $9.9 million , respectively. Defined Benefit Pension Plans — The Company maintains certain non-contributory defined benefit pension plans. The Company’s funding policy is to contribute actuarially determined amounts allowable under tax and statutory regulations for the qualified plans. The Company uses a September 30th measurement date for its defined benefit pension plans. The Company maintains certain qualified, non-contributory defined benefit pension plans, which together cover certain union employees. The plans provide benefits of stated amounts for each year of service. The plan assets as of September 30, 2017 and 2016 were approximately $69.9 million and $67.0 million , respectively. The Company’s projected benefit obligation for these defined benefit pension plans at September 30, 2017 and 2016 was $91.7 million and $100.6 million , respectively. The total liability recognized at September 30, 2017 and 2016 was $21.8 million and $33.6 million , respectively. The decrease in the total liability at September 30, 2017 compared to September 30, 2016 is primarily attributable to the change in pension assumptions, particularly a higher discount rate and expected rate of return on assets, for the AmSafe Bridport Limited pension plan. The net periodic pension cost recognized in the consolidated statements of income for the years ended September 30, 2017 , 2016 , and 2015 was $1.7 million , $1.0 million , and $0.6 million , respectively. F-19 The Company has a non-qualified, non-contributory defined benefit pension plan, which covers certain retired employees. The plan is unfunded and provides defined benefits based on the final average salary of the employees as defined in the plan. The projected benefit obligation for this defined benefit pension plan and the total liability recognized in the Consolidated Balance Sheet at September 30, 2017 and 2016 was approximately $8.8 million and $8.6 million , respectively. The net periodic pension cost recognized in the consolidated statements of income for each of the years ended September 30, 2017 , 2016 and 2015 was $0.4 million . 13. INCOME TAXES The Company’s income tax provision on income from continuing operations consists of the following for the periods shown below (in thousands): | Fiscal Years Ended September 30, ---------+--------------------------------- | 2017 | | 2016 | | 2015 ---------+----------------------------------+---------+------+---------+----- Current | | | | | ---------+----------------------------------+---------+------+---------+----- Federal | $ | 179,884 | | | $ | 153,957 | | $ | 163,182 ---------+----------------------------------+---------+------+---------+------+---------+---------+---+-------- State | 8,596 | | | 9,234 | | | 7,823 ---------+----------------------------------+---------+------+---------+------+---------+-------- Foreign | 21,327 | | | 12,703 | | | 17,947 ---------+----------------------------------+---------+------+---------+------+---------+-------- | 209,807 | | | 175,894 | | | 188,952 ---------+----------------------------------+---------+------+---------+------+---------+-------- Deferred | (918 | ) | | 5,808 | | | 660 ---------+----------------------------------+---------+------+---------+------+---------+-------- | $ | 208,889 | | | $ | 181,702 | | $ | 189,612 ---------+----------------------------------+---------+------+---------+------+---------+---------+---+-------- The differences between the income tax provision on income from continuing operations at the federal statutory income tax rate and the tax provision shown in the accompanying consolidated statements of income for the periods shown below are as follows (in thousands): | Fiscal Years Ended September 30, -----------------------------------------------------+--------------------------------- | 2017 | | 2016 | | 2015 -----------------------------------------------------+----------------------------------+---------+------+---------+----- Tax at statutory rate of 35% | $ | 293,129 | | | $ | 268,841 | | | $ | 222,888 -----------------------------------------------------+----------------------------------+---------+------+---------+------+---------+---------+---+---+-------- State and local income taxes, net of federal benefit | 4,042 | | | 2,677 | | | 4,931 | -----------------------------------------------------+----------------------------------+---------+------+---------+------+---------+---------+-- Stock compensation | (50,314 | ) | | (43,565 | ) | | — | -----------------------------------------------------+----------------------------------+---------+------+---------+------+---------+---------+-- Foreign rate differential | (29,685 | ) | | (30,079 | ) | | (14,332 | ) -----------------------------------------------------+----------------------------------+---------+------+---------+------+---------+---------+-- Domestic manufacturing deduction | (17,832 | ) | | (16,902 | ) | | (17,834 | ) -----------------------------------------------------+----------------------------------+---------+------+---------+------+---------+---------+-- Other—net | 9,549 | | | 730 | | | (6,041 | ) -----------------------------------------------------+----------------------------------+---------+------+---------+------+---------+---------+-- Income tax provision | $ | 208,889 | | | $ | 181,702 | | | $ | 189,612 -----------------------------------------------------+----------------------------------+---------+------+---------+------+---------+---------+---+---+-------- The components of the deferred taxes consist of the following at September 30 (in thousands): | 2017 | | 2016 --------------------------------------------------------------+----------+----------+----- Deferred tax liabilities: | | | --------------------------------------------------------------+----------+----------+----- Intangible assets | $ | (647,140 | ) | | $ | (627,633 | ) --------------------------------------------------------------+----------+----------+------+----------+---+----------+-- Property, plant and equipment | (29,240 | ) | | (31,438 | ) --------------------------------------------------------------+----------+----------+------+----------+-- Unremitted foreign earnings | (10,784 | ) | | (9,434 | ) --------------------------------------------------------------+----------+----------+------+----------+-- Employee benefits, compensation and other accrued obligations | 107,195 | | | 86,229 | --------------------------------------------------------------+----------+----------+------+----------+-- Inventory | 31,077 | | | 22,382 | --------------------------------------------------------------+----------+----------+------+----------+-- Net operating losses | 33,462 | | | 29,266 | --------------------------------------------------------------+----------+----------+------+----------+-- Interest rate swaps and caps | 15,961 | | | 36,478 | --------------------------------------------------------------+----------+----------+------+----------+-- Environmental | 15,518 | | | 16,958 | --------------------------------------------------------------+----------+----------+------+----------+-- Product warranties | 7,419 | | | 9,007 | --------------------------------------------------------------+----------+----------+------+----------+-- Other | 8,797 | | | 3,216 | --------------------------------------------------------------+----------+----------+------+----------+-- Total | (467,735 | ) | | (464,969 | ) --------------------------------------------------------------+----------+----------+------+----------+-- Add: Valuation allowance | (33,214 | ) | | (27,286 | ) --------------------------------------------------------------+----------+----------+------+----------+-- Total net deferred tax liabilities | $ | (500,949 | ) | | $ | (492,255 | ) --------------------------------------------------------------+----------+----------+------+----------+---+----------+-- F-20 At September 30, 2017 , the Company has United Kingdom net operating loss carryforwards of approximately $23.3 million , German net operating loss carryforwards of approximately $4.3 million and state net operating loss carryforwards of approximately $819.5 million that expire in various years from 2017 to 2034 . A valuation allowance has been established equal to the amount of the net operating losses that the Company believes will not be utilized. The Company had state tax credit carryforwards of $2.6 million that expire from 2023 to 2029 . The Company and its subsidiaries file income tax returns in the U.S. federal jurisdiction and various state and local jurisdictions, as well as foreign jurisdictions located in Belgium, Canada, China, France, Germany, Hong Kong, Hungary, Malaysia, Mexico, Norway, Singapore, Sri Lanka, Sweden and the United Kingdom. The Company is no longer subject to U.S. federal examinations for years before fiscal 2014. The Company is currently under examination in the U.S. for its fiscal 2014 federal taxes. The Company expects the examinations to be completed during fiscal 2018. In addition, the Company is subject to state income tax examinations for fiscal years 2009 and later. The cumulative amount of the Company’s foreign undistributed net earnings for which no deferred taxes have been provided is approximately $176.0 million at September 30, 2017 . The Company has no plans to repatriate such earnings in the foreseeable future. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows (in thousands): | 2017 | | 2016 -------------------------------------------------------------+--------+-------+----- Balance at beginning of period | $ | 8,706 | | | $ | 6,859 -------------------------------------------------------------+--------+-------+------+--------+---+------ Additions based on tax positions related to the prior year | 500 | | | 2,014 | -------------------------------------------------------------+--------+-------+------+--------+-- Additions based on tax positions related to the current year | 1,643 | | | 913 | -------------------------------------------------------------+--------+-------+------+--------+-- Reductions based on tax positions related to the prior year | (963 | ) | | (801 | ) -------------------------------------------------------------+--------+-------+------+--------+-- Lapse in statute of limitations | (1,231 | ) | | (1,483 | ) -------------------------------------------------------------+--------+-------+------+--------+-- Acquisitions | — | | | 1,204 | -------------------------------------------------------------+--------+-------+------+--------+-- Balance at end of period | $ | 8,655 | | | $ | 8,706 -------------------------------------------------------------+--------+-------+------+--------+---+------ Unrecognized tax benefits at September 30, 2017 and 2016 , the recognition of which would have an effect on the effective tax rate for each fiscal year, amounted to $8.7 million in each period. The Company classifies all income tax related interest and penalties as income tax expense, which were not significant for the years ended September 30, 2017 , 2016 and 2015 . As of September 30, 2017 and 2016 , the Company accrued $1.2 million and $1.1 million , respectively, for the potential payment of interest and penalties. The Company anticipates no significant changes to its total unrecognized tax benefits through fiscal 2017 . 14. ENVIRONMENTAL LIABILITIES Our operations and facilities are subject to a number of federal, state, local and foreign environmental laws and regulations that govern, among other things, discharges of pollutants into the air and water, the generation, handling, storage and disposal of hazardous materials and wastes, the remediation of contamination and the health and safety of our employees. Environmental laws and regulations may require that the Company investigate and remediate the effects of the release or disposal of materials at sites associated with past and present operations. Certain facilities and third-party sites utilized by the Company have been identified as potentially responsible parties under the federal superfund laws and comparable state laws. The Company is currently involved in the investigation and remediation of a number of sites under applicable laws. Estimates of the Company’s environmental liabilities are based on current facts, laws, regulations and technology. These estimates take into consideration the Company’s prior experience and professional judgment of the Company’s environmental advisors. Estimates of the Company’s environmental liabilities are further subject to uncertainties regarding the nature and extent of site contamination, the range of remediation alternatives available, evolving remediation standards, imprecise engineering evaluations and cost estimates, the extent of corrective actions that may be required and the number and financial condition of other potentially responsible parties, as well as the extent of their responsibility for the remediation. Accordingly, as investigation and remediation proceed, it is likely that adjustments in the Company’s accruals will be necessary to reflect new information. The amounts of any such adjustments could have a material adverse effect on the Company’s results of operations or cash flows in a given period. Based on currently available information, however, the Company does not believe that future environmental costs in excess of those accrued with respect to sites for which the Company has been identified as a potentially responsible party are likely to have a material adverse effect on the Company’s financial condition. Environmental liabilities are recorded when the liability is probable and the costs are reasonably estimable, which generally is not later than at completion of a feasibility study or when the Company has recommended a remedy or has committed to an appropriate plan of action. The Company also takes into consideration the estimated period of time in which payments will be required. The liabilities are reviewed periodically and, as investigation and remediation proceed, adjustments are made as necessary. F-21 Liabilities for losses from environmental remediation obligations do not consider the effects of inflation and anticipated expenditures are not discounted to their present value. The liabilities are not offset by possible recoveries from insurance carriers or other third parties, but do reflect anticipated allocations among potentially responsible parties at federal superfund sites or similar state-managed sites, third party indemnity obligations, and an assessment of the likelihood that such parties will fulfill their obligations at such sites. The Company’s consolidated balance sheets includes environmental remediation obligations at September 30, 2017 and 2016 of $39.9 million and $46.1 million , respectively. 15. CAPITAL STOCK TD Group consists of 224,400,000 shares of $.01 par value common stock and 149,600,000 shares of $.01 par value preferred stock. The total number of shares of common stock issued at September 30, 2017 and 2016 was 56,093,659 and 55,767,767 , respectively. The total number of shares held in treasury at September 30, 2017 and 2016 were 4,159,207 and 2,433,035 , respectively. There were no shares of preferred stock outstanding at September 30, 2017 and 2016 . The terms of the preferred stock have not been established. The Board of Directors has previously authorized a common share repurchase program, which has been subject to amendments. On January 26, 2017, our Board of Directors increased the authorized amount of repurchases allowable under the stock program from $450 million to $472 million . The increase in the allowable repurchases under the stock repurchase program aligned the program with the restricted payments allowable under the Credit Agreement. On March 7, 2017, our Board of Directors authorized a new stock repurchase program replacing the $472 million program permitting repurchases of a portion of outstanding shares not to exceed $600 million in the aggregate, subject to any restrictions specified in the Credit Agreement and/or Indentures governing the existing Notes. During the fiscal year ended September 30, 2017, in the aggregate, the Company repurchased 1,723,624 shares at a cost of $389.8 million at the weighted average cost of $226.16 under its stock repurchase programs. As of September 30, 2017, the remaining amount of repurchases allowable under the $600 million program was $360.2 million subject to any restrictions specified in the Credit Agreement and/or Indentures governing the existing Notes. On November 8, 2017, o ur Board of Directors, authorized a new stock repurchase program replacing the $600 million program permitting repurchases of our outstanding shares not to exceed $650 million in the aggregate, subject to any restrictions specified in the Credit Agreement and/or Indentures governing the existing Notes. 16. SEGMENTS The Company’s businesses are organized and managed in three reporting segments: Power & Control, Airframe and Non-aviation. The Power & Control segment includes operations that primarily develop, produce and market systems and components that predominately provide power to or control power of the aircraft utilizing electronic, fluid, power and mechanical motion control technologies. Major product offerings include mechanical/electro-mechanical actuators and controls, ignition systems and engine technology, specialized pumps and valves, power conditioning devices, specialized AC/DC electric motors and generators, databus and power controls, high performance hoists, winches and lifting devices and cargo loading and handling systems. Primary customers of this segment are engine and power system and subsystem suppliers, airlines, third party maintenance suppliers, military buying agencies and repair depots. Products are sold in the original equipment and aftermarket market channels. The Airframe segment includes operations that primarily develop, produce and market systems and components that are used in non-power airframe applications utilizing airframe and cabin structure technologies. Major product offerings include engineered latching and locking devices, rods and locking devices, engineered connectors and elastomers, cockpit security components and systems, aircraft audio systems, specialized lavatory components, seat belts and safety restraints, engineered interior surfaces and related components, lighting and control technology, military personnel parachutes and cargo delivery systems. Primary customers of this segment are airframe manufacturers and cabin system suppliers and subsystem suppliers, airlines, third party maintenance suppliers, military buying agencies and repair depots. Products are sold in the original equipment and aftermarket market channels. The Non-aviation segment includes operations that primarily develop, produce and market products for non-aviation markets. Major product offerings include seat belts and safety restraints for ground transportation applications, mechanical/electro-mechanical actuators and controls for space applications, and refueling systems for heavy equipment used in mining, construction and other industries. Primary customers of this segment are off-road vehicle suppliers and subsystem suppliers, child restraint system suppliers, satellite and space system suppliers and manufacturers of heavy equipment used in mining, construction and other industries. F-22 The primary measurement used by management to review and assess the operating performance of each segment is EBITDA As Defined. The Company defines EBITDA As Defined as earnings before interest, taxes, depreciation and amortization plus certain non-operating items recorded as corporate expenses including refinancing costs, acquisition-related costs, transaction-related costs and non-cash compensation charges incurred in connection with the Company’s stock option plans. Acquisition-related costs represent accounting adjustments to inventory associated with acquisitions of businesses and product lines that were charged to cost of sales when the inventory was sold; costs incurred to integrate acquired businesses and product lines into the Company’s operations, facility relocation costs and other acquisition-related costs; transaction related costs comprising deal fees; legal, financial and tax diligence expenses and valuation costs that are required to be expensed as incurred and other acquisition accounting adjustments. EBITDA As Defined is not a measurement of financial performance under GAAP. Although the Company uses EBITDA As Defined to assess the performance of its business and for various other purposes, the use of this non-GAAP financial measure as an analytical tool has limitations, and it should not be considered in isolation or as a substitute for analysis of the Company’s results of operations as reported in accordance with GAAP. The Company’s segments are reported on the same basis used internally for evaluating performance and for allocating resources. The accounting policies for each segment are the same as those described in the summary of significant accounting policies in the Company’s consolidated financial statements. Intersegment sales and transfers are recorded at values based on market prices, which creates intercompany profit on intersegment sales or transfers that is eliminated in consolidation. Intersegment sales were insignificant for the periods presented below. Certain corporate-level expenses are allocated to the operating segments. The following table presents net sales by reportable segment (in thousands): | Fiscal Years Ended September 30, --------------------------------+--------------------------------- | 2017 | | 2016 | | 2015 --------------------------------+----------------------------------+-----------+------+-----------+----- Net sales to external customers | | | | | --------------------------------+----------------------------------+-----------+------+-----------+----- Power & Control | $ | 1,948,166 | | | $ | 1,621,741 | | $ | 1,330,135 --------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+---------- Airframe | 1,442,073 | | | 1,447,894 | | | 1,280,706 --------------------------------+----------------------------------+-----------+------+-----------+------+-----------+---------- Non-aviation | 114,047 | | | 101,776 | | | 96,274 --------------------------------+----------------------------------+-----------+------+-----------+------+-----------+---------- | $ | 3,504,286 | | | $ | 3,171,411 | | $ | 2,707,115 --------------------------------+----------------------------------+-----------+------+-----------+------+-----------+-----------+---+---------- The following table reconciles EBITDA As Defined by segment to consolidated income from continuing operations before income taxes (in thousands): | Fiscal Years Ended September 30, ------------------------------------------------------+--------------------------------- | 2017 | | 2016 | | 2015 ------------------------------------------------------+----------------------------------+---------+------+-----------+----- EBITDA As Defined | | | | | ------------------------------------------------------+----------------------------------+---------+------+-----------+----- Power & Control | $ | 981,041 | | | $ | 787,418 | | | $ | 653,050 ------------------------------------------------------+----------------------------------+---------+------+-----------+------+---------+-----------+---+---+-------- Airframe | 726,619 | | | 709,858 | | | 585,472 | ------------------------------------------------------+----------------------------------+---------+------+-----------+------+---------+-----------+-- Non-aviation | 41,460 | | | 28,228 | | | 22,406 | ------------------------------------------------------+----------------------------------+---------+------+-----------+------+---------+-----------+-- Total segment EBITDA As Defined | 1,749,120 | | | 1,525,504 | | | 1,260,928 | ------------------------------------------------------+----------------------------------+---------+------+-----------+------+---------+-----------+-- Unallocated corporate expenses | 38,557 | | | 30,308 | | | 27,274 | ------------------------------------------------------+----------------------------------+---------+------+-----------+------+---------+-----------+-- Total Company EBITDA As Defined | 1,710,563 | | | 1,495,196 | | | 1,233,654 | ------------------------------------------------------+----------------------------------+---------+------+-----------+------+---------+-----------+-- Depreciation and amortization | 141,025 | | | 121,670 | | | 93,663 | ------------------------------------------------------+----------------------------------+---------+------+-----------+------+---------+-----------+-- Interest expense, net | 602,589 | | | 483,850 | | | 418,785 | ------------------------------------------------------+----------------------------------+---------+------+-----------+------+---------+-----------+-- Acquisition-related costs | 31,191 | | | 57,699 | | | 36,205 | ------------------------------------------------------+----------------------------------+---------+------+-----------+------+---------+-----------+-- Stock compensation expense | 45,524 | | | 48,306 | | | 31,500 | ------------------------------------------------------+----------------------------------+---------+------+-----------+------+---------+-----------+-- Refinancing costs | 39,807 | | | 15,794 | | | 18,393 | ------------------------------------------------------+----------------------------------+---------+------+-----------+------+---------+-----------+-- Other, net | 12,997 | | | (239 | ) | | (1,716 | ) ------------------------------------------------------+----------------------------------+---------+------+-----------+------+---------+-----------+-- Income from continuing operations before income taxes | $ | 837,430 | | | $ | 768,116 | | | $ | 636,824 ------------------------------------------------------+----------------------------------+---------+------+-----------+------+---------+-----------+---+---+-------- F-23 The following table presents capital expenditures and depreciation and amortization by segment (in thousands): | Fiscal Years Ended September 30, ------------------------------+--------------------------------- | 2017 | | 2016 | | 2015 ------------------------------+----------------------------------+---------+------+--------+----- Capital expenditures | | | | | ------------------------------+----------------------------------+---------+------+--------+----- Power & Control | $ | 32,424 | | | $ | 25,120 | | $ | 24,664 ------------------------------+----------------------------------+---------+------+--------+------+---------+--------+---+------- Airframe | 34,526 | | | 16,498 | | | 28,086 ------------------------------+----------------------------------+---------+------+--------+------+---------+------- Non-aviation | 3,981 | | | 2,169 | | | 1,889 ------------------------------+----------------------------------+---------+------+--------+------+---------+------- Corporate | 82 | | | 195 | | | 232 ------------------------------+----------------------------------+---------+------+--------+------+---------+------- | $ | 71,013 | | | $ | 43,982 | | $ | 54,871 ------------------------------+----------------------------------+---------+------+--------+------+---------+--------+---+------- Depreciation and amortization | | | | | ------------------------------+----------------------------------+---------+------+--------+----- Power & Control | $ | 85,681 | | | $ | 65,488 | | $ | 39,336 ------------------------------+----------------------------------+---------+------+--------+------+---------+--------+---+------- Airframe | 51,440 | | | 52,198 | | | 50,355 ------------------------------+----------------------------------+---------+------+--------+------+---------+------- Non-aviation | 2,745 | | | 2,860 | | | 2,846 ------------------------------+----------------------------------+---------+------+--------+------+---------+------- Corporate | 1,159 | | | 1,124 | | | 1,126 ------------------------------+----------------------------------+---------+------+--------+------+---------+------- | $ | 141,025 | | | $ | 121,670 | | $ | 93,663 ------------------------------+----------------------------------+---------+------+--------+------+---------+--------+---+------- The following table presents total assets by segment (in thousands): | September 30, 2017 | | September 30, 2016 ----------------------------------+--------------------+-----------+------------------- Total assets | | | ----------------------------------+--------------------+-----------+------------------- Power & Control | $ | 5,218,006 | | | $ | 5,184,303 ----------------------------------+--------------------+-----------+--------------------+-----------+---+----------- Airframe | 3,923,172 | | | 3,922,532 | ----------------------------------+--------------------+-----------+--------------------+-----------+-- Non-aviation | 142,389 | | | 131,319 | ----------------------------------+--------------------+-----------+--------------------+-----------+-- Corporate | 614,594 | | | 1,488,123 | ----------------------------------+--------------------+-----------+--------------------+-----------+-- Assets of discontinued operations | 77,500 | | | — | ----------------------------------+--------------------+-----------+--------------------+-----------+-- | $ | 9,975,661 | | | $ | 10,726,277 ----------------------------------+--------------------+-----------+--------------------+-----------+---+----------- The Company’s sales principally originate from the United States, and the Company’s long-lived assets are principally located in the United States. 17. STOCK-BASED COMPENSATION The Company’s stock compensation plans are designed to assist the Company in attracting, retaining, motivating and rewarding key employees, directors or consultants, and promoting the creation of long-term value for stockholders by closely aligning the interests of these individuals with those of the Company’s stockholders. The Company’s stock compensation plans provide for the granting of stock options, restricted stock and other stock-based incentives. Non-cash stock compensation expense recognized by the Company during the years ended September 30, 2017 , 2016 and 2015 was $45.5 million , $48.3 million and $31.5 million , respectively. The weighted-average grant date fair value of options granted during the fiscal years ended September 30, 2017 , 2016 and 2015 was $67.11 , $57.47 and $65.57 , respectively. Compensation expense is recognized based upon probability assessments of awards that are expected to vest in future periods. Such probability assessments are subject to revision and, therefore, unrecognized compensation expense is subject to future changes in estimate. As of September 30, 2017 , there was approximately $52.4 million of total unrecognized compensation expense related to non-vested awards expected to vest, which is expected to be recognized over a weighted-average period of 2.6 years . F-24 The fair value of the Company’s employee stock options was estimated at the date of grant using a Black-Scholes-Merton option-pricing model with the following weighted average assumptions for all options granted during the fiscal years ended: | Fiscal Years Ended September 30, ---------------------------------+--------------------------------- | 2017 | 2016 | 2015 ---------------------------------+----------------------------------+----------------+--------------- Risk-free interest rate | 1.56% to 2.01% | 1.33% to 1.73% | 1.33% to 1.64% ---------------------------------+----------------------------------+----------------+--------------- Expected life of options | 5 years | 5 years | 5 years ---------------------------------+----------------------------------+----------------+--------------- Expected dividend yield of stock | — | — | — ---------------------------------+----------------------------------+----------------+--------------- Expected volatility of stock | 25% | 25% | 35% ---------------------------------+----------------------------------+----------------+--------------- The risk-free interest rate is based upon the Treasury bond rates as of the grant date. The average expected life of stock-based awards is based on the Company’s actual historical exercise experience. Expected volatility of stock was calculated using a rate based upon the historical volatility of TransDigm’s common stock. Notwithstanding the special cash dividends declared and paid from time to time, the Company historically has not declared and paid regular cash dividends and does not anticipate declaring and paying regular cash dividends in future periods; thus, no dividend rate assumption is used. The total fair value of options vested during fiscal years ended September 30, 2017 , 2016 and 2015 was $42.9 million , $36.6 million and $14.9 million , respectively. 2014 Stock Option Plan In July 2014, the Board of Directors of TD Group adopted a new stock option plan, which was subsequently approved by stockholders on October 2, 2014. The 2014 stock option plan permits TD Group to award our key employees, directors or consultants stock options. The total number of shares of TD Group common stock reserved for issuance or delivery under the 2014 stock option plan is 5,000,000 , subject to adjustment in the event of any stock dividend or split, reorganization, recapitalization, merger, share exchange or any other similar corporate transaction or event. Performance Vested Stock Options —All of the options granted through September 30, 2017 under the 2014 stock option plan have been pursuant to an equity incentive program adopted by the Company in 2008. Under the 2008 equity incentive program, all of the options granted will vest based on the Company’s achievement of established operating performance goals. The following table summarizes the activity, pricing and other information for the Company’s performance vested stock-based award activity during the fiscal year ended September 30, 2017 : | Number ofOptions | | Weighted-AverageExercise Price PerOption | | Weighted-AverageRemainingContractual Term | AggregateIntrinsic Value ----------------------------------+------------------+---+------------------------------------------+--------+--------------------------------------------+------------------------- Outstanding at September 30, 2016 | 147,935 | | | $ | 228.73 | | | ----------------------------------+------------------+---+------------------------------------------+--------+--------------------------------------------+--------------------------+-----------+-- Granted | 738,974 | | | 266.18 | | | ----------------------------------+------------------+---+------------------------------------------+--------+--------------------------------------------+--------------------------+---------- Exercised | (930 | ) | | 231.16 | | | ----------------------------------+------------------+---+------------------------------------------+--------+--------------------------------------------+--------------------------+---------- Forfeited | (23,280 | ) | | 251.79 | | | ----------------------------------+------------------+---+------------------------------------------+--------+--------------------------------------------+--------------------------+---------- Expired | (640 | ) | | 232.64 | | | ----------------------------------+------------------+---+------------------------------------------+--------+--------------------------------------------+--------------------------+---------- Outstanding at September 30, 2017 | 862,059 | | | $ | 260.20 | | 9.0 years | $ | (3,925,661 | ) ----------------------------------+------------------+---+------------------------------------------+--------+--------------------------------------------+--------------------------+-----------+---+------------+-- Expected to vest | 397,725 | | | $ | 260.33 | | 9.0 years | $ | (1,861,447 | ) ----------------------------------+------------------+---+------------------------------------------+--------+--------------------------------------------+--------------------------+-----------+---+------------+-- Exercisable at September 30, 2017 | 122,975 | | | $ | 246.01 | | 8.8 years | $ | 1,186,026 | ----------------------------------+------------------+---+------------------------------------------+--------+--------------------------------------------+--------------------------+-----------+---+------------+-- At September 30, 2017 , there were 4,137,011 remaining shares available for award under TD Group’s 2014 stock option plan. 2006 Stock Incentive Plan In conjunction with the consummation of the Company’s initial public offering, a 2006 stock incentive plan was adopted by TD Group. In July 2008 and March 2011, the plan was amended to increase the number of shares available for issuance thereunder. TD Group reserved 8,119,668 shares of its common stock for issuance to key employees, directors or consultants under the plan. Awards under the plan may be in the form of options, restricted stock or other stock-based awards. Options granted under the plan will expire no later than the tenth anniversary of the applicable date of grant of the options, and will have an exercise price of not less than the fair market value of our common stock on the date of grant. Restricted stock granted under the plan vests over three years . Restricted Stock —The Company granted 17,700 restricted stock units with a weighted-average grant date fair value of $189.97 during the fiscal year ended September 30, 2015. During the fiscal year ended September 30, 2017 , 5,900 restricted stock units vested, and 5,900 restricted stock units were outstanding at September 30, 2017 . F-25 Performance Vested Stock Options —All of the options granted under the 2006 stock incentive plan have been pursuant to an equity incentive program adopted by the Company in 2008. Under the 2008 equity incentive program, all of the options granted will vest based on the Company’s achievement of established operating performance goals. The following table summarizes the activity, pricing and other information for the Company’s performance vested stock-based award activity during the fiscal year ended September 30, 2017 : | Number ofOptions | | Weighted-AverageExercise Price PerOption | | Weighted-AverageRemainingContractual Term | AggregateIntrinsic Value ----------------------------------+------------------+---+------------------------------------------+--------+--------------------------------------------+------------------------- Outstanding at September 30, 2016 | 5,239,871 | | | $ | 133.20 | | | ----------------------------------+------------------+---+------------------------------------------+--------+--------------------------------------------+--------------------------+-----------+-- Granted | — | | | — | | | ----------------------------------+------------------+---+------------------------------------------+--------+--------------------------------------------+--------------------------+---------- Exercised | (315,478 | ) | | 66.67 | | | ----------------------------------+------------------+---+------------------------------------------+--------+--------------------------------------------+--------------------------+---------- Forfeited | (138,179 | ) | | 188.90 | | | ----------------------------------+------------------+---+------------------------------------------+--------+--------------------------------------------+--------------------------+---------- Expired | (100 | ) | | 226.34 | | | ----------------------------------+------------------+---+------------------------------------------+--------+--------------------------------------------+--------------------------+---------- Outstanding at September 30, 2017 | 4,786,114 | | | $ | 135.95 | | 5.2 years | $ | 572,875,252 ----------------------------------+------------------+---+------------------------------------------+--------+--------------------------------------------+--------------------------+-----------+---+------------ Expected to vest | 1,052,250 | | | $ | 200.32 | | 7.4 years | $ | 58,217,596 ----------------------------------+------------------+---+------------------------------------------+--------+--------------------------------------------+--------------------------+-----------+---+------------ Exercisable at September 30, 2017 | 3,464,551 | | | $ | 110.36 | | 4.3 years | $ | 503,350,041 ----------------------------------+------------------+---+------------------------------------------+--------+--------------------------------------------+--------------------------+-----------+---+------------ The 2006 stock incentive plan expired on March 14, 2016 and no further shares were granted under the plan thereafter. 2003 Stock Option Plan Certain executives and key employees of the Company were granted stock options under TD Group’s 2003 stock option plan. Upon the closing of the acquisition of the Company by Warburg Pincus in 2003, certain employees rolled over certain then-existing options to purchase shares of common stock of TransDigm Holdings. These employees were granted rollover options to purchase an aggregate of 3,870,152 shares of common stock of TD Group (after giving effect to the 149.60 for 1.00 stock split effected on March 14, 2006) . All rollover options granted were fully vested on the date of grant. In addition to shares of common stock reserved for issuance upon the exercise of rollover options, an aggregate of 5,469,301 shares of TD Group’s common stock were reserved for issuance upon the exercise of new management options. In general, approximately 20% of all new management options vested based on employment service or a change in control. These time vested options had a graded vesting schedule of up to four years . Approximately 80% of all new management options vested (i) based upon the satisfaction of specified performance criteria, which is annual and cumulative EBITDA As Defined targets through 2008, or (ii) upon the occurrence of a change in control if the Investor Group (defined as Warburg Pincus and the other initial investors in TD Group) received a minimum specified rate of return. Unless terminated earlier, the options expire ten years from the date of grant. TD Group reserved a total of 9,339,453 shares of its common stock for issuance to the Company’s employees under the plan, which had all been issued as of September 30, 2013. Time Vested Stock Options —During the fiscal year ended September 30, 2016, 5,486 of the Company’s time vested stock-based options, with a weighted-average exercise price per option of $39.88 , were exercised. There were no remaining options outstanding as of September 30, 2016. Performance Vested Stock Options —The following table summarizes the activity, pricing and other information for the Company’s performance vested stock-based award activity during the fiscal year ended September 30, 2017 : | Number ofOptions | | Weighted-AverageExercise Price PerOption | | Weighted-AverageRemainingContractual Term | AggregateIntrinsic Value ----------------------------------+------------------+---+------------------------------------------+-------+-------------------------------------------+------------------------- Outstanding at September 30, 2016 | 86,329 | | | $ | 120.72 | | | ----------------------------------+------------------+---+------------------------------------------+-------+-------------------------------------------+--------------------------+-----------+-- Granted | — | | | — | | | ----------------------------------+------------------+---+------------------------------------------+-------+-------------------------------------------+--------------------------+---------- Exercised | (8,500 | ) | | 34.88 | | | ----------------------------------+------------------+---+------------------------------------------+-------+-------------------------------------------+--------------------------+---------- Outstanding at September 30, 2017 | 77,829 | | | $ | 130.09 | | 5.1 years | $ | 9,772,209 ----------------------------------+------------------+---+------------------------------------------+-------+-------------------------------------------+--------------------------+-----------+---+---------- Exercisable at September 30, 2017 | 77,829 | | | $ | 130.09 | | 5.1 years | $ | 9,772,209 ----------------------------------+------------------+---+------------------------------------------+-------+-------------------------------------------+--------------------------+-----------+---+---------- The total intrinsic value of time, performance and rollover options exercised during the fiscal years ended September 30, 2017 , 2016 and 2015 was $61.1 million , $133.2 million and $206.9 million , respectively. In addition to shares issued pursuant to options exercised, during the fiscal year ended September 30, 2017 , 984 shares of common stock were issued with a weighted-average grant date fair value of $243.36 as payment to directors in lieu of cash. F-26 Dividend Equivalent Plans Pursuant to the Third Amended and Restated TransDigm Group Incorporated 2003 Stock Option Plan Dividend Equivalent Plan, the Second Amended and Restated TransDigm Group Incorporated 2006 Stock Incentive Plan Dividend Equivalent Plan and the 2014 Stock Option Plan Dividend Equivalent Plan, all of the options granted under the 2003 stock option plan, the 2006 stock incentive plan and the 2014 stock option plan are entitled to certain dividend equivalent payments in the event of the declaration of a dividend by the Company. Dividend equivalent payments on vested options were $19.5 million , $3.0 million and $3.4 million during the years ended September 30, 2017 , 2016 and 2015 , respectively. During the first quarter of 2017, in connection with the special dividend declared in October 2016, we paid $1,280.1 million for the special dividend and $76.4 million for the related dividend equivalent payments. During the fourth quarter of 2017, in connection with the special dividend declared in August 2017, we paid $1,142.2 million for the special dividend and $63.3 million for the related dividend equivalent payments. At September 30, 2017, there was $56.5 million recorded in accrued liabilities and $39.4 million accrued in other non-current liabilities on the consolidated balance sheets related to the future dividend equivalent payments. 18. LEASES TransDigm leases certain manufacturing facilities, offices, equipment and vehicles. Such leases, some of which are noncancelable and, in many cases, include renewals, expire at various dates. Rental expense during the years ended September 30, 2017 , 2016 and 2015 was $19.0 million , $18.3 million and $14.0 million , respectively. Future minimum rental commitments at September 30, 2017 under operating leases having initial or remaining non-cancelable lease terms exceeding one year are $18.0 million in fiscal 2018 , $17.5 million in fiscal 2019 , $14.6 million in fiscal 2020 , $12.6 million in fiscal 2021 , $11.5 million in fiscal 2022 , and $33.6 million thereafter. F-27 19. FAIR VALUE MEASUREMENTS The following tables present our assets and liabilities that are measured at fair value on a recurring basis and are categorized using the fair value hierarchy. The fair value hierarchy has three levels based on the reliability of the inputs used to determine fair value. Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities. Level 2 inputs are quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, and inputs (other than quoted prices) that are observable for the asset or liability, either directly or indirectly. Level 3 inputs are unobservable inputs for the asset or liability. A financial asset or liability’s classification within the hierarchy is determined based on the lowest level input that is significant to the fair value measurement. The following summarizes the carrying amounts and fair values of financial instruments (in thousands): | | September 30, 2017 | | September 30, 2016 ---------------------------------------------------------------------+-------+--------------------+-----------+------------------- | Level | CarryingAmount | | Fair Value | CarryingAmount | | Fair Value ---------------------------------------------------------------------+-------+--------------------+-----------+--------------------+----------------+---+----------- Assets: | | | | | | | ---------------------------------------------------------------------+-------+--------------------+-----------+--------------------+----------------+---+----------- Cash and cash equivalents | 1 | | $ | 650,561 | | $ | 650,561 | | $ | 1,586,994 | | $ | 1,586,994 ---------------------------------------------------------------------+-------+--------------------+-----------+--------------------+----------------+---+------------+-----------+---+-----------+---+---+---------- Interest rate cap agreements (1) | 2 | | 12,904 | | 12,904 | | | 4,232 | | 4,232 | ---------------------------------------------------------------------+-------+--------------------+-----------+--------------------+----------------+---+------------+-----------+---+-----------+-- Interest rate swap agreements (1) | 2 | | 2,905 | | 2,905 | | | — | — | | — ---------------------------------------------------------------------+-------+--------------------+-----------+--------------------+----------------+---+------------+-----------+---+-----------+-- Liabilities: | | | | | | | ---------------------------------------------------------------------+-------+--------------------+-----------+--------------------+----------------+---+----------- Interest rate swap agreements (2) | 2 | | 20,740 | | 20,740 | | | 29,191 | | 29,191 | ---------------------------------------------------------------------+-------+--------------------+-----------+--------------------+----------------+---+------------+-----------+---+-----------+-- Interest rate swap agreements (3) | 2 | | 9,731 | | 9,731 | | | 53,824 | | 53,824 | ---------------------------------------------------------------------+-------+--------------------+-----------+--------------------+----------------+---+------------+-----------+---+-----------+-- Short-term borrowings - trade receivable securitization facility (4) | 1 | | 299,587 | | 299,587 | | | 199,771 | | 199,771 | ---------------------------------------------------------------------+-------+--------------------+-----------+--------------------+----------------+---+------------+-----------+---+-----------+-- Long-term debt, including current portion: | | | | | | | ---------------------------------------------------------------------+-------+--------------------+-----------+--------------------+----------------+---+----------- Term loans (4) | 2 | | 6,889,957 | | 6,965,628 | | | 5,234,607 | | 5,284,037 | ---------------------------------------------------------------------+-------+--------------------+-----------+--------------------+----------------+---+------------+-----------+---+-----------+-- 2020 Notes (4) | 1 | | 546,757 | | 558,250 | | | 545,701 | | 566,500 | ---------------------------------------------------------------------+-------+--------------------+-----------+--------------------+----------------+---+------------+-----------+---+-----------+-- 2021 Notes (4) | 1 | | — | | — | | | 496,859 | | 530,000 | ---------------------------------------------------------------------+-------+--------------------+-----------+--------------------+----------------+---+------------+-----------+---+-----------+-- 2022 Notes (4) | 1 | | 1,143,059 | | 1,178,750 | | | 1,141,619 | | 1,214,688 | ---------------------------------------------------------------------+-------+--------------------+-----------+--------------------+----------------+---+------------+-----------+---+-----------+-- 2024 Notes (4) | 1 | | 1,191,958 | | 1,236,000 | | | 1,190,782 | | 1,266,000 | ---------------------------------------------------------------------+-------+--------------------+-----------+--------------------+----------------+---+------------+-----------+---+-----------+-- 2025 Notes (4) | 1 | | 750,149 | | 776,807 | | | 445,856 | | 469,125 | ---------------------------------------------------------------------+-------+--------------------+-----------+--------------------+----------------+---+------------+-----------+---+-----------+-- 2026 Notes (4) | 1 | | 941,194 | | 971,375 | | | 940,412 | | 985,625 | ---------------------------------------------------------------------+-------+--------------------+-----------+--------------------+----------------+---+------------+-----------+---+-----------+-- (1) | Included in other non-current assets on the consolidated balance sheet. ----+------------------------------------------------------------------------ (2) | Included in accrued liabilities on the consolidated balance sheet. ----+------------------------------------------------------------------- (3) | Included in other non-current liabilities on the consolidated balance sheet. ----+----------------------------------------------------------------------------- (4) | The carrying amount of the debt instrument is presented net of the debt issuance costs. ----+---------------------------------------------------------------------------------------- The Company values its financial instruments using an industry standard market approach, in which prices and other relevant information is generated by market transactions involving identical or comparable assets or liabilities. No financial instruments were recognized using unobservable inputs. Interest rate swaps were measured at fair value using quoted market prices for the swap interest rate indexes over the term of the swap discounted to present value versus the fixed rate of the contract. The interest rate caps were measured at fair value using implied volatility rates of each individual caplet and the yield curve for the related periods. The estimated fair value of the Company’s term loans was based on information provided by the agent under the Company’s senior secured credit facility. The estimated fair values of the Company’s notes were based upon quoted market prices. There has not been any impact to the fair value of derivative liabilities due to the Company’s own credit risk. Similarly, there has not been any impact to the fair value of derivative assets based on the Company’s evaluation of counterparties’ credit risks. The fair value of cash and cash equivalents, trade accounts receivable-net and accounts payable approximated book value due to the short-term nature of these instruments at September 30, 2017 and 2016 . F-28 20. DERIVATIVES AND HEDGING ACTIVITIES The Company is exposed to, among other things, the impact of changes in interest rates in the normal course of business. The Company’s risk management program is designed to manage the exposure and volatility arising from these risks, and utilizes derivative financial instruments to offset a portion of these risks. The Company uses derivative financial instruments only to the extent necessary to hedge identified business risks and does not enter into such transactions for trading purposes. The Company generally does not require collateral or other security with counterparties to these financial instruments and is therefore subject to credit risk in the event of nonperformance; however, the Company monitors credit risk and currently does not anticipate nonperformance by other parties. The Company has agreements with each of its swap and cap counterparties that contain a provision whereby if the Company defaults on the credit facility the Company could also be declared in default on its swaps and caps, resulting in an acceleration of payment under the swaps and caps. Interest rate swap and cap agreements are used to manage interest rate risk associated with floating-rate borrowings under our credit facility. The interest rate swap and cap agreements utilized by the Company effectively modify the Company’s exposure to interest rate risk by converting a portion of the Company’s floating-rate debt to a fixed rate basis through the expiration date of the interest rate swap and cap agreements, thereby reducing the impact of interest rate changes on future interest expense. These agreements involve the receipt of floating rate amounts in exchange for fixed rate interest payments over the term of the agreements without an exchange of the underlying principal amount. These derivative instruments qualify as effective cash flow hedges under GAAP. For these cash flow hedges, the effective portion of the gain or loss from the financial instruments was initially reported as a component of accumulated other comprehensive loss in stockholders’ deficit and subsequently reclassified into earnings in the same line as the hedged item in the same period or periods during which the hedged item affected earnings. The following table summarizes the Company’s interest rate swap agreements: Aggregate Notional Amount (in millions) | Start Date | End Date | Related Debt | Conversion of Related Variable Rate Debt to Fixed Rate of: ----------------------------------------+------------+------------+----------------------+----------------------------------------------------------- $1,000 | 9/30/2014 | 6/30/2019 | Tranche G Term Loans | 5.4% (2.4% plus the 3% margin percentage) ----------------------------------------+------------+------------+----------------------+----------------------------------------------------------- $400 | 9/30/2017 | 9/30/2022 | Tranche G Term Loans | 4.9% (1.9% plus the 3% margin percentage) ----------------------------------------+------------+------------+----------------------+----------------------------------------------------------- $750 | 6/30/2020 | 6/30/2022 | Tranche F Term Loans | 5.5% (2.5% plus the 3% margin percentage) ----------------------------------------+------------+------------+----------------------+----------------------------------------------------------- $500 | 12/30/2016 | 12/31/2021 | Tranche F Term Loans | 4.9% (1.9% plus the 3% margin percentage) ----------------------------------------+------------+------------+----------------------+----------------------------------------------------------- $1,000 | 6/28/2019 | 6/30/2021 | Tranche F Term Loans | 4.8% (1.8% plus the 3% margin percentage) ----------------------------------------+------------+------------+----------------------+----------------------------------------------------------- $750 | 3/31/2016 | 6/30/2020 | Tranche D Term Loans | 5.8% (2.8% plus the 3% margin percentage) ----------------------------------------+------------+------------+----------------------+----------------------------------------------------------- The following table summarizes the Company’s interest rate cap agreements: Aggregate Notional Amount (in millions) | Start Date | End Date | Related Debt | Offsets Variable Rate Debt Attributable to Fluctuations Above: ----------------------------------------+------------+------------+----------------------+--------------------------------------------------------------- $750 | 6/30/2020 | 6/30/2022 | Tranche F Term Loans | Three month LIBO rate of 2.5% ----------------------------------------+------------+------------+----------------------+--------------------------------------------------------------- $400 | 12/30/2016 | 12/31/2021 | Tranche F Term Loans | Three month LIBO rate of 2.5% ----------------------------------------+------------+------------+----------------------+--------------------------------------------------------------- $400 | 6/30/2016 | 6/30/2021 | Tranche F Term Loans | Three month LIBO rate of 2.0% ----------------------------------------+------------+------------+----------------------+--------------------------------------------------------------- $750 | 9/30/2015 | 6/30/2020 | Tranche E Term Loans | Three month LIBO rate of 2.5% ----------------------------------------+------------+------------+----------------------+--------------------------------------------------------------- F-29 All interest rate swap and cap agreements are recognized in our consolidated balance sheets at fair value. In accordance with GAAP, certain derivative asset and liability balances are offset where master netting agreements provide for the legal right of setoff. For classification purposes, we record the net fair value of each type of derivative position that is expected to settle in less than one year with each counterparty as a net current asset or liability and each type of long-term position as a net long-term asset or liability. The amounts shown in the table below represent the gross amounts of recognized assets and liabilities, the amounts offset in the consolidated balance sheet and the net amounts of assets and liabilities presented therein. | September 30, 2017 | | September 30, 2016 -------------------------------------------------------+--------------------+--------+------------------- | Asset | | Liability | | Asset | | Liability -------------------------------------------------------+--------------------+--------+--------------------+---------+-------+---------+---------- Interest rate cap agreements | $ | 12,904 | | | $ | — | | $ | 4,232 | | $ | — | -------------------------------------------------------+--------------------+--------+--------------------+---------+-------+---------+-----------+---+---------+---+---+---------+-- Interest rate swap agreements | 9,235 | | | (36,801 | ) | | — | | (83,015 | ) -------------------------------------------------------+--------------------+--------+--------------------+---------+-------+---------+-----------+---+---------+-- Total | 22,139 | | | (36,801 | ) | | 4,232 | | (83,015 | ) -------------------------------------------------------+--------------------+--------+--------------------+---------+-------+---------+-----------+---+---------+-- Effect of counterparty netting | (6,330 | ) | | 6,330 | | | — | | — | -------------------------------------------------------+--------------------+--------+--------------------+---------+-------+---------+-----------+---+---------+-- Net derivatives as classified in the balance sheet (1) | $ | 15,809 | | | $ | (30,471 | ) | $ | 4,232 | | $ | (83,015 | ) -------------------------------------------------------+--------------------+--------+--------------------+---------+-------+---------+-----------+---+---------+---+---+---------+-- (1) | Refer to Note 19, "Fair Value Measurements," for the consolidated balance sheet classification of our interest rate swap and cap agreements. ----+--------------------------------------------------------------------------------------------------------------------------------------------- In connection with the refinancing of the 2011 Term Loans, the Company no longer designated the interest rate swap agreements relating to the $353 million aggregate notional amount as cash flow hedges for accounting purposes. Accordingly, amounts previously recorded as a component of accumulated other comprehensive loss in stockholder’s deficit amortized into earnings totaled $3.2 million for the fiscal year ended September 30, 2015. There was no remaining amortization for these dedesignated swap agreements as of September 30, 2015. Based on the fair value amounts of the interest rate swap and cap agreements determined as of September 30, 2017 , the estimated net amount of existing gains and losses and caplet amortization expected to be reclassified into interest expense within the next twelve months is approximately $24.9 million . Effective September 30, 2016, the Company redesignated the interest rate cap agreements related to the $400 million and the $750 million aggregate notional amount with cap rates of 2.0% and 2.5% , respectively, based on the expected probable cash flows associated with the 2016 term loans and 2015 term loans in consideration of the Company’s ability to select one-month, two-month, three-month, or six-month LIBO rate set forth in the Credit Agreement. Accordingly, amounts previously recorded as a component of accumulated other comprehensive loss in stockholder’s deficit amortized into interest expense was $3.8 million for the fiscal year ended September 30, 2017. The accumulated other comprehensive loss to be reclassified into interest expense over the remaining term of the cap agreements is $10.8 million with a related tax benefit of $4.0 million as of September 30, 2017. The amount recorded as a component of accumulated other comprehensive loss in stockholders’ deficit related to these redesignated interest rate cap hedges as of September 30, 2016 was approximately $14.6 million with a related tax benefit of $5.5 million . F-30 21. ACCUMULATED OTHER COMPREHENSIVE LOSS The following table presents the components of “Accumulated other comprehensive loss” (“AOCI”) in the consolidated balance sheets, net of taxes, for the years ended September 30, 2017 , 2016 and 2015 (in thousands): | Unrealized (loss) gain on derivatives designated and qualifying as cash flow hedges (2) | | Defined benefit pension plan activity (3) | | Currency translation adjustment | | Total ----------------------------------------------------------------------------+-----------------------------------------------------------------------------------------+---------+-------------------------------------------+---------+---------------------------------+---------+-------- Balance at September 30, 2015 | $ | (51,492 | ) | | $ | (12,013 | ) | | $ | (32,504 | ) | $ | (96,009 | ) ----------------------------------------------------------------------------+-----------------------------------------------------------------------------------------+---------+-------------------------------------------+---------+---------------------------------+---------+---------+---+---+---------+---+---+----------+-- Other comprehensive loss before reclassification | (9,664 | ) | | (12,284 | ) | | (31,846 | ) | | (53,794 | ) ----------------------------------------------------------------------------+-----------------------------------------------------------------------------------------+---------+-------------------------------------------+---------+---------------------------------+---------+---------+---+---+---------+-- Amounts reclassified from AOCI related to interest rate swap agreements (1) | 16 | | | — | | | — | | | 16 | ----------------------------------------------------------------------------+-----------------------------------------------------------------------------------------+---------+-------------------------------------------+---------+---------------------------------+---------+---------+---+---+---------+-- Net current-period other comprehensive loss | $ | (9,648 | ) | | $ | (12,284 | ) | | $ | (31,846 | ) | $ | (53,778 | ) ----------------------------------------------------------------------------+-----------------------------------------------------------------------------------------+---------+-------------------------------------------+---------+---------------------------------+---------+---------+---+---+---------+---+---+----------+-- Balance at September 30, 2016 | $ | (61,140 | ) | | $ | (24,297 | ) | | $ | (64,350 | ) | $ | (149,787 | ) ----------------------------------------------------------------------------+-----------------------------------------------------------------------------------------+---------+-------------------------------------------+---------+---------------------------------+---------+---------+---+---+---------+---+---+----------+-- Other comprehensive gain before reclassification | 32,072 | | | 7,932 | | | 22,241 | | | 62,245 | ----------------------------------------------------------------------------+-----------------------------------------------------------------------------------------+---------+-------------------------------------------+---------+---------------------------------+---------+---------+---+---+---------+-- Amounts reclassified from AOCI related to interest rate swap agreements (1) | 2,399 | | | — | | | — | | | 2,399 | ----------------------------------------------------------------------------+-----------------------------------------------------------------------------------------+---------+-------------------------------------------+---------+---------------------------------+---------+---------+---+---+---------+-- Net current-period other comprehensive gain | $ | 34,471 | | | $ | 7,932 | | | $ | 22,241 | | $ | 64,644 | ----------------------------------------------------------------------------+-----------------------------------------------------------------------------------------+---------+-------------------------------------------+---------+---------------------------------+---------+---------+---+---+---------+---+---+----------+-- Balance at September 30, 2017 | $ | (26,669 | ) | | $ | (16,365 | ) | | $ | (42,109 | ) | $ | (85,143 | ) ----------------------------------------------------------------------------+-----------------------------------------------------------------------------------------+---------+-------------------------------------------+---------+---------------------------------+---------+---------+---+---+---------+---+---+----------+-- (1) | This component of AOCI is included in interest expense (see Note 20, “Derivatives and Hedging Activities,” for additional details). ----+------------------------------------------------------------------------------------------------------------------------------------ (2) | Unrealized (loss) gain represents interest rate swap and cap agreements, net of taxes of $(20,663), $6,868 and $20,716 for the years ended September 30, 2017, 2016 and 2015, respectively. ----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (3) | Defined benefit pension plan activity represent pension liability adjustments, net of taxes of $(4,130), $6,017 and $3,299, respectively. ----+------------------------------------------------------------------------------------------------------------------------------------------ A summary of reclassifications out of accumulated other comprehensive loss for or the years ended September 30, 2017 is provided below (in thousands): Description of reclassifications out of accumulated other comprehensive loss | Amount reclassified -----------------------------------------------------------------------------+-------------------- Amortization from redesignated interest rate cap agreements (1) | $ | 3,829 -----------------------------------------------------------------------------+---------------------+------ Deferred tax benefit from redesignated interest rate cap agreements | (1,430 | ) -----------------------------------------------------------------------------+---------------------+------ Losses reclassified into earnings, net of tax | $ | 2,399 -----------------------------------------------------------------------------+---------------------+------ (1) | This component of accumulated other comprehensive loss is included in interest expense (see Note 20, “Derivatives and Hedging Activity,” for additional information). ----+---------------------------------------------------------------------------------------------------------------------------------------------------------------------- F-31 22. DISCONTINUED OPERATIONS In connection with the settlement of a Department of Justice investigation into the competitive effects of the acquisition, during the fourth quarter of 2017, the Company committed to dispose of the Schroth business. Therefore, Schroth was classified as held-for-sale as of September 30, 2017. The results of operations of Schroth are reflected as discontinued operations in the accompanying consolidated financial statements for all periods presented. The Company previously acquired Schroth in February 2017 (refer to Note 2, “Acquisitions”). Schroth designs and manufactures proprietary, highly engineered, advanced safety systems for aviation, racing and military ground vehicles around the world. The loss from discontinued operations in the consolidated statements of income includes a $32.0 million impairment charge to write down the Schroth assets to fair value. The impairment charge recorded in the fourth quarter of 2017 was based on an internal assessment of the recovery of Schroth’s assets. Schroth’s assets have been recorded at fair value in the consolidated balance sheets as of September 30, 2017. The following is the summarized operating results from the date of acquisition of February 22, 2017 to September 30, 2017 (in thousands): | 2017 ------------------------------------------------------------+-------- Net sales | $ | 24,590 | ------------------------------------------------------------+---------+---------+-- Loss from discontinued operations before income taxes | (5,709 | ) ------------------------------------------------------------+---------+-------- Loss on classification as held-for-sale before income taxes | (32,000 | ) ------------------------------------------------------------+---------+-------- Income tax benefit | 6,055 | ------------------------------------------------------------+---------+-------- Loss from discontinued operations | $ | (31,654 | ) ------------------------------------------------------------+---------+---------+-- At September 30, 2017, Schroth’s assets-held-for sale and liabilities held-for sale are $77.5 million and $17.3 million , respectively. The following is the summarized balance sheet of Schroth’s assets and liabilities held-for-sale as of September 30, 2017 (in thousands): Assets and Liabilities of Discontinued Operations Held-for-Sale | Fiscal Year Ended September 30, 2017 ----------------------------------------------------------------+------------------------------------- Trade accounts receivable—Net | $ | 5,975 ----------------------------------------------------------------+--------------------------------------+------- Inventories—Net | 9,060 | ----------------------------------------------------------------+--------------------------------------+------- Prepaid expenses and other | 809 | ----------------------------------------------------------------+--------------------------------------+------- Property, plant, and equipment—Net | 4,367 | ----------------------------------------------------------------+--------------------------------------+------- Goodwill | 26,783 | ----------------------------------------------------------------+--------------------------------------+------- Other intangible assets—Net | 29,841 | ----------------------------------------------------------------+--------------------------------------+------- Other | 665 | ----------------------------------------------------------------+--------------------------------------+------- Total assets of discontinued operations | $ | 77,500 ----------------------------------------------------------------+--------------------------------------+------- Accounts payable | $ | 1,247 ----------------------------------------------------------------+--------------------------------------+------- Accrued liabilities | 12,801 | ----------------------------------------------------------------+--------------------------------------+------- Deferred income taxes | 3,256 | ----------------------------------------------------------------+--------------------------------------+------- Total liabilities of discontinued operations | $ | 17,304 ----------------------------------------------------------------+--------------------------------------+------- F-32 23. QUARTERLY FINANCIAL DATA (UNAUDITED) | First QuarterEndedDecember 31, 2016 | | Second QuarterEndedApril 1, 2017 | | Third QuarterEndedJuly 1, 2017 | | Fourth QuarterEndedSeptember 30, 2017 -----------------------------------------------------------------------+------------------------------------------+---------+----------------------------------+---------+--------------------------------+---------+-------------------------------------- | (in thousands, except per share amounts) -----------------------------------------------------------------------+----------------------------------------- Year Ended September 30, 2017(1) | | | | | | | -----------------------------------------------------------------------+------------------------------------------+---------+----------------------------------+---------+--------------------------------+---------+-------------------------------------- Net sales(2) | $ | 814,018 | | | $ | 868,728 | | | $ | 897,655 | | $ | 923,885 -----------------------------------------------------------------------+------------------------------------------+---------+----------------------------------+---------+--------------------------------+---------+---------------------------------------+---+---+---------+---+---+-------- Gross profit(2) | 444,255 | | | 489,437 | | | 519,696 | | | 531,239 | -----------------------------------------------------------------------+------------------------------------------+---------+----------------------------------+---------+--------------------------------+---------+---------------------------------------+---+---+---------+-- Income from continuing operations(2) | 118,871 | | | 155,691 | | | 169,832 | | | 184,147 | -----------------------------------------------------------------------+------------------------------------------+---------+----------------------------------+---------+--------------------------------+---------+---------------------------------------+---+---+---------+-- Loss from discontinued operations(2) | — | | | (186 | ) | | (779 | ) | | (30,689 | ) -----------------------------------------------------------------------+------------------------------------------+---------+----------------------------------+---------+--------------------------------+---------+---------------------------------------+---+---+---------+-- Net income(2) | 118,871 | | | 155,505 | | | 169,053 | | | 153,458 | -----------------------------------------------------------------------+------------------------------------------+---------+----------------------------------+---------+--------------------------------+---------+---------------------------------------+---+---+---------+-- Net earnings per share from continuing operations—basic and diluted(3) | $ | 0.41 | | | $ | 2.78 | | | $ | 3.09 | | $ | 2.21 -----------------------------------------------------------------------+------------------------------------------+---------+----------------------------------+---------+--------------------------------+---------+---------------------------------------+---+---+---------+---+---+-------- Net loss per share from discontinued operations—basic and diluted(3) | — | | | — | | | (0.01 | ) | | (0.56 | ) -----------------------------------------------------------------------+------------------------------------------+---------+----------------------------------+---------+--------------------------------+---------+---------------------------------------+---+---+---------+-- Net earnings per share—basic and diluted(3) | $ | 0.41 | | | $ | 2.78 | | | $ | 3.08 | | $ | 1.65 -----------------------------------------------------------------------+------------------------------------------+---------+----------------------------------+---------+--------------------------------+---------+---------------------------------------+---+---+---------+---+---+-------- | First QuarterEndedJanuary 2, 2016 | | Second QuarterEndedApril 2, 2016 | | Third QuarterEndedJuly 2, 2016 | | Fourth QuarterEndedSeptember 30, 2016 --------------------------------------------+------------------------------------------+---------+----------------------------------+---------+--------------------------------+---------+-------------------------------------- | (in thousands, except per share amounts) --------------------------------------------+----------------------------------------- Year Ended September 30, 2016 | | | | | | | --------------------------------------------+------------------------------------------+---------+----------------------------------+---------+--------------------------------+---------+-------------------------------------- Net sales(2) | $ | 701,695 | | | $ | 796,801 | | $ | 797,692 | $ | 875,223 --------------------------------------------+------------------------------------------+---------+----------------------------------+---------+--------------------------------+---------+---------------------------------------+---+---------+---+-------- Gross profit(2) | 374,567 | | | 425,662 | | | 443,515 | | 484,319 --------------------------------------------+------------------------------------------+---------+----------------------------------+---------+--------------------------------+---------+---------------------------------------+---+-------- Net income(2) | 129,441 | | | 141,683 | | | 160,622 | | 154,668 --------------------------------------------+------------------------------------------+---------+----------------------------------+---------+--------------------------------+---------+---------------------------------------+---+-------- Net earnings per share—basic and diluted(3) | $ | 2.23 | | | $ | 2.52 | | $ | 2.88 | $ | 2.77 --------------------------------------------+------------------------------------------+---------+----------------------------------+---------+--------------------------------+---------+---------------------------------------+---+---------+---+-------- (1) | Results adjusted to reflect amounts reclassified to discontinued operations due to the Company’s classification of Schroth as discontinued operations at September 30, 2017. See Note 22, “Discontinued Operations,” for additional information. ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (2) | The Company’s operating results include the results of operations of acquisitions from the effective date of each acquisition. See Note 2 “Acquisitions,” for additional details. ----+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (3) | The sum of the earnings per share for the four quarters in a year does not necessarily equal the total year earnings per share. ----+-------------------------------------------------------------------------------------------------------------------------------- 24. SUPPLEMENTAL GUARANTOR INFORMATION TransDigm’s 2020 Notes, 2022 Notes, 2024 Notes, 2025 Notes and 2026 Notes are jointly and severally guaranteed, on a senior subordinated basis, by TD Group and TransDigm Inc.’s 100% Domestic Restricted Subsidiaries, as defined in the Indentures. The following supplemental condensed consolidating financial information presents, in separate columns, the balance sheets of the Company as of September 30, 2017 and September 30, 2016 and its statements of income and cash flows for the fiscal years ended September 30, 2017 , 2016 and 2015 for (i) TransDigm Group on a parent only basis with its investment in subsidiaries recorded under the equity method, (ii) TransDigm Inc. including its directly owned operations and non-operating entities, (iii) the Subsidiary Guarantors on a combined basis, (iv) Non-Guarantor Subsidiaries and (v) the Company on a consolidated basis. Separate financial statements of TransDigm Inc. are not presented because TransDigm Inc.’s 2020 Notes, 2022 Notes, 2024 Notes, 2025 Notes and 2026 Notes are fully and unconditionally guaranteed on a senior subordinated basis by TD Group and all existing 100% owned domestic subsidiaries of TransDigm Inc. and because TD Group has no significant operations or assets separate from its investment in TransDigm Inc. F-33 TRANSDIGM GROUP INCORPORATED CONDENSED CONSOLIDATING BALANCE SHEET AS OF SEPTEMBER 30, 2017 (Amounts in Thousands) | TransDigmGroup | | TransDigmInc. | | SubsidiaryGuarantors | | Non-GuarantorSubsidiaries | | Eliminations | | TotalConsolidated ---------------------------------------------------------------+----------------+------------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+------------------ ASSETS | | | | | | | | | | | ---------------------------------------------------------------+----------------+------------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+------------------ CURRENT ASSETS: | | | | | | | | | | | ---------------------------------------------------------------+----------------+------------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+------------------ Cash and cash equivalents | $ | 2,416 | | | $ | 439,473 | | | $ | (203 | ) | $ | 208,875 | | $ | — | | $ | 650,561 ---------------------------------------------------------------+----------------+------------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+---+-------------+---+---+---------- Trade accounts receivable—Net | — | | | — | | | 25,069 | | | 652,807 | | (41,749 | ) | 636,127 | ---------------------------------------------------------------+----------------+------------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- Inventories—Net | — | | | 47,051 | | | 571,712 | | | 114,018 | | (2,100 | ) | 730,681 | ---------------------------------------------------------------+----------------+------------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- Assets held-for-sale | — | | | — | | | 6,428 | | | 71,072 | | — | | 77,500 | ---------------------------------------------------------------+----------------+------------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- Prepaid expenses and other | — | | | 4,746 | | | 24,141 | | | 9,796 | | — | | 38,683 | ---------------------------------------------------------------+----------------+------------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- Total current assets | 2,416 | | | 491,270 | | | 627,147 | | | 1,056,568 | | (43,849 | ) | 2,133,552 | ---------------------------------------------------------------+----------------+------------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- INVESTMENT IN SUBSIDIARIES AND INTERCOMPANY BALANCES | (2,953,620 | ) | | 10,263,999 | | | 7,599,210 | | | 966,675 | | (15,876,264 | ) | — | ---------------------------------------------------------------+----------------+------------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- PROPERTY, PLANT AND EQUIPMENT—Net | — | | | 16,032 | | | 261,434 | | | 47,458 | | — | | 324,924 | ---------------------------------------------------------------+----------------+------------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- GOODWILL | — | | | 85,905 | | | 4,996,034 | | | 663,399 | | — | | 5,745,338 | ---------------------------------------------------------------+----------------+------------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- OTHER INTANGIBLE ASSETS—Net | — | | | 27,620 | | | 1,438,006 | | | 252,236 | | — | | 1,717,862 | ---------------------------------------------------------------+----------------+------------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- OTHER | — | | | 20,316 | | | 27,567 | | | 6,102 | | — | | 53,985 | ---------------------------------------------------------------+----------------+------------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- TOTAL ASSETS | $ | (2,951,204 | ) | | $ | 10,905,142 | | | $ | 14,949,398 | | $ | 2,992,438 | | $ | (15,920,113 | ) | $ | 9,975,661 ---------------------------------------------------------------+----------------+------------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+---+-------------+---+---+---------- LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT) | | | | | | | | | | | ---------------------------------------------------------------+----------------+------------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+------------------ CURRENT LIABILITIES: | | | | | | | | | | | ---------------------------------------------------------------+----------------+------------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+------------------ Current portion of long-term debt | $ | — | | | $ | 69,454 | | | $ | — | | $ | — | | $ | — | | $ | 69,454 ---------------------------------------------------------------+----------------+------------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+---+-------------+---+---+---------- Short-term borrowings—trade receivable securitization facility | — | | | — | | | — | | | 299,587 | | — | | 299,587 | ---------------------------------------------------------------+----------------+------------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- Accounts payable | — | | | 14,712 | | | 137,948 | | | 37,667 | | (41,566 | ) | 148,761 | ---------------------------------------------------------------+----------------+------------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- Accrued liabilities | — | | | 180,916 | | | 103,902 | | | 51,070 | | — | | 335,888 | ---------------------------------------------------------------+----------------+------------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- Liabilities held-for-sale | — | | | — | | | — | | | 17,304 | | — | | 17,304 | ---------------------------------------------------------------+----------------+------------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- Total current liabilities | — | | | 265,082 | | | 241,850 | | | 405,628 | | (41,566 | ) | 870,994 | ---------------------------------------------------------------+----------------+------------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- LONG-TERM DEBT | — | | | 11,393,620 | | | — | | | — | | — | | 11,393,620 | ---------------------------------------------------------------+----------------+------------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- DEFERRED INCOME TAXES | — | | | 442,415 | | | (99 | ) | | 58,633 | | — | | 500,949 | ---------------------------------------------------------------+----------------+------------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- OTHER NON-CURRENT LIABILITIES | — | | | 61,347 | | | 73,245 | | | 26,710 | | — | | 161,302 | ---------------------------------------------------------------+----------------+------------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- Total liabilities | — | | | 12,162,464 | | | 314,996 | | | 490,971 | | (41,566 | ) | 12,926,865 | ---------------------------------------------------------------+----------------+------------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- STOCKHOLDERS’ (DEFICIT) EQUITY | (2,951,204 | ) | | (1,257,322 | ) | | 14,634,402 | | | 2,501,467 | | (15,878,547 | ) | (2,951,204 | ) ---------------------------------------------------------------+----------------+------------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- TOTAL LIABILITIES AND STOCKHOLDERS’ (DEFICIT) EQUITY | $ | (2,951,204 | ) | | $ | 10,905,142 | | | $ | 14,949,398 | | $ | 2,992,438 | | $ | (15,920,113 | ) | $ | 9,975,661 ---------------------------------------------------------------+----------------+------------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+---+-------------+---+---+---------- F-34 TRANSDIGM GROUP INCORPORATED CONDENSED CONSOLIDATING BALANCE SHEET AS OF SEPTEMBER 30, 2016 (Amounts in Thousands) | TransDigmGroup | | TransDigmInc. | | SubsidiaryGuarantors | | Non-GuarantorSubsidiaries | | Eliminations | | TotalConsolidated ---------------------------------------------------------------+----------------+----------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+------------------ ASSETS | | | | | | | | | | | ---------------------------------------------------------------+----------------+----------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+------------------ CURRENT ASSETS: | | | | | | | | | | | ---------------------------------------------------------------+----------------+----------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+------------------ Cash and cash equivalents | $ | 13,560 | | | $ | 1,421,251 | | | $ | 8,808 | | $ | 143,375 | | $ | — | | $ | 1,586,994 ---------------------------------------------------------------+----------------+----------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+---+-------------+---+---+----------- Trade accounts receivable—Net | — | | | — | | | 26,210 | | | 561,124 | | (10,995 | ) | 576,339 | ---------------------------------------------------------------+----------------+----------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- Inventories—Net | — | | | 42,309 | | | 586,648 | | | 96,229 | | (1,175 | ) | 724,011 | ---------------------------------------------------------------+----------------+----------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- Prepaid expenses and other | — | | | 8,209 | | | 27,381 | | | 7,763 | | — | | 43,353 | ---------------------------------------------------------------+----------------+----------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- Total current assets | 13,560 | | | 1,471,769 | | | 649,047 | | | 808,491 | | (12,170 | ) | 2,930,697 | ---------------------------------------------------------------+----------------+----------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- INVESTMENT IN SUBSIDIARIES AND INTERCOMPANY BALANCES | (665,050 | ) | | 9,671,019 | | | 6,182,809 | | | 861,647 | | (16,050,425 | ) | — | ---------------------------------------------------------------+----------------+----------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- PROPERTY, PLANT AND EQUIPMENT—Net | — | | | 15,991 | | | 250,544 | | | 44,045 | | — | | 310,580 | ---------------------------------------------------------------+----------------+----------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- GOODWILL | — | | | 68,593 | | | 4,952,950 | | | 657,909 | | — | | 5,679,452 | ---------------------------------------------------------------+----------------+----------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- OTHER INTANGIBLE ASSETS—Net | — | | | 24,801 | | | 1,483,285 | | | 256,257 | | — | | 1,764,343 | ---------------------------------------------------------------+----------------+----------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- OTHER | — | | | 10,319 | | | 24,063 | | | 6,823 | | — | | 41,205 | ---------------------------------------------------------------+----------------+----------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- TOTAL ASSETS | $ | (651,490 | ) | | $ | 11,262,492 | | | $ | 13,542,698 | | $ | 2,635,172 | | $ | (16,062,595 | ) | $ | 10,726,277 ---------------------------------------------------------------+----------------+----------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+---+-------------+---+---+----------- LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT) | | | | | | | | | | | ---------------------------------------------------------------+----------------+----------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+------------------ CURRENT LIABILITIES: | | | | | | | | | | | ---------------------------------------------------------------+----------------+----------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+------------------ Current portion of long-term debt | $ | — | | | $ | 52,645 | | | $ | — | | $ | — | | $ | — | | $ | 52,645 ---------------------------------------------------------------+----------------+----------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+---+-------------+---+---+----------- Short-term borrowings—trade receivable securitization facility | — | | | — | | | — | | | 199,771 | | — | | 199,771 | ---------------------------------------------------------------+----------------+----------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- Accounts payable | — | | | 15,347 | | | 120,455 | | | 31,560 | | (11,287 | ) | 156,075 | ---------------------------------------------------------------+----------------+----------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- Accrued liabilities | — | | | 159,909 | | | 123,646 | | | 60,557 | | — | | 344,112 | ---------------------------------------------------------------+----------------+----------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- Total current liabilities | — | | | 227,901 | | | 244,101 | | | 291,888 | | (11,287 | ) | 752,603 | ---------------------------------------------------------------+----------------+----------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- LONG-TERM DEBT | — | | | 9,943,191 | | | — | | | — | | — | | 9,943,191 | ---------------------------------------------------------------+----------------+----------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- DEFERRED INCOME TAXES | — | | | 434,013 | | | (544 | ) | | 58,786 | | — | | 492,255 | ---------------------------------------------------------------+----------------+----------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- OTHER NON-CURRENT LIABILITIES | — | | | 82,677 | | | 70,124 | | | 36,917 | | — | | 189,718 | ---------------------------------------------------------------+----------------+----------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- Total liabilities | — | | | 10,687,782 | | | 313,681 | | | 387,591 | | (11,287 | ) | 11,377,767 | ---------------------------------------------------------------+----------------+----------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- STOCKHOLDERS’ (DEFICIT) EQUITY | (651,490 | ) | | 574,710 | | | 13,229,017 | | | 2,247,581 | | (16,051,308 | ) | (651,490 | ) ---------------------------------------------------------------+----------------+----------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+-- TOTAL LIABILITIES AND STOCKHOLDERS’ (DEFICIT) EQUITY | $ | (651,490 | ) | | $ | 11,262,492 | | | $ | 13,542,698 | | $ | 2,635,172 | | $ | (16,062,595 | ) | $ | 10,726,277 ---------------------------------------------------------------+----------------+----------+---------------+------------+----------------------+------------+---------------------------+---+--------------+------------+-------------------+-------------+-----------+------------+---+-------------+---+---+----------- F-35 TRANSDIGM GROUP INCORPORATED CONDENSED CONSOLIDATING STATEMENT OF INCOME AND COMPREHENSIVE INCOME FOR THE YEAR ENDED SEPTEMBER 30, 2017 (Amounts in thousands) | TransDigmGroup | | TransDigmInc. | | SubsidiaryGuarantors | | Non-GuarantorSubsidiaries | | Eliminations | | TotalConsolidated ------------------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+------------------ NET SALES | $ | — | | | $ | 143,631 | | | $ | 2,911,950 | | $ | 535,129 | | $ | (86,424 | ) | $ | 3,504,286 ------------------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+---+------------+---+---+---------- COST OF SALES | — | | | 79,403 | | | 1,191,770 | | | 333,985 | | (85,499 | ) | 1,519,659 | ------------------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- GROSS PROFIT | — | | | 64,228 | | | 1,720,180 | | | 201,144 | | (925 | ) | 1,984,627 | ------------------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- SELLING AND ADMINISTRATIVE EXPENSES | 69 | | | 97,677 | | | 284,819 | | | 33,010 | | — | | 415,575 | ------------------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- AMORTIZATION OF INTANGIBLE ASSETS | — | | | 1,003 | | | 80,053 | | | 8,170 | | — | | 89,226 | ------------------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- (LOSS) INCOME FROM OPERATIONS | (69 | ) | | (34,452 | ) | | 1,355,308 | | | 159,964 | | (925 | ) | 1,479,826 | ------------------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- INTEREST EXPENSE (INCOME)—Net | — | | | 614,353 | | | (1,248 | ) | | (10,516 | ) | — | | 602,589 | ------------------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- REFINANCING COSTS | — | | | 39,807 | | | — | | | — | | — | | 39,807 | ------------------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- EQUITY IN INCOME OF SUBSIDIARIES | (596,956 | ) | | (1,318,945 | ) | | — | | | — | | 1,915,901 | | — | ------------------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES | 596,887 | | | 630,333 | | | 1,356,556 | | | 170,480 | | (1,916,826 | ) | 837,430 | ------------------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- INCOME TAX PROVISION | — | | | 33,377 | | | 156,251 | | | 19,261 | | — | | 208,889 | ------------------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- INCOME FROM CONTINUING OPERATIONS | 596,887 | | | 596,956 | | | 1,200,305 | | | 151,219 | | (1,916,826 | ) | 628,541 | ------------------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- LOSS FROM DISCONTINUED OPERATIONS, NET OF TAX | — | | | — | | | (9,496 | ) | | (22,158 | ) | — | | (31,654 | ) ------------------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- NET INCOME | 596,887 | | | 596,956 | | | 1,190,809 | | | 129,061 | | (1,916,826 | ) | 596,887 | ------------------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAX | 64,644 | | | 31,603 | | | 16,310 | | | 58,856 | | (106,769 | ) | 64,644 | ------------------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- TOTAL COMPREHENSIVE INCOME | $ | 661,531 | | | $ | 628,559 | | | $ | 1,207,119 | | $ | 187,917 | | $ | (2,023,595 | ) | $ | 661,531 ------------------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+---+------------+---+---+---------- F-36 TRANSDIGM GROUP INCORPORATED CONDENSED CONSOLIDATING STATEMENT OF INCOME AND COMPREHENSIVE INCOME FOR THE YEAR ENDED SEPTEMBER 30, 2016 (Amounts in Thousands) | TransDigmGroup | | TransDigmInc. | | SubsidiaryGuarantors | | Non-GuarantorSubsidiaries | | Eliminations | | TotalConsolidated ----------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+------------------ NET SALES | $ | — | | | $ | 132,407 | | | $ | 2,580,091 | | $ | 486,198 | | $ | (27,285 | ) | $ | 3,171,411 ----------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+---+------------+---+---+---------- COST OF SALES | — | | | 75,521 | | | 1,105,893 | | | 289,219 | | (27,285 | ) | 1,443,348 | ----------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- GROSS PROFIT | — | | | 56,886 | | | 1,474,198 | | | 196,979 | | — | | 1,728,063 | ----------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- SELLING AND ADMINISTRATIVE EXPENSES | — | | | 114,546 | | | 210,209 | | | 58,103 | | — | | 382,858 | ----------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- AMORTIZATION OF INTANGIBLE ASSETS | — | | | 684 | | | 65,299 | | | 11,462 | | — | | 77,445 | ----------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- (LOSS) INCOME FROM OPERATIONS | — | | | (58,344 | ) | | 1,198,690 | | | 127,414 | | — | | 1,267,760 | ----------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- INTEREST EXPENSE (INCOME)—Net | — | | | 490,974 | | | 259 | | | (7,383 | ) | — | | 483,850 | ----------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- REFINANCING COSTS | — | | | 15,794 | | | — | | | — | | — | | 15,794 | ----------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- EQUITY IN INCOME OF SUBSIDIARIES | (586,414 | ) | | (1,044,371 | ) | | — | | | — | | 1,630,785 | | — | ----------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- INCOME BEFORE INCOME TAXES | 586,414 | | | 479,259 | | | 1,198,431 | | | 134,797 | | (1,630,785 | ) | 768,116 | ----------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- INCOME TAX (BENEFIT) PROVISION | — | | | (107,155 | ) | | 285,887 | | | 2,970 | | — | | 181,702 | ----------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- NET INCOME | $ | 586,414 | | | $ | 586,414 | | | $ | 912,544 | | $ | 131,827 | | $ | (1,630,785 | ) | $ | 586,414 ----------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+---+------------+---+---+---------- OTHER COMPREHENSIVE (LOSS) INCOME, NET OF TAX | (53,778 | ) | | 6,381 | | | (9,598 | ) | | (39,461 | ) | 42,678 | | (53,778 | ) ----------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- TOTAL COMPREHENSIVE INCOME | $ | 532,636 | | | $ | 592,795 | | | $ | 902,946 | | $ | 92,366 | | $ | (1,588,107 | ) | $ | 532,636 ----------------------------------------------+----------------+---------+---------------+------------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+---+------------+---+---+---------- F-37 TRANSDIGM GROUP INCORPORATED CONDENSED CONSOLIDATING STATEMENT OF INCOME AND COMPREHENSIVE INCOME FOR THE YEAR ENDED SEPTEMBER 30, 2015 (Amounts in Thousands) | TransDigmGroup | | TransDigmInc. | | SubsidiaryGuarantors | | Non-GuarantorSubsidiaries | | Eliminations | | TotalConsolidated ----------------------------------------------+----------------+---------+---------------+----------+----------------------+---------+---------------------------+---+--------------+-----------+------------------ NET SALES | $ | — | | | $ | 131,378 | | | $ | 2,262,842 | | $ | 324,675 | | $ | (11,780 | ) | $ | 2,707,115 ----------------------------------------------+----------------+---------+---------------+----------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+---+------------+---+---+---------- COST OF SALES | — | | | 79,174 | | | 973,908 | | | 215,968 | | (11,780 | ) | 1,257,270 | ----------------------------------------------+----------------+---------+---------------+----------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- GROSS PROFIT | — | | | 52,204 | | | 1,288,934 | | | 108,707 | | — | | 1,449,845 | ----------------------------------------------+----------------+---------+---------------+----------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- SELLING AND ADMINISTRATIVE EXPENSES | — | | | 72,792 | | | 197,914 | | | 50,918 | | — | | 321,624 | ----------------------------------------------+----------------+---------+---------------+----------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- AMORTIZATION OF INTANGIBLE ASSETS | — | | | 1,392 | | | 45,337 | | | 7,490 | | — | | 54,219 | ----------------------------------------------+----------------+---------+---------------+----------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- (LOSS) INCOME FROM OPERATIONS | — | | | (21,980 | ) | | 1,045,683 | | | 50,299 | | — | | 1,074,002 | ----------------------------------------------+----------------+---------+---------------+----------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- INTEREST EXPENSE (INCOME)—Net | — | | | 430,224 | | | (487 | ) | | (10,952 | ) | — | | 418,785 | ----------------------------------------------+----------------+---------+---------------+----------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- REFINANCING COSTS | — | | | 18,393 | | | — | | | — | | — | | 18,393 | ----------------------------------------------+----------------+---------+---------------+----------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- EQUITY IN INCOME OF SUBSIDIARIES | (447,212 | ) | | (773,510 | ) | | — | | | — | | 1,220,722 | | — | ----------------------------------------------+----------------+---------+---------------+----------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- INCOME BEFORE INCOME TAXES | 447,212 | | | 302,913 | | | 1,046,170 | | | 61,251 | | (1,220,722 | ) | 636,824 | ----------------------------------------------+----------------+---------+---------------+----------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- INCOME TAX (BENEFIT) PROVISION | — | | | (144,299 | ) | | 315,017 | | | 18,894 | | — | | 189,612 | ----------------------------------------------+----------------+---------+---------------+----------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- NET INCOME | $ | 447,212 | | | $ | 447,212 | | | $ | 731,153 | | $ | 42,357 | | $ | (1,220,722 | ) | $ | 447,212 ----------------------------------------------+----------------+---------+---------------+----------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+---+------------+---+---+---------- OTHER COMPREHENSIVE (LOSS) INCOME, NET OF TAX | (70,838 | ) | | (55,338 | ) | | 770 | | | (29,147 | ) | 83,715 | | (70,838 | ) ----------------------------------------------+----------------+---------+---------------+----------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+-- TOTAL COMPREHENSIVE INCOME (LOSS) | $ | 376,374 | | | $ | 391,874 | | | $ | 731,923 | | $ | 13,210 | | $ | (1,137,007 | ) | $ | 376,374 ----------------------------------------------+----------------+---------+---------------+----------+----------------------+---------+---------------------------+---+--------------+-----------+-------------------+------------+---------+-----------+---+------------+---+---+---------- F-38 TRANSDIGM GROUP INCORPORATED CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS FOR THE YEAR ENDED SEPTEMBER 30, 2017 (Amounts in thousands) | TransDigmGroup | | TransDigmInc. | | SubsidiaryGuarantors | | Non-GuarantorSubsidiaries | | Eliminations | | TotalConsolidated ------------------------------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+-----------+------------------ NET CASH (USED IN) PROVIDED BY OPERATING ACTIVITIES | $ | (69 | ) | | $ | (587,800 | ) | | $ | 1,334,099 | | $ | 42,028 | | $ | 475 | $ | 788,733 ------------------------------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+-----------+-------------------+------+---------+------------+---+-----+---+-------- INVESTING ACTIVITIES: | | | | | | | | | | | ------------------------------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+-----------+------------------ Capital expenditures | — | | | (1,984 | ) | | (63,305 | ) | | (5,724 | ) | — | | (71,013 | ) ------------------------------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+-----------+-------------------+------+---------+------------+-- Acquisition of business, net of cash acquired | — | | | (136,295 | ) | | — | | | — | | — | | (136,295 | ) ------------------------------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+-----------+-------------------+------+---------+------------+-- Acquisition of Schroth, net of cash acquired | — | | | (79,695 | ) | | — | | | — | | — | | (79,695 | ) ------------------------------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+-----------+-------------------+------+---------+------------+-- Net cash used in investing activities | — | | | (217,974 | ) | | (63,305 | ) | | (5,724 | ) | — | | (287,003 | ) ------------------------------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+-----------+-------------------+------+---------+------------+-- FINANCING ACTIVITIES: | | | | | | | | | | | ------------------------------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+-----------+------------------ Intercompany activities | 2,939,121 | | | (1,682,518 | ) | | (1,279,805 | ) | | 23,677 | | (475 | ) | — | ------------------------------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+-----------+-------------------+------+---------+------------+-- Proceeds from exercise of stock options | 21,177 | | | — | | | — | | | — | | — | | 21,177 | ------------------------------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+-----------+-------------------+------+---------+------------+-- Dividends paid | (2,581,552 | ) | | — | | | — | | | — | | — | | (2,581,552 | ) ------------------------------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+-----------+-------------------+------+---------+------------+-- Treasury stock purchased | (389,821 | ) | | — | | | — | | | — | | — | | (389,821 | ) ------------------------------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+-----------+-------------------+------+---------+------------+-- Proceeds from term loans, net | — | | | 2,937,773 | | | — | | | — | | — | | 2,937,773 | ------------------------------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+-----------+-------------------+------+---------+------------+-- Repayment on term loans | — | | | (1,284,698 | ) | | — | | | — | | — | | (1,284,698 | ) ------------------------------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+-----------+-------------------+------+---------+------------+-- Cash tender and redemption of senior subordinated notes due 2021, including premium | — | | | (528,847 | ) | | — | | | — | | — | | (528,847 | ) ------------------------------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+-----------+-------------------+------+---------+------------+-- Proceeds from senior subordinated notes, net | — | | | 300,386 | | | — | | | — | | — | | 300,386 | ------------------------------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+-----------+-------------------+------+---------+------------+-- Proceeds from trade receivable securitization facility, net | — | | | 99,471 | | | — | | | — | | — | | 99,471 | ------------------------------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+-----------+-------------------+------+---------+------------+-- Financing fees and other | — | | | (17,571 | ) | | — | | | — | | — | | (17,571 | ) ------------------------------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+-----------+-------------------+------+---------+------------+-- Net cash (used in) provided by financing activities | (11,075 | ) | | (176,004 | ) | | (1,279,805 | ) | | 23,677 | | (475 | ) | (1,443,682 | ) ------------------------------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+-----------+-------------------+------+---------+------------+-- EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS | — | | | — | | | — | | | 5,519 | | — | | 5,519 | ------------------------------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+-----------+-------------------+------+---------+------------+-- NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS | (11,144 | ) | | (981,778 | ) | | (9,011 | ) | | 65,500 | | — | | (936,433 | ) ------------------------------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+-----------+-------------------+------+---------+------------+-- CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD | 13,560 | | | 1,421,251 | | | 8,808 | | | 143,375 | | — | | 1,586,994 | ------------------------------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+-----------+-------------------+------+---------+------------+-- CASH AND CASH EQUIVALENTS, END OF PERIOD | $ | 2,416 | | | $ | 439,473 | | | $ | (203 | ) | $ | 208,875 | | $ | — | $ | 650,561 ------------------------------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+-----------+-------------------+------+---------+------------+---+-----+---+-------- F-39 TRANSDIGM GROUP INCORPORATED CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS FOR THE YEAR ENDED SEPTEMBER 30, 2016 (Amounts in Thousands) | TransDigmGroup | | TransDigmInc. | | SubsidiaryGuarantors | | Non-GuarantorSubsidiaries | | Eliminations | | TotalConsolidated -------------------------------------------------------------+----------------+--------+---------------+------------+----------------------+-----------+---------------------------+---+--------------+---------+------------------ NET CASH (USED IN) PROVIDED BY OPERATING ACTIVITIES | $ | — | | | $ | (230,931 | ) | | $ | 944,152 | | $ | (25,496 | ) | | $ | (4,427 | ) | $ | 683,298 -------------------------------------------------------------+----------------+--------+---------------+------------+----------------------+-----------+---------------------------+---+--------------+---------+-------------------+-------+---------+---+------------+---+--------+---+---+---------- INVESTING ACTIVITIES: | | | | | | | | | | | -------------------------------------------------------------+----------------+--------+---------------+------------+----------------------+-----------+---------------------------+---+--------------+---------+------------------ Capital expenditures | — | | | (1,716 | ) | | (32,608 | ) | | (9,658 | ) | — | | | (43,982 | ) -------------------------------------------------------------+----------------+--------+---------------+------------+----------------------+-----------+---------------------------+---+--------------+---------+-------------------+-------+---------+---+------------+-- Acquisition of business, net of cash acquired | — | | | (1,399,064 | ) | | — | | | — | | — | | | (1,399,064 | ) -------------------------------------------------------------+----------------+--------+---------------+------------+----------------------+-----------+---------------------------+---+--------------+---------+-------------------+-------+---------+---+------------+-- Net cash used in investing activities | — | | | (1,400,780 | ) | | (32,608 | ) | | (9,658 | ) | — | | | (1,443,046 | ) -------------------------------------------------------------+----------------+--------+---------------+------------+----------------------+-----------+---------------------------+---+--------------+---------+-------------------+-------+---------+---+------------+-- FINANCING ACTIVITIES: | | | | | | | | | | | -------------------------------------------------------------+----------------+--------+---------------+------------+----------------------+-----------+---------------------------+---+--------------+---------+------------------ Intercompany activities | 192,703 | | | 580,487 | | | (910,647 | ) | | 133,030 | | 4,427 | | | — | -------------------------------------------------------------+----------------+--------+---------------+------------+----------------------+-----------+---------------------------+---+--------------+---------+-------------------+-------+---------+---+------------+-- Proceeds from exercise of stock options | 30,112 | | | — | | | — | | | — | | — | | | 30,112 | -------------------------------------------------------------+----------------+--------+---------------+------------+----------------------+-----------+---------------------------+---+--------------+---------+-------------------+-------+---------+---+------------+-- Dividends paid | (3,000 | ) | | — | | | — | | | — | | — | | | (3,000 | ) -------------------------------------------------------------+----------------+--------+---------------+------------+----------------------+-----------+---------------------------+---+--------------+---------+-------------------+-------+---------+---+------------+-- Treasury stock repurchased | (207,755 | ) | | — | | | — | | | — | | — | | | (207,755 | ) -------------------------------------------------------------+----------------+--------+---------------+------------+----------------------+-----------+---------------------------+---+--------------+---------+-------------------+-------+---------+---+------------+-- Proceeds from term loans, net | — | | | 1,711,515 | | | — | | | — | | — | | | 1,711,515 | -------------------------------------------------------------+----------------+--------+---------------+------------+----------------------+-----------+---------------------------+---+--------------+---------+-------------------+-------+---------+---+------------+-- Repayment on term loans | — | | | (834,409 | ) | | — | | | — | | — | | | (834,409 | ) -------------------------------------------------------------+----------------+--------+---------------+------------+----------------------+-----------+---------------------------+---+--------------+---------+-------------------+-------+---------+---+------------+-- Proceeds from senior subordinated notes, net | — | | | 939,584 | | | — | | | — | | — | | | 939,584 | -------------------------------------------------------------+----------------+--------+---------------+------------+----------------------+-----------+---------------------------+---+--------------+---------+-------------------+-------+---------+---+------------+-- Financing fees and other | — | | | (3,580 | ) | | — | | | — | | — | | | (3,580 | ) -------------------------------------------------------------+----------------+--------+---------------+------------+----------------------+-----------+---------------------------+---+--------------+---------+-------------------+-------+---------+---+------------+-- Net cash provided by (used in) financing activities | 12,060 | | | 2,393,597 | | | (910,647 | ) | | 133,030 | | 4,427 | | | 1,632,467 | -------------------------------------------------------------+----------------+--------+---------------+------------+----------------------+-----------+---------------------------+---+--------------+---------+-------------------+-------+---------+---+------------+-- EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS | — | | | — | | | — | | | 242 | | — | | | 242 | -------------------------------------------------------------+----------------+--------+---------------+------------+----------------------+-----------+---------------------------+---+--------------+---------+-------------------+-------+---------+---+------------+-- NET INCREASE IN CASH AND CASH EQUIVALENTS | 12,060 | | | 761,886 | | | 897 | | | 98,118 | | — | | | 872,961 | -------------------------------------------------------------+----------------+--------+---------------+------------+----------------------+-----------+---------------------------+---+--------------+---------+-------------------+-------+---------+---+------------+-- CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD | 1,500 | | | 659,365 | | | 7,911 | | | 45,257 | | — | | | 714,033 | -------------------------------------------------------------+----------------+--------+---------------+------------+----------------------+-----------+---------------------------+---+--------------+---------+-------------------+-------+---------+---+------------+-- CASH AND CASH EQUIVALENTS, END OF PERIOD | $ | 13,560 | | | $ | 1,421,251 | | | $ | 8,808 | | $ | 143,375 | | | $ | — | | $ | 1,586,994 -------------------------------------------------------------+----------------+--------+---------------+------------+----------------------+-----------+---------------------------+---+--------------+---------+-------------------+-------+---------+---+------------+---+--------+---+---+---------- F-40 TRANSDIGM GROUP INCORPORATED CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS FOR THE YEAR ENDED SEPTEMBER 30, 2015 (Amounts in Thousands) | TransDigmGroup | | TransDigmInc. | | SubsidiaryGuarantors | | Non-GuarantorSubsidiaries | | Eliminations | | TotalConsolidated ----------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+---------+------------------ NET CASH (USED IN) PROVIDED BY OPERATING ACTIVITIES | $ | — | | | $ | (298,797 | ) | | $ | 734,130 | | $ | 82,451 | | $ | 3,154 | $ | 520,938 ----------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+---------+-------------------+--------+--------+------------+---+-------+---+-------- INVESTING ACTIVITIES: | | | | | | | | | | | ----------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+---------+------------------ Capital expenditures | — | | | (2,871 | ) | | (44,564 | ) | | (7,436 | ) | — | | (54,871 | ) ----------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+---------+-------------------+--------+--------+------------+-- Acquisition of businesses, net of cash acquired | | | | (1,624,278 | ) | | — | | | — | | — | | (1,624,278 | ) ----------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+---------+-------------------+--------+--------+------------+-- Net cash used in investing activities | — | | | (1,627,149 | ) | | (44,564 | ) | | (7,436 | ) | — | | (1,679,149 | ) ----------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+---------+-------------------+--------+--------+------------+-- FINANCING ACTIVITIES: | | | | | | | | | | | ----------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+---------+------------------ Intercompany activities | (120,862 | ) | | 867,990 | | | (685,448 | ) | | (58,526 | ) | (3,154 | ) | — | ----------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+---------+-------------------+--------+--------+------------+-- Excess tax benefits related to share-based payment arrangements | 61,965 | | | — | | | — | | | — | | — | | 61,965 | ----------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+---------+-------------------+--------+--------+------------+-- Proceeds from exercise of stock options | 61,674 | | | — | | | — | | | — | | — | | 61,674 | ----------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+---------+-------------------+--------+--------+------------+-- Dividends paid | (3,365 | ) | | — | | | — | | | — | | — | | (3,365 | ) ----------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+---------+-------------------+--------+--------+------------+-- Proceeds from term loans, net | — | | | 1,515,954 | | | — | | | — | | — | | 1,515,954 | ----------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+---------+-------------------+--------+--------+------------+-- Repayment on term loans | — | | | (1,025,318 | ) | | — | | | — | | — | | (1,025,318 | ) ----------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+---------+-------------------+--------+--------+------------+-- Proceeds from senior subordinated notes, net | — | | | 445,303 | | | — | | | — | | — | | 445,303 | ----------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+---------+-------------------+--------+--------+------------+-- Financing fees and other | — | | | (1,266 | ) | | — | | | — | | — | | (1,266 | ) ----------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+---------+-------------------+--------+--------+------------+-- Net cash (used in) provided by financing activities | (588 | ) | | 1,802,663 | | | (685,448 | ) | | (58,526 | ) | (3,154 | ) | 1,054,947 | ----------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+---------+-------------------+--------+--------+------------+-- EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS | — | | | — | | | — | | | (2,251 | ) | — | | (2,251 | ) ----------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+---------+-------------------+--------+--------+------------+-- NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS | (588 | ) | | (123,283 | ) | | 4,118 | | | 14,238 | | — | | (105,515 | ) ----------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+---------+-------------------+--------+--------+------------+-- CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD | 2,088 | | | 782,648 | | | 3,793 | | | 31,019 | | — | | 819,548 | ----------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+---------+-------------------+--------+--------+------------+-- CASH AND CASH EQUIVALENTS, END OF PERIOD | $ | 1,500 | | | $ | 659,365 | | | $ | 7,911 | | $ | 45,257 | | $ | — | $ | 714,033 ----------------------------------------------------------------+----------------+-------+---------------+------------+----------------------+----------+---------------------------+---+--------------+---------+-------------------+--------+--------+------------+---+-------+---+-------- ***** F-41 TRANSDIGM GROUP INCORPORATED VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED SEPTEMBER 30, 2017 , 2016 , AND 2015 (Amounts in Thousands) Column A | Column B | | Column C | | Column D | | Column E --------------------------------------------+------------------------------+-------+--------------+--------+---------------------------+-------+----------------------- | Balance atBeginning ofPeriod | | Additions | | Deductions fromReserve(1) | | Balance atEnd ofPeriod --------------------------------------------+------------------------------+-------+--------------+--------+---------------------------+-------+----------------------- Description | Charged to Costsand Expenses | | Acquisitions | --------------------------------------------+------------------------------+-------+--------------+------- Year Ended September 30, 2017 | | | | | | | | --------------------------------------------+------------------------------+-------+--------------+--------+---------------------------+-------+------------------------+-- Allowance for doubtful accounts | $ | 4,414 | | | $ | 1,095 | | $ | 363 | | $ | (2,053 | ) | $ | 3,819 --------------------------------------------+------------------------------+-------+--------------+--------+---------------------------+-------+------------------------+---+---------+---+--------+--------+---+---+------ Reserve for excess and obsolete inventory | 80,039 | | | 17,361 | | | 4,254 | | (21,879 | ) | 79,775 | --------------------------------------------+------------------------------+-------+--------------+--------+---------------------------+-------+------------------------+---+---------+---+--------+------- Valuation allowance for deferred tax assets | 27,286 | | | 5,928 | | | — | | — | | 33,214 | --------------------------------------------+------------------------------+-------+--------------+--------+---------------------------+-------+------------------------+---+---------+---+--------+------- Year Ended September 30, 2016 | | | | | | | | --------------------------------------------+------------------------------+-------+--------------+--------+---------------------------+-------+------------------------+-- Allowance for doubtful accounts | $ | 3,801 | | | $ | 1,043 | | $ | 724 | | $ | (1,154 | ) | $ | 4,414 --------------------------------------------+------------------------------+-------+--------------+--------+---------------------------+-------+------------------------+---+---------+---+--------+--------+---+---+------ Reserve for excess and obsolete inventory | 64,158 | | | 26,407 | | | — | | (10,526 | ) | 80,039 | --------------------------------------------+------------------------------+-------+--------------+--------+---------------------------+-------+------------------------+---+---------+---+--------+------- Valuation allowance for deferred tax assets | 17,645 | | | 9,641 | | | — | | — | | 27,286 | --------------------------------------------+------------------------------+-------+--------------+--------+---------------------------+-------+------------------------+---+---------+---+--------+------- Year Ended September 30, 2015 | | | | | | | | --------------------------------------------+------------------------------+-------+--------------+--------+---------------------------+-------+------------------------+-- Allowance for doubtful accounts | $ | 4,091 | | | $ | (376 | ) | $ | 271 | | $ | (185 | ) | $ | 3,801 --------------------------------------------+------------------------------+-------+--------------+--------+---------------------------+-------+------------------------+---+---------+---+--------+--------+---+---+------ Reserve for excess and obsolete inventory | 55,586 | | | 15,554 | | | — | | (6,982 | ) | 64,158 | --------------------------------------------+------------------------------+-------+--------------+--------+---------------------------+-------+------------------------+---+---------+---+--------+------- Valuation allowance for deferred tax assets | 24,267 | | | (6,622 | ) | | — | | — | | 17,645 | --------------------------------------------+------------------------------+-------+--------------+--------+---------------------------+-------+------------------------+---+---------+---+--------+------- (1) | The amounts in this column represent charge-offs net of recoveries and the impact of foreign currency translation adjustments. ----+------------------------------------------------------------------------------------------------------------------------------- F-42 EXHIBIT INDEX TO FORM 10-K FOR THE YEAR ENDED SEPTEMBER 30, 2017 EXHIBITNO. | DESCRIPTION -----------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3.54 | Certificate of Formation, filed June 28, 2007, of Avionic Instruments LLC -----------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3.165 | Certificate of Formation, filed December 13, 2016, of Wings Acquisition Sub LLC (now known as Interiors In Flight LLC) -----------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3.166 | Limited Liability Agreement of Wings Acquisition Sub LLC (now known as Interiors in Flight LLC) -----------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3.167 | Certificate of Formation, filed December 13, 2016, of Wings Acquisition Co LLC (now known as SCHROTH Safety Products LLC) -----------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3.168 | Limited Liability Agreement of Wings Acquisition Co LLC (now known as SCHROTH Safety Products LLC) -----------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.48 | Ninth Amendment to the Receivables Purchase Agreement dated as of August 1, 2017, among TransDigm Receivables LLC, TransDigm Inc., PNC Bank, National Association, as a Committed Purchaser, as Purchaser Agent for its Purchaser Group and as Administrator, Atlantic Asset Securitization LLC, as a Conduit Purchaser, Credit Agricole Corporate and Investment Bank, as a Committed Purchaser and as a Purchaser Agent for its and Atlantic’s Purchaser Group, and Fifth Third Bank, as a Committed Purchaser and as Purchaser Agent for its Purchaser Group -----------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 12.1 | Statement of Computation of Ratio of Earnings to Fixed Charges -----------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 21.1 | Subsidiaries of TransDigm Group Incorporated -----------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 23.1 | Consent of Independent Registered Public Accounting Firm -----------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.1 | Certification by Principal Executive Officer of TransDigm Group Incorporated pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. -----------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.2 | Certification by Principal Financial Officer of TransDigm Group Incorporated pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. -----------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 32.1 | Certification by Principal Executive Officer of TransDigm Group Incorporated pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. -----------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 32.2 | Certification by Principal Financial Officer of TransDigm Group Incorporated pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. -----------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101 | Financial Statements and Notes to Consolidated Financial Statements formatted in XBRL. -----------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Woodward, Inc.

108312

10-K

0000108312-17-000026

wwd-20170930 Q4 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ☒ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended September 30, 2017 or ☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _____ to _____  | ------------------------------------------------------------------+-------------------------------------  | ------------------------------------------------------------------+-------------------------------------  | ------------------------------------------------------------------+------------------------------------- Commission file number 000-08408 ----------------------------------------------------------------- WOODWARD, INC. ----------------------------------------------------------------- (Exact name of registrant as specified in its charter) -----------------------------------------------------------------  Delaware | 36-1984010 ------------------------------------------------------------------+-------------------------------------  (State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) ------------------------------------------------------------------+-------------------------------------  1081 Woodward Way, Fort Collins, Colorado | 80524 ------------------------------------------------------------------+-------------------------------------  (Address of principal executive offices) | (Zip Code) ------------------------------------------------------------------+------------------------------------- (970) 482-5811 -----------------------------------------------------------------  (Registrant’s telephone number, including area code) ----------------------------------------------------------------- Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☒ No ☐ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐ No ☒ Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No ☐ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large accelerated filer ☒ Accelerated filer ☐ Non-accelerated filer ☐ Smaller reporting company ☐ Emerging growth company ☐ If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒ Aggregate market value of registrant’s common stock held by non-affiliates of the registrant, based upon the closing price of a share of the registrant’s common stock on March 31, 2017 as reported on The NASDAQ Global Select Market on that date: $2,972,702,291. For purposes of this calculation, shares of common stock held by (i) persons holding more than 5% of the outstanding shares of stock, (ii) officers and directors of the registrant, and (iii) the Woodward Governor Company Profit Sharing Trust, Woodward Governor Company Deferred Shares Trust, or the Woodward Charitable Trust, as of March 31, 2017, are excluded in that such persons may be deemed to be affiliates. This determination is not necessarily conclusive of affiliate status. As of November 9, 2017, 61,238,422 shares of the registrant’s common stock with a par value of $0.001455 per share were outstanding.  DOCUMENTS INCORPORATED BY REFERENCE Portions of our proxy statement for the Annual Meeting of Stockholders to be held January 24, 2018, are incorporated by reference into Parts II and III of this Form 10-K, to the extent indicated.     | | ------------------+---------------------------------------------------------------------------------------------------------+-----  | | ------------------+---------------------------------------------------------------------------------------------------------+----- TABLE OF CONTENTS -----------------  | | Page ------------------+---------------------------------------------------------------------------------------------------------+----- PART I -----------------  | Forward Looking Statements | 2 ------------------+---------------------------------------------------------------------------------------------------------+----- Item 1. | Business | 4 ------------------+---------------------------------------------------------------------------------------------------------+----- Item 1A. | Risk Factors | 12 ------------------+---------------------------------------------------------------------------------------------------------+----- Item 1B. | Unresolved Staff Comments | 23 ------------------+---------------------------------------------------------------------------------------------------------+----- Item 2. | Properties | 23 ------------------+---------------------------------------------------------------------------------------------------------+----- Item 3. | Legal Proceedings | 24 ------------------+---------------------------------------------------------------------------------------------------------+----- Item 4. | Mine Safety Disclosures | 24 ------------------+---------------------------------------------------------------------------------------------------------+----- PART II ----------------- Item 5. | Market Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchase of Equity Securities | 24 ------------------+---------------------------------------------------------------------------------------------------------+----- Item 6. | Selected Financial Data | 26 ------------------+---------------------------------------------------------------------------------------------------------+----- Item 7. | Management’s Discussion and Analysis of Financial Condition and Results of Operations | 28 ------------------+---------------------------------------------------------------------------------------------------------+----- Item 7A. | Quantitative and Qualitative Disclosures About Market Risk | 47 ------------------+---------------------------------------------------------------------------------------------------------+----- Item 8. | Financial Statements and Supplementary Data | 50 ------------------+---------------------------------------------------------------------------------------------------------+----- Item 9. | Changes in and Disagreements with Accountants on Accounting and Financial Disclosures | 101 ------------------+---------------------------------------------------------------------------------------------------------+----- Item 9A. | Controls and Procedures | 101 ------------------+---------------------------------------------------------------------------------------------------------+----- Item 9B. | Other Information | 103 ------------------+---------------------------------------------------------------------------------------------------------+----- PART III ----------------- Item 10. | Directors, Executive Officers and Corporate Governance | 103 ------------------+---------------------------------------------------------------------------------------------------------+----- Item 11. | Executive Compensation | 103 ------------------+---------------------------------------------------------------------------------------------------------+----- Item 12. | Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters | 103 ------------------+---------------------------------------------------------------------------------------------------------+----- Item 13. | Certain Relationships and Related Transactions, and Director Independence | 103 ------------------+---------------------------------------------------------------------------------------------------------+----- Item 14. | Principal Accountant Fees and Services | 103 ------------------+---------------------------------------------------------------------------------------------------------+----- PART IV ----------------- Item 15. | Exhibits and Financial Statement Schedules | 104 ------------------+---------------------------------------------------------------------------------------------------------+----- Item 16. | Form 10-K Summary | 107 ------------------+---------------------------------------------------------------------------------------------------------+-----  | Signatures | 108 ------------------+---------------------------------------------------------------------------------------------------------+----- 1 PART I  Forward Looking Statements This Annual Report on Form 10-K, including “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains forward-looking statements regarding future events and our future results within the meaning of the Private Securities Litigation Reform Act of 1995. All statements other than statements of historical fact are statements that are deemed forward-looking statements. These statements are based on current expectations, estimates, forecasts, and projections about the industries in which we operate and the beliefs and assumptions of management. Words such as “anticipate,” “believe,” “estimate,” “seek,” “goal,” “expect,” “forecast,” “intend,” “continue,” “outlook,” “plan,” “project,” “target,” “strive,” “can,” “could,” “may,” “should,” “will,” “would,” variations of such words, and similar expressions are intended to identify such forward-looking statements. In addition, any statements that refer to projections of our future financial performance, our anticipated growth and trends in our businesses, and other characteristics of future events or circumstances are forward-looking statements. Forward-looking statements may include, among others, statements relating to: · | future sales, earnings, cash flow, uses of cash, and other measures of financial performance; --+---------------------------------------------------------------------------------------------- · | trends in our business and the markets in which we operate, including expectations in those markets in future periods; --+----------------------------------------------------------------------------------------------------------------------- · | our expected expenses in future periods and trends in such expenses over time; --+------------------------------------------------------------------------------- · | descriptions of our plans and expectations for future operations; --+------------------------------------------------------------------ · | plans and expectations relating to the performance of our joint venture with General Electric Company; --+------------------------------------------------------------------------------------------------------- · | investments in new campuses, business sites and related business developments; --+------------------------------------------------------------------------------- · | the effect of economic trends or growth; --+----------------------------------------- · | the expected levels of activity in particular industries or markets and the effects of changes in those levels; --+---------------------------------------------------------------------------------------------------------------- · | the scope, nature, or impact of acquisition activity and integration of such acquisition into our business; --+------------------------------------------------------------------------------------------------------------ · | the research, development, production, and support of new products and services; --+--------------------------------------------------------------------------------- · | new business opportunities; --+---------------------------- · | restructuring and alignment costs and savings; --+----------------------------------------------- · | our plans, objectives, expectations and intentions with respect to business opportunities that may be available to us; --+----------------------------------------------------------------------------------------------------------------------- · | our liquidity, including our ability to meet capital spending requirements and operations; --+------------------------------------------------------------------------------------------- · | future repurchases of common stock; --+------------------------------------ · | future levels of indebtedness and capital spending; --+---------------------------------------------------- · | the stability of financial institutions, including those lending to us; and --+---------------------------------------------------------------------------- · | pension and other postretirement plan assumptions and future contributions. --+---------------------------------------------------------------------------- Readers are cautioned that these forward-looking statements are only predictions and are subject to risks, uncertainties, and assumptions that are difficult to predict, including: · | a decline in business with, or financial distress of, our significant customers; --+--------------------------------------------------------------------------------- · | global economic uncertainty and instability in the financial markets; --+---------------------------------------------------------------------- · | our ability to manage product liability claims, product recalls or other liabilities associated with the products and services that we provide; --+------------------------------------------------------------------------------------------------------------------------------------------------ · | our ability to obtain financing, on acceptable terms or at all, to implement our business plans, complete acquisitions, or otherwise take advantage of business opportunities or respond to business pressures; --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | the long sales cycle, customer evaluation process, and implementation period of some of our products and services; --+------------------------------------------------------------------------------------------------------------------- · | our ability to implement and realize the intended effects of any restructuring and alignment efforts; --+------------------------------------------------------------------------------------------------------ · | our ability to successfully manage competitive factors, including prices, promotional incentives, competitor product development, industry consolidation, and commodity and other input cost increases; --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | our ability to manage our expenses and product mix while responding to sales increases or decreases; --+----------------------------------------------------------------------------------------------------- · | the ability of our subcontractors to perform contractual obligations and our suppliers to provide us with materials of sufficient quality or quantity required to meet our production needs at favorable prices or at all; --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | our ability to monitor our technological expertise and the success of, and/or costs associated with, our product development activities; --+----------------------------------------------------------------------------------------------------------------------------------------- · | consolidation in the aerospace market and our participation in a strategic joint venture with General Electric Company may make it more difficult to secure long-term sales in certain aerospace markets; --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | our debt obligations, our debt service requirements, and our ability to operate our business, pursue business strategies and incur additional debt in light of covenants contained in our outstanding debt agreements; --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | our ability to manage additional tax expense and exposures; --+------------------------------------------------------------ · | risks related to our U.S. Government contracting activities, including liabilities resulting from legal and regulatory proceedings, inquiries, or investigations related to such activities; --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | the potential of a significant reduction in defense sales due to decreases in the amount of U.S. Federal defense spending or other specific budget cuts impacting defense programs in which we participate; --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 2 · | changes in government spending patterns, priorities, subsidy programs and/or regulatory requirements; --+------------------------------------------------------------------------------------------------------ · | future impairment charges resulting from changes in the estimates of fair value of reporting units or of long-lived assets; --+---------------------------------------------------------------------------------------------------------------------------- · | future results of our subsidiaries; --+------------------------------------ · | environmental liabilities related to manufacturing activities and/or real estate acquisitions; --+----------------------------------------------------------------------------------------------- · | our continued access to a stable workforce and favorable labor relations with our employees; --+--------------------------------------------------------------------------------------------- · | physical and other risks related to our operations and suppliers, including natural disasters, which could disrupt production; --+------------------------------------------------------------------------------------------------------------------------------- · | our ability to successfully manage regulatory, tax, and legal matters (including the adequacy of amounts accrued for contingencies, the U.S. Foreign Corrupt Practices Act, international trade regulations, and product liability, patent, and intellectual property matters); --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | our financial statements are subject to changes in accounting standards that could adversely impact our profitability or financial position; --+--------------------------------------------------------------------------------------------------------------------------------------------- · | risks related to our common stock, including changes in prices and trading volumes; --+------------------------------------------------------------------------------------ · | risks from operating internationally, including the impact on reported earnings from fluctuations in foreign currency exchange rates, tariffs, and compliance with and changes in the legal and regulatory environments of the United States and the countries in which we operate; --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ · | risks associated with global political and economic uncertainty in the European Union and elsewhere; --+----------------------------------------------------------------------------------------------------- · | fair value of defined benefit plan assets and assumptions used in determining our retirement pension and other postretirement benefit obligations and related expenses including, among others, discount rates and investment return on pension assets; --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | industry risks, including changes in commodity prices for oil, natural gas, and other minerals, unforeseen events that may reduce commercial aviation, and changing emissions standards; --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | our operations may be adversely affected by information systems interruptions or intrusions; and --+------------------------------------------------------------------------------------------------- · | certain provisions of our charter documents and Delaware law that could discourage or prevent others from acquiring our company. --+--------------------------------------------------------------------------------------------------------------------------------- These factors are representative of the risks, uncertainties, and assumptions that could cause actual outcomes and results to differ materially from what is expressed or forecast in our forward-looking statements. Other factors are discussed under the caption “Risk Factors” in Part I, Item 1A in this Annual Report on Form 10-K for the fiscal year ended September 30, 2017 (this “Form 10-K”). We undertake no obligation to revise or update any forward-looking statements for any reason, except as required by applicable law. Unless we have indicated otherwise or the context otherwise requires, references in this Form 10-K to “Woodward,” “the Company,” “we,” “us,” and “our” refer to Woodward, Inc. and its consolidated subsidiaries. Except where we have otherwise indicated or the context otherwise requires, amounts presented in this Form 10-K are in thousands, except per share amounts. 3  Item 1. Business General Woodward enhances the global quality of life, creating innovative energy control solutions that optimize the performance, efficiency and emissions of our customers’ products. We are an independent designer, manufacturer, and service provider of energy control and optimization solutions. We design, produce and service reliable, efficient, low-emission, and high-performance energy control products for diverse applications in challenging environments. We have production and assembly facilities in the United States, Europe and Asia, and promote our products and services through our worldwide locations. Our strategic focus is providing energy control and optimization solutions for the aerospace and industrial markets. The precise and efficient control of energy, including motion, fluid, combustion and electrical energy, is a growing requirement in the markets we serve. Our customers look to us to optimize the efficiency, emissions and operation of power equipment in both commercial and defense operations. Our core technologies leverage well across our markets and customer applications, enabling us to develop and integrate cost-effective and state-of-the-art fuel, combustion, fluid, actuation and electronic systems. We focus primarily on serving original equipment manufacturers (“OEMs”) and equipment packagers, partnering with them to bring superior component and system solutions to their demanding applications. We also provide aftermarket repair, maintenance, replacement and other service support for our installed products. Our components and integrated systems optimize performance of commercial aircraft, defense aircraft, military ground vehicles and other equipment, gas and steam turbines, wind turbines, including converters and power grid related equipment, industrial diesel, gas, bio-diesel and dual fuel reciprocating engines, and electrical power systems. Our innovative motion, fluid, combustion, and electrical energy control systems help our customers offer more cost-effective, cleaner, and more reliable equipment. Woodward was established in 1870, incorporated in 1902, and is headquartered in Fort Collins, Colorado. The mailing address of our world headquarters is 1081 Woodward Way, Fort Collins, Colorado 80524. Our telephone number at that location is (970) 482-5811, and our website is www.woodward.com. None of the information contained on our website is incorporated into this document by reference. Markets and Principal Lines of Business We serve the aerospace and industrial markets through our two reportable segments – Aerospace and Industrial. Our customers require technological solutions to meet their needs for performance, efficiency, and reliability, and to reduce their costs of operation. Within the aerospace market, we provide systems, components and solutions for both commercial and defense applications. Our key focus areas within this market are: · | Propulsion and combustion control solutions for turbine powered aircraft; and --+------------------------------------------------------------------------------ · | Fluid and motion control solutions for critical aerospace and defense applications. --+------------------------------------------------------------------------------------ Within the industrial market, our key focus areas are: · | Applications and control solutions for machines that produce electricity utilizing conventional or renewable energy sources; and --+--------------------------------------------------------------------------------------------------------------------------------- · | Fluid, motion, and combustion control solutions for complex oil and gas, industrial, and transportation applications. --+---------------------------------------------------------------------------------------------------------------------- Additional information about our operations in fiscal year 2017 and outlook for the future, including certain segment information, is included in “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Additional information about our business segments and certain geographical information is included in Note 20, Segment information and Note 21, Supplemental quarterly financial data (Unaudited), to the Consolidated Financial Statements in “Item 8 – Financial Statements and Supplementary Data.”  Products, Services and Applications Aerospace Our Aerospace segment designs, manufactures and services systems and products for the management of fuel, air, combustion and motion control. These products include fuel pumps, metering units, actuators, air valves, specialty valves, fuel nozzles, and thrust reverser actuation systems for turbine engines and nacelles, as well as flight deck controls, actuators, servocontrols, motors and sensors for aircraft. These products are used on commercial and private aircraft and rotorcraft, as well as on military fixed-wing aircraft and rotorcraft, guided weapons, and other defense systems. We have significant content on a wide variety of commercial aircraft, rotorcraft and business jet platforms, such as the Airbus A320neo, Boeing 737 MAX and 787, Bell 429 and Gulfstream G650. We also have significant content on defense applications such 4 as Blackhawk and Apache helicopters, F-18 and F-35 fighter jets, and guided tactical weapons (for example, the Joint Direct Attack Munition (“JDAM”)). Revenues from the Aerospace segment are generated by sales to OEMs, tier-one suppliers, and prime contractors, and through aftermarket sales of components, such as provisioning spares or replacements, and spare parts. We also provide aftermarket maintenance, repair and overhaul, as well as other services to commercial airlines, repair facilities, military depots, third party repair shops, and other end users. Industrial Our Industrial segment designs, produces and services systems and products for the management of fuel, air, fluids, gases, motion, combustion and electricity. These products include actuators, valves, pumps, injectors, solenoids, ignition systems, speed controls, electronics and software, power converters, sensors and other devices that measure, communicate and protect electrical distribution systems. Our products are used on industrial gas turbines (including heavy frame and aeroderivative turbines), steam turbines, reciprocating engines (including engines on natural gas vehicles), electric power generation and power distribution systems, wind turbines, and compressors. The equipment on which our products are found is used to generate and distribute power; to extract and distribute fossil and renewable fuels; in the mining of other commodities; and to convert fuel to work in marine, mobile, and industrial equipment applications. Revenues from our Industrial segment are generated primarily by sales to OEMs and by providing aftermarket products and other related services to our OEM customers. Our Industrial segment also sells products through an independent network of distributors and, in some cases, directly to end users. Customers For the fiscal year ended September 30, 2017, approximately 43% of our consolidated net sales were made to our five largest customers. Sales to our five largest customers represented approximately 42% of our consolidated net sales for the fiscal year ended September 30, 2016 and approximately 40% of our consolidated net sales for the fiscal year ended September 30, 2015. Sales to our largest customer, General Electric, accounted for approximately 16% of our consolidated net sales in the fiscal year ended September 30, 2017, 17% of our consolidated net sales in the fiscal year ended September 30, 2016, and 18% of our consolidated net sales in the fiscal year ended September 30, 2015. Our accounts receivable from General Electric represented approximately 10% of total accounts receivable as of September 30, 2017 and 14% as of September 30, 2016. We believe General Electric and our other significant customers are creditworthy and will be able to satisfy their credit obligations to us. The following customers account for approximately 10% or more of sales to each of our reportable segments for the fiscal year ended September 30, 2017.   | -----------+------------------------------------------------------------------------------  | -----------+------------------------------------------------------------------------------  | Customer -----------+------------------------------------------------------------------------------ Aerospace | The Boeing Company, United Technologies Corporation, General Electric Company -----------+------------------------------------------------------------------------------ Industrial | General Electric Company -----------+------------------------------------------------------------------------------ Competitive Environment Our products and product support services are sold worldwide into a variety of markets. In all markets, we compete on the basis of differentiated technology and design, product performance and conformity with customer specifications. Additional factors are customer service and support, including on-time delivery and customer partnering, product quality, price, reputation and local presence. Both of our segments operate in uniquely competitive environments. We believe that new competitors face significant barriers to entry into many of our markets, including various government mandated certification requirements to compete in the aerospace and industrial markets in which we participate. Aerospace industry has significant product certification requirements to meet safety regulations, which form a basis for competition as well as a barrier to entry. Technological innovation and design, product performance and conformity with customer specifications, and product quality and reliability are of utmost importance in the aerospace and defense industry. In addition, on-time delivery, pricing, and joint development capabilities with customers are points of competition within this market. Our customers include airframe and aircraft engine OEM manufacturers and suppliers to these manufacturers. We supply these customers with technologically innovative system and component solutions and align our technology roadmaps with our customers. We focus on responding to needs for reduced cost and weight, emission control and reliability improvements. We compete with numerous companies around the world that specialize in fuel and air management, combustion, electronic control, aircraft motion control, flight deck control, and thrust reverser products. Our competitors in aerospace include divisions of Eaton, Honeywell, Moog, and Parker Hannifin, and United Technologies Corporation Aerospace Systems (“UTC Aerospace Systems”) and its subsidiaries. In addition, some of our OEM customers are capable of developing and manufacturing similar 5 products internally. Several competitors are also customers for our products, such as Honeywell, Parker Hannifin, and UTC Aerospace Systems. Our products offer high levels of field reliability, which provides end users an advantage in life-cycle cost. We address competition in aftermarket service through responsiveness to our customers’ needs, providing short turnaround times, greater performance such as longer time between repairs, and maintaining a global presence. Some of our customers are affiliated with our competitors through ownership or joint venture agreements. We compete in part by establishing relationships with our customers’ engineering organizations, and by offering innovative technical and commercial solutions to meet their market requirements. During fiscal year 2016 we entered into a strategic joint venture (“JV”) with General Electric Company (“GE”), acting through its GE Aviation business unit. The JV sells fuel systems for GE’s large engine programs and is described further in Note 4, Joint Venture, in the Notes to the Consolidated Financial Statements in “Item 8 – Financial Statements and Supplementary Data.” Industrial operates in the global markets for industrial turbines, industrial reciprocating engines, electric power generation systems, power distribution networks, and wind turbines. Many of these markets are subject to regulartory product and performance certifications to meet emissions and safety requirements, which form a basis for competition as well as a barrier to entry. We compete with numerous companies that specialize in various engine, turbine, and power management products, and our OEM customers are often capable of developing and manufacturing similiar products internally. Many of our customers are large global OEMs that require suppliers to support them around the world and to meet increasingly higher requirements in terms of safety, quality, delivery, reliability and cost. Competitors include ABB, Emerson, Heinzmann GmbH & Co., Hoerbiger, Invensys, L’Orange GmbH, Meggitt, Robert Bosch AG, and Schweitzer Electric. OEM customers with internal capabilities for similar products include Caterpillar, Cummins, General Electric, Siemens and Wartsila. We believe we are a market leader in providing our customers advanced technology and superior product performance at a competitive price. We focus on developing and maintaining close relationships with our OEM customers’ engineering teams. Competitive success is based on the development of innovative components and systems that are aligned with the OEMs’ technology roadmaps to achieve future reliability, emission, efficiency, and fuel flexibility targets. Government Contracts and Regulation Portions of our business, particularly in our Aerospace segment, are heavily regulated. We contract with numerous U.S. Government agencies and entities, including all of the branches of the U.S. military, the National Aeronautics and Space Administration (“NASA”), and the Departments of Defense, Homeland Security, and Transportation. We also contract with similar government authorities outside the United States, subject in all cases to applicable law. The U.S. Government, and potentially other governments, may terminate any of our government contracts, or any government contracts under which we are a subcontractor, at their convenience, as well as for default based on specified performance measurements. If any of our U.S. government contracts were to be terminated for convenience, we generally would be entitled to receive payment for work completed and allowable termination or cancellation costs. If any of our U.S. government contracts were to be terminated for our default, the U.S. Government generally would pay only for the work accepted, and could require us to pay the difference between the original contract price and the cost to re-procure the contract items, net of the work accepted from the original contract. The U.S. Government could also hold us liable for damages resulting from the default. We must comply with, and are affected by, laws and regulations relating to the formation, administration and performance of U.S. Government contracts. These laws and regulations, among other things: · | require accurate, complete and current disclosure and certification of cost and pricing data in connection with certain contracts; --+----------------------------------------------------------------------------------------------------------------------------------- · | impose specific and unique cost accounting practices that may differ from accounting principles generally accepted in the United States (“U.S. GAAP”), and therefore require robust systems to reconcile; --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | impose regulations that define allowable and unallowable costs and otherwise govern our right to reimbursement under certain cost-based U.S. Government contracts; --+------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | impose manufacturing specifications and other quality standards that may be more restrictive than for non-government business activities; and --+---------------------------------------------------------------------------------------------------------------------------------------------- · | restrict the use and dissemination of information classified for national security purposes due to the regulations of the U.S. Government and foreign governments pertaining to the export of certain products and technical data. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Sales made directly to U.S. Government agencies and entities, or indirectly through third party manufacturers utilizing Woodward parts and subassemblies, collectively represented 23% of our sales for fiscal year 2017, 21% of our sales for fiscal year 2016, and 18% of our sales for fiscal year 2015. The level of U.S. spending for defense, alternative energy and other programs, and the mix of programs to which such funding is allocated, is subject to periodic congressional appropriation actions, and is subject to change, including elimination, at any time. 6 U.S. Government related sales from our reportable segments for fiscal years 2017, 2016 and 2015 were as follows:   | | | | | | | | | | | | ------------------------------+------------------------------+---------+--------------------------------+---+------------------+----+-------+-----------+----+-----------+-----+--  | | | | | | | | | | | | ------------------------------+------------------------------+---------+--------------------------------+---+------------------+----+-------+-----------+----+-----------+-----+--  | Direct U.S. Government Sales | | Indirect U.S. Government Sales | | Commercial Sales | | Total ------------------------------+------------------------------+---------+--------------------------------+---+------------------+----+------ Year ended September 30, 2017 | | | | | | | | | | | | ------------------------------+------------------------------+---------+--------------------------------+---+------------------+----+-------+-----------+----+-----------+-----+-- Aerospace | $ | 106,685 | | $ | 362,536 | | $ | 873,118 | $ | 1,342,339 ------------------------------+------------------------------+---------+--------------------------------+---+------------------+----+-------+-----------+----+---------- Industrial | | 3,726 | | | 10,814 | | | 741,806 | | 756,346 ------------------------------+------------------------------+---------+--------------------------------+---+------------------+----+-------+-----------+----+---------- Total net external sales | $ | 110,411 | | $ | 373,350 | | $ | 1,614,924 | $ | 2,098,685 ------------------------------+------------------------------+---------+--------------------------------+---+------------------+----+-------+-----------+----+---------- Percentage of total net sales | | 5 | % | | | 18 | % | | 77 | % | 100 | % ------------------------------+------------------------------+---------+--------------------------------+---+------------------+----+-------+-----------+----+-----------+-----+--  | | | | | | | | | | | | ------------------------------+------------------------------+---------+--------------------------------+---+------------------+----+-------+-----------+----+-----------+-----+-- Year ended September 30, 2016 | | | | | | | | | | | | ------------------------------+------------------------------+---------+--------------------------------+---+------------------+----+-------+-----------+----+-----------+-----+-- Aerospace | $ | 103,026 | | $ | 310,952 | | $ | 819,198 | $ | 1,233,176 ------------------------------+------------------------------+---------+--------------------------------+---+------------------+----+-------+-----------+----+---------- Industrial | | 6,550 | | | 9,845 | | | 773,507 | | 789,902 ------------------------------+------------------------------+---------+--------------------------------+---+------------------+----+-------+-----------+----+---------- Total net external sales | $ | 109,576 | | $ | 320,797 | | $ | 1,592,705 | $ | 2,023,078 ------------------------------+------------------------------+---------+--------------------------------+---+------------------+----+-------+-----------+----+---------- Percentage of total net sales | | 5 | % | | | 16 | % | | 79 | % | 100 | % ------------------------------+------------------------------+---------+--------------------------------+---+------------------+----+-------+-----------+----+-----------+-----+--  | | | | | | | | | | | | ------------------------------+------------------------------+---------+--------------------------------+---+------------------+----+-------+-----------+----+-----------+-----+-- Year ended September 30, 2015 | | | | | | | | | | | | ------------------------------+------------------------------+---------+--------------------------------+---+------------------+----+-------+-----------+----+-----------+-----+-- Aerospace | $ | 92,322 | | $ | 258,391 | | $ | 810,170 | $ | 1,160,883 ------------------------------+------------------------------+---------+--------------------------------+---+------------------+----+-------+-----------+----+---------- Industrial | | 4,836 | | | 8,839 | | | 863,745 | | 877,420 ------------------------------+------------------------------+---------+--------------------------------+---+------------------+----+-------+-----------+----+---------- Total net external sales | $ | 97,158 | | $ | 267,230 | | $ | 1,673,915 | $ | 2,038,303 ------------------------------+------------------------------+---------+--------------------------------+---+------------------+----+-------+-----------+----+---------- Percentage of total net sales | | 5 | % | | | 13 | % | | 82 | % | 100 | % ------------------------------+------------------------------+---------+--------------------------------+---+------------------+----+-------+-----------+----+-----------+-----+-- Seasonality We do not believe our sales, in total or in either business segment, are subject to significant seasonal variation. However, our sales have generally been lower in the first quarter of our fiscal year as compared to the immediately preceding quarter due to fewer working days resulting from the observance of various holidays and scheduled plant shutdowns for annual maintenance. Sales Order Backlog Our backlog of unshipped sales orders by segment as of October 31, 2017 and 2016 was as follows:   | | | | | | | -----------+------------------+-----------+-----------------------------------------------+----+------------------+---+--------  | | | | | | | -----------+------------------+-----------+-----------------------------------------------+----+------------------+---+--------  | October 31, 2017 | | % Expected to be filled by September 30, 2018 | | October 31, 2016 -----------+------------------+-----------+-----------------------------------------------+----+----------------- Aerospace | $ | 826,096 | | 77 | % | $ | 685,792 -----------+------------------+-----------+-----------------------------------------------+----+------------------+---+-------- Industrial | | 189,283 | | 93 | | | 189,397 -----------+------------------+-----------+-----------------------------------------------+----+------------------+---+--------  | $ | 1,015,379 | | 80 | % | $ | 875,189 -----------+------------------+-----------+-----------------------------------------------+----+------------------+---+-------- Our current estimate of the sales order backlog is based on unshipped sales orders that are open in our order entry systems. Unshipped orders are not necessarily an indicator of future sales levels because of variations in lead times and customer production schedules. Manufacturing We operate manufacturing and assembly plants in the United States, Europe and Asia. Our products consist of mechanical, electronic and electromechanical systems and components. Aluminum, iron and steel are primary raw materials used to produce our mechanical components. Other commodities, such as gold, copper and nickel, are also used in the manufacture of our products, although in much smaller quantities. We purchase various goods, including component parts and services used in production, logistics and product development processes from third parties. Generally there are numerous sources for the raw materials and components used in our products, which we believe are sufficiently available to meet current requirements. We maintain global strategic sourcing models to meet our global facilities' production needs while building long-term supplier relationships and efficiently managing our overall supply costs. We expect our suppliers to maintain adequate levels of quality raw materials and component parts, and to deliver such parts on a timely basis to support production of our various products. We use a variety of agreements with suppliers intended to protect our intellectual property and processes and to monitor and mitigate risks of disruption in our supply base that could cause a business disruption to our production schedules or to our customers. The risks 7 monitored include supplier financial viability, business continuity, quality, delivery and protection of our intellectual property and processes. Our customers expect us to maintain adequate levels of certain finished goods and certain component parts to support our warranty commitments and sales to our aftermarket customers, and to deliver such parts on a timely basis to support our customers’ standard and customary needs. We carry certain finished goods and component parts in inventory to meet these rapid delivery requirements of our customers. The Securities and Exchange Commission (“SEC”) adopted disclosure rules for companies that use tantalum, tin, tungsten, and gold or their derivatives (collectively referred to as “conflict minerals”) in their products, with substantial supply chain verification requirements in the event the conflict minerals come or may come from the Democratic Republic of Congo or adjoining countries. The European Union is considering the imposition of similar reporting obligations. Our conflict minerals report for calendar year 2016 was filed with the SEC on May 24, 2017. We may face reputational challenges with our customers, stockholders and other stakeholders if we use and/or are unable to sufficiently verify the origins of the conflict minerals used in our products. Further, due to the complexity of our supply chain, the implementation of the existing U.S. requirements and any additional European requirements could affect the sourcing and availability of metals used in the manufacture of a number of parts contained in our products. Regardless, we have and will continue to incur costs associated with compliance, including time-consuming and costly efforts to determine the source of conflict minerals that may be used in our products. Research and Development We finance our research and development activities primarily with our own independent research and development funds. Our research and development costs include basic research, applied research, component and systems development, and other concept formulation studies. Company funded expenditures related to new product development activities are expensed as incurred and are separately reported in the Company’s Consolidated Statements of Earnings. Across both of our segments, research and development costs totaled $126,519 in fiscal year 2017, $126,170 in fiscal year 2016, and $134,485 in fiscal year 2015. Research and development costs were 6.0% of consolidated net sales in fiscal year 2017 compared to 6.2% in fiscal year 2016 and 6.6% in fiscal year 2015. See “Research and development costs” in Note 1, Operations and summary of significant accounting policies, to the Consolidated Financial Statements in “Item 8 – Financial Statements and Supplementary Data.” Aerospace is focused on developing systems and components that we believe will be instrumental in helping our customers achieve their objectives of lower fuel consumption, lighter weight, more efficient performance, reduced emissions, and improved operating economics. Our development efforts support technology for a wide range of: · | aerospace turbine engine applications, which include commercial, business and military turbofan engines of various thrust classes, turboshaft engines and turboprop engines; --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | electromechanical and hydraulic actuation systems for flight deck-to-flight surface control of fixed-wing aircraft and rotorcraft, and turbine engine nacelles, as well as guidance for weapon systems; and --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ · | motion control components for integration into comprehensive actuation systems. --+-------------------------------------------------------------------------------- The aerospace industry has moved toward more electric (“fly-by-wire”), lighter weight aircraft, while demanding increased reliability and redundancy. In response, we are developing an expanded family of intelligent flight deck control products (including throttle and rudder controls) with both conventional and fly-by-wire technology, as well as motor driven actuation systems. We collaborate closely with our customers as they develop their technology plans, which leads to new product concepts. We believe this collaboration allows us to develop technology that is aligned with our customers’ needs and therefore, increases the likelihood that our systems and components will be selected for inclusion in the platforms developed by our customers. Further, we believe our close collaboration with our customers during preliminary design stages allows us to provide products that deliver the component and system performance necessary to bring greater value to our customers. Most technology development programs begin years before an expected entry to service, such as those for the next generation of commercial aircraft. Other development programs result in nearer-term product launches associated with new OEM offerings, product upgrades, or product replacements on existing programs. Some of the major projects/programs we are developing are listed below. We developed the fuel system, air management system, and actuation hardware for CFM International’s LEAP engine program. We also developed the actuation system, combustion system and oil system components for Pratt & Whitney’s Geared Turbo Fan (“GTF”) engine program. These programs target applications in the single aisle and regional aircraft markets with entry into service in the 2016 to 2020 timeframe. Both the LEAP engine and the GTF engine have been selected by Airbus as options to power its A320neo aircraft, which entered service in 2016. In addition, the LEAP engine was selected exclusively by Boeing for its 737 MAX, which entered service in 2017, and by Comac for its C919 aircraft. The GTF engine was selected exclusively by Bombardier for its CSeries aircraft, which also entered service in 2016, by Embraer for its EJets E2 aircraft family, and by Irkut for the MS-21 aircraft. 8 During fiscal year 2016 we entered into a JV with GE, acting through its GE Aviation business unit. The JV sells fuel systems for GE’s large engine programs. The JV is developing the fuel system for the GE9X engine (which will power the Boeing 777X). We have been selected as the JV’s supplier of this fuel system. We are the supplier for the thrust reverser actuation system (“TRAS”) for the Boeing 737 MAX and the CFM LEAP-engined Airbus A320neo. We are developing the TRAS for the Boeing 777X and the Airbus A330neo, and have been awarded the new nacelle version of the GTF-engined Airbus A320neo. The A330neo is scheduled to enter service in 2018, and the 777X in 2020. We are currently developing the fuel system, air management components, and actuation hardware for the Passport engine program, as well as the TRAS for the integrated propulsion system. Passport is the next generation GE Aviation engine for the large business aviation market, and has been selected by Bombardier to power its Global 7000 and 8000 long-range business aircraft, expected to enter into service in 2018 and 2019, respectively. In addition, we developed sensor solutions for the Airbus A350 high lift system, an actuation sub-system for the Boeing 787-9 that improves fuel burn, flight deck components for the Bombardier CSeries and control and sensing solutions for the Boeing KC-46A refueling tanker boom subsystem. We are currently developing flight deck components for the Bombardier Global 7000 and 8000 aircraft. Industrial is focused on developing improved technologies, including integrated control systems and system components, that will enable our OEM customers to cost-effectively meet mandated emissions regulations and fuel efficiency demands, allow for usage of a wider range of fuel sources, increase reliability (particularly in harsh environments), reduce total cost of ownership, support global infrastructure growth, and safely distribute power on the electrical grid. Our efforts include research and development of technologies and products that improve combustion processes and provide more precise flow of various fuels and gases in our customers’ gas turbines and industrial reciprocating engines. We also develop electronic devices and software that provide improved control and protection of reciprocating engines, gas turbines, steam turbines, wind turbines, and engine- and turbine-powered equipment. In addition, we are developing advanced prognostic and predictive intelligence into many of our complex products. Major development projects include enhancement of high pressure common rail diesel fuel injection systems, comprehensive gas engine control systems, fuel flow control valves and actuators, and various other technologies. Our technologies help our OEM customers’ engines, turbines, power generation, power distribution, compressor and other powered equipment operate more efficiently and more reliably. Employees As of October 31, 2017, we employed approximately 6,900 full-time employees of which approximately 1,600 were located outside of the United States, with the majority in Germany, Poland and China. We believe that our relationships with our employees are good. Approximately 17% of our total full-time workforce were union employees as of October 31, 2017, all of whom work for our Aerospace segment and are located in the United States. The collective bargaining agreements with our union employees are generally renewed through contract renegotiation near the contract expiration dates. The MPC Employees Representative Union contract, which covers 491 employees as of October 31, 2017, expires October 1, 2021. The Local Lodge 727-N International Association of Machinists and Aerospace Workers agreement, which covers 438 employees as of October 31, 2017, expires April 22, 2021. The International Union, United Automobile, Aerospace and Agricultural Implement Workers of America and Local No. 509 agreement, which covers 233 employees as of October 31, 2017, expires June 4, 2021. We believe that our relationships with our union employees and the representative unions are good. Almost all of our other employees in the United States were at-will employees as of October 31, 2017, and therefore, not subject to any type of employment contract or agreement. Our executive officers each have change-in-control agreements which have been filed with the SEC. Outside of the United States, we enter into employment contracts and agreements in those countries in which such relationships are mandatory or customary, including coordination through local works’ councils. The provisions of these agreements correspond in each case with the required or customary terms in the subject jurisdiction. Patents, Intellectual Property, and Licensing We own numerous patents and other intellectual property, and have licenses for the use of patents and other intellectual property owned by others, which relate to our products and their manufacture. In addition to owning a large portfolio of intellectual property, we also license intellectual property to and from third parties. For example, the U.S. Government has certain rights in our patents and other intellectual property developed in performance of certain government contracts, and it may use or authorize others to use the inventions covered by such patents for government purposes as allowed by law. Intellectual property not covered by patents (or patent applications) includes trade secrets and other technological know-how that is not patentable or for which we have elected not to seek patent protection, including intellectual property relating to our manufacturing processes and engineering designs. Such unpatented technology, including research, development and engineering 9 technical skills and know-how, as well as unpatented software, is important to our overall business and to the operations of each of our segments. While our intellectual property assets taken together are important, we do not believe our business or either of our segments would be materially affected by the expiration of any particular intellectual property right or termination of any particular intellectual property patent license agreement. As of September 30, 2017, our Consolidated Balance Sheet includes $171,882 of net intangible assets. This value represents the carrying values, net of amortization, of certain assets acquired in various business acquisitions and does not purport to represent the fair value of our acquired intellectual property as of September 30, 2017. U.S. GAAP requires that research and development costs be expensed as incurred; therefore, as we develop new intellectual property in the normal course of business, the costs of developing such assets are expensed as incurred, with no corresponding intangible asset recorded. Environmental Matters and Climate Change The Company is regulated by federal, state and international environmental laws governing our use, transport and disposal of substances and control of emissions. Compliance with these existing laws has not had a material impact on our capital expenditures, earnings or global competitive position. We use hazardous materials and/or regulated materials in our manufacturing operations. We also own, operate, and may acquire facilities that were formerly owned and operated by others that used such materials. We believe that the risk that a significant release of regulated materials has occurred in the past or will occur in the future cannot be completely eliminated or prevented. From time to time we engage in environmental remedial acitivites, generally in coordination with other companies, pursuant to federal and state laws. In addition, we may be exposed to other environmental costs including participation in superfund sites or other similar jurisdictional initiatives. When it is reasonably probable we will pay remediation costs at a site, and those costs can be reasonably estimated, we accrue a liability for such future costs with a related charge against our earnings. In formulating that estimate and recognizing those costs, we do not consider amounts expected to be recovered from insurance companies, or others, until such recovery is assured. Currently, we have no sites undergoing remediation. Our manufacturing facilities generally do not produce significant volumes or quantities of byproducts, including greenhouse gases, that would be considered hazardous waste or otherwise harmful to the environment. We do not expect legislation currently pending or expected in the next several years to have a significant negative impact on our operations in any of our segments. Domestic and foreign legislative initiatives on emissions control, renewable energy, and climate change tend to favorably impact the sale of our energy control products. For example, our Industrial segment produces inverters for wind turbines and energy control products that help our customers maximize engine efficiency and minimize wasteful emissions, including greenhouse gases. Executive Officers of the Registrant Information about our executive officers is provided below. There are no family relationships between any of the executive officers listed below. Thomas A. Gendron, Age 56. Chairman of the Board since January 2008; Chief Executive Officer, President, and Director since July 2005; Chief Operating Officer and President September 2002 through June 2005; Vice President and General Manager of Industrial Controls June 2001 through September 2002; Vice President of Industrial Controls April 2000 through May 2001; Director of Global Marketing and Industrial Controls’ Business Development February 1999 through March 2000. Robert F. Weber, Jr., Age 63. Vice Chairman, Chief Financial Officer and Treasurer since September 2011, and Chief Financial Officer and Treasurer since August 2005. Prior to August 2005, Mr. Weber was employed at Motorola, Inc. for 17 years, where he held various positions, including Corporate Vice President and General Manager - EMEA Auto. Prior to this role, Mr. Weber served in a variety of financial positions at both a corporate and operating unit level with Motorola. Martin V. Glass, Age 60. President, Airframe Systems since April 2011; President, Turbine Systems October 2009 through April 2011; Group Vice President, Turbine Systems September 2007 through September 2009; Vice President of the Aircraft Engine Systems Customer Business Segment December 2002 through August 2007; Director of Sales, Marketing, and Engineering February 2000 through December 2002. Mr. Glass has announced his retirement from the Company effective February 2, 2018. Sagar Patel, Age 51. President, Aircraft Turbine Systems since June 2011. Prior to this role, Mr. Patel was employed at General Electric for 18 years, most recently serving as President, Mechanical Systems, GE Aviation, from March 2009 through June 2010. He served as President, Aerostructures, GE Aviation from July 2008 through July 2009 and as President and General Manager, MRS Systems, Inc., GE Aircraft Engines, from October 2005 through June 2008. Chad R. Preiss, Age 52. President, Industrial Control Systems since November 2016, President, Engine Systems October 2009 through November 2016; Group Vice President, Engine Systems October 2008 through September 2009; Vice President, Sales, Service, and Marketing, Engine Systems December 2007 through September 2008; and Vice President, Industrial Controls September 10 2004 through December 2007. Prior to this role, Mr. Preiss served in a variety of engineering and marketing/sales management roles, including Director of Business Development, since joining Woodward in 1988. A. Christopher Fawzy, Age 48. Corporate Vice President, General Counsel, Corporate Secretary and Chief Compliance Officer since October 2009; Vice President, General Counsel, and Corporate Secretary June 2007 through September 2009. Mr. Fawzy became the Company’s Chief Compliance Officer in August 2009. Prior to joining Woodward, Mr. Fawzy was employed by Mentor Corporation, a global medical device company. He joined Mentor in 2001 and served as Corporate Counsel, then was promoted to General Counsel in 2003, and was appointed Vice President, General Counsel and Secretary in 2004. Other Corporate Officers of the Registrant Information about our other corporate officers is provided below. There are no family relationships between any of the corporate officers listed below or between any of the corporate officers listed below and the aforementioned executive officers. James D. Rudolph, Age 56. Corporate Vice President since November 2016, President, Industrial Turbomachinery Systems April 2011 through November 2016; Corporate Vice President, Global Sourcing October 2009 through April 2011; Vice President, Global Sourcing April 2009 through October 2009; Director of Global Sourcing April 2005 through April 2009; Director of Engineering for Industrial Controls March 2000 through April 2005. Prior to March 2000, Mr. Rudolph served in a variety of engineering, operations and sales roles since joining Woodward in 1984. Steven J. Meyer, Age 57. Corporate Vice President, Human Resources since October 2009; Vice President, Human Resources November 2006 through September 2009; Director, Global Human Resources November 2002 through October 2006; Director, Human Resources for Industrial Controls July 1997 through October 2002. Prior to joining Woodward, Mr. Meyer was employed by PG&E Corporation and Nortel in a variety of roles in human resources. Matthew F. Taylor, Age 55. Corporate Vice President, Supply Chain since February 2011; Vice President, Engine Fluid Systems and Controls Center of Excellence (“CoE”) October 2009 through February 2011; General Manager, Fluid Systems and Controls CoE December 2006 through October 2009; Director of Operations, Fluid Systems and Controls June 2005 through December 2006. Prior to joining Woodward in June 2005, Mr. Taylor was the Vice President and General Manager, Warner Electric and served in a variety of general management roles at Eaton Corporation from February 1998 through August 2003. Matt R. Cook, Age 46. Corporate Vice President, Information Technology since January 2014; Director, Global Business Systems July 2012 through January 2014. Prior to joining Woodward, Mr. Cook was employed by Satcon Corporation as Vice President, Global Information Technology. Prior to Satcon, Mr. Cook served in a variety of senior roles in information technology and business development. John D. Tysver, Age 55. Corporate Vice President, Technology since October 2016; Vice President, Aircraft Turbine Systems’ Programs, Systems and Research & Development July 2015 through October 2016; Vice President and General Manager of Aircraft Turbine Systems’ Fuel Systems Center of Excellence April 2011 through July 2015; Vice President of Turbine Systems’ Systems & Engineering October 2009 through April 2011; Director of Turbine Systems’ Systems & Engineering November 2006 through October 2009. Prior to November 2006, Mr. Tysver served in a variety of engineering leadership roles since joining Woodward in March 1991. Prior to joining Woodward, Mr. Tysver served in engineering roles at Sundstrand (now UTC Aerospace Systems). Information available on Woodward’s Website and Social Media Through a link on the Investor Information section of our website, www.woodward.com, we make available, free of charge, the following filings as soon as reasonably practicable after they are electronically filed or furnished to the SEC: our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, Proxy Statements on Schedule 14A, and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as well as Section 16 reports of our officers and directors. The SEC also maintains a website that contains our SEC filings. The address of the site is www.sec.gov. Further, a copy of this Annual Report on Form 10-K is located at the SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. Information on the operation of the Public Reference Room can be obtained by calling the SEC at 1-800-SEC-0330. We provide notifications of news or announcements regarding our financial performance, including SEC filings, investor events, press and earnings releases as part of our investor relations website. We have used, and intend to continue to use, our investor relations website, as well as the following as of the date of this filing, as means of disclosing material non-public information and for complying with the disclosure obligations under Regulation FD: · | Twitter: @woodward_inc --+----------------------- · | Facebook: Facebook.com/woodwardinc --+----------------------------------- · | LinkedIn: Linkedin.com/company/woodward --+---------------------------------------- · | Google Plus: +WoodwardInc --+-------------------------- · | YouTube: YouTube.com/user/woodwardinc --+-------------------------------------- · | Goldenline (Poland): http://www.goldenline.pl/firma/woodward --+------------------------------------------------------------- · | XING (Germany): https://www.xing.com/companies/woodwardinc. --+------------------------------------------------------------ 11 None of the information contained on our website, or the above-mentioned social media sites, is incorporated into this document by reference. Stockholders may obtain, without charge, a single copy of Woodward’s 2017 Annual Report on Form 10-K upon written request to the Corporate Secretary, Woodward, Inc., 1081 Woodward Way, Fort Collins, Colorado 80524.  Item 1A.Risk Factors Investment in our securities involves risk. An investor or potential investor should consider the risks summarized in this section when making investment decisions regarding our securities. Important factors that could individually, or together with one or more other factors, affect our business, results of operations, financial condition, and/or cash flows include, but are not limited to, the following: Company Risks A significant portion of our revenue is concentrated among a relatively small number of customers. A decline in business with, or financial distress of, such customers could decrease our consolidated net sales or impair our ability to collect amounts due and payable and have a material adverse effect on our business, financial condition, results of operations and cash flows. We have fewer customers than many companies with similar sales volumes. For the fiscal year ended September 30, 2017, approximately 43% of our consolidated net sales were made to our five largest customers. Sales to our five largest customers for the fiscal year ended September 30, 2016 represented approximately 42% of our consolidated net sales. Sales to our largest customer, General Electric, accounted for approximately 16% of our consolidated net sales in the fiscal year ended September 30, 2017, 17% in the fiscal year ended September 30, 2016 and 18% in the fiscal year ended September 30, 2015. Accounts receivable from General Electric represented approximately 10% of accounts receivable at September 30, 2017 and 14% at September 30, 2016. Sales to our next largest customer accounted for approximately 11% of our consolidated net sales in the fiscal year ended September 30, 2017, 8% in the fiscal year ended September 30, 2016, and 7% in the fiscal year ended September 30, 2015. If any of our significant customers were to change suppliers, in-source production, institute significant restructuring or cost-cutting measures, or experience financial distress, these significant customers may substantially reduce, or otherwise be unable to pay for, purchases from us. Accordingly, our consolidated net sales could decrease significantly or we may experience difficulty collecting, or be unable to collect, amounts due and payable, which could have a material adverse effect on our business, financial condition, results of operations, and cash flows. Instability in the financial markets and global or regional economic weakness or uncertainty could have a material adverse effect on the ability of our customers to perform their obligations to us and on their demand for our products and services. Over the last six to eight years, there has been widespread concern over the instability in the financial markets and their influence on the global economy. As a result of the extreme volatility in the credit and capital markets and global economic uncertainty, our current or potential customers may experience cash flow problems and, as a result, may modify, delay or cancel plans to purchase our products. Additionally, if our customers face financial distress or are unable to secure necessary financing, they may not be able to pay, or may delay payment of, accounts receivable that are owed to us. Any inability of current or potential customers to pay us for our products may adversely affect our earnings and cash flows. In addition, the general economic environment significantly affects demand for our products and services. Periods of slowing economic activity, for example the global industrial recession currently impacting many of our markets, may cause global or regional slowdowns in spending on infrastructure development in the markets in which we operate, and customers may reduce their purchases of our products and services. In addition, weakness or uncertainty in any of our global markets, such as economic uncertainty in China, may materially adversely affect one or more areas of our business. There can be no assurance that any market and economic uncertainty in the United States or internationally would not have a material adverse effect on our business, financial condition, results of operations, and cash flows. Our profitability may suffer if we are unable to manage our expenses due to sales increases, sales decreases, or impacts of capital expansion projects, or if we experience change in product mix. Some of our expenses are relatively fixed in relation to changes in sales volume and are difficult to adjust in the short term. Expenses driven by business activity other than sales level and other long-term expenditures, such as fixed manufacturing overhead, capital expenditures and research and development costs, may be difficult to reduce in a timely manner in response to a reduction in sales. Expenses such as depreciation or amortization, which are the result of past capital expenditures or business acquisitions, are generally fixed regardless of sales levels. In addition, the achievement of manufacturing efficiencies associated with capital expansion projects may not meet management’s current expectations. Due to our long sales cycle, in periods of sales increases it may be difficult to rapidly increase our production of finished goods, particularly if such sales increases are unanticipated. An increase in the production of our finished goods requires increases in both the purchases of raw materials and components and in the size of our workforce. If a sudden, unanticipated need for raw materials, components and labor arises in order to meet unexpected sales demand, we could experience difficulties in sourcing raw materials, components and labor at a favorable cost or to meet our production needs. These factors could result in delays in fulfilling customer sales contracts, damage to our reputation and relationships with our 12 customers, an inability to meet the demands of the markets that we serve, which in turn could prevent us from taking advantage of business opportunities or responding to competitive pressures, and result in an increase in variable and fixed costs leading to a decrease in net earnings or even net losses. In addition, we sell products that have varying profit margins, and increases or decreases in sales of our various products may change the mix of products that we sell during any period. Any of these events could have a material adverse effect on our business, financial condition, results of operations, and cash flows. The long sales cycle, customer evaluation process and implementation period of our products and services may increase the costs of obtaining orders and reduce the predictability of sales cycles and our inventory requirements. Our products and services are technologically complex. Prospective customers generally must commit significant resources to test and evaluate our products and to install and integrate them into larger systems. Orders expected in one quarter may shift to another quarter or be cancelled with little advance notice as a result of customers’ budgetary constraints, internal acceptance reviews and other factors affecting the timing of customers’ purchase decisions. In addition, customers often require a significant number of product presentations and demonstrations before reaching a sufficient level of confidence in the product’s performance and compatibility with the approvals that typically accompany capital expenditure approval processes. The difficulty in forecasting demand increases the challenge in anticipating sales cycles and our inventory requirements, which may cause us to over-produce finished goods and could result in inventory write-offs, or could cause us to under-produce finished goods. Any such over-production or under-production could have a material adverse effect on our business, financial condition, results of operations, and cash flows. Our product development activities may not be successful, may be more costly than currently anticipated, or we may not be able to produce newly developed products at a cost that meets the anticipated product cost structure. Our business involves a significant level of product development activities, generally in connection with our customers’ development activities. Industry standards, customer expectations, or other products may emerge that could render one or more of our products or services less desirable or obsolete. Maintaining our market position requires continued investment in research and development. During an economic downturn or a subsequent recovery, we may need to maintain our investment in research and development, which may limit our ability to reduce these expenses in proportion to a sales shortfall. In addition, increased investments in research and development may divert resources from other potential investments in our business, such as acquisitions or investments in our facilities, processes and operations. If these activities are not as successful as currently anticipated, are not completed on a timely basis, or are more costly than currently anticipated, or if we are not able to produce newly developed products at a cost that meets the anticipated product cost structure, then our future sales, margins and/or earnings could be lower than expected, which could have a material adverse effect on our business, financial condition, results of operations, and cash flows. Our business may be adversely affected by government contracting risks. Sales made directly to U.S. Government agencies and entities were 5% of total net sales during fiscal year 2017, 5% during fiscal year 2016, and 5% during fiscal year 2015, primarily in the aerospace market. Sales made directly to U.S. Government agencies and entities, or indirectly through third party manufacturers, such as tier-one prime contractors, utilizing Woodward parts and subassemblies, accounted for approximately 23% of total sales in fiscal year 2017, 21% in fiscal year 2016, and 18% in fiscal year 2015. Our contracts with the U.S. Government are subject to certain unique risks, including the risks set forth below, some of which are beyond our control, which could have a material adverse effect on our business, financial condition, results of operations, and cash flows. · | The level of U.S. defense spending is subject to periodic congressional appropriation actions and is subject to change at any time. The mix of programs to which such funding is allocated is also uncertain, and we can provide no assurance that an increase in defense spending will be allocated to programs that would benefit our business. If the amount of spending were to decrease, or there were a shift from certain aerospace and defense programs on which we have content to other programs on which we do not, our sales could decrease. In addition, one or more of the aerospace or defense programs that we currently support could be phased-out or terminated. Any such reductions in U.S. Government needs under these existing aerospace and defense programs, unless offset by other aerospace and defense programs and opportunities, could have a material adverse effect on our sales. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | Our U.S. Government contracts and the U.S. Government contracts of our customers are subject to modification, curtailment or termination by the government, either for the convenience of the government or for default as a result of a failure by us or our customers to perform under the applicable contract. If any of our contracts are terminated by the U.S. Government, our backlog would be reduced, in accordance with contract terms, by the expected value of the remaining work under such contracts. In addition, we are not the prime contractor on most of our contracts for supply to the U.S. Government, and the U.S. Government could terminate a prime contract under which we are a subcontractor, irrespective of the quality of our products and services as a subcontractor. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | We must comply with procurement laws and regulations relating to the formation, administration and performance of our U.S. Government contracts and the U.S. Government contracts of our customers. The U.S. Government may change procurement laws and regulations from time to time. A violation of U.S. Government procurement laws or regulations, a change in U.S. Government procurement laws and regulations, or a termination arising out of our default could expose us to liability, debarment, or suspension and could have an adverse effect on our ability to compete for future contracts and orders. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 13 · | We are subject to government inquiries, audits and investigations due to our business relationships with the U.S. Government and the heavily regulated industries in which we do business. In addition, our contract costs are subject to audits by the U.S. Government. U.S. Government agencies, including the Defense Contract Audit Agency and the Defense Contract Management Agency, routinely audit government contractors and subcontractors. These agencies review our performance under contracts, cost structure and compliance with applicable laws, regulations, and standards, as well as the adequacy of and our compliance with our internal control systems and policies. Any costs found to be misclassified or inaccurately allocated to a specific contract would be deemed non-reimbursable, and to the extent already reimbursed, would be refunded. Any inadequacies in our systems and policies could result in withholds on billed receivables, penalties and reduced future business. Any inquiries or investigations, including those related to our contract pricing, could potentially result in civil and criminal penalties and administrative sanctions, including termination of contracts, forfeiture of profits, suspension of payments, fines, suspension, and/or debarment from participating in future business opportunities with the U.S. Government. Such actions could harm our reputation, even if such allegations are later determined to be unfounded, and could have a material adverse effect on our business, results of operations, financial condition and cash flows. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Product liability claims, product recalls or other liabilities associated with the products and services we provide may force us to pay substantial damage awards and other expenses that could exceed our accruals and insurance coverage. The manufacture and sale of our products and the services we provide expose us to risks of product and other tort claims, and any resulting liability. We currently have and have had in the past product liability claims relating to our products, and we will likely be subject to additional product liability claims in the future for past, current and future products. Some of these claims may have a material adverse effect on our business, financial condition, results of operations and cash flows. We also provide certain services to our customers and are subject to claims with respect to the services provided. In providing such services, we may rely on subcontractors to perform all or a portion of the contracted services. It is possible that we could be liable to our customers for work performed by a subcontractor. Regardless of the outcome, product liability claims can be expensive to defend, can divert the attention of management and other personnel for significant periods of time, and can cause reputational damage. While we believe that we have appropriate insurance coverage available to us related to any such claims, our insurance may not cover all liabilities or be available in the future at a cost acceptable to us. An unsuccessful result in connection with a product liability claim, where the liabilities are not covered by insurance or for which indemnification or other recovery is not available, could have a material adverse effect on our business, financial condition, results of operations, and cash flows. Suppliers may be unable to provide us with materials of sufficient quality or quantity required to meet our production needs at favorable prices or at all. We are dependent upon suppliers for parts and raw materials used in the manufacture of components that we sell to our customers, and our raw material costs are subject to commodity market fluctuations. We may experience an increase in costs for parts or raw materials that we source from our suppliers, or we may experience a shortage of parts or raw materials for various reasons, such as the loss of a significant supplier, high overall demand creating shortages in parts and supplies we use, financial distress, work stoppages, natural disasters, fluctuations in commodity prices, or production or distribution difficulties that may affect one or more of our suppliers. In particular, current or future global economic uncertainty may affect the financial stability of our key suppliers or their access to financing, which may in turn affect their ability to perform their obligations to us. Our customers rely on us to provide on-time delivery and have certain rights if our delivery standards are not maintained. A significant increase in our supply costs, including for raw materials that are subject to commodity price fluctuations, or a protracted interruption of supplies for any reason, could result in the delay of one or more of our customer contracts or could damage our reputation and relationships with customers. In addition, quality and sourcing issues that our suppliers may experience can also adversely affect the quality and effectiveness of our products and services and may result in liability or reputational harm to us. Any of these events could have a material adverse effect on our business, financial condition, results of operations, and cash flows. Subcontractors may fail to perform contractual obligations, which would adversely affect our ability to meet our obligations to our customers. We frequently subcontract portions of work due under contracts with our customers and are dependent on the continued availability and satisfactory performance by these subcontractors. Nonperformance or underperformance by subcontractors could materially impact our ability to perform obligations to our customers. A subcontractor’s failure to perform could result in a customer terminating our contract for default, expose us to liability, substantially impair our ability to compete for future contracts and orders, and limit our ability to enforce fully all of our rights under these agreements, including any rights to indemnification. Any of these events could have a material adverse effect on our business, financial condition, results of operations, and cash flows. We have engaged in restructuring and alignment activities from time to time and may need to implement further restructurings or alignments in the future, and there can be no assurance that our restructuring or alignment efforts will have the intended effects. From time to time, we have responded to changes in our industry and the markets we serve, or other changes in our business, by restructuring or aligning our operations. Our restructuring activities have included workforce management and other restructuring charges related to acquired businesses, including, among others, changes associated with integrating similar operations, managing our 14 workforce, vacating or consolidating certain facilities and cancelling certain contracts. Due to cost reduction measures or changes in the industry and markets in which we compete, we may decide to implement restructuring or alignment activities in the future, such as closing plants, moving production lines, or making additions, reductions or other changes to our management or workforce. These restructuring and/or alignment activities generally result in charges and expenditures that may adversely affect our financial results for one or more periods. Restructuring and/or alignment activities can create unanticipated consequences, such as instability or distraction among our workforce, and we cannot be sure that any restructuring or alignment efforts that we undertake will be successful. A variety of risks could cause us not to realize expected cost savings, including, among others, the following: · | higher than expected severance costs related to staff reductions; --+------------------------------------------------------------------ · | higher than expected retention costs for employees that will be retained; --+-------------------------------------------------------------------------- · | higher costs to hire new employees or delays or difficulty hiring the employees needed; --+---------------------------------------------------------------------------------------- · | higher than expected stand-alone overhead expenses; --+---------------------------------------------------- · | delays in the anticipated timing of activities related to our cost-saving plan; and --+------------------------------------------------------------------------------------ · | other unexpected costs associated with operating the business. --+--------------------------------------------------------------- If we are unable to structure our operations in the light of evolving market conditions, it could have a material adverse effect on our business, financial condition, results of operations, and cash flows. Consolidation in the aerospace market and our participation in a strategic joint venture with GE may make it more difficult to secure long-term sales in certain aerospace markets. In January 2016, Woodward and General Electric Company (“GE”), acting through its GE Aviation business unit, consummated the formation of a strategic joint venture between Woodward and GE (the “JV”). The JV agreement does not restrict Woodward from entering into any market, however, consolidation in the aircraft engine market is increasingly prevalent, resulting in fewer engine manufacturers, and thus it may become more difficult for Woodward to secure new business with GE competitors on similar product applications both within and outside the specific JV market space. Additionally, if GE fails to win new content in the market space covered by the JV, Woodward may be prevented from expanding content on future commercial aircraft engines in those markets. We may not be able to obtain financing, on acceptable terms or at all, to implement our business plans, complete acquisitions, or otherwise take advantage of business opportunities or respond to competitive pressures. During the last several years, global financial markets, including the credit and debt and equity capital markets, and economic conditions have been volatile. These issues, along with significant write-offs in the financial services sector, the re-pricing of credit risk, and the global economic uncertainty, have in the past made, and may in the future make, it difficult to obtain financing. In addition, as a result of concerns about the stability of financial markets generally and the solvency of counterparties specifically, the cost of obtaining money from the credit markets may increase as many lenders and institutional investors have or may increase interest rates, enact tighter lending standards, refuse to refinance existing debt at maturity either at all or on terms similar to existing debt, and reduce and, in some cases, cease to provide financing to borrowers. Due to these factors, we cannot be certain that financing, to the extent needed, will be available on acceptable terms or at all. If financing is not available when needed, or is available only on unacceptable terms, we may be unable to implement our business plans, complete acquisitions, fund significant capital expenditures, or otherwise take advantage of business opportunities or respond to competitive pressures, any of which could have a material adverse effect on our business, financial condition, results of operations, and cash flows. Our debt obligations and the restrictive covenants in the agreements governing our debt could limit our ability to operate our business or pursue our business strategies, could adversely affect our business, financial condition, results of operations, and cash flows, and could significantly reduce stockholder benefits from a change of control event. As of September 30, 2017, our total debt was $614,680, excluding unamortized debt issuance costs and including $32,600 of borrowings on our revolving credit facility, of which all was classified as current, $393,000 in unsecured notes denominated in U.S. dollars issued in private placements, and $189,080 of unsecured notes denominated in Euros issued in private placements. Our debt obligations could require us to dedicate a portion of our cash flow from operations to payments on our indebtedness, reducing the availability of our cash flow for other purposes, including business development efforts and mergers and acquisitions. We are contractually obligated under the agreements governing our long-term debt to make principal payments of $0 in fiscal year 2018, $143,000 in fiscal year 2019, $0 in fiscal year 2020, $100,000 in fiscal year 2021, $0 in fiscal year 2022, and the remaining $339,080 is due in subsequent fiscal years. Interest on our long-term notes is payable semi-annually, with the exception of the Series J Notes which is payable quarterly, each year until all principal is paid. Our debt obligations could make us more vulnerable to general adverse economic and industry conditions and could limit our flexibility in planning for, or reacting to, changes in our business and the industries in which we operate, thereby placing us at a disadvantage to our competitors that have less indebtedness. Our existing revolving credit facility and note purchase agreements impose financial covenants on us and our subsidiaries that require us to maintain certain leverage ratios and minimum levels of consolidated net worth. Certain of these agreements require us to repay outstanding borrowings with portions of the proceeds we receive from certain sales of property or assets and specified future debt offerings. 15 These financial covenants place certain restrictions on our business that may affect our ability to execute our business strategy successfully or take other actions that we believe would be in the best interests of our Company. These restrictions include limitations or restrictions, among other things, on our ability and the ability of our subsidiaries to: · | incur additional indebtedness; --+------------------------------- · | pay dividends or make distributions on our capital stock or certain other restricted payments or investments; --+-------------------------------------------------------------------------------------------------------------- · | purchase or redeem stock; --+-------------------------- · | issue stock of our subsidiaries; --+--------------------------------- · | make domestic and foreign investments and extend credit; --+--------------------------------------------------------- · | engage in transactions with affiliates; --+---------------------------------------- · | transfer and sell assets; --+-------------------------- · | effect a consolidation or merger or sell, transfer, lease, or otherwise dispose of all or substantially all of our assets; and --+------------------------------------------------------------------------------------------------------------------------------- · | create liens on our assets to secure debt. --+------------------------------------------- These agreements contain certain customary events of default, including certain cross-default provisions related to other outstanding debt arrangements. Any breach of the covenants under these agreements or other event of default could cause a default under these agreements and/or a cross-default under our other debt arrangements, which could restrict our ability to borrow under our revolving credit facility. If there were an event of default under certain provisions of our debt arrangements that was not cured or waived, the holders of the defaulted debt may be able to cause all amounts outstanding with respect to the debt instrument, plus any required settlement costs, to be due and payable immediately. Our assets and cash flow may not be sufficient to fully repay borrowings under our outstanding debt instruments if accelerated upon an event of default. If we are unable to repay, refinance, or restructure our indebtedness as required, or amend the covenants contained in these agreements, the lenders or note holders may be entitled to obtain a lien or institute foreclosure proceedings against our assets. Any of these events could have a material adverse effect on our business, financial condition, results of operations, and cash flows. The Company, at its option, is permitted at any time to prepay all or any part of the then-outstanding principal amount of any series of our private placement notes, together with interest accrued on such amount to be prepaid to the date of prepayment, plus any applicable prepayment compensation amount. The prepayment compensation amount for the Euro denominated private placement notes includes any net gain or loss realized by the lenders on swap transactions entered into by the lenders under which the lenders would receive payment in U.S. dollars in exchange for scheduled Euro payments of principal and interest on the Euro denominated private placement notes by the Company to the lenders, adjusted for theoretical lender returns foregone on hypothetical reinvestments in U.S. Treasury securities. However, in the case of an event of default as defined in the loan documents, including a change in control event, the prepayment compensation amount will not be less than zero. Depending on the movement of foreign exchange rates over the terms of the Euro denominated private placement notes, such payments could have a material adverse effect on our business, financial condition, results of operations, and cash flows and could significantly reduce stockholder benefits from a change of control event. Additional tax expense or additional tax exposures could affect our future profitability. Approximately 24%, in fiscal year 2017, and 23%, in fiscal year 2016, of our earnings before income taxes was earned in jurisdictions outside the United States. Accordingly, we are subject to income taxes in both the United States and various non-U.S. jurisdictions. Our tax liabilities are dependent upon the distribution mix of operating income among these different jurisdictions. Our tax expense includes estimates of additional tax that may be incurred and reflects various estimates, projections, and assumptions that could impact the valuation of our deferred tax assets and liabilities. Our future operating results could be adversely affected by changes in the effective tax rate, which could be caused by, among other things: · | changes in the mix of earnings in countries with differing statutory tax rates; --+-------------------------------------------------------------------------------- · | changes in our overall profitability; --+-------------------------------------- · | changes in tax legislation and tax rates; --+------------------------------------------ · | changes in tax incentives; --+--------------------------- · | changes in U.S. GAAP; --+---------------------- · | changes in the projected realization of deferred tax assets and liabilities; --+----------------------------------------------------------------------------- · | changes in management’s assessment of the amount of earnings indefinitely reinvested offshore; and --+--------------------------------------------------------------------------------------------------- · | the results of audits and examinations of previously filed tax returns and continuing assessments of our tax exposures. --+------------------------------------------------------------------------------------------------------------------------ We derive a significant portion of our revenues from sales to countries outside the United States and purchase raw materials and components from suppliers outside of the United States; therefore, we are subject to the risks inherent in doing business in other countries. In 2017, approximately 42% of our total sales were made to customers in jurisdictions outside of the United States (including products manufactured in the United States and sold outside the United States as well as products manufactured in international locations), including approximately 10% of our total sales to Brazil, Russia, India and China, known as the “BRIC” countries. We also purchase raw materials and components from suppliers outside the United States. 16 Accordingly, our business and results of operations are subject to risks associated with doing business internationally, including: · | fluctuations in foreign exchange rates; --+---------------------------------------- · | limitations on repatriation of earnings; --+----------------------------------------- · | transportation delays and interruptions; --+----------------------------------------- · | political, social and economic instability and disruptions; --+------------------------------------------------------------ · | government embargos or trade restrictions; --+------------------------------------------- · | the imposition of duties and tariffs and other trade barriers; --+--------------------------------------------------------------- · | import and export controls; --+---------------------------- · | changes in labor conditions; --+----------------------------- · | changes in regulatory environments; --+------------------------------------ · | the potential for nationalization of enterprises; --+-------------------------------------------------- · | difficulties in staffing and managing multi-national operations; --+----------------------------------------------------------------- · | limitations on the Company’s ability to enforce legal rights and remedies, including protection of intellectual property; --+-------------------------------------------------------------------------------------------------------------------------- · | difficulty of enforcing agreements and collecting receivables through some foreign legal systems; --+-------------------------------------------------------------------------------------------------- · | acts of terrorism or war; --+-------------------------- · | potentially adverse tax consequences; and --+------------------------------------------ · | difficulties in implementing restructuring actions on a timely basis. --+---------------------------------------------------------------------- We are also subject to U.S. laws prohibiting companies from doing business in certain countries, or restricting the type of business that may be conducted in these countries. The cost of compliance with increasingly complex and often conflicting regulations governing various matters worldwide, including foreign investment, employment, import, export, business acquisitions, environmental and taxation matters, land use rights, property, and other matters, can also impair our flexibility in modifying product, marketing, pricing or other strategies for growing our businesses, as well as our ability to improve productivity and maintain acceptable operating margins. We must also comply with restrictions on exports imposed under the U.S. Export Control Laws and Sanctions Programs. These laws and regulations change from time to time and may restrict foreign sales. In 2017, approximately 5% of our total sales were recorded in the Peoples’ Republic of China (“China”) and we have operations in China. Certain of our independent registered public accounting firm’s audit documentation related to their audit report included in this annual report may be located in the China. The Public Company Accounting Oversight Board (“PCAOB”) currently cannot inspect audit documentation located in China and, as such, prevents the PCAOB from regularly evaluating audit work of any auditors that was performed in China, including that performed by our independent auditors in China. As a result, investors may be deprived of the full benefits of PCAOB oversight of our global audits via their inspections. The inability of the PCAOB to conduct inspections of audit work performed in China makes it more difficult to evaluate the effectiveness of our Chinese independent auditor’s audit procedures as compared to auditors in other jurisdictions that are subject to PCAOB inspections on all of their work. Sales and purchases in currencies other than the U.S. dollar expose us to fluctuations in foreign currencies relative to the U.S. dollar. These exposures may change over time as our business and business practices evolve, and they could have a material adverse effect on our financial results and cash flows. An increase in the value of the U.S. dollar could increase the real cost to our customers of our products in those markets outside the United States where we sell in U.S. dollars, and a weakened U.S. dollar could increase the cost of local operating expenses and procurement of raw materials to the extent that we must purchase components in foreign currencies. Foreign currency exchange rate risk is reduced through several means, including the maintenance of local production facilities in the markets served, invoicing of customers in the same currency as the source of the products, and prompt settlement of inter-company balances utilizing a global netting system. While we monitor our exchange rate exposures and seek to reduce the risk of volatility, our actions may not be successful in significantly mitigating such volatility. Of the $87,552 of cash and cash equivalents held at September 30, 2017, $87,383 was held by our foreign locations. We are not presently aware of any significant restrictions on the repatriation of these funds, although a portion is considered indefinitely reinvested in these foreign subsidiaries. If these funds were needed to fund our operations or satisfy obligations in the United States, then they could be repatriated and their repatriation into the United States may cause us to incur additional U.S. income taxes or foreign withholding taxes. Any additional U.S. taxes could be offset, in whole or in part, by foreign tax credits. The amount of such taxes and application of tax credits would be dependent on the income tax laws and other circumstances at the time these amounts are repatriated. Based on these variables, it is impractical to determine the income tax liability that might be incurred if these funds were to be repatriated. In addition, uncertain global economic conditions arising from circumstances such as slowing growth in emerging regions could result in reduced customer confidence and decreased demand for our products and services, disruption in payment patterns and higher default rates, a tightening of credit markets, increased risk regarding supplier performance, increased counterparty risk with respect to the financial institutions with which we do business, and exchange rate fluctuations. While we employ comprehensive controls regarding global cash management to guard against cash or investment loss and to ensure our ability to fund our operations and commitments, a material disruption to the financial institutions with whom we transact business could have a material adverse effect on our international operations or on our business, financial condition, results of operations, and cash flows. 17 Political and economic uncertainty in the European Union could adversely impact our business, results of operations, financial condition and prospects. Credit rating downgrades in certain European countries and/or speculation regarding changes to the composition or viability of the European Union (“EU”) create uncertain global economic conditions. On June 23, 2016, the United Kingdom (“UK”) voted to leave the EU. The UK’s voluntary exit from the EU, generally referred to as the “Brexit,” triggered short-term financial volatility, including a decline in the value of the Great Britain Pound (“GBP”) in comparison to both the U.S. dollar (“USD”) and the European Union countries’ Euro (“EUR”). In addition, a process of negotiation will be required to determine the future terms of the UK’s relationship with the EU, and the legal and regulatory framework that will be applicable in the UK may change. This uncertainty before, during and after the period of negotiation could have a negative economic impact and result in further volatility in the markets for several years. The impact of the Brexit referendum and such ongoing uncertainty may result in various economic and financial consequences for businesses operating in the UK, the EU and beyond. We derive a significant portion of our revenues from non-U.S. sales and are subject to the risks inherent in doing business in other countries, including the UK. During fiscal year 2017, approximately 3% of our consolidated net sales were invoiced to customers in the UK through both our Aerospace and our Industrial reportable segments. Approximately 23% of our consolidated net sales were invoiced to customers in Europe overall. Woodward and its various subsidiaries hold financial assets and liabilities denominated in GBP and EUR, including cash and cash equivalents, accounts receivable, postretirement defined benefit pension plan assets and liabilities, and accounts payable, and the future impacts of the Brexit and the continued uncertainty surrounding the EU could have a material impact on our business, financial condition, results of operations and cash flows. Changes in the estimates of fair value of reporting units or of long-lived assets, particularly goodwill, may result in future impairment charges, which could have a material adverse effect on our business, financial condition, results of operations and cash flows. Over time, the fair values of long-lived assets change. At September 30, 2017, we had $556,545 of goodwill, representing 20% of our total assets. We test goodwill for impairment at the reporting unit level on an annual basis and more often if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Based on the relevant U.S. GAAP authoritative guidance, we aggregate components of a single operating segment into a reporting unit, if appropriate. Future goodwill impairment charges may occur if estimates of fair values decrease, which would reduce future earnings. We also test property, plant, and equipment and other intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Future asset impairment charges may occur if asset utilization declines, if customer demand decreases, or for a number of other reasons, which would reduce future earnings. Any such impairment charges could have a material adverse effect on our business, financial condition, results of operations, and cash flows. Impairment charges would also reduce our consolidated stockholders’ equity and increase our debt-to-total-capitalization ratio, which could negatively impact our credit rating and access to the debt and equity markets. During the fourth quarter of fiscal year 2017, we completed our annual goodwill impairment test as of July 31, 2017 for the fiscal year ended September 30, 2017 during the fourth quarter. In performing the annual goodwill impairment test, we determined it was appropriate to aggregate certain components of the same operating segment into a single reporting unit. The identification of reporting units and consideration of aggregation criteria requires management’s judgment. Further, we use the income approach based on a discounted cash flow method that incorporates various estimates and assumptions. The results of our fiscal year 2017 annual goodwill impairment test performed as of July 31, 2017 indicated the estimated fair values of each of our reporting units were in excess of their carrying amounts, and accordingly, no impairment existed. There can be no assurance that our estimates and assumptions of the fair value of our reporting units, the current economic environment, or the other inputs used in forecasting the present value of forecasted cash flows used to estimate the fair value of our reporting units will prove to be accurate projections of future performance, and any material error in our estimates and assumptions, could result in us needing to take a material impairment charge, which would have the effects discussed above. As part of our ongoing monitoring efforts, we will continue to consider the global economic environment and its potential impact on our businesses, as well as other factors, in assessing goodwill and long-lived assets for possible indications of impairment. Our manufacturing activities may result in future environmental costs or liabilities. We use hazardous materials and/or regulated materials in our manufacturing operations. We also own, operate, and may acquire facilities that were formerly owned and operated by others that used such materials. The risk that a significant release of regulated materials has occurred in the past or will occur in the future cannot be completely eliminated or prevented. As a result, we are subject to a substantial number of costly regulations. In particular, we are required to comply with increasingly stringent requirements of federal, state, and local environmental, occupational health and safety laws and regulations in the United States, the European Union, and other territories, including those governing emissions to air, discharges to water, noise and odor emissions, the generation, handling, storage, transportation, treatment and disposal of waste materials, and the cleanup of contaminated properties and human health and safety. Compliance with these laws and regulations results in ongoing costs. We cannot be certain that we have been, or will at all times be, in complete compliance with all environmental requirements, or that we will not incur additional material costs or 18 liabilities in connection with these requirements. In addition, we may be exposed to other environmental costs such as participation in superfund sites or other similar jurisdictional initiatives. As a result, we may incur material costs or liabilities or be required to undertake future environmental remediation activities that could damage our reputation and have a material adverse effect on our business, financial condition, results of operations, and cash flows. Our financial and operating performance depends on continued access to a stable workforce and on favorable labor relations with our employees. Certain of our operations in the United States and internationally involve different employee/employer relationships and the existence of works’ councils. In addition, approximately 22% of our workforce in the United States is unionized, and is expected to remain unionized for the foreseeable future. Competition for technical personnel in the industries in which we compete is intense. Our future success depends in part on our continued ability to hire, train, assimilate, and retain qualified personnel. There is no assurance that we will continue to be successful in recruiting qualified employees in the future. Further, we periodically need to renegotiate our collective bargaining agreements, and any failure to negotiate new agreements or extensions in a timely manner could result in work stoppages or slowdowns. Any significant increases in labor costs, deterioration of employee relations, including any conflicts with works’ councils or unions, or slowdowns or work stoppages at any of our locations, whether due to employee turnover, changes in availability of qualified technical personnel, or otherwise, could have a material adverse effect on our business, our relationships with customers, and our financial condition, results of operations, and cash flows. Our operations and suppliers may be subject to physical and other risks, including natural disasters that could disrupt production and have a material adverse effect on our business, financial condition, results of operations and cash flows. Our operations include principal facilities in the United States, China, Germany, and Poland. In addition, we operate sales and service facilities in Brazil, Bulgaria, India, Japan, the Netherlands, the Republic of Korea and the United Kingdom. We also have suppliers for materials and parts inside and outside the United States. Our operations and sources of supply could be disrupted by unforeseen events, including fires, tornadoes, tsunamis, hurricanes, earthquakes, floods and other forms of severe weather in countries in which we operate or in which our suppliers are located, any of which could adversely affect our operations and financial performance. Natural disasters, public health concerns, war, political unrest, terrorist activity, equipment failures, power outages, or other unforeseen events could result in physical damage to, and complete or partial closure of, one or more of our manufacturing facilities, or could cause temporary or long-term disruption in the supply of component products from some local and international suppliers, disruption in the transport of our products and significant delays in the shipment of products and the provision of services, which could in turn cause the loss of sales and customers. Existing insurance arrangements may not provide protection for all of the costs that may arise from such events. Accordingly, disruption of our operations or the operations of a significant supplier could have a material adverse effect on our business, financial condition, results of operations, and cash flows. Our intellectual property rights may not be sufficient to protect all our products or technologies. Our success depends in part on our ability to obtain patents or rights to patents, protect trade secrets and know-how, and prevent others from infringing on our patents, trademarks, and other intellectual property rights. Some of our intellectual property is not covered by patents (or patent applications) and includes trade secrets and other know-how that is not patentable or for which we have elected not to seek patent protection, including intellectual property relating to our manufacturing processes and engineering designs. We will be able to protect our intellectual property from unauthorized use by third parties only to the extent that it is covered by valid and enforceable patents, trademarks, licenses or other valid intellectual property rights. Patent protection generally involves complex legal and factual questions and, therefore, enforceability of patent rights cannot be predicted with certainty; thus, any patents that we own or license from others may not provide us with adequate protection against competitors. Moreover, the laws of certain foreign countries do not recognize intellectual property rights or protect them to the same extent as do the laws of the United States. Additionally, our commercial success depends significantly on our ability to operate without infringing upon the patent and other proprietary rights of others. Our current or future technologies may, regardless of our intent, infringe upon the patents or violate other proprietary rights of third parties. In the event of such infringement or violation, we may face expensive litigation or indemnification obligations and may be prevented from selling existing products and pursuing product development or commercialization. If we are unable to sufficiently protect our patent and other proprietary rights or if we infringe on the patent or proprietary rights of others, our business, financial condition, results of operations, and cash flows could be materially adversely affected. Amounts accrued for contingencies may be inadequate to cover the amount of loss when the matters are ultimately resolved. In addition to intellectual property and product liability matters, we are currently involved or may become involved in claims, pending or threatened litigation or other legal proceedings, investigations or regulatory proceedings regarding employment or other regulatory, legal, or contractual matters arising in the ordinary course of business. There is no certainty that the results of these matters will be favorable to the Company. We accrue for known individual matters if we believe it is probable that the matter will result in a loss when ultimately resolved using estimates of the most likely amount of loss. There may be additional losses that have not been accrued, or liabilities may exceed our estimates, which could have a material adverse effect on our business, financial condition, results of operations, and cash flows. 19 We could be adversely affected by violations of the U.S. Foreign Corrupt Practices Act and similar worldwide anti-bribery laws and regulations. The U.S. Foreign Corrupt Practices Act (“FCPA”) and similar anti-bribery laws and regulations in other jurisdictions generally prohibit companies and their intermediaries from making improper payments to non-U.S. government officials for the purpose of obtaining or retaining business or securing an improper business advantage. Our policies mandate compliance with these anti-bribery laws. However, we operate in many parts of the world and sell to industries that have experienced corruption to some degree. If we are found to be liable for FCPA or other similar anti-bribery law or regulatory violations, whether due to our or others’ actions or inadvertence, we could be subject to civil and criminal penalties or other sanctions that could have a material adverse impact on our business, financial condition, results of operations and cash flows. Our net postretirement benefit obligation liabilities may increase, and the fair value of our pension plan assets may decrease, which could require us to make additional and/or unexpected cash contributions to our pension plans, increase the amount of postretirement benefit expenses, affect our liquidity or affect our ability to comply with the terms of our outstanding debt arrangements. Accounting for retirement, pension and postretirement benefit obligations and related expense requires the use of assumptions, including a weighted-average discount rate, an expected long-term rate of return on assets, a net healthcare cost trend rate, and projected mortality rates, among others. Benefit obligations and benefit costs are sensitive to changes in these assumptions. As a result, assumption changes could result in increases in our obligation amounts and expenses. If interest rates decline, the present value of our postretirement benefit plan liabilities may increase faster than the value of plan assets, resulting in significantly higher unfunded positions in some of our pension plans. As of September 30, 2017, we had $224,712 in invested pension plan assets. Investment losses may result in decreases to our pension plan assets. Funding estimates are based on certain assumptions, including discount rates, interest rates, mortality, fair value of assets and expected return on plan assets and are subject to changes in government regulations in the countries in which our employees work. Volatility in the financial markets may impact future discount and interest rate assumptions. Significant changes in investment performance or a change in the portfolio mix of invested assets can result in increases or decreases in the valuation of plan assets or in a change of the expected rate of return on plan assets. Also, new accounting standards on fair value measurement may impact the calculation of future funding levels. We periodically review our assumptions, and any such revision can significantly change the present value of future benefits, and in turn, the funded status of our pension plans and the resulting periodic pension expense. Changes in our pension benefit obligations and the related net periodic costs or credits may occur as a result of variances of actual results from our assumptions, and we may be required to make additional cash contributions in the future beyond those which have been estimated. In addition, our existing revolving credit facility and note purchase agreements contain continuing covenants and events of default regarding our pension plans, including provisions regarding the unfunded liabilities related to those pension plans. See the discussion above concerning “Our debt obligations and the restrictive covenants in the agreements governing our debt could limit our ability to operate our business or pursue our business strategies, and could adversely affect our business, financial condition, results of operations, and cash flows.” To the extent that the present values of benefits incurred for pension obligations are greater than values of the assets supporting those obligations or if we are required to make additional or unexpected contributions to our pension plans for any reason, our ability to comply with the terms of our outstanding debt arrangements, and our business, financial condition, results of operations, and cash flows may be adversely affected. Our business operations may be adversely affected by information systems interruptions or intrusion. We are dependent on various information systems throughout our company to administer, store and support multiple business activities. If these systems are damaged, cease to function properly or are subject to cybersecurity attacks, such as unauthorized access, malicious software and other violations, we could experience production downtimes, operational delays, other detrimental impacts on our operations or ability to provide products and services to our customers, the compromising of confidential or otherwise protected information, destruction or corruption of data, security breaches, other manipulation or improper use of our systems or networks, financial losses from remedial actions, loss of business or potential liability, and/or damage to our reputation, any of which could have a material adverse effect on our business, financial condition, results of operations, and cash flows. While we attempt to mitigate these risks by employing a number of measures, including technical security controls, employee training, comprehensive monitoring of our networks and systems, and maintenance of backup and protective systems, our systems, networks, products, solutions and services remain potentially vulnerable to additional known or unknown threats. Our financial statements are subject to changes in accounting standards that could adversely impact our profitability or financial position. Our financial statements are subject to the application of U.S. GAAP, which are periodically revised and/or expanded. Accordingly, from time to time, we are required to adopt new or revised accounting standards issued by recognized authoritative bodies, including the Financial Accounting Standards Board. Recently, accounting standard setters issued new guidance which further 20 interprets or seeks to revise accounting pronouncements related to revenue recognition and lease accounting as well as to issue new standards expanding disclosures. The impact of accounting pronouncements that have been issued but not yet implemented is disclosed in our annual and quarterly reports on Form 10-K and Form 10-Q. An assessment of proposed standards is not provided, as such proposals are subject to change through the exposure process and, therefore, their effects on our financial statements cannot be fully assessed at this time. It is possible that future accounting standards we are required to adopt could change the current accounting treatment that we apply to our consolidated financial statements and that such changes could have a material adverse effect on our reported results of operations and financial position. Additionally, any inability by the Company to timely and properly implement such changes could have a material adverse effect on our ability to timely file future financial statements upon adoption of, and in accordance with, such new accounting standards, which could have a material adverse effect on our business and negatively affect our share price. Industry Risks Unforeseen events may occur that significantly reduce commercial aviation, which could adversely affect our business, financial condition and results of operations. A significant portion of our business is related to commercial aviation. Global economic downturn and uncertainty in the marketplace typically lead to a general reduction in demand for air transportation services, leading some airlines to withdraw aircraft from service, which negatively affects sales of our aerospace components and services. These economic conditions can similarly affect our sales of systems and components for new business jet aircraft. The commercial airline industry tends to be cyclical and capital spending by airlines and aircraft manufacturers may be influenced by a variety of factors, including current and future traffic levels, aircraft fuel pricing, labor issues, competition, the retirement of older aircraft, regulatory changes, terrorism and related safety concerns, general economic conditions, worldwide airline profits and backlog levels. In the event these or other economic indicators stagnate or worsen, market demand for our components and systems could be negatively affected by renewed reductions in demand for air transportation services or commercial airlines’ financial difficulties, which could have a material adverse effect on our business, financial condition, results of operations, and cash flows. The U.S. Government may change acquisition priorities and/or reduce spending, which could adversely affect our business, financial condition and results of operations. The U.S. Government participates in a wide variety of operations, including homeland defense, counterinsurgency, counterterrorism, and other defense-related operations that employ our products and services. U.S. defense spending has historically been cyclical in nature, and defense budgets tend to rise when perceived threats to national security increase the level of concern over the country’s safety. The U.S. Government continues to adjust its funding priorities in response to changes in the perceived threat environment, the political environment, and changes in budgetary priorities. In addition, defense spending currently faces pressures due to the overall economic and political environment, budget deficits, and competing budget priorities. A decrease in U.S. Government defense spending or changes in the spending allocation could result in one or more of our programs being reduced, delayed, or terminated. Shifts in domestic and international spending and tax policy, changes in security, defense, and intelligence priorities, changes in government budget appropriations, general and political economic conditions and developments, and other factors may affect a decision to fund, or the level of funding for, existing or proposed programs. If the priorities of the U.S. Government change and/or defense spending is reduced, this may adversely affect our business, financial condition, results of operations, and cash flows. Increasing emission standards that drive certain product sales may be eased or delayed, which could reduce our competitive advantage. We sell components and systems that have been designed to meet strict emission standards, including standards that have not yet been implemented but are expected to be implemented soon. If these emission standards are eased, developed products may become unnecessary and/or our future sales could be lower as potential customers select alternative products or delay adoption of our products, which would have a material adverse effect on our business, financial condition, results of operations, and cash flows. Natural gas prices may increase significantly and disproportionately to other sources of fuels used for power generation, which could reduce our sales and adversely affect our business, financial condition and results of operations. Commercial producers of electricity use many of our components and systems, most predominately in their power plants that use natural gas as their fuel source. Commercial producers of electricity are often in a position to manage the use of different power plant facilities and make decisions based on operating costs. Compared to other sources of fuels used for power generation, natural gas prices have increased slower than fuel oil, but about the same as coal. This increase in natural gas prices and any future increases, whether in absolute dollars or relative to other fuel costs such as oil, could impact the sales mix of our components and systems, which could have a material adverse effect on our business, financial condition, results of operations, and cash flows. 21 Long-term reduced commodity prices for oil, natural gas, and other minerals may depress the markets for certain of our products and services, particularly those from our Industrial segment. Many of our Industrial segment OEM and aftermarket customers and our Aerospace segment rotorcraft product lines’ customers provide goods and services that support various industrial extraction activities, including mining, oil and gas exploration and extraction, and transportation of raw materials from extraction sites to refineries and/or processing facilities. Long-term lower prices for commodities such as oil, natural gas, gold, tin, and various other minerals could reduce exploration activities and place downward pressure on demand for our goods and services that support exploration and extraction activities. Changes in government subsidy programs and regulatory requirements may result in decreased demand for our products. The U.S. Government, as well as various foreign governments, provide for various stimulus programs or subsidies, such as grants, loan guarantees and tax incentives, relating to renewable energy, alternative energy, energy efficiency and electric power infrastructure. Some of these programs have expired, which may affect the economic feasibility or timing of future projects. Additionally, while a significant amount of stimulus funds and subsidies are available to support various projects, we cannot predict the timing and scope of any investments to be made by our customers under stimulus funding and subsidies or whether stimulus funding and subsidies will result in increased demand for our products. Investments for renewable energy, alternative energy and electric power infrastructure under stimulus programs and subsidies may not occur, may be less than anticipated or may be delayed, any of which would negatively impact demand for our products. Other current and potential regulatory initiatives may not result in increased demand for our products. It is not certain whether existing regulatory requirements will create sufficient incentives for new projects, when or if proposed regulatory requirements will be enacted, or whether any potentially beneficial provisions will be included in the regulatory requirement. Uncertainty with respect to government subsidy programs and regulatory requirements could cause decreased demand for our products as investments are delayed or become economically unfeasible, which could have a material adverse effect on our business, financial condition, results of operations, and cash flows. We operate in a highly competitive industry and, if we are unable to compete effectively in one or more of our markets, our business, financial condition and results of operations may be adversely affected. We face intense competition from a number of established competitors in the United States and abroad, some of which are larger in size or are divisions of large diversified companies with substantially greater financial resources. In addition, global competition continues to increase. Companies compete on the basis of providing products that meet the needs of customers, as well as on the basis of price, quality, and customer service. Changes in competitive conditions, including the availability of new products and services, the introduction of new channels of distribution, and changes in OEM and aftermarket pricing, could impact our relationships with our customers and may adversely affect future sales, which could have a material adverse effect on our business, financial condition, results of operations, and cash flows. Further, the markets in which we operate experience rapidly changing technologies and frequent introductions of new products and services. The technological expertise we have developed and maintained could become less valuable if a competitor were to develop a breakthrough technology that would allow it to match or exceed the performance of existing technologies at a lower cost. If we are unable to develop competitive technologies, future sales or earnings could be lower than expected, which could have a material adverse effect on our business, financial condition, results of operations, and cash flows. In all of our markets, customers frequently develop new supply chain initiatives and/or sourcing models which could create new opportunities, but also could apply pressure to our customer relationships and/or strategic position with those customers. Industry consolidation trends could reduce our sales opportunities, decrease sales prices, and drive down demand for our products. There has been consolidation and there may be further consolidation in the aerospace, power, and process industries. The consolidation in these industries has resulted in customers with vertically integrated operations, including increased in-sourcing capabilities, which may result in economies of scale for those companies. If our customers continue to seek to control more aspects of vertically integrated projects, cost pressures resulting in further integration or industry consolidation could reduce our sales opportunities, decrease sales prices, and drive down demand for our products, which could have a material adverse effect on our business, financial condition, results of operations, and cash flows. Investment Risks The historic market price of our common stock may not be indicative of future market prices. The market price of our common stock has fluctuated over time. Stock markets in general have experienced extreme price and volume volatility particularly over the past few years. The trading price of our common stock ranged from a high of $78.95 per share to a low of $57.09 per share during the twelve months ended September 30, 2017. The following factors, among others, could cause the price of our common stock in the public market to fluctuate significantly: · | general economic conditions, particularly in the aerospace, power generation and process and transportation industries; --+------------------------------------------------------------------------------------------------------------------------ 22 · | variations in our quarterly results of operation; --+-------------------------------------------------- · | a change in sentiment in the market regarding our operations or business prospects; --+------------------------------------------------------------------------------------ · | the addition or departure of key personnel; and --+------------------------------------------------ · | announcements by us or our competitors of new business, acquisitions or joint ventures. --+---------------------------------------------------------------------------------------- Fluctuations in our stock price often occur without regard to specific operating performance. The price of our common stock could fluctuate based upon the above factors or other factors, including those that have little to do with our company, and these fluctuations could be material. The typical daily trading volume of our common stock may affect an investor’s ability to sell significant stock holdings in the future without negatively affecting stock price. As of September 30, 2017, we had 72,960 shares of common stock issued, of which 11,739 shares were held as treasury shares. In addition, stockholders who each own 5% or greater of our shares hold a total of approximately 23% of the outstanding shares of our common stock. During the fourth quarter of fiscal year 2017, the average daily trading volume of our stock was approximately 249 shares. While the level of trading activity will vary each day, our typical daily trading volume is relatively low and represents only a small percentage of total shares of stock outstanding. As a result, a stockholder who sells a significant number of shares of stock in a short period of time could negatively affect our share price. Certain anti-takeover provisions of our charter documents and under Delaware law could discourage or prevent others from acquiring our company. Our certificate of incorporation and bylaws contain provisions that: · | provide for a classified board; --+-------------------------------- · | provide that directors may be removed only for cause by holders of at least two-thirds of the outstanding shares of common stock; --+---------------------------------------------------------------------------------------------------------------------------------- · | authorize our board of directors to fill vacant directorships or to increase or decrease the size of our board of directors; --+----------------------------------------------------------------------------------------------------------------------------- · | permit us to issue, without stockholder approval, up to 10,000 shares of preferred stock, in one or more series and, with respect to each series, to fix the designation, powers, preferences and rights of the shares of the series; --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | require special meetings of stockholders to be called by holders of at least two-thirds of the outstanding shares of common stock; --+----------------------------------------------------------------------------------------------------------------------------------- · | prohibit stockholders from acting by written consent; --+------------------------------------------------------ · | require advance notice for stockholder proposals and nominations for election to the board of directors to be acted upon at meetings of stockholders; and --+---------------------------------------------------------------------------------------------------------------------------------------------------------- · | require the affirmative vote of two-thirds of the outstanding shares of our common stock for amendments to our certificate of incorporation and certain business combinations, including mergers, consolidations, sales of all or substantially all of our assets or dissolution. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- In addition, Section 203 of the Delaware General Corporation Law limits business combinations with owners of more than 15% of our stock that have not been approved by the board of directors. These provisions and other similar provisions make it more difficult for a third party to acquire us without negotiation. Our board of directors could choose not to negotiate a potential acquisition that it does not believe to be in our best interest. Accordingly, the potential acquirer could be discouraged from offering to acquire us, or could be prevented by the anti-takeover measures, from successfully completing a hostile acquisition.  Item 1B.Unresolved Staff Comments None.  Item 2.Properties Our principal plants are as follows: United States Duarte, California – Aerospace segment manufacturing and engineering Fort Collins, Colorado (two plants) – Corporate headquarters and Industrial segment manufacturing and engineering Greenville, South Carolina (leased) –Industrial segment manufacturing and Aerospace and Industrial segments engineering Loveland, Colorado –Industrial segment manufacturing and Aerospace and Industrial segments engineering Niles, Illinois – Aerospace segment manufacturing and Aerospace and Industrial segments engineering Rockford, Illinois (two plants) – Aerospace segment manufacturing and engineering 23 Santa Clarita, California – Aerospace segment manufacturing and engineering Zeeland, Michigan – Aerospace segment manufacturing and engineering Other Countries Aken, Germany (leased) –Industrial segment manufacturing and engineering Kempen, Germany –Industrial segment manufacturing and engineering Krakow, Poland –Industrial segment manufacturing and Aerospace and Industrial segments engineering Tianjin, Peoples’ Republic of China (leased) –Industrial segment assembly In addition to the principal plants listed above, we own or lease other facilities used primarily for sales, service activities, assembly, and/or engineering activities in Brazil, Bulgaria, China, India, Japan, the Netherlands, the Republic of Korea, the United Kingdom, Germany, and the United States. Our principal plants are suitable and adequate for the manufacturing and other activities performed at those plants, and we believe our utilization levels are generally high.  Item 3.Legal Proceedings Woodward is currently involved in claims, pending or threatened litigation or other legal proceedings, investigations and/or regulatory proceedings arising in the normal course of business, including, among others, those relating to product liability claims, employment matters, worker’s compensation claims, contractual disputes, product warranty claims and alleged violations of various laws and regulations. We accrue for known individual matters where we believe that it is probable the matter will result in a loss when ultimately resolved using estimates of the most likely amount of loss. While the outcome of pending claims, legal and regulatory proceedings, and investigations cannot be predicted with certainty, management believes that any liabilities that may result from these claims, proceedings and investigations will not have a material effect on Woodward's liquidity, financial condition, or results of operations.  Item 4.Mine Safety Disclosures Not applicable.  PART II Item 5.Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Our common stock is listed on The NASDAQ Global Select Market and is traded under the symbol “WWD.” At November 3, 2017, there were approximately 900 holders of record. Dividends We have historically paid cash dividends on our common stock on a quarterly basis, subject in any quarter to the approval of the Board of Directors. See below and Note 18, Stockholders’ Equity in the Notes to the Consolidated Financial Statements in “Item 8 – Financial Statements and Supplementary Data” for more information. The following table sets forth the high and low sales prices of our common stock and dividends paid for the periods indicated.   | | | | | | | | | | | | | | ---------------+---------------------------------+-------+------+---+----------------+------+-------+-----+---+----------------+---+-------+---+------  | | | | | | | | | | | | | | ---------------+---------------------------------+-------+------+---+----------------+------+-------+-----+---+----------------+---+-------+---+------  | Fiscal Year Ended September 30, ---------------+--------------------------------  | 2017 | | 2016 ---------------+---------------------------------+-------+-----  | High | | Low | | Cash Dividends | High | | Low | | Cash Dividends ---------------+---------------------------------+-------+------+---+----------------+------+-------+-----+---+--------------- First quarter | $ | 71.46 | | $ | 57.09 | $ | 0.110 | | $ | 51.34 | $ | 39.68 | $ | 0.100 ---------------+---------------------------------+-------+------+---+----------------+------+-------+-----+---+----------------+---+-------+---+------ Second quarter | $ | 72.28 | | $ | 65.47 | $ | 0.125 | | $ | 53.50 | $ | 41.24 | $ | 0.110 ---------------+---------------------------------+-------+------+---+----------------+------+-------+-----+---+----------------+---+-------+---+------ Third quarter | $ | 71.50 | | $ | 65.22 | $ | 0.125 | | $ | 59.60 | $ | 50.70 | $ | 0.110 ---------------+---------------------------------+-------+------+---+----------------+------+-------+-----+---+----------------+---+-------+---+------ Fourth quarter | $ | 78.95 | | $ | 65.76 | $ | 0.125 | | $ | 63.98 | $ | 56.00 | $ | 0.110 ---------------+---------------------------------+-------+------+---+----------------+------+-------+-----+---+----------------+---+-------+---+------  24 Performance Graph The following graph compares the cumulative 10-year total return to stockholders on our common stock relative to the cumulative total returns of the S&P Midcap 400 index, the S&P Industrial Machinery index, and the S&P Industrials index. The graph shows total stockholder return assuming an investment of $100 (with reinvestment of all dividends) was made on September 30, 2007 in our common stock and in each of the three indexes and tracks relative performance through September 30, 2017. With the addition of the S&P Industrials index to the graph below, we anticipate removing reference to the S&P Industrial Machinery index in future annual filings, as we believe the S&P Industrial index more closely aligns to our business operations. We have used a period of 10 years as we believe that our stock performance should be reviewed over a period that is reflective of our long-term business cycle.       | | | | | | | | | | | | | | | | | | | | | | -------------------------+---+--------+---+--------+---+-------+---+--------+---+-------+---+--------+---+--------+---+--------+---+--------+---+--------+---+-------  | | | | | | | | | | | | | | | | | | | | | | -------------------------+---+--------+---+--------+---+-------+---+--------+---+-------+---+--------+---+--------+---+--------+---+--------+---+--------+---+-------  | | 9/07 | | 9/08 | | 9/09 | | 9/10 | | 9/11 | | 9/12 | | 9/13 | | 9/14 | | 9/15 | | 9/16 | | 9/17 -------------------------+---+--------+---+--------+---+-------+---+--------+---+-------+---+--------+---+--------+---+--------+---+--------+---+--------+---+------- Woodward, Inc. | $ | 100.00 | $ | 113.68 | $ | 79.09 | $ | 106.63 | $ | 90.85 | $ | 113.55 | $ | 137.61 | $ | 161.65 | $ | 139.23 | $ | 215.53 | $ | 269.67 -------------------------+---+--------+---+--------+---+-------+---+--------+---+-------+---+--------+---+--------+---+--------+---+--------+---+--------+---+------- S&P Midcap 400 | | 100.00 | | 83.32 | | 80.73 | | 95.08 | | 93.87 | | 120.65 | | 154.05 | | 172.25 | | 174.66 | | 201.43 | | 236.71 -------------------------+---+--------+---+--------+---+-------+---+--------+---+-------+---+--------+---+--------+---+--------+---+--------+---+--------+---+------- S&P Industrial Machinery | | 100.00 | | 73.80 | | 72.70 | | 93.04 | | 81.70 | | 119.24 | | 163.79 | | 180.20 | | 171.65 | | 229.78 | | 288.27 -------------------------+---+--------+---+--------+---+-------+---+--------+---+-------+---+--------+---+--------+---+--------+---+--------+---+--------+---+------- S&P Industrials | | 100.00 | | 75.32 | | 65.76 | | 78.54 | | 74.93 | | 97.11 | | 124.79 | | 145.73 | | 140.41 | | 168.13 | | 205.71 -------------------------+---+--------+---+--------+---+-------+---+--------+---+-------+---+--------+---+--------+---+--------+---+--------+---+--------+---+------- The stock price performance included in this graph is not necessarily indicative of future stock price performance. 25 Sales of Unregistered Securities None.     | | | | | | | | ---------------------------------------------------------------------------------------------+----------------------------------+---------------------------------------+-------+--------------------------------------------------------------------------------------+---------+--------------------------------------------------------------------------------------------------------------------------------+---+--------  | | | | | | | | ---------------------------------------------------------------------------------------------+----------------------------------+---------------------------------------+-------+--------------------------------------------------------------------------------------+---------+--------------------------------------------------------------------------------------------------------------------------------+---+-------- Issuer Purchases of Equity Securities(In thousands, except for shares and per share amounts) | Total Number of Shares Purchased | Weighted Average Price Paid Per Share | | Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs (1) | | Maximum Number (or Approximate Dollar Value) of Shares that may yet be Purchased under the Plans or Programs at Period End (1) ---------------------------------------------------------------------------------------------+----------------------------------+---------------------------------------+-------+--------------------------------------------------------------------------------------+---------+------------------------------------------------------------------------------------------------------------------------------- July 1, 2017 through July 31, 2017 (2) | 285 | $ | 69.94 | | - | | $ | 438,771 ---------------------------------------------------------------------------------------------+----------------------------------+---------------------------------------+-------+--------------------------------------------------------------------------------------+---------+--------------------------------------------------------------------------------------------------------------------------------+---+-------- August 1, 2017 through August 31, 2017 | - | | - | | - | | | 438,771 ---------------------------------------------------------------------------------------------+----------------------------------+---------------------------------------+-------+--------------------------------------------------------------------------------------+---------+--------------------------------------------------------------------------------------------------------------------------------+---+-------- September 1, 2017 through September 30, 2017 (2) | 141,902 | | 70.41 | | 141,604 | | | 428,803 ---------------------------------------------------------------------------------------------+----------------------------------+---------------------------------------+-------+--------------------------------------------------------------------------------------+---------+--------------------------------------------------------------------------------------------------------------------------------+---+--------  (1) | In November 2016, our Board of Directors terminated the Company’s prior stock repurchase program and replaced it with a new program for the purchase of up to $500,000 of Woodward’s outstanding shares of common stock on the open market or in privately negotiated transactions over a three-year period that will end in 2019. ----+-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------  (2) | Under a trust established for the purposes of administering the Woodward Executive Benefit Plan, 285 shares of common stock were acquired in July 2017 on the open market related to the deferral of compensation by certain eligible members of Woodward’s management who irrevocably elected to invest some or all of their deferred compensation in Woodward common stock. In addition, 298 shares of common stock were acquired in September 2017 on the open market related to the reinvestment of dividends for shares of treasury stock held for deferred compensation. Shares owned by the trust, which is a separate legal entity, are included in "Treasury stock held for deferred compensation" in the Consolidated Balance Sheets. ----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Item 6. Selected Financial Data The following selected financial data should be read in conjunction with the Consolidated Financial Statements and related notes which appear in “Item 8 – Financial Statements and Supplementary Data” of this Form 10-K.   | | | | | | | | | | | | -------------------------------------+-----------------------------------------+-----------+------+---+-----------+------+-----------+------+---+-----------+---+----------  | | | | | | | | | | | | -------------------------------------+-----------------------------------------+-----------+------+---+-----------+------+-----------+------+---+-----------+---+----------  | Year Ended September 30, -------------------------------------+----------------------------------------  | 2017 | | 2016 | | 2015 | 2014 | | 2013 -------------------------------------+-----------------------------------------+-----------+------+---+-----------+------+-----------+-----  | (In thousands except per share amounts) -------------------------------------+---------------------------------------- Net sales (1) | $ | 2,098,685 | | $ | 2,023,078 | $ | 2,038,303 | | $ | 2,001,240 | $ | 1,935,976 -------------------------------------+-----------------------------------------+-----------+------+---+-----------+------+-----------+------+---+-----------+---+---------- Net earnings (1)(2)(3)(4) | | 200,507 | | | 180,838 | | 181,452 | | | 165,844 | | 145,942 -------------------------------------+-----------------------------------------+-----------+------+---+-----------+------+-----------+------+---+-----------+---+---------- Earnings per share: | | | | | | | | | | | | -------------------------------------+-----------------------------------------+-----------+------+---+-----------+------+-----------+------+---+-----------+---+---------- Basic earnings per share | | 3.27 | | | 2.92 | | 2.81 | | | 2.50 | | 2.13 -------------------------------------+-----------------------------------------+-----------+------+---+-----------+------+-----------+------+---+-----------+---+---------- Diluted earnings per share | | 3.16 | | | 2.85 | | 2.75 | | | 2.45 | | 2.10 -------------------------------------+-----------------------------------------+-----------+------+---+-----------+------+-----------+------+---+-----------+---+---------- Cash dividends per share | | 0.485 | | | 0.430 | | 0.380 | | | 0.320 | | 0.320 -------------------------------------+-----------------------------------------+-----------+------+---+-----------+------+-----------+------+---+-----------+---+---------- Income taxes (4) | | 52,240 | | | 45,648 | | 59,497 | | | 61,400 | | 53,629 -------------------------------------+-----------------------------------------+-----------+------+---+-----------+------+-----------+------+---+-----------+---+---------- Interest expense | | 27,430 | | | 26,776 | | 24,864 | | | 22,804 | | 26,703 -------------------------------------+-----------------------------------------+-----------+------+---+-----------+------+-----------+------+---+-----------+---+---------- Interest income | | 1,725 | | | 2,025 | | 787 | | | 271 | | 273 -------------------------------------+-----------------------------------------+-----------+------+---+-----------+------+-----------+------+---+-----------+---+---------- Depreciation expense | | 55,140 | | | 41,550 | | 45,994 | | | 43,773 | | 37,254 -------------------------------------+-----------------------------------------+-----------+------+---+-----------+------+-----------+------+---+-----------+---+---------- Amortization expense | | 25,777 | | | 27,486 | | 29,241 | | | 33,580 | | 36,979 -------------------------------------+-----------------------------------------+-----------+------+---+-----------+------+-----------+------+---+-----------+---+---------- Capital expenditures | | 92,336 | | | 175,692 | | 286,612 | | | 207,106 | | 141,600 -------------------------------------+-----------------------------------------+-----------+------+---+-----------+------+-----------+------+---+-----------+---+---------- Weighted-average shares outstanding: | | | | | | | | | | | | -------------------------------------+-----------------------------------------+-----------+------+---+-----------+------+-----------+------+---+-----------+---+---------- Basic shares outstanding | | 61,366 | | | 61,893 | | 64,684 | | | 66,432 | | 68,392 -------------------------------------+-----------------------------------------+-----------+------+---+-----------+------+-----------+------+---+-----------+---+---------- Diluted shares outstanding | | 63,512 | | | 63,556 | | 66,056 | | | 67,776 | | 69,602 -------------------------------------+-----------------------------------------+-----------+------+---+-----------+------+-----------+------+---+-----------+---+----------   26     | | | | | | | | | | | | -------------------------------------+------------------------+-----------+------+---+-----------+------+-----------+------+---+-----------+---+----------  | | | | | | | | | | | | -------------------------------------+------------------------+-----------+------+---+-----------+------+-----------+------+---+-----------+---+----------  | At September 30, -------------------------------------+-----------------------  | 2017 | | 2016 | | 2015 | 2014 | | 2013 -------------------------------------+------------------------+-----------+------+---+-----------+------+-----------+-----  | (Dollars in thousands) -------------------------------------+----------------------- Working capital | $ | 593,955 | | $ | 463,811 | $ | 579,211 | | $ | 627,981 | $ | 498,757 -------------------------------------+------------------------+-----------+------+---+-----------+------+-----------+------+---+-----------+---+---------- Total assets | | 2,757,109 | | | 2,642,362 | | 2,512,404 | | | 2,358,603 | | 2,171,539 -------------------------------------+------------------------+-----------+------+---+-----------+------+-----------+------+---+-----------+---+---------- Long-term debt, less current portion | | 580,286 | | | 577,153 | | 848,488 | | | 708,110 | | 449,152 -------------------------------------+------------------------+-----------+------+---+-----------+------+-----------+------+---+-----------+---+---------- Total debt | | 612,886 | | | 727,153 | | 850,918 | | | 708,110 | | 549,152 -------------------------------------+------------------------+-----------+------+---+-----------+------+-----------+------+---+-----------+---+---------- Total liabilities (5) | | 1,385,726 | | | 1,429,767 | | 1,359,300 | | | 1,197,659 | | 1,028,994 -------------------------------------+------------------------+-----------+------+---+-----------+------+-----------+------+---+-----------+---+---------- Stockholders’ equity | | 1,371,383 | | | 1,212,595 | | 1,153,104 | | | 1,160,944 | | 1,142,545 -------------------------------------+------------------------+-----------+------+---+-----------+------+-----------+------+---+-----------+---+---------- Full-time worker members | | 6,829 | | | 6,852 | | 6,955 | | | 6,701 | | 6,736 -------------------------------------+------------------------+-----------+------+---+-----------+------+-----------+------+---+-----------+---+----------  Notes: 1. | On December 28, 2012, Woodward acquired from GE Aviation Systems LLC (the “Seller”) substantially all of the assets and certain liabilities of the Seller's thrust reverser actuation systems business located in Duarte, California (the “Duarte Business”). As the Duarte Business was acquired at the end of the first quarter of fiscal year 2013, net sales for fiscal year 2014 were higher than fiscal year 2013, as fiscal year 2014 included $31,432 of sales from the Duarte Business during the period October 2013 through December 2013. ---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 2. | In the first quarter of fiscal year 2016, Woodward recorded special charges totaling approximately $16,100 related to its efforts to consolidate facilities, reduce costs and address current market conditions. ---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3. | In the third quarter of fiscal year 2013, Woodward recorded a specific charge of $15,707 related to the alignment of its renewable power business to the economic environment and then foreseeable future. ---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4. | In fiscal year 2016, Woodward recognized a tax benefit of $6,500, or $0.10 per basic and diluted share, related to the retroactive impact of the permanent reinstatement of the U.S. research and experimentation credit (“R&E Credit”) pertaining to fiscal year 2015. In fiscal year 2015, Woodward recognized a tax benefit of $5,818, or $0.09 per basic and diluted share, related to the retroactive impact of the reinstatement of the R&E Credit pertaining to fiscal year 2014. In fiscal year 2013, Woodward recognized a tax benefit of $4,911, or $0.07 per basic and diluted share, related to the retroactive impact of the reinstatement of the R&E Credit pertaining to fiscal year 2012. ---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 5. | On January 4, 2016, Woodward and General Electric Company (“GE”), acting through its GE Aviation business unit, consummated the formation of a strategic joint venture between Woodward and GE (the “JV”). Woodward determined that the JV formation was not the culmination of an earnings event because Woodward has significant performance obligations to support the future operations of the JV. Therefore, Woodward recorded the $250,000 consideration received from GE for its purchase of a 50% equity interest in the JV as deferred income. The $250,000 deferred income will be recognized as an increase to net sales in proportion to revenue realized on sales of applicable fuel systems within the scope of the JV in a particular period as a percentage of total revenue expected to be realized by Woodward over the estimated remaining lives of the underlying commercial aircraft engine programs assigned to the JV. Total liabilities include $243,347 as of September 30, 2017, and $244,739 as of September 30, 2016 of unamortized deferred income realized related to the JV formation. ---+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 27  Item 7.Management's Discussion and Analysis of Financial Condition and Results of Operations OVERVIEW Woodward enhances the global quality of life and sustainability by optimizing energy use through improved efficiency and lower emissions. We are an independent designer, manufacturer, and service provider of energy control and optimization solutions. We design, produce and service reliable, efficient, low-emission, and high-performance energy control products for diverse applications in challenging environments. We have production and assembly facilities in the United States, Europe and Asia, and promote our products and services through our worldwide locations. Our strategic focus is providing energy control and optimization solutions for the aerospace and industrial markets. The precise and efficient control of energy, including motion, fluid, combustion and electrical energy, is a growing requirement in the markets we serve. Our customers look to us to optimize the efficiency, emissions and operation of power equipment in both commercial and defense operations. Our core technologies leverage well across our markets and customer applications, enabling us to develop and integrate cost-effective and state-of-the-art fuel, combustion, fluid, actuation and electronic systems. We focus primarily on serving OEMs and equipment packagers, partnering with them to bring superior component and system solutions to their demanding applications. We also provide aftermarket repair, maintenance, replacement and other service support for our installed products. Our components and integrated systems optimize performance of commercial aircraft, defense aircraft, military ground vehicles and other equipment, gas and steam turbines, wind turbines, including converters and power grid related equipment, industrial diesel, gas, bio-diesel and dual fuel reciprocating engines, and electrical power systems. Our innovative motion, fluid, combustion and electrical energy control systems help our customers offer more cost-effective, cleaner, and more reliable equipment. Management’s discussion and analysis should be read together with the Consolidated Financial Statements and Notes included in this report. Dollar and number of share amounts contained in this discussion and elsewhere in this Annual Report on Form 10-K are in thousands, except per share amounts.  BUSINESS ENVIRONMENT AND TRENDS We serve the aerospace and industrial markets. Aerospace Markets Our aerospace products and systems are primarily used to provide propulsion, actuation and motion control in both commercial and defense fixed-wing aircraft, rotorcraft, guided weapons, and other defense systems. Commercial and Civil Aircraft – In the commercial aerospace markets, global air traffic continued to grow in fiscal year 2017. Commercial aircraft production has increased as aircraft operators continue to take delivery of new aircraft models that are more fuel efficient aircraft and retire older aircraft. This trend toward more fuel efficient aircraft favors our product offerings because we have more content on the newer generation of aircraft that have recently entered service or are scheduled to go into production over the next several years. We expect production levels to remain strong due to solid order backlogs for the new aircraft models. Business and General Aviation market demand – including business jets, turboprops and helicopters – was down in 2017 as a result of depressed global demand, which we expect to continue into fiscal year 2018, due to economic conditions and low oil and gas prices. We have been awarded content on the Airbus A320neo and A330neo, Bell 429, Boeing 737 MAX, 787, 747-8 and 777X, Bombardier CSeries, Comac C919, Irkut MS-21 and a variety of business jet platforms, among others. We continue to explore opportunities on new engine and aircraft programs that are under consideration or have been recently announced. Defense – The defense industry continues under the minimal-growth regime of the Budget Control Act of 2011 and related procurement reductions and delays. Our involvement with a wide variety of defense programs in fixed-wing aircraft, rotorcraft and weapons systems has provided relative stability for our defense market sales, as some newer programs increase (e.g. F-35 Lightning II and KC-46A Tanker) while some legacy programs are reduced (e.g. F/A-18 E/F Super Hornet and V-22 Osprey). Others are relatively steady (e.g. UH-60 Black Hawk and A-64 Apache helicopter programs). We have significant motion control system content for the refueling boom on the KC-46A, which enters low rate production in late calendar year 2017. Weapons programs for which we have significant sales include the Joint Direct Attack Munition (“JDAM”), Small Diameter Bomb (“SDB”) and AIM-9X guided tactical weapon systems. We expect modest production rate increases, relative to recent years, for these weapons programs in fiscal year 2018. Aftermarket – Our commercial aftermarket business has increased, as our products have been selected for new aerospace platforms and our content has increased across existing platforms. With the entry into service of the new single aisle aircraft (Boeing 737 MAX and Airbus A320neo), we have seen a significant increase in initial provisioning sales to the operators of these new aircraft. In addition, we have experienced gains in commercial aftermarket related to repairs and spare parts for programs such as Airbus A320 and Boeing 777. 28 U.S. government sustainment funds continue to be prioritized to defense aircraft platforms on which we have content. Defense aftermarket was down slightly in fiscal year 2017, and we expect it to be variable in future periods, as it has been in the past. Variability is generally attributable to the cycling of various upgrade programs, as well as actual usage. Industrial Markets Our industrial products are used worldwide in various types of turbine- and reciprocating engine-powered equipment, including wind turbines and electric power generation and distribution systems, ships, locomotives, compressors, pumps, and other mobile and industrial machines. Industrial Turbines – The demand for turbines for power generation, which consists mainly of heavy frames, aero derivatives and steam, was down in fiscal year 2017 compared to fiscal year 2016 as a result of excess inventory in the channel, increased efficiency, and the impact of renewables. Demand also softened for turbine aftermarket products and services driven by the low price of oil and energy. Start reliability, fuel flexibility, and part-load efficiency are all key drivers of the turbine market as the conversion from coal to natural gas usage continues, and we believe Woodward is well positioned to meet these market needs on the existing and next generation turbines. Though the increasing global demand for energy supports long-term growth for turbines, we expect market softness to continue into fiscal year 2018 due to weak near-term demand for electricity resulting from the continuing impact of renewables and greater efficiency in energy demand. Reciprocating Engines – Woodward’s key markets for engine control technologies are power generation, transportation (including natural gas fueled trucks and buses in Asia, mining, and shipping), and oil and gas. We saw significant increases in sales of fuel systems for natural gas fueled trucks and buses in China, where an improving economy and the government’s focus on compliance with improved emissions standards drove strong demand. We expect this demand in China and other parts of Asia to continue through fiscal year 2018. In addition, we saw increased sales of large engines used in oil and gas and distributed power generation applications in 2017 related to increasing rig counts and capital investments. We anticipate these trends to continue into fiscal year 2018. We expect customer share gains and increased scope on the latest generation reciprocating engines, as well as continued demand for aftermarket products and services, to have a favorable impact on Woodward in fiscal year 2018. Government emissions requirements across many regions and new engine applications are driving demand for more sophisticated control systems, as is customer demand for improved engine efficiencies and increased reliability. Energy policies in some countries encourage the use of natural gas and other alternative fuels over carbon-rich petroleum fuels, which we expect will drive increased demand for our alternative fuel clean engine control technologies. Renewable Power – The renewable power industry continued to grow in fiscal year 2017 and is expected to grow at a more moderate pace through the next decade. Uncertainty regarding government renewable mandates is subsiding, thereby reducing market volatility in the renewable power industry. Currently, capital investment and operating costs for onshore wind continue to substantially decline, driving the levelized cost of energy (“LCOE”) toward parity with most fossil fuel energy sources. In the medium to longer term, we anticipate this trend to continue in the onshore market and is now emerging in the offshore wind market. The trend for larger turbines (greater than 3 megawatts onshore and 6 megawatts offshore) will continue to transform OEM product portfolios, further reducing the LCOE. While the renewable power market remains robust, Woodward is being unfavorably impacted by regional dynamics as well as short-term platform transitions by a few of our customers. Looking forward, we anticipate that integration of renewable energy sources into the grid and increased global energy demand will drive new opportunities for our advanced control and protection solutions. RESULTS OF OPERATIONS Reclassification In our Statements of Earnings for the periods presented prior to fiscal year 2017 we have reclassified the amortization of intangible assets from a separate line to an allocated expense/cost component of cost of goods sold and selling, general and administrative expenses based on the nature of the intangible asset that is being amortized. Prior year amounts have been recast to reflect this reclassification. Additional information about the reclassification is included in Note 1, Operations and summary of significant accounting policies, to the Consolidated Financial Statements in “Item 8 – Financial Statements and Supplementary Data.” Operational Highlights Net sales for fiscal year 2017 were $2,098,685, an increase of $75,607, or 3.7%, from $2,023,078 for the prior fiscal year. Aerospace segment sales for fiscal year 2017 were up 8.9% to $1,342,339, compared to $1,233,176 for the prior fiscal year. Industrial segment sales for fiscal year 2017 were down 4.2% to $756,346, compared to $789,902 for the prior fiscal year. Net earnings for fiscal year 2017 were $200,507, or $3.16 per diluted share, compared to $180,838, or $2.85 per diluted share, for fiscal year 2016. Net earnings for fiscal year 2016 included approximately $16,100 of pre-tax special charges related to our efforts to consolidate facilities, reduce costs and address current market conditions, which was equal to approximately $9,900 net of tax. The effective tax rate in fiscal year 2017 was 20.7%, compared to 20.2% for the prior fiscal year. 29 Earnings before interest and taxes (“EBIT”), which is a Non-U.S. GAAP financial measure, for fiscal year 2017 were $278,452, up 10.8% from $251,237 in fiscal year 2016. Earnings before interest, taxes, depreciation and amortization (“EBITDA”), which is also a non-U.S. GAAP financial measure, for fiscal year 2017 were $359,369, up 12.2% from $320,273 for fiscal year 2016. EBIT and EBITDA for fiscal year 2016 included the special charges of approximately $16,100 discussed above. (A reconciliation of these non-U.S. GAAP financial measures to the closest U.S. GAAP financial measure can be found under the caption “Non-U.S. GAAP Measures” in this Item 7 – Management’s Discussion and Analysis of Financial Conditions and Results of Operations.) Aerospace segment earnings as a percent of segment net sales increased to 19.2% in fiscal year 2017 from 18.8% in the prior fiscal year. Industrial segment earnings as a percent of segment net sales was 10.4% in both fiscal years 2017 and 2016. Liquidity Highlights Net cash provided by operating activities for fiscal year 2017 was $307,537, compared to $435,379 for fiscal year 2016. Net cash provided by operating activities for fiscal year 2016 included $155,000 of after-tax proceeds related to the formation of a strategic joint venture (the “JV”) between Woodward and General Electric Company (the “JV Proceeds”). (For further discussion of the JV, see Note 4, Joint venture in the Notes to the Consolidated Financial Statements in “Item 8 – Financial Statements and Supplementary Data.”) The year-over-year increase in net cash provided by operating activities (after excluding the JV Proceeds for fiscal year 2016) is primarily attributable to an earnings increase of $19,669 in fiscal 2017 compared to the prior fiscal year. Changes in working capital also provided a net source of cash of $651 in fiscal year 2017 as compared to a net use of cash of $9,387 in prior fiscal year, with an increase in cash provided of $47,198 due mainly to accounts payable increasing in the current fiscal year compared to fiscal year 2016 related primarily to the timing of payments for various accounts payable for the current fiscal year that occurred after the fiscal year end, which was mostly offset by an increase in usage of cash of $43,961 due to accounts receivable increasing more in fiscal year 2017 compared to the increase in the prior fiscal year. For fiscal year 2017, adjusted free cash flow, which we define as net cash flows provided by operating activities less payments for property, plant and equipment and less the net after-tax JV Proceeds and is a non-U.S. GAAP financial measure, was $215,201, compared to $104,687 for fiscal year 2016. The increase is primarily attributable to lower payments for property, plant and equipment and the higher net earnings in fiscal year 2017 as compared to fiscal year 2016. Changes in working capital also provided a net source of cash in fiscal year 2017 as compared to the prior fiscal year due to the increase in cash provided by accounts payable as described above, partially offset by the increase in cash used in accounts receivable in fiscal year 2017 as compared to fiscal year 2016. (A reconciliation of this non-U.S. GAAP financial measures to the closest U.S. GAAP financial measure can be found under the caption “Non-U.S. GAAP Measures” in this Item 7 – Management’s Discussion and Analysis of Financial Conditions and Results of Operations.) At September 30, 2017, we held $87,552 in cash and cash equivalents, and had total outstanding debt of $612,886 with additional borrowing availability of $956,779, net of outstanding letters of credit, under our revolving credit agreement. At September 30, 2017, we had additional borrowing capacity of $7,530 under various foreign lines of credit and foreign overdraft facilities.  Consolidated Statements of Earnings and Other Selected Financial Data The following table sets forth selected consolidated statements of earnings data as a percentage of net sales for each period indicated:   | | | | | | | | | | | | | ----------------------------------------------+---+--------------------------+----------------+------+---+-----------+----------------+-------+---+---+----------------+-------+--  | | | | | | | | | | | | | ----------------------------------------------+---+--------------------------+----------------+------+---+-----------+----------------+-------+---+---+----------------+-------+--  | | Year Ended September 30, ----------------------------------------------+---+-------------------------  | | 2017 | | 2016 | | 2015 ----------------------------------------------+---+--------------------------+----------------+------+---+----------  | | | % of Net Sales | | | | % of Net Sales | | | | % of Net Sales ----------------------------------------------+---+--------------------------+----------------+------+---+-----------+----------------+-------+---+---+--------------- Net sales | $ | 2,098,685 | 100 | % | $ | 2,023,078 | | 100 | % | $ | 2,038,303 | 100 | % ----------------------------------------------+---+--------------------------+----------------+------+---+-----------+----------------+-------+---+---+----------------+-------+-- Costs and expenses: | | | | | | | | | | | | | ----------------------------------------------+---+--------------------------+----------------+------+---+-----------+----------------+-------+---+---+----------------+-------+-- Cost of goods sold | | 1,526,126 | 72.7 | | | 1,483,960 | | 73.4 | | | 1,462,833 | 71.8 | ----------------------------------------------+---+--------------------------+----------------+------+---+-----------+----------------+-------+---+---+----------------+-------+-- Selling, general, and administrative expenses | | 176,633 | 8.4 | | | 174,017 | | 8.6 | | | 177,121 | 8.7 | ----------------------------------------------+---+--------------------------+----------------+------+---+-----------+----------------+-------+---+---+----------------+-------+-- Research and development costs | | 126,519 | 6.0 | | | 126,170 | | 6.2 | | | 134,485 | 6.6 | ----------------------------------------------+---+--------------------------+----------------+------+---+-----------+----------------+-------+---+---+----------------+-------+-- Interest expense | | 27,430 | 1.3 | | | 26,776 | | 1.3 | | | 24,864 | 1.2 | ----------------------------------------------+---+--------------------------+----------------+------+---+-----------+----------------+-------+---+---+----------------+-------+-- Interest income | | (1,725) | (0.1) | | | (2,025) | | (0.1) | | | (787) | (0.0) | ----------------------------------------------+---+--------------------------+----------------+------+---+-----------+----------------+-------+---+---+----------------+-------+-- Other (income) expense, net | | (9,045) | (0.4) | | | (12,306) | | (0.6) | | | (1,162) | (0.1) | ----------------------------------------------+---+--------------------------+----------------+------+---+-----------+----------------+-------+---+---+----------------+-------+-- Total costs and expenses | | 1,845,938 | 88.0 | | | 1,796,592 | | 88.8 | | | 1,797,354 | 88.2 | ----------------------------------------------+---+--------------------------+----------------+------+---+-----------+----------------+-------+---+---+----------------+-------+-- Earnings before income taxes | | 252,747 | 12.0 | | | 226,486 | | 11.2 | | | 240,949 | 11.8 | ----------------------------------------------+---+--------------------------+----------------+------+---+-----------+----------------+-------+---+---+----------------+-------+-- Income tax expense | | 52,240 | 2.5 | | | 45,648 | | 2.3 | | | 59,497 | 2.9 | ----------------------------------------------+---+--------------------------+----------------+------+---+-----------+----------------+-------+---+---+----------------+-------+-- Net earnings | $ | 200,507 | 9.6 | | $ | 180,838 | | 8.9 | | $ | 181,452 | 8.9 | ----------------------------------------------+---+--------------------------+----------------+------+---+-----------+----------------+-------+---+---+----------------+-------+-- 30 Other select financial data:     | | | | | ------------------------------------------------------------+---------------+-----------+---------------+---+----------  | | | | | ------------------------------------------------------------+---------------+-----------+---------------+---+----------  | September 30, | | September 30, ------------------------------------------------------------+---------------+-----------+--------------  | 2017 | | 2016 ------------------------------------------------------------+---------------+-----------+-------------- Working capital | $ | 593,955 | | $ | 463,811 ------------------------------------------------------------+---------------+-----------+---------------+---+---------- Short-term borrowings and current portion of long-term debt | | 32,600 | | | 150,000 ------------------------------------------------------------+---------------+-----------+---------------+---+---------- Total debt | | 612,886 | | | 727,153 ------------------------------------------------------------+---------------+-----------+---------------+---+---------- Total stockholders' equity | | 1,371,383 | | | 1,212,595 ------------------------------------------------------------+---------------+-----------+---------------+---+----------       2017 RESULTS OF OPERATIONS 2017 Sales Compared to 2016 Consolidated net sales for fiscal year 2017 increased 3.7% to $2,098,685 from $2,023,078 in fiscal year 2016. Details of the changes in consolidated net sales are as follows:    | | ---------------------------------------------------------------+---+----------  | | ---------------------------------------------------------------+---+---------- Consolidated net sales for the period ended September 30, 2016 | $ | 2,023,078 ---------------------------------------------------------------+---+---------- Aerospace volume | | 98,340 ---------------------------------------------------------------+---+---------- Industrial volume | | (25,399) ---------------------------------------------------------------+---+---------- Effects of changes in price and sales mix | | 7,680 ---------------------------------------------------------------+---+---------- Effects of changes in foreign currency rates | | (5,014) ---------------------------------------------------------------+---+---------- Consolidated net sales for the period ended September 30, 2017 | $ | 2,098,685 ---------------------------------------------------------------+---+---------- The increase in net sales for fiscal year 2017 was primarily attributable to increased defense OEM sales and increased commercial aftermarket and OEM sales in the Aerospace segment and increased sales of fuel systems for Compressed Natural Gas (“CNG”) trucks in Asia in our Industrial segment, partially offset by decreased industrial gas turbine aftermarket and OEM sales and wind turbine converter sales in our Industrial segment. Our worldwide sales activities are primarily denominated in USD, EUR, GBP, Japanese Yen (“JPY”), and Chinese Renminbi (“RMB”). As the USD, EUR, GBP, JPY and RMB fluctuate against each other and other currencies, we are exposed to gains or losses on sales transactions. For additional information on foreign currency exchange rate risk, please refer to the risk factor titled “We derive a significant portion of our revenues from sales to countries outside the United States and purchase raw materials and components from suppliers outside of the U.S.; therefore, we are subject to the risks inherent in doing business in other countries” set forth under the caption “Risk Factors” in Part I, Item 1A of this Form 10-K and Item 7A, “Quantitative and Qualitative Disclosures about Market Risk.” 2017 Costs and Expenses Compared to 2016 Costs and expenses for fiscal year 2016 included special charges totaling approximately $16,100 ($13,300 included in cost of goods sold, $1,700 included in selling, general and administrative expenses, and $1,100 included in research and development costs) related to our efforts to consolidate facilities, reduce costs and address current market conditions in fiscal year 2016. There were no comparable costs and expenses recorded in fiscal year 2017. Cost of goods sold increased by $42,166 to $1,526,126, or 72.7% of net sales, for fiscal year 2017 from $1,483,960, or 73.4% of net sales, for fiscal year 2016. The increase in cost of goods sold for fiscal year 2017 as compared to fiscal year 2016 is primarily attributable to higher sales volume and planned facility ramp-up costs in our Aerospace segment in the current fiscal year. Fiscal year 2017 also included increased new facility expenses for our new Colorado facilities as compared to the prior fiscal year. The increase year-over-year was partially offset by the inclusion of special charges in fiscal year 2016 of approximately $13,300, as described above, for which no such similar charge was recorded in fiscal year 2017. Gross margin (as measured by net sales less cost of goods sold, divided by net sales) was 27.3% for fiscal year 2017, compared to 26.6% for fiscal year 2016. The increase in gross margin for fiscal year 2017 as compared to fiscal year 2016 was due to the inclusion in cost of goods sold of approximately $13,300 of special charges in fiscal year 2016 and fixed cost leverage on higher sales volume in our Aerospace segment in fiscal year 2017, partially offset by unfavorable mix and increases in facility ramp-up costs in fiscal year 2017 in both our Aerospace and Industrial segments. Selling, general, and administrative expenses increased by $2,616, or 1.5%, to $176,633 for fiscal year 2017, as compared to $174,017 for fiscal year 2016. Selling, general, and administrative expenses as a percentage of net sales was 8.4% for fiscal year 2017, as compared to 8.6% for fiscal year 2016. The increase in selling, general and administrative expenses for fiscal year 2017 was primarily due to normal variability in costs, partially offset by savings associated with cost reduction initiatives previously implemented. In addition, fiscal year 2016 included special charges of approximately $1,700, described above, recorded in the first quarter of fiscal year 2016. 31 Research and development costs increased by $349, or 0.3%, to $126,519 for fiscal year 2017, as compared to $126,170 for fiscal year 2016. Research and development costs decreased as a percentage of net sales to 6.0% for fiscal year 2017, as compared to 6.2% for fiscal year 2016. Research and development costs in fiscal year 2017 were slightly higher due primarily to normal variability. The first quarter of fiscal year 2016 included special charges of approximately $1,100 described above. Our research and development activities extend across almost all of our customer base, and we anticipate ongoing variability in research and development due to the timing of customer business needs on current and future programs. Interest expense increased to $27,430, or 1.3% of net sales for fiscal year 2017, compared to $26,776, or 1.3% of net sales, for fiscal year 2016. The slight increase in interest expense is primarily attributable to lower amounts of capitalized interest as compared to fiscal year 2016, as capital projects have been completed, partially offset by a decrease in higher interest debt due to the retirement of $57,000 of 7.81% Series E notes in fiscal year 2016. Income taxes were provided at an effective rate on earnings before income taxes of 20.7% for fiscal year 2017, compared to 20.2% for fiscal year 2016. The changes in components of our effective tax rate (as a percentage of earnings before income taxes) were attributable to the following:   | | ------------------------------------------------------------+-------+--  | | ------------------------------------------------------------+-------+-- Effective tax rate at September 30, 2016 | 20.2 | % ------------------------------------------------------------+-------+-- Research and experimentation credit | 3.6 | ------------------------------------------------------------+-------+-- State and local taxes | (0.7) | ------------------------------------------------------------+-------+-- Adjustment of prior period tax items | (0.7) | ------------------------------------------------------------+-------+-- Taxes on international activities | (5.4) | ------------------------------------------------------------+-------+-- Net excess income tax benefit from stock-based compensation | 1.2 | ------------------------------------------------------------+-------+-- Domestic production activity deduction | 0.6 | ------------------------------------------------------------+-------+-- Other | 1.9 | ------------------------------------------------------------+-------+-- Effective tax rate at September 30, 2017 | 20.7 | % ------------------------------------------------------------+-------+-- The increase in the year-over-year effective tax rate for fiscal year 2017 is primarily attributable to the retroactive benefit of the U.S. research and experimentation credit pursuant to the December 18, 2015 enactment of the Protecting Americans from Tax Hikes Act of 2015, which was included in the effective tax rate for the first quarter of fiscal year 2016, but did not repeat in fiscal year 2017, and a smaller favorable rate adjustment for the net excess income tax benefit from stock-based compensation in the current fiscal year compared to the prior fiscal year. This increase was partially offset by the impact of the repatriation to the United States of certain net foreign profits and losses in the first quarter of fiscal year 2017. The U.S. foreign tax credits available as a result of the repatriation of the foreign net earnings were greater than the U.S. taxes payable on these net foreign earnings. The excess U.S. foreign tax credits are expected to be used to offset U.S. taxes on other foreign source income. In addition this increase was also partially offset by larger favorable resolutions of tax matters in the current fiscal year compared to the prior fiscal year. The total amount of the gross liability for worldwide unrecognized tax benefits reported in other liabilities in the Consolidated Balance Sheets was $20,132 at September 30, 2017 and $23,526 at September 30, 2016. At September 30, 2017, the amount of the liability for unrecognized tax benefits that would impact Woodward’s effective tax rate, if recognized, was $9,677. At this time, we estimate it is reasonably possible that the liability for unrecognized tax benefits will decrease by as much as $7,726 in the next twelve months due to a number of factors including the completion of reviews by tax authorities and the expiration of certain statutes of limitations. We accrue for potential interest and penalties related to unrecognized tax benefits in tax expense. Woodward had accrued interest and penalties of $1,123 as of September 30, 2017 and $1,273 as of September 30, 2016. Woodward’s tax returns are subject to audits by U.S. federal, state, and foreign tax authorities, and these audits are at various stages of completion at any given time. Reviews of tax matters by authorities and lapses of the applicable statutes of limitation may result in changes to tax expense. Fiscal years remaining open to examination in significant foreign jurisdictions include 2008 and thereafter, and for the United States include fiscal years 2014 and thereafter. Woodward is currently under examination by the Internal Revenue Service for the fiscal year ended September 30, 2014. Woodward has concluded U.S. federal income tax examinations through fiscal year 2012. Woodward is generally subject to U.S. state income tax examinations for fiscal years 2012 and the periods thereafter. 32 SEGMENT RESULTS Woodward serves the aerospace and industrial markets through its two reportable segments – Aerospace and Industrial. When appropriate, our reportable segments are aggregations of our operating segments. See Note 20, Segment information, in the Notes to the Consolidated Financial Statements in “Item 8 – Financial Statements and Supplementary Data” for further information regarding our segments. The following table presents sales by segment:   | | | | | | | | | | | | | -----------------------+--------------------------+-----------+------+-------+------+---+-----------+-------+---+---+-----------+-------+--  | | | | | | | | | | | | | -----------------------+--------------------------+-----------+------+-------+------+---+-----------+-------+---+---+-----------+-------+--  | Year Ended September 30, -----------------------+-------------------------  | 2017 | | 2016 | | 2015 -----------------------+--------------------------+-----------+------+-------+----- Net sales: | | | | | | | | | | | -----------------------+--------------------------+-----------+------+-------+------+---+-----------+-------+---+---+---------- Aerospace | $ | 1,342,339 | | 64.0 | % | $ | 1,233,176 | 61.0 | % | $ | 1,160,883 | 57.0 | % -----------------------+--------------------------+-----------+------+-------+------+---+-----------+-------+---+---+-----------+-------+-- Industrial | | 756,346 | | 36.0 | | | 789,902 | 39.0 | | | 877,420 | 43.0 | -----------------------+--------------------------+-----------+------+-------+------+---+-----------+-------+---+---+-----------+-------+-- Consolidated net sales | $ | 2,098,685 | | 100.0 | % | $ | 2,023,078 | 100.0 | % | $ | 2,038,303 | 100.0 | % -----------------------+--------------------------+-----------+------+-------+------+---+-----------+-------+---+---+-----------+-------+-- The following table presents earnings by segment:    | | | | | | | ------------------------------------------+--------------------------+----------+------+---+----------+---+---------  | | | | | | | ------------------------------------------+--------------------------+----------+------+---+----------+---+---------  | Year Ended September 30, ------------------------------------------+-------------------------  | 2017 | | 2016 | | 2015 ------------------------------------------+--------------------------+----------+------+---+--------- Aerospace | $ | 257,813 | | $ | 232,166 | $ | 187,747 ------------------------------------------+--------------------------+----------+------+---+----------+---+--------- Industrial | | 78,991 | | | 82,237 | | 126,641 ------------------------------------------+--------------------------+----------+------+---+----------+---+--------- Nonsegment expenses | | (58,352) | | | (63,166) | | (49,362) ------------------------------------------+--------------------------+----------+------+---+----------+---+--------- Interest expense, net | | (25,705) | | | (24,751) | | (24,077) ------------------------------------------+--------------------------+----------+------+---+----------+---+--------- Consolidated earnings before income taxes | | 252,747 | | | 226,486 | | 240,949 ------------------------------------------+--------------------------+----------+------+---+----------+---+--------- Income tax expense | | 52,240 | | | 45,648 | | 59,497 ------------------------------------------+--------------------------+----------+------+---+----------+---+--------- Consolidated net earnings | $ | 200,507 | | $ | 180,838 | $ | 181,452 ------------------------------------------+--------------------------+----------+------+---+----------+---+---------  The following table presents earnings by segment as a percent of segment net sales:   | | | | | | | -----------+--------------------------+---+------+------+------+------+--  | | | | | | | -----------+--------------------------+---+------+------+------+------+--  | Year Ended September 30, -----------+-------------------------  | 2017 | | 2016 | | 2015 -----------+--------------------------+---+------+------+----- Aerospace | 19.2 | % | | 18.8 | % | 16.2 | % -----------+--------------------------+---+------+------+------+------+-- Industrial | 10.4 | | | 10.4 | | 14.4 | -----------+--------------------------+---+------+------+------+------+--  2017 Segment Results Compared to 2016 Aerospace Aerospace segment net sales were $1,342,339 for fiscal year 2017, up 8.9% compared to $1,233,176 for fiscal year 2016. The increase in segment net sales for fiscal year 2017 as compared to fiscal year 2016 was driven primarily by increased defense OEM sales and increased commercial aftermarket and OEM sales in fiscal year 2017. Defense aftermarket sales were slightly down in fiscal year 2017 as compared to fiscal year 2016. U.S. government funds continue to be prioritized for defense platforms on which we have content. Defense OEM sales continued to increase in fiscal year 2017, driven by sales of smart weapons, as demand has remained strong. Defense aftermarket sales decreased slightly in fiscal year 2017 as compared to fiscal year 2016, reflecting variability in the timing of continued maintenance needs and upgrade programs. Commercial aftermarket sales increased significantly in fiscal year 2017 as compared to fiscal year 2016, benefitting from both the initial provisioning for new platforms and increased utilization of existing fleets. Commercial OEM sales were up for fiscal year 2017 as compared to fiscal year 2016 due to next generation aircraft programs driving strong commercial OEM sales, reflecting the increased production of certain next generation aircraft on which Woodward has increased content, partially offset by continuing weakness in business jets and rotorcraft. 33 Aerospace segment earnings increased by $25,647, or 11.0%, to $257,813 for fiscal year 2017, compared to $232,166 for fiscal year 2016. The increase in Aerospace segment earnings for fiscal year 2017 were due to the following:    | | -------------------------------------------------+---+--------- Earnings for the period ended September 30, 2016 | $ | 232,166 -------------------------------------------------+---+--------- Sales volume | | 50,555 -------------------------------------------------+---+--------- Price, sales mix and productivity | | (6,032) -------------------------------------------------+---+--------- New facility costs | | (11,462) -------------------------------------------------+---+--------- Joint venture earnings | | (3,635) -------------------------------------------------+---+--------- Other, net | | (3,779) -------------------------------------------------+---+--------- Earnings for the period ended September 30, 2017 | $ | 257,813 -------------------------------------------------+---+---------  Aerospace segment earnings as a percentage of segment net sales were 19.2% for fiscal year 2017, compared to 18.8% for fiscal year 2016. The increase in aerospace segment earnings was primarily attributable to higher sales volume, partially offset by new facility costs, unfavorable mix and lower JV earnings. Industrial Industrial segment net sales decreased by 4.2% to $756,346 for fiscal year 2017, compared to $789,902 for fiscal year 2016. Industrial gas turbine aftermarket and OEM sales and renewables sales declined in fiscal year 2017 as compared to fiscal year 2016. The decline in industrial gas turbine sales was the result of excess inventory in the channel, increased efficiency, and the impact of renewables. The decline in renewables sales was due to unfavorable regional dynamics in the wind turbine market, as well as short-term platform transitions by some of our customers. Sales of fuel systems for CNG trucks in Asia increased in fiscal year 2017 as compared to fiscal year 2016 as the Chinese government continues to encourage natural gas usage. In addition, reciprocating engine power generation applications were up in fiscal year 2017 as compared to fiscal year 2016. Industrial segment earnings decreased by $3,246, or 3.9%, to $78,991 for fiscal year 2017, compared to $82,237 for fiscal year 2016. The decrease in Industrial segment earnings for fiscal year 2017 was due to the following:   | | -------------------------------------------------+---+--------- Earnings for the period ended September 30, 2016 | $ | 82,237 -------------------------------------------------+---+--------- Sales volume | | (14,042) -------------------------------------------------+---+--------- Price, sales mix and productivity | | (3,506) -------------------------------------------------+---+--------- Savings from cost reduction initiatives | | 17,233 -------------------------------------------------+---+--------- New facility costs | | (4,692) -------------------------------------------------+---+--------- Effects of changes in foreign currency rates | | (870) -------------------------------------------------+---+--------- Other, net | | 2,631 -------------------------------------------------+---+--------- Earnings for the period ended September 30, 2017 | $ | 78,991 -------------------------------------------------+---+--------- Industrial segment earnings as a percentage of sales were 10.4% for both fiscal years 2017 and 2016. The decrease in segment earnings for fiscal year 2017 as compared to the same period of fiscal year 2016 was driven primarily by the impact of lower sales volume, unfavorable sales mix, and the increase in new facility costs, which were partially offset by the savings associated with cost reduction initiatives previously implemented. Nonsegment expenses Nonsegment expenses decreased to $58,352 for fiscal year 2017, compared to $63,166 for fiscal year 2016. As a percent of net sales, nonsegment expenses were 2.8% of net sales for fiscal year 2017, compared to 3.1% of net sales for fiscal year 2016. The decrease in nonsegment expenses in fiscal year 2017 as compared to fiscal year 2016 is due to special charges taken in the first quarter of fiscal year 2016 as described above, which did not recur in fiscal year 2017, partially offset by normal variability in costs. 34 2016 RESULTS OF OPERATIONS 2016 Sales Compared to 2015 Consolidated net sales in fiscal year 2016 decreased 0.7% to $2,023,078 from $2,038,303 in fiscal year 2015. Details of the changes in consolidated net sales are as follows:   | | ---------------------------------------------------------------+---+----------  | | ---------------------------------------------------------------+---+---------- Consolidated net sales for the period ended September 30, 2015 | $ | 2,038,303 ---------------------------------------------------------------+---+---------- Aerospace volume | | 58,399 ---------------------------------------------------------------+---+---------- Industrial volume | | (66,568) ---------------------------------------------------------------+---+---------- Effects of changes in price and sales mix | | 7,829 ---------------------------------------------------------------+---+---------- Effects of changes in foreign currency rates | | (14,885) ---------------------------------------------------------------+---+---------- Consolidated net sales for the period ended September 30, 2016 | $ | 2,023,078 ---------------------------------------------------------------+---+---------- The decrease in net sales for fiscal year 2016 was primarily attributable to continued weakness across nearly all our Industrial segment markets, partially offset by increased commercial aftermarket and defense sales in the Aerospace segment markets. Our net sales were negatively impacted by $14,885 in fiscal year 2016 by fluctuations in foreign currency exchange rates compared to fiscal year 2015. Nearly all of the foreign currency impact to our net sales was realized through our Industrial segment, primarily due to changes in the EUR. 2016 Costs and Expenses Compared to 2015 Costs and expenses for fiscal year 2016 include special charges, recorded in the first quarter, totaling approximately $16,100 ($13,300 included in cost of goods sold, $1,700 included in selling, general and administrative expenses, and $1,100 included in research and development costs) related to our efforts to consolidate facilities, reduce costs and address current market conditions. Cost savings realized during fiscal year 2016 related to these charges generally offset the expenses recorded in the first quarter of fiscal year 2016. Cost of goods sold increased by $21,127 to $1,483,960, or 73.4% of net sales, for fiscal year 2016 from $1,462,833, or 71.8% of net sales, for fiscal year 2015. The increase in cost of goods sold was primarily attributable to the inclusion in fiscal year 2016 of approximately $13,300 of special charges recorded in the first quarter, as described above. In addition, cost of goods sold increased due to increased sales in our Aerospace segment and planned new facility start-up expenses for our new Rockford-area and Colorado facilities, partially offset by the effects of lower sales volume in our Industrial segment. Gross margin (as measured by net sales less cost of goods sold, divided by net sales) was 26.6% for fiscal year 2016, compared to 28.2% for fiscal year 2015. Gross margin for fiscal year 2016 was lower compared to fiscal year 2015, primarily related to the inclusion in cost of goods sold of approximately $13,300 of special charges in the first quarter of fiscal year 2016, as well as planned new facility start-up expenses for our new Rockford-area and Colorado facilities. Selling, general, and administrative expenses decreased by $3,104, or 1.8%, to $174,017 for fiscal year 2016 as compared to $177,121 for fiscal year 2015. Selling, general, and administrative expenses as a percentage of net sales was 8.6% for fiscal year 2016 as compared to 8.7% for fiscal year 2015. The decrease in selling, general and administrative expenses for fiscal year 2016 was due to the inclusion in fiscal year 2015 of expenses associated with our negotiations to enter into the JV agreement with GE for which there was no equivalent expense in fiscal year 2016, as well as normal variability in costs. In fiscal year 2016, these decreases were partially offset by the special charges of approximately $1,700 described above. Research and development costs decreased by $8,315, or 6.2%, to $126,170 for fiscal year 2016, as compared to $134,485 for fiscal year 2015. Research and development costs decreased as a percentage of net sales to 6.2% for fiscal year 2016 as compared to 6.6% for fiscal year 2015. Research and development costs in fiscal year 2016 were impacted by variability in the timing of projects and expenses. In addition, fiscal year 2016 includes the special charges of approximately $1,100 described above. Interest expense increased to $26,776, or 1.3% of net sales, for fiscal year 2016, compared to $24,864, or 1.2% of net sales, for fiscal year 2015. The increase in interest expense was primarily attributable to lower amounts of capitalized interest in fiscal year 2016 as compared to fiscal year 2015, as capital projects have been completed. 35 Income taxes were provided at an effective rate on earnings before income taxes of 20.2% for fiscal year 2016, compared to 24.7% for fiscal year 2015. The changes in components of our effective tax rate (as a percentage of earnings before income taxes) were attributable to the following:   | | ------------------------------------------------------------+-------+--  | | ------------------------------------------------------------+-------+-- Effective tax rate at September 30, 2015 | 24.7 | % ------------------------------------------------------------+-------+-- Research and experimentation credit | (3.5) | ------------------------------------------------------------+-------+-- Adjustment of prior period tax items | 1.9 | ------------------------------------------------------------+-------+-- Net excess income tax benefit from stock-based compensation | (2.6) | ------------------------------------------------------------+-------+-- Other | (0.3) | ------------------------------------------------------------+-------+-- Effective tax rate at September 30, 2016 | 20.2 | % ------------------------------------------------------------+-------+--  The decrease in the year-over-year effective tax rate for fiscal year 2016 as compared to fiscal year 2015 is primarily attributable to the permanent extension, in fiscal year 2016, of the U.S. research and experimentation credit (“R&E Credit”) and the recognition through earnings of a net excess income tax benefit from stock compensation due to the fiscal year 2016 adoption of ASU 2016-09, “Improvements to Employee Share-Based Payments Accounting.” Additionally, there were fewer favorable resolutions, reviews of tax matters, and lapses of applicable statutes of limitation in fiscal year 2016 as compared to fiscal year 2015.  2016 Segment Results Compared to 2015 Aerospace Aerospace segment net sales were $1,233,176 for fiscal year 2016, up 6.2% compared to $1,160,883 for fiscal year 2015. The increase in segment net sales for fiscal year 2016 as compared to fiscal year 2015 was driven primarily by increased defense sales for aftermarket and OEM, and increased commercial aftermarket sales, partially offset by slightly weaker commercial OEM sales. U.S. government funds continued to be prioritized for defense platforms on which we have content. Defense sales, for both aftermarket and OEM, continued to increase in fiscal year 2016, primarily related to conflicts in the Middle East. Sales of smart weapons were particularly strong in fiscal year 2016, as end-customers replenished their stock. Commercial aftermarket sales were up in fiscal year 2016 compared to fiscal year 2015, as global passenger traffic growth continued to drive aircraft utilization and our market share continued to grow. Commercial OEM sales were down slightly for fiscal year 2016 as compared to fiscal year 2015 due to lower rotorcraft OEM sales, primarily related to lower extraction demands due to depressed oil prices, as well as variability in business jet demand. These decreases were partially offset by increases in large transport OEM sales as aircraft deliveries of narrow-body and wide-body aircraft continued to increase based on steady airline demand and new product introductions. Aerospace segment earnings increased by $44,419, or 23.7%, to $232,166 for fiscal year 2016, compared to $187,747 for fiscal year 2015. The net increase in Aerospace segment earnings for fiscal year 2016 was due to the following:   | | -------------------------------------------------+---+-------- Earnings for the period ended September 30, 2015 | $ | 187,747 -------------------------------------------------+---+-------- Sales volume | | 26,775 -------------------------------------------------+---+-------- Price, sales mix and productivity | | 13,274 -------------------------------------------------+---+-------- Joint venture earnings | | 6,204 -------------------------------------------------+---+-------- Other, net | | (1,834) -------------------------------------------------+---+-------- Earnings for the period ended September 30, 2016 | $ | 232,166 -------------------------------------------------+---+--------  Aerospace segment earnings as a percentage of sales were 18.8% for fiscal year 2016, compared to 16.2% for fiscal year 2015. The increase was primarily attributable to higher sales volume, which included more high-margin aftermarket sales. Industrial Industrial segment net sales decreased by 10.0% to $789,902 for fiscal year 2016, compared to $877,420 for fiscal year 2015. The decrease in segment net sales for fiscal year 2016, as compared to fiscal year 2015 was driven by ongoing weakness across many of our Industrial segment markets. In particular, there was further deterioration of the natural gas truck market in China and continued weakness in reciprocating engine power generation and other OEM large capital equipment projects. This weakness was primarily due to delayed maintenance and capital infrastructure investments due to slowing economic growth in China and other global markets, as well as continued depressed oil and gas pricing. In addition, the first quarter of fiscal year 2015 had unusually strong sales in the natural gas truck market in Asia, which was not repeated in fiscal year 2016. This weakness was partially offset in fiscal year 2016 by strength in industrial turbomachinery aftermarket sales. 36 Foreign currency exchange rates had an unfavorable impact on sales of approximately $13,000 for fiscal year 2016 compared to fiscal year 2015. Industrial segment earnings decreased by $44,404, or 35.1%, to $82,237 for fiscal year 2016, compared to $126,641 for fiscal year 2015. The decrease in Industrial segment earnings for fiscal year 2016 was due to the following:   | | -------------------------------------------------+---+--------- Earnings for the period ended September 30, 2015 | $ | 126,641 -------------------------------------------------+---+--------- Sales volume | | (33,509) -------------------------------------------------+---+--------- Price, sales mix and productivity | | (4,322) -------------------------------------------------+---+--------- Decrease in research and development expenses | | 6,989 -------------------------------------------------+---+--------- New facility start-up costs | | (5,868) -------------------------------------------------+---+--------- Effects of changes in foreign currency rates | | (3,169) -------------------------------------------------+---+--------- Other, net | | (4,525) -------------------------------------------------+---+--------- Earnings for the period ended September 30, 2016 | $ | 82,237 -------------------------------------------------+---+---------  Industrial segment earnings as a percentage of sales were 10.4% for fiscal year 2016, compared to 14.4% for fiscal year 2015. The decrease in segment earnings for fiscal year 2016 as compared to fiscal year 2015 was driven by the impact of lower sales volume, unfavorable product mix, and costs associated with our new facility in Colorado. In addition, foreign currency exchange rates had an unfavorable impact of $3,169 for fiscal year 2016 compared to fiscal year 2015. Nonsegment expenses Nonsegment expenses increased to $63,166 for fiscal year 2016, compared to $49,362 for fiscal year 2015. As a percent of net sales, nonsegment expenses increased to 3.1% of net sales for fiscal year 2016, compared to 2.4% of net sales for fiscal year 2015. The increase in nonsegment expenses in fiscal year 2016 as compared to fiscal year 2015 was due to special charges taken in the first quarter of fiscal year 2016 totaling approximately $16,100 as described above. LIQUIDITY AND CAPITAL RESOURCES Historically, we have satisfied our working capital needs, as well as capital expenditures, product development and other liquidity requirements associated with our operations, with cash flow provided by operating activities and borrowings under our credit facilities. Historically, we have also issued debt to supplement our cash needs or repay our other indebtedness. We expect that cash generated from our operating activities, together with borrowings under our revolving credit facility and other borrowing capacity, will be sufficient to fund our continuing operating needs, including capital expansion funding for the foreseeable future. Our aggregate cash and cash equivalents were $87,552 at September 30, 2017 and $81,090 at September 30, 2016, and our working capital was $593,955 at September 30, 2017 and $463,811 at September 30, 2016. Of the $87,552 of cash and cash equivalents held at September 30, 2017, $87,383 was held by our foreign locations. We are not presently aware of any significant restrictions on the repatriation of these funds, although a portion is considered indefinitely reinvested in these foreign subsidiaries. If these funds were needed to fund our operations or satisfy obligations in the United States, then they could be repatriated and their repatriation into the United States may cause us to incur additional U.S. income taxes or foreign withholding taxes. Any additional U.S. taxes could be offset, in part or in whole, by foreign tax credits. The amount of such taxes and application of tax credits would be dependent on the income tax laws and other circumstances at the time these amounts are repatriated. Based on these variables, it is impractical to determine the income tax liability that might be incurred if these funds were to be repatriated. Consistent with common business practice in China, our Chinese subsidiary accepts bankers’ acceptance notes from Chinese customers, in settlement of certain customer accounts receivable. Bankers’ acceptance notes are financial instruments issued by Chinese financial institutions as part of financing arrangements between the financial institution and a customer of the financial institution. Bankers’ acceptance notes represent a commitment by the issuing financial institution to pay a certain amount of money at a specified future maturity date to the legal owner of the bankers’ acceptance note as of the maturity date. The maturity date of bankers’ acceptance notes varies, but it is our policy to only accept bankers’ acceptance notes with maturity dates no more than 180 days from the date of our receipt of such draft. The issuing financial institution is the obligor, not our customers. Upon our acceptance of a bankers’ acceptance note from a customer, such customer has no further obligation to pay us for the related accounts receivable balance. We had bankers’ acceptance notes of $38,243 at September 30, 2017 and $5,093 at September 30, 2016 recorded as non-customer accounts receivable on our consolidated balance sheets. The increase in the amount of bankers’ acceptance notes is due to the higher sales of natural gas truck and bus systems in China. We only accept bankers’ acceptance notes issued by banks that are believed to be creditworthy and to which the credit risks associated with the bankers’ acceptance notes are believed to be low. Our revolving credit facility matures in April 2020 and provides a borrowing capacity of up to $1,000,000 with the option to increase total available borrowings to up to $1,200,000, subject to lenders’ participation. We can borrow against our $1,000,000 revolving credit facility as long as we are in compliance with all of our debt covenants. Historically, we have used borrowings under our revolving credit facilities to meet certain short-term working capital needs, as well as for strategic uses, including repurchases of 37 our common stock, payments of dividends, acquisitions, and facilities expansions. In addition, we have various foreign credit facilities, some of which are tied to net amounts on deposit at certain foreign financial institutions. These foreign credit facilities are reviewed annually for renewal. We use borrowings under these foreign credit facilities to finance certain local operations on a periodic basis. For further discussion of our $1,000,000 revolving credit facility and our other credit facilities, see Note 12, Credit facilities, short-term borrowings and long-term debt in the Notes to the Consolidated Financial Statements in “Item 8 – Financial Statements and Supplementary Data.” At September 30, 2017, we had total outstanding debt of $612,886 consisting of amounts borrowed under our revolving credit facility and various series of unsecured notes due between 2018 and 2031, with additional borrowing availability of $956,779 under our revolving credit facility, net of outstanding letters of credit, and additional borrowing availability of $7,530 under various foreign credit facilities. For further discussion of our notes, see Note 12, Credit facilities, short-term borrowings and long-term debt in the Notes to the Consolidated Financial Statements in “Item 8 – Financial Statements and Supplementary Data.” At September 30, 2017, we had $32,600 of borrowings outstanding under our revolving credit facility, all of which was classified as short-term. Revolving credit facility and short-term borrowing activity during the fiscal year ended September 30, 2017 were as follows:   | | --------------------------------------------------------+---+--------  | | --------------------------------------------------------+---+-------- Maximum daily balance during the period | $ | 317,700 --------------------------------------------------------+---+-------- Average daily balance during the period | $ | 242,966 --------------------------------------------------------+---+-------- Weighted average interest rate on average daily balance | | 1.96% --------------------------------------------------------+---+-------- We believe we were in compliance with all our debt covenants as of September 30, 2017. See Note 12, Credit facilities, short-term borrowings and long-term debt in the Notes to the Consolidated Financial Statements in “Item 8 – Financial Statements and Supplementary Data,” for more information about our covenants. In addition to utilizing our cash resources to fund the working capital needs of our business, we evaluate additional strategic uses of our funds, including the repurchase of our common stock, payment of dividends, significant capital expenditures, consideration of strategic acquisitions and other potential uses of cash. Our ability to service our long-term debt, to remain in compliance with the various restrictions and covenants contained in our debt agreements, and to fund working capital, capital expenditures and product development efforts will depend on our ability to generate cash from operating activities, which in turn is subject to, among other things, future operating performance as well as general economic, financial, competitive, legislative, regulatory, and other conditions, some of which may be beyond our control. On January 4, 2016, we consummated the formation of a strategic joint venture between Woodward and GE. GE purchased from Woodward a 50% ownership interest in the JV for a $250,000 cash payment to Woodward. In addition, GE will pay contingent consideration to Woodward consisting of fifteen annual payments of $4,894 per year beginning January 4, 2017 subject to certain claw-back conditions. The $250,000 cash consideration received from GE on January 4, 2016 was taxable in the United States upon receipt. The taxes of approximately $95,000 associated with this cash consideration were paid through estimated payments made during fiscal year 2016. In the first quarter of fiscal year 2016, we executed a 10b5-1 plan to repurchase up to $125,000 of our common stock for a period that ended on April 20, 2016. During the fiscal year ended September 30, 2016, we purchased 2,635 shares of our common stock for $125,000 under the 10b5-1 plan, using a portion of the $250,000 received from GE. In fiscal year 2015, we completed $125,000 of share repurchases through an accelerated stock repurchase program. This was part of a previously announced $250,000 stock repurchase initiative. In the first quarter of fiscal year 2017, our Board of Directors terminated the Company’s prior stock repurchase program and replaced it with a new program for the repurchase of up to $500,000 of Woodward’s outstanding shares of common stock on the open market or in privately negotiated transactions over a three-year period that will end in 2019 (the “2016 Authorization”). In fiscal year 2017, we purchased 1,027 shares of our common stock under the 2016 Authorization for $71,197, of which 491 shares were purchased pursuant to 10b5-1 plans and 536 were purchased pursuant to a 10b-18 plan. For our Aerospace segment, in fiscal year 2015 we completed construction of a manufacturing and office building on a second campus in the greater-Rockford, Illinois area. This campus is intended to support the expected growth in our Aerospace segment over the next ten years and beyond, as a result of our being awarded a substantial number of new system platforms, particularly on narrow-body aircraft. We have been purchasing production equipment for the second campus and anticipate continuing such purchases as new aircraft platforms ramp up to full production volumes. We believe that cash flows from operations, along with our contractually committed borrowings and other borrowing capability, will continue to be sufficient to fund anticipated capital spending requirements and our operations for the foreseeable future. However, we could be adversely affected if the financial institutions providing our capital requirements refuse to honor their contractual commitments, cease lending, or declare bankruptcy. We believe the lending institutions participating in our credit arrangements are financially stable. 38 Cash Flows   | | | | | | | | -------------------------------------------------------------+---------------+-----------+------+---+-----------+------+---+----------  | Year Ended -------------------------------------------------------------+--------------  | September 30, -------------------------------------------------------------+--------------  | 2017 | | 2016 | | | 2015 -------------------------------------------------------------+---------------+-----------+------+---+-----------+----- Net cash provided by operating activities | $ | 307,537 | | $ | 435,379 | | $ | 295,990 -------------------------------------------------------------+---------------+-----------+------+---+-----------+------+---+---------- Net cash used in investing activities | | (91,866) | | | (173,946) | | | (284,083) -------------------------------------------------------------+---------------+-----------+------+---+-----------+------+---+---------- Net cash used in financing activities | | (211,813) | | | (260,993) | | | (34,006) -------------------------------------------------------------+---------------+-----------+------+---+-----------+------+---+---------- Effect of exchange rate changes on cash and cash equivalents | | 2,604 | | | (1,552) | | | (10,986) -------------------------------------------------------------+---------------+-----------+------+---+-----------+------+---+---------- Net change in cash and cash equivalents | | 6,462 | | | (1,112) | | | (33,085) -------------------------------------------------------------+---------------+-----------+------+---+-----------+------+---+---------- Cash and cash equivalents at beginning of year | | 81,090 | | | 82,202 | | | 115,287 -------------------------------------------------------------+---------------+-----------+------+---+-----------+------+---+---------- Cash and cash equivalents at end of year | $ | 87,552 | | $ | 81,090 | | $ | 82,202 -------------------------------------------------------------+---------------+-----------+------+---+-----------+------+---+---------- 2017 Cash Flows Compared to 2016 Net cash flows provided by operating activities for fiscal year 2017 was $307,537, compared to $435,379 in fiscal year 2016. The decrease in cash provided by operating activities in fiscal year 2017 compared to fiscal year 2016 was primarily attributable to the JV Proceeds of $155,000 received in the prior year. This decrease was partially offset by an earnings increase of $19,669 in fiscal 2017 compared to the prior fiscal year and changes in working capital providing a net source of cash of $651 in fiscal year 2017 as compared to a net use of cash of $9,387 the prior fiscal year. Working capital changes reflected an increase in cash provided of $47,198 due mainly to accounts payable increasing in the current fiscal year compared to fiscal year 2016 related primarily to the timing of payments for various accounts payable for the current fiscal year that occurred after the fiscal year end, which was mostly offset by an increase in usage of cash of $43,961 due to accounts receivable increasing more in fiscal year 2017 compared to the increase in the prior fiscal year. Net cash flows used in investing activities for fiscal year 2017 was $91,866, compared to $173,946 in fiscal year 2016. The decrease in cash used in investing activities compared to the prior fiscal year is due primarily to decreased payments for capital expenditures. Payments for property, plant and equipment decreased by $83,356 to $92,336 in fiscal year 2017, as compared to $175,692 in fiscal year 2016, related mainly to lower equipment purchases in the current year associated with the our Aerospace segment facility in the greater-Rockford, Illinois area and completion of our Industrial segment facility in Fort Collins, Colorado. Net cash flows used in financing activities for fiscal year 2017 was $211,813, compared to $260,993 in fiscal year 2016. During fiscal year 2017, we had net debt payments of $124,512, compared to net debt payments of $123,875 in fiscal year 2016. We utilized $71,197 to repurchase 1,027 shares of our common stock in fiscal year 2017 under the 2016 Authorization, compared to $125,000 to repurchase 2,635 shares of our common stock in fiscal year 2016 under the then existing stock repurchase program. 2016 Cash Flows Compared to 2015 Net cash flows provided by operating activities for fiscal year 2016 was $435,379, compared to $295,990 in fiscal year 2015. The increase in net cash provided by operating activities is primarily attributable to the after-tax proceeds related to the formation of the JV between Woodward and GE. Net cash flows used in investing activities for fiscal year 2016 was $173,946, compared to $284,083 in fiscal year 2015. The decrease in cash used in investing activities in fiscal year 2016 compared to fiscal year 2015 is due to decreased payments for capital expenditures. Payments for property, plant and equipment decreased by $110,920 to $175,692 in fiscal year 2016 as compared to $286,612 in fiscal year 2015 related mainly to the development of a second campus in the greater-Rockford, Illinois area, a new facility in Niles, Illinois, and a new campus at our Fort Collins, Colorado headquarters. The manufacturing and office building in the greater-Rockford, Illinois area and the new facility in Niles, Illinois were both completed in fiscal year 2015. Our Fort Collins campus was completed in fiscal year 2016. Net cash flows used in financing activities for fiscal year 2016 was $260,993, compared to $34,006 in fiscal year 2015. During fiscal year 2016, we had net debt payments of $123,875 compared to net debt borrowings of $143,361 in fiscal year 2015. We utilized $125,000 to repurchase 2,635 shares of our common stock in fiscal year 2016 under the then existing stock repurchase program, compared to $157,160 to repurchase 3,128 shares of our common stock in fiscal year 2015. Off-Balance Sheet Arrangements As of September 30, 2017, we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K promulgated by the SEC, that have or are reasonably likely to have a current or future effect on our financial condition, changes in our financial condition, revenues, or expenses, results of operations, liquidity, capital expenditures, or capital resources, that are material to investors. 39  Contractual Obligations A summary of our consolidated contractual obligations and commitments as of September 30, 2017 is as follows:   | | | | | | | | | | | | | | ---------------------------------+---------------------------+----------------+------+---+---------+------+--------+------+---+------------+---+--------+---+--------  | | | | | | | | | | | | | | ---------------------------------+---------------------------+----------------+------+---+---------+------+--------+------+---+------------+---+--------+---+--------  | Year Ending September 30, ---------------------------------+--------------------------  | 2018 | | 2019 | | 2020 | 2021 | | 2022 | | Thereafter ---------------------------------+---------------------------+----------------+------+---+---------+------+--------+------+---+-----------  | | (in thousands) ---------------------------------+---------------------------+--------------- Long-term debt principal | $ | - | | $ | 143,000 | $ | - | | $ | 100,000 | $ | - | $ | 339,080 ---------------------------------+---------------------------+----------------+------+---+---------+------+--------+------+---+------------+---+--------+---+-------- Interest on debt obligations (1) | | 21,603 | | | 18,290 | | 11,670 | | | 10,548 | | 8,677 | | 32,726 ---------------------------------+---------------------------+----------------+------+---+---------+------+--------+------+---+------------+---+--------+---+-------- Operating leases | | 6,315 | | | 4,265 | | 3,872 | | | 3,188 | | 2,148 | | 3,427 ---------------------------------+---------------------------+----------------+------+---+---------+------+--------+------+---+------------+---+--------+---+-------- Capital leases | | 444 | | | 451 | | 122 | | | - | | - | | - ---------------------------------+---------------------------+----------------+------+---+---------+------+--------+------+---+------------+---+--------+---+-------- Purchase obligations (2) | | 299,267 | | | 17,993 | | 232 | | | 66 | | - | | - ---------------------------------+---------------------------+----------------+------+---+---------+------+--------+------+---+------------+---+--------+---+-------- Other (3) | | - | | | - | | - | | | - | | - | | 20,132 ---------------------------------+---------------------------+----------------+------+---+---------+------+--------+------+---+------------+---+--------+---+-------- Total | $ | 327,629 | | $ | 183,999 | $ | 15,896 | | $ | 113,802 | $ | 10,825 | $ | 395,365 ---------------------------------+---------------------------+----------------+------+---+---------+------+--------+------+---+------------+---+--------+---+-------- (1) | Interest obligations on floating rate debt instruments are calculated for future periods using interest rates in effect as of September 30, 2017. See Note 12, Credit facilities, short-term borrowings and long-term debt, in the Notes to the Consolidated Financial Statements in “Item 8 – Financial Statements and Supplementary Data” for further details on our long-term debt. ----+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (2) | Purchase obligations include amounts committed under legally enforceable contracts or purchase orders for goods and services with defined terms as to price, quantity, delivery, and termination liability. ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ (3) | The $20,132 included in other obligations in the “Thereafter” column represents our best reasonable estimate for uncertain tax positions at this time and may change in future periods, as the timing of the payments and whether such payments will actually be required cannot be reasonably estimated. ----+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- The above table does not reflect the following items: · | As of September 30, 2017, there were $32,600 of outstanding borrowings on our revolving credit facility, all of which were classified as short-term based on our intent and ability to pay this amount in the next twelve months. Our revolving credit facility matures in April 2020. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | Contributions to our retirement pension benefit plans, which we estimate will total approximately $614 in fiscal year 2018. As of September 30, 2017 our pension plans were net underfunded by $2,787 based on projected benefit obligations. Statutory pension contributions in future fiscal years will vary as a result of a number of factors, including actual plan asset returns and interest rates. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | Contributions to our other postretirement benefit plans, which we estimate will total $3,871 in fiscal year 2018. Other postretirement contributions are made on a “pay-as-you-go” basis as payments are made to healthcare providers, and such contributions will vary as a result of changes in the future cost of postretirement healthcare benefits provided for covered retirees. As of September 30, 2017, our other postretirement benefit plans were underfunded by $32,252 based on projected benefit obligations. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ · | Business commitments made to certain customers to perform under long-term product development projects, some of which may result in near-term financial losses. Such losses, if any, are recognized when they become likely to occur. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- In connection with the sale of the Fuel & Pneumatics product line during fiscal year 2009, Woodward assigned to a subsidiary of the purchaser its rights and responsibilities related to certain contracts with the U.S. Government. Woodward provided to the U.S. Government a customary guarantee of the purchaser’s subsidiary’s obligations under the contracts. The purchaser and its affiliates have agreed to indemnify Woodward for any liability incurred with respect to the guarantee. Guarantees and letters of credit totaling approximately $10,972 were outstanding as of September 30, 2017, some of which were secured by parent guarantees from Woodward or by Woodward line of credit facilities. In the event of a change in control of Woodward, as defined in change-in-control agreements with our current corporate officers, we may be required to pay termination benefits to such officers. New Accounting Standards From time to time, the Financial Accounting Standards Board (“FASB”) or other standards-setting bodies issue new accounting pronouncements. Updates to the FASB Accounting Standards Codification are communicated through issuance of an Accounting 40 Standards Update. Unless otherwise discussed, we believe that the impact of recently issued guidance, whether adopted or to be adopted in the future, is not expected to have a material impact on our Consolidated Financial Statements upon adoption. To understand the impact of recently issued guidance, whether adopted or to be adopted, please review the information provided in Note 2, New accounting standards, in the Notes to the Consolidated Financial Statements in “Item 8 – Financial Statements and Supplementary Data.”  Non-U.S. GAAP Financial Measures EBIT, EBITDA, free cash flow, and adjusted free cash flow are financial measures not prepared and presented in accordance with U.S. GAAP. However, we believe these non-U.S. GAAP financial measures provide additional information that enables readers to evaluate our business from the perspective of management. Earnings based non-U.S. GAAP financial measures Management uses EBIT to evaluate Woodward’s performance without financing and tax related considerations, as these elements may not fluctuate with operating results. Management uses EBITDA in evaluating Woodward’s operating performance, making business decisions, including developing budgets, managing expenditures, forecasting future periods, and evaluating capital structure impacts of various strategic scenarios. Securities analysts, investors and others frequently use EBIT and EBITDA in their evaluation of companies, particularly those with significant property, plant, and equipment, and intangible assets subject to amortization. EBIT and EBITDA for the fiscal years ended September 30, 2017, September 30, 2016, and September 30, 2015 were as follows:   | | | | | | | ----------------------------------+--------------------------+---------+------+---+---------+---+--------  | | | | | | | ----------------------------------+--------------------------+---------+------+---+---------+---+--------  | Year Ended September 30, ----------------------------------+-------------------------  | 2017 | | 2016 | | 2015 ----------------------------------+--------------------------+---------+------+---+-------- Net earnings (U.S. GAAP) | $ | 200,507 | | $ | 180,838 | $ | 181,452 ----------------------------------+--------------------------+---------+------+---+---------+---+-------- Income taxes | | 52,240 | | | 45,648 | | 59,497 ----------------------------------+--------------------------+---------+------+---+---------+---+-------- Interest expense | | 27,430 | | | 26,776 | | 24,864 ----------------------------------+--------------------------+---------+------+---+---------+---+-------- Interest income | | (1,725) | | | (2,025) | | (787) ----------------------------------+--------------------------+---------+------+---+---------+---+-------- EBIT (Non-U.S. GAAP) | | 278,452 | | | 251,237 | | 265,026 ----------------------------------+--------------------------+---------+------+---+---------+---+-------- Amortization of intangible assets | | 25,777 | | | 27,486 | | 29,241 ----------------------------------+--------------------------+---------+------+---+---------+---+-------- Depreciation expense | | 55,140 | | | 41,550 | | 45,994 ----------------------------------+--------------------------+---------+------+---+---------+---+-------- EBITDA (Non-U.S. GAAP) | $ | 359,369 | | $ | 320,273 | $ | 340,261 ----------------------------------+--------------------------+---------+------+---+---------+---+-------- The use of these non-U.S. GAAP financial measures is not intended to be considered in isolation of, or as a substitute for, the financial information prepared and presented in accordance with U.S. GAAP. As EBIT and EBITDA exclude certain financial information compared with net earnings, the most comparable U.S. GAAP financial measure, users of this financial information should consider the information that is excluded. Our calculations of EBIT and EBITDA may differ from similarly titled measures used by other companies, limiting their usefulness as comparative measures. Cash flow-based non-U.S. GAAP financial measures Management uses free cash flow, which is defined by the Company as net cash flows provided by operating activities less payments for property, plant and equipment, as well as adjusted free cash flow, which is defined by the Company as free cash flow less the net after-tax JV Proceeds, in reviewing the financial performance of Woodward’s various business groups and evaluating cash levels. We believe free cash flow and adjusted free cash flow are useful measures for investors because they portray our ability to generate cash from our businesses for purposes such as paying interest on our indebtedness, repaying maturing debt, funding business acquisitions, purchasing our common stock, and paying dividends. In addition, securities analysts, investors, and others frequently use free cash flow in their evaluation of companies. The use of these non-U.S. GAAP financial measures is not intended to be considered in isolation of, or as substitutes for, the financial information prepared and presented in accordance with U.S. GAAP. Neither free cash flow nor adjusted free cash flow necessarily represent funds available for discretionary use, and neither is necessarily a measure of our ability to fund our cash needs. In particular, the gross proceeds received in connection with the formation of the JV was a discrete positive cash flow event not expected to recur. Our calculations of free cash flow and adjusted free cash flow may differ from similarly titled measures used by other companies, limiting its usefulness as a comparative measure. 41 Free cash flow and adjusted free cash flow for the fiscal years ended September 30, 2017, September 30, 2016, and September 30, 2015 were as follows:   | | | | | | | -------------------------------------------------------+--------------------------+----------+------+---+-----------+---+----------  | | | | | | | -------------------------------------------------------+--------------------------+----------+------+---+-----------+---+----------  | Year Ended September 30, -------------------------------------------------------+-------------------------  | 2017 | | 2016 | | 2015 -------------------------------------------------------+--------------------------+----------+------+---+---------- Net cash provided by operating activities (U.S. GAAP) | $ | 307,537 | | $ | 435,379 | $ | 295,990 -------------------------------------------------------+--------------------------+----------+------+---+-----------+---+---------- Payments for property, plant and equipment | | (92,336) | | | (175,692) | | (286,612) -------------------------------------------------------+--------------------------+----------+------+---+-----------+---+---------- Free cash flow (Non-U.S. GAAP) | $ | 215,201 | | $ | 259,687 | $ | 9,378 -------------------------------------------------------+--------------------------+----------+------+---+-----------+---+---------- Less: Gross proceeds from formation of joint venture | | - | | | 250,000 | | - -------------------------------------------------------+--------------------------+----------+------+---+-----------+---+---------- Tax payments related to formation of joint venture | | - | | | (95,000) | | - -------------------------------------------------------+--------------------------+----------+------+---+-----------+---+---------- Net after-tax proceeds from formation of joint venture | | - | | | 155,000 | | - -------------------------------------------------------+--------------------------+----------+------+---+-----------+---+---------- Adjusted free cash flow (Non-U.S. GAAP) | $ | 215,201 | | $ | 104,687 | $ | 9,378 -------------------------------------------------------+--------------------------+----------+------+---+-----------+---+----------    CRITICAL ACCOUNTING POLICIES AND ESTIMATES The preparation of financial statements and related disclosures in conformity with U.S. GAAP requires us to make judgments, assumptions, and estimates that affect the amounts reported in the Consolidated Financial Statements and accompanying notes. Note 1, Operations and summary of significant accounting policies, to the Consolidated Financial Statements describes the significant accounting policies and methods used in the preparation of the Consolidated Financial Statements. The estimates and assumptions described below are those that we consider to be most critical to an understanding of our financial statements because they involve significant judgments and uncertainties. All of these estimates reflect our best judgment about current, and for some estimates, future economic and market conditions and their effects based on information available as of the date of these financial statements. As estimates are updated or actual amounts are known, our critical accounting estimates are revised, and operating results may be affected by the revised estimates. Actual results may differ from these estimates under different assumptions or conditions. Our management has discussed the development and selection of these critical accounting estimates with the Audit Committee of our Board of Directors, and the Audit Committee has reviewed our disclosures in this Management’s Discussion and Analysis. Revenue recognition Woodward recognizes revenue when the following criteria are met: 1) persuasive evidence of an arrangement exists, 2) delivery of the product has occurred or services have been rendered, 3) price is fixed or determinable, and 4) collectability is reasonably assured. In implementing the four criteria stated above, we have found that determining when the risks and rewards of ownership have passed to the customer, which determines whether persuasive evidence of an arrangement exists and if delivery has occurred, may require judgment. The passage of title indicates transfer of the risks and rewards of ownership from Woodward to the customer; however, contract- and customer-specific circumstances are reviewed by management to ensure that transfer of title constitutes the transfer of the risks and rewards of ownership. Examples of situations requiring management review and judgment, with respect to the passage of the risks and rewards of ownership, include: interpretation of customer-specific contract terms, situations where substantive performance obligations exist, such as completion of product testing that remain after product delivery to the customer, situations that require customer acceptance (or in some instances regulatory acceptance) of the product, and situations in countries whose laws provide for retention of some form of title by sellers such that Woodward is able to recover goods in the event a customer defaults on payment. Based on management’s determination, if the risks and rewards of ownership have not passed to the customer, revenue is deferred until this requirement is met. Inventory Inventories are valued at the lower of cost or net realizable value. Inventory cost is determined using methods that approximate the first-in, first-out basis. We include product costs, labor and related fixed and variable overhead in the cost of inventories. Inventory net realizable values are determined by giving substantial consideration to the expected product selling price. We estimate expected selling prices based on our historical recovery rates, general economic and market conditions, the expected channel of disposition, and current customer contracts and preferences. Actual results may differ from our estimates due to changes in resale or market value and the mix of these factors. Management monitors inventory for events or circumstances, such as negative margins, recent sales history suggesting lower sales value, or changes in customer preferences, which would indicate the net realizable value of 42 inventory is less than the carrying value of inventory, and management records adjustments as necessary. When inventory is written down below cost, such reduced amount is considered the cost for subsequent accounting purposes. Our recording of inventory at the lower of cost or net realizable value has not historically required material adjustments once initially established. The carrying value of inventory was $473,505 at September 30, 2017 and $461,683 at September 30, 2016. If economic conditions, customer product requirements, or other factors significantly reduce future customer demand for our products from forecast levels, then future adjustments to the carrying value of inventory may become necessary. We attempt to maintain inventory quantities at levels considered necessary to fill expected orders in a reasonable time frame, which we believe mitigates our exposure to future inventory carrying cost adjustments. Depreciation and amortization The carrying value of property, plant and equipment was $922,043 at September 30, 2017 and $876,350 at September 30, 2016. Depreciation expense was $55,140 in fiscal year 2017, $41,550 in fiscal year 2016 and $45,994 in fiscal year 2015. Depreciation of property, plant and equipment is generally computed using the straight-line method, which requires estimates of asset useful lives and ultimate salvage value. In fiscal year 2015, we completed and placed into service a manufacturing and office building for our Aerospace segment on a second campus in the greater-Rockford, Illinois area and began occupying the new facility. This campus is intended to support the expected growth in our Aerospace segment over the next ten years and beyond, necessitated as a result of our being awarded a substantial number of new system platforms, particularly on narrow-body aircraft. In addition, in fiscal year 2015, we completed an addition to and renovation of a building in Niles, Illinois that we had acquired in September 2013. Most of our operations that formerly resided in nearby Skokie, Illinois, were relocated to this new facility in fiscal year 2015. In fiscal year 2016, we completed construction of a manufacturing building for our Industrial segment and a corporate headquarters building on a second campus in Fort Collins, Colorado. This campus is intended to support the future growth of our Industrial segment by supplementing our existing Colorado manufacturing facilities. We began occupying the new campus in our second quarter of fiscal year 2016. Concurrent with and in relation to our significant investment in three new campuses and related equipment, in fiscal year 2016, Woodward initiated a comprehensive review of its depreciation lives as required by U.S. GAAP to evaluate the estimates of the useful lives of Woodward assets. This review resulted in estimates of the useful lives of both existing and new assets generally in excess of those utilized prior to fiscal year 2016. The revised estimates were used in fiscal year 2016 and will be used going forward and resulted in a downward adjustment of depreciation on existing assets of approximately $12,000 for fiscal year 2016. The carrying value of intangible assets was $171,882 at September 30, 2017 and $197,650 at September 30, 2016. Amortization expense was $25,777 in fiscal year 2017, $27,486 in fiscal year 2016 and $29,241 in fiscal year 2015. Amortization of intangible assets is generally computed using patterns that reflect the periods over which the economic benefits of the assets are expected to be realized. Impairment losses are recognized if the carrying amount of an intangible is both not estimated to be recoverable and exceeds it fair value. Reviews for impairment of goodwill At September 30, 2017, we had $556,545 of goodwill, representing 20% of our total assets. Goodwill is tested for impairment at the reporting unit level on an annual basis and more often if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Based on the relevant U.S. GAAP authoritative guidance, we aggregate components of a single operating segment into a reporting unit, if appropriate. For purposes of performing the impairment tests, we identify reporting units in accordance with U.S. GAAP. The identification of reporting units and consideration of the aggregation of components into a single reporting unit requires management judgment. The impairment tests consist of comparing the fair value of reporting units, determined using discounted cash flows, with their carrying amount including goodwill. If the carrying amount of the reporting unit exceeds its fair value, we compare the implied fair value of goodwill with its carrying amount. If the carrying amount of goodwill exceeds the implied fair value of goodwill, an impairment loss would be recognized to reduce the carrying amount to its implied fair value. Woodward has not recorded any impairment charges. During the fourth quarter, Woodward completed its annual goodwill impairment test as of July 31, 2017 for the fiscal year ended September 30, 2017. At that date, Woodward determined it was appropriate to aggregate certain components of the same operating segment into a single reporting unit. The fair value of each of Woodward’s reporting units was determined using an income approach based on a discounted cash flow method. This method represents a Level 3 input (based upon a fair value hierarchy established by U.S. GAAP) and incorporates various estimates and assumptions, the most significant being projected revenue growth rates, earnings margins, future tax rates and the present value, based on an estimated weighted-average cost of capital (or the discount rate) and terminal growth rate, of forecasted cash flows. Management projects revenue growth rates, earnings margins and cash flows based on each reporting unit’s current operational results, expected performance and operational strategies over a ten-year period. These projections are adjusted to reflect current economic conditions and demand for certain products, and require considerable management judgment. 43 Forecasted cash flows used in the July 31, 2017 impairment test were discounted using weighted-average cost of capital assumptions ranging from 9.57% to 13.86%. The terminal values of the forecasted cash flows were calculated using the Gordon Growth Model and assumed an annual compound growth rate after ten years of 3.39%. These inputs, which are unobservable in the market, represent management’s best estimate of what market participants would use in determining the present value of the Company’s forecasted cash flows. Changes in these estimates and assumptions can have a significant impact on the fair value of forecasted cash flows. Woodward evaluated the reasonableness of the reporting units resulting fair values utilizing a market multiple method. The results of Woodward’s annual goodwill impairment test performed as of July 31, 2017, indicated the estimated fair value of each reporting unit was significantly in excess of its carrying value, and accordingly, no impairment existed. Increasing the discount rate by 20%, decreasing the growth rate by 20%, or decreasing forecasted cash flow by 20%, would also not have resulted in an impairment charge at July 31, 2017. As part of the Company’s ongoing monitoring efforts to assess goodwill for possible indications of impairment, we will continue to consider a wide variety of factors, including but not limited to the global economic environment and its potential impact on Woodward’s business. There can be no assurance that our estimates and assumptions regarding forecasted cash flows of certain reporting units, the current economic environment, or the other inputs used in forecasting the present value of forecasted cash flows will prove to be accurate projections of future performance. Postretirement benefits The Company provides various benefits to certain employees through defined benefit pension plans and other postretirement benefit plans. A September 30 measurement date is used to value plan assets and obligations for all Woodward defined benefit pension and other postretirement benefit plans. For financial reporting purposes, net periodic benefits expense and related obligations are calculated using a number of significant actuarial assumptions, including anticipated discount rates, rates of compensation increases, long-term return on defined benefit plan investments, and anticipated healthcare cost increases. Based on these actuarial assumptions, at September 30, 2017, our recorded assets and liabilities included a net liability of $2,787 for our defined benefit pension plans and a net liability of $32,252 for our other postretirement benefit plans. Changes in net periodic expense or the amounts of recorded assets and liabilities may occur in the future due to changes in these assumptions. Estimates of the value of postretirement benefit obligations, and related net periodic benefits expense, are dependent on actuarial assumptions, including future interest rates, compensation rates, mortality trends, healthcare cost trends, termination and retirement rates, and returns on defined benefit plan investments. It should be noted that economic factors and conditions often affect multiple assumptions simultaneously, and the effects of changes in assumptions are not necessarily linear due to factors such as the 10% corridor applied to the larger of the postretirement benefit obligation or the fair market value of plan assets used to determine the amortization of actuarial net gains or losses. Mortality assumptions are based on published mortality studies developed primarily based on past experience of the broad population and modified for projected longevity trends. The projected benefit obligations in the United States as of September 30, 2017 and September 30, 2016 was based on the Society of Actuaries (“SOA”) RP-2014 Mortality Tables Report projected back to 2006 using the SOA’s Mortality Improvement Scale MP-2014 (“MP-2014”) and projected forward using a custom projection scale based on MP-2014 with a 10-year convergence period and a long-term rate of 0.75%. As of September 30, 2017 and September 30, 2016, mortality assumptions in Japan were based on the Standard rates 2014, and mortality assumptions for the United Kingdom were based on the Self-administered pension scheme (“SAPS”) S2 “all” tables with a projected 1.5% annual improvement rate. Primary actuarial assumptions for our defined benefit pension plans were determined as follows: · | The discount rate assumption is intended to reflect the rate at which the retirement benefits could be effectively settled based upon the assumed timing of the benefit payments. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- In the United States, Woodward uses a bond portfolio matching analysis based on recently traded, non-callable bonds rated AA or better that have at least $50 million outstanding to determine the benefit obligations at year end. In the United Kingdom and Japan, Woodward uses a high-quality corporate bond yield curve matched with separate cash flows to develop a single rate to determine the single rate equivalent to settle the entire benefit obligations in each jurisdiction. For the fiscal years ended September 30, 2017 and 2016, the discount rate used to determine periodic service cost and interest cost components of the overall benefit costs was based on spot rates derived from the same high-quality corporate bond yield curve used to determine the September 30, 2016 and 2015 benefit obligation, respectively, matched with separate cash flows for each future year. 44 These rates are sensitive to changes in interest rates.   | | | | | ------------------------------------------------------------------------+-------------------------+----------+-------------+---+--------  | | | | | ------------------------------------------------------------------------+-------------------------+----------+-------------+---+--------  | Change In Discount Rate ------------------------------------------------------------------------+------------------------  | 1% increase | | 1% decrease ------------------------------------------------------------------------+-------------------------+----------+------------ Defined benefit pension benefits: | | | | | ------------------------------------------------------------------------+-------------------------+----------+-------------+---+-------- 2018 Net Periodic Benefit Cost | $ | (27) | | $ | 1,270 ------------------------------------------------------------------------+-------------------------+----------+-------------+---+-------- 2018 Projected Service and Interest Costs | | 561 | | | (1,045) ------------------------------------------------------------------------+-------------------------+----------+-------------+---+-------- Accumulated Post Retirement Benefit Obligation as of September 30, 2017 | | (29,012) | | | 36,375 ------------------------------------------------------------------------+-------------------------+----------+-------------+---+-------- · | Compensation increase assumptions, where applicable, are based upon historical experience and anticipated future management actions. An increase in the rate would increase our obligation and expense. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------  · | Mortality trends assumptions are based on published actuarial data and are sometimes modified to reflect projected longevity trends. Increases in life expectancy of participants greater than assumed would increase our obligation and expense. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------  In determining the long-term rate of return on plan assets, we consider the asset investment mix for each plan. For example, fixed-income securities generally have a lower rate of return than equity securities. We assume that the historical long-term compound growth rates of similar equity and fixed-income securities will predict the future returns of investments in the various plan portfolios. We consider the potential impacts of changes in general market conditions, but because our assumptions are based on long-term rates of return, short-term market conditions generally have an insignificant effect on our assumptions. Changes in asset allocations are managed on a plan-by-plan basis, taking into consideration factors such as the average age of the plan participants and the projected timing of future benefit payments.   | | | | | ----------------------------------+-----------------------------------------+-------+---------------+---+--------  | | | | | ----------------------------------+-----------------------------------------+-------+---------------+---+--------  | Change In Rate of Return on Plan Assets ----------------------------------+----------------------------------------  | 0.5% increase | | 0.5% decrease ----------------------------------+-----------------------------------------+-------+-------------- Defined benefit pension benefits: | | | | | ----------------------------------+-----------------------------------------+-------+---------------+---+-------- 2018 Net Periodic Benefit Cost | $ | 1,104 | | $ | (1,104) ----------------------------------+-----------------------------------------+-------+---------------+---+-------- If, as of the beginning of the year, the net plan gain or loss recognized in accumulated other comprehensive income exceeds 10% of the greater of the plan projected benefit obligation or the market-related value of plan assets, the amortization out of accumulated other comprehensive income into current period expense is that excess divided by the average remaining service period of employees expected to receive benefits under the plan.  Primary actuarial assumptions for our other postretirement benefit plans were determined as follows: · | The discount rate assumption is intended to reflect the rate at which the postretirement benefits could be effectively settled based upon the assumed timing of the benefit payments. --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- In the United States, Woodward uses a bond portfolio matching analysis based on recently traded, non-callable bonds rated AA or better that have at least $50 million outstanding to determine the benefit obligations at year end.  In the United Kingdom, Woodward uses a high-quality corporate bond yield curve matched with separate cash flows to develop a single rate to determine the single rate equivalent to settle the entire benefit obligations in each jurisdiction. For the fiscal years ended September 30, 2017 and September 30, 2016, the discount rate used to determine periodic service cost and interest cost components of the overall benefit costs was based on spot rates derived from the same high-quality corporate bond yield curve used to determine the September 30, 2016 and 2015 benefit obligation, respectively, matched with separate cash flows for each future year.  These rates are sensitive to changes in interest rates.   | | | | | ------------------------------------------------------------------------+-------------------------+---------+-------------+---+------  | | | | | ------------------------------------------------------------------------+-------------------------+---------+-------------+---+------  | Change In Discount Rate ------------------------------------------------------------------------+------------------------  | 1% increase | | 1% decrease ------------------------------------------------------------------------+-------------------------+---------+------------ Other postretirement benefits: | | | | | ------------------------------------------------------------------------+-------------------------+---------+-------------+---+------ 2018 Net Periodic Benefit Cost | $ | 158 | | $ | (52) ------------------------------------------------------------------------+-------------------------+---------+-------------+---+------ 2018 Projected Service and Interest Costs | | 186 | | | (226) ------------------------------------------------------------------------+-------------------------+---------+-------------+---+------ Accumulated Post Retirement Benefit Obligation as of September 30, 2017 | | (2,582) | | | 2,990 ------------------------------------------------------------------------+-------------------------+---------+-------------+---+------ · | Mortality trends assumptions are based on published actuarial data and are sometimes modified to reflect projected longevity trends. Increases in life expectancy of participants greater than assumed would increase our obligation and expense. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 45  The assumed health care trend rate represents the rate at which health care costs are assumed to increase and is based on historical and expected experience. Changes in our projections of future health care costs due to general economic conditions and those specific to health care (e.g., technology driven cost changes) will impact this trend rate.    | | | | | ------------------------------------------------------------------------------+---------------------------------------+-------+-------------+---+--------  | Change In Health Care Cost Trend Rate ------------------------------------------------------------------------------+--------------------------------------  | 1% increase | | 1% decrease ------------------------------------------------------------------------------+---------------------------------------+-------+------------ Effect on projected fiscal year 2018 service and interest cost | $ | 113 | | $ | (99) ------------------------------------------------------------------------------+---------------------------------------+-------+-------------+---+-------- Effect on accumulated postretirement benefit obligation at September 30, 2017 | | 2,960 | | | (2,605) ------------------------------------------------------------------------------+---------------------------------------+-------+-------------+---+-------- · | If, as of the beginning of the year, the net plan gain or loss recognized in accumulated other comprehensive income exceeds 10% of the plan accumulated postretirement benefit obligation, the amortization out of accumulated other comprehensive income into current period expense is that excess divided by the average remaining service period of employees expected to receive benefits under the plan. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------  Variances from our fiscal year end estimates for these variables could materially affect our recognized postretirement benefit obligation liabilities. On a near-term basis, such changes are unlikely to have a material impact on reported earnings, since such adjustments are recorded to other comprehensive earnings and recognized into expense over a number of years. Significant changes in estimates could, however, materially affect the carrying amounts of benefit obligation liabilities, including accumulated benefit obligations, which could affect compliance with the provisions of our debt arrangements and future borrowing capacity. Income taxes We are subject to income taxes in the United States and numerous foreign jurisdictions. Significant judgment is required in evaluating our tax positions and determining our provision for income taxes. During the ordinary course of business, there are many transactions and calculations for which the ultimate tax determination is uncertain. We establish reserves for tax-related uncertainties based on estimates of whether, and the extent to which, additional taxes will be due. The reserves are established when we believe that certain positions are likely to be challenged and may not be fully sustained on review by tax authorities. We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit or refinement of an estimate. Although we believe our reserves are reasonable, no assurance can be given that the final outcome of these matters will be consistent with what is reflected in our historical income tax provisions and accruals. To the extent that the final tax outcome of these matters is different from the amounts recorded, such differences will impact the current provision for income taxes. The provision for income taxes includes the impact of reserve positions and changes to reserves that are considered appropriate. As of September 30, 2017 and September 30, 2016, unrecognized gross tax benefits for which recognition has been deferred were $20,132 and $23,526, respectively. Significant judgment is also required in determining any valuation allowance recorded against deferred tax assets. The determination of the amount of valuation allowance to be provided on recorded deferred tax assets involves estimates regarding the timing and amount of the reversal of taxable temporary differences, expected future taxable income, and the impact of tax planning strategies. A valuation allowance is established to offset any deferred tax assets if, based upon the available evidence, it is more likely than not that some or all of the deferred tax asset will not be realized. In assessing the need for a valuation allowance, we consider all available evidence including past operating results, estimates of future taxable income, and the feasibility of tax planning strategies. Changes in the relevant facts can significantly impact the judgment or need for valuation allowances. In the event we change our determination as to the amount of deferred tax assets that can be realized, we will adjust our valuation allowance with a corresponding impact to the provision for income taxes in the period in which such determination is made. Our valuation allowance was $3,714 as of September 30, 2017 and $3,317 as of September 30, 2016. Our effective tax rates differ from the U.S. statutory rate primarily due to the tax impact of foreign operations, adjustments of valuation allowances, research tax credits, state taxes, and tax audit settlements. In addition to potential local country tax law and policy changes that could impact the provision for income taxes, management’s judgment about and intentions concerning the repatriation of foreign earnings could also significantly impact the provision for income taxes. Management reassesses its judgment regularly, taking into consideration the potential tax impacts of these judgments and intentions. Our provision for income taxes is subject to volatility and could be affected by earnings that are different than those anticipated in countries which have lower or higher tax rates; by transfer pricing adjustments; and/or changes in tax laws, regulations, and accounting principles, including accounting for uncertain tax positions, or interpretations thereof. There can be no assurance that these items will remain stable over time. Additionally, with the adoption of ASU 2016-09, “Improvements to Employee Share-Based Payments Accounting,” in fiscal year 2016, Woodward is recording through income tax expense all future excess tax benefits and tax deficiencies from stock options exercised. This new guidance creates unpredictable volatility in the effective tax rate because the additional expense or benefit recognized each quarter is based on the timing of the employee’s election to exercise any vested stock 46 options outstanding, which is outside Woodward’s control, and the market price of Woodward’s shares at the time of exercise, which is subject to market volatility. In addition, we are subject to examination of our income tax returns by the relevant tax authorities in the jurisdictions in which we are subject to taxes. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes. There can be no assurance that the outcomes from these examinations will not have a significant effect on our operating results, financial condition, and cash flows. Item 7A.Quantitative and Qualitative Disclosures About Market Risk In the normal course of business, we have exposures to interest rate risk from our long-term and short-term debt, and our postretirement benefit plans, and foreign currency exchange rate risk related to our foreign operations and foreign currency transactions. Interest Rate Risk We use derivative instruments as risk management tools that involve little complexity, and are not used for trading or speculative purposes. In June 2013, in connection with Woodward’s expected refinancing of current maturities on its existing long-term debt, Woodward entered into a treasury lock agreement with a notional amount of $25,000 that qualified as a cash flow hedge under ASC Topic 815, “Derivatives and Hedging.” The objective of this derivative instrument was to hedge the risk of variability in cash flows attributable to changes in the designated benchmark interest rate over a seven-year period related to the future interest payments on a portion of anticipated future debt issuances. A portion of our long and short-term debt is sensitive to changes in interest rates. As of September 30, 2017 our Series J Notes of $50,000 and advances on our revolving credit facility are at interest rates that fluctuate with market rates. A hypothetical 1% increase in the assumed effective interest rates that apply to the variable rate loan outstanding as of September 30, 2017 and the average borrowings on our revolving credit facility in fiscal year 2017 would cause our annual interest expense to increase approximately $2,930. A hypothetical 1% decrease in the assumed effective interest rates that apply to the variable rate loan outstanding as of September 30, 2017 and the average borrowings on our revolving credit facility in fiscal year 2017 would decrease our annual interest expense by approximately $2,930. The discount rate and future return on plan asset assumptions used to calculate the funding status of our retirement benefit plans are also sensitive to changes in interest rates. The weighted average discount rate assumption used to value the defined benefit pension plans as of September 30, 2017 was 3.80% in the United States, 2.56% in the United Kingdom, and 0.58% in Japan. The weighted average discount rate assumption used to value the other postretirement benefit plans was 3.78%. In the United States, the discount rate used to determine the periodic benefit costs for the year ending September 30, 2018 is consistent with the discount rate used to determine the benefit obligation as of September 30, 2017, or 3.80%. Woodward derives this discount rate from a bond portfolio matching analysis based on recently traded, non-callable bonds rated AA or better that have at least $50 million outstanding. In the United Kingdom and Japan, Woodward utilizes the spot rate approach to calculate the service cost and interest cost components for determining benefit costs for the year ending September 30, 2018. The weighted average discount rate assumption used to value the service costs for the defined benefit pension plans will be 2.58% in the United Kingdom, and 0.72% in Japan. The weighted average discount rate assumption used to value the interest costs for the defined benefit pension plans will be 2.59% in the United Kingdom, and 0.55% in Japan. The weighted average discount rate assumption used to value the periodic benefits costs for the other postretirement plans in for the year ending September 30, 2018 is consistent with the discount rate used to determine the benefit obligation as of September 30, 2017, or 3.80% for the United States and 1.86% for the United Kingdom. The following information illustrates the sensitivity of the net periodic benefit cost and the projected accumulated benefit obligation to a change in the discount rate assumed. Amounts relating to foreign plans are translated at the spot rate on September 30, 2017. It should be noted that economic factors and conditions often affect multiple assumptions simultaneously and the effects of changes in assumptions are not necessarily linear due to factors such as the 10% corridor applied to the larger of the postretirement benefit obligation or the fair market value of plan assets when determining amortization of actuarial net gains or losses. 47   | | | | | | | | ----------------------------------+-------------+--------------------------------+-------+-------------------------------------------+---+-------------------------------------------------------------------------+---+---------  | | | | | | | | ----------------------------------+-------------+--------------------------------+-------+-------------------------------------------+---+-------------------------------------------------------------------------+---+---------  | | Increase/(Decrease) In ----------------------------------+-------------+------------------------------- Assumption | Change | 2018 Net Periodic Benefit Cost | | 2018 Projected Service and Interest Costs | | Accumulated Post Retirement Benefit Obligation as of September 30, 2017 ----------------------------------+-------------+--------------------------------+-------+-------------------------------------------+---+------------------------------------------------------------------------ Defined benefit pension benefits: | | | | | | | | ----------------------------------+-------------+--------------------------------+-------+-------------------------------------------+---+-------------------------------------------------------------------------+---+--------- Change in discount rate | 1% increase | $ | (27) | | $ | 561 | $ | (29,012) ----------------------------------+-------------+--------------------------------+-------+-------------------------------------------+---+-------------------------------------------------------------------------+---+---------  | 1% decrease | | 1,270 | | | (1,045) | | 36,375 ----------------------------------+-------------+--------------------------------+-------+-------------------------------------------+---+-------------------------------------------------------------------------+---+--------- Other postretirement benefits: | | | | | | | | ----------------------------------+-------------+--------------------------------+-------+-------------------------------------------+---+-------------------------------------------------------------------------+---+--------- Change in discount rate | 1% increase | | 158 | | | 186 | | (2,582) ----------------------------------+-------------+--------------------------------+-------+-------------------------------------------+---+-------------------------------------------------------------------------+---+---------  | 1% decrease | | (52) | | | (226) | | 2,990 ----------------------------------+-------------+--------------------------------+-------+-------------------------------------------+---+-------------------------------------------------------------------------+---+---------  Foreign Currency Exchange Rate Risk and Related Hedging Activities We are impacted by changes in foreign currency exchange rates when we sell product in currencies different from the currency in which product and manufacturing costs were incurred. The functional currencies and our purchasing and sales activities primarily include USD, EUR, RMB, JPY and GBP. We may also be impacted by changes in the relative buying power of our customers, which may impact sales volumes either positively or negatively. As these currencies fluctuate against each other, and other currencies, we are exposed to foreign currency exchange rate risk on sales, purchasing transactions, and labor. Foreign currency exchange rate risk is reduced through the maintenance of local production facilities in the markets we serve, which we believe creates a natural hedge to our foreign currency exchange rate exposure. For the years ended September 30, 2017 and 2016, the percentages of our net sales denominated in a currency other than the USD were as follows:   | | -----------------------------+---------------------------------------+--------------------------------------  | | -----------------------------+---------------------------------------+--------------------------------------  | Percentage of Net Sales | Percentage of Net Sales -----------------------------+---------------------------------------+--------------------------------------  | For the Year Ended September 30, 2017 | For the Year Ended September 30, 2016 -----------------------------+---------------------------------------+-------------------------------------- Functional currency: | | -----------------------------+---------------------------------------+-------------------------------------- EUR | 10.3% | 12.7% -----------------------------+---------------------------------------+-------------------------------------- RMB | 5.4% | 2.4% -----------------------------+---------------------------------------+-------------------------------------- JPY | 2.5% | 3.1% -----------------------------+---------------------------------------+-------------------------------------- GBP | 1.9% | 1.7% -----------------------------+---------------------------------------+-------------------------------------- All other foreign currencies | 1.8% | 2.3% -----------------------------+---------------------------------------+--------------------------------------  | 21.9% | 22.2% -----------------------------+---------------------------------------+--------------------------------------  | | -----------------------------+---------------------------------------+-------------------------------------- Currency exchange rates vary daily and often one currency strengthens against the USD while another currency weakens. Because of the complex interrelationship of our worldwide supply chains and distribution channels, it is difficult to quantify the impact of a particular change in exchange rates. From time to time, we will enter into a foreign currency exchange rate contract to hedge against changes in foreign currency exchange rates on liabilities expected to be settled at a future date. Market risk arises from the potential adverse effects on the value of derivative instruments that result from a change in foreign currency exchange rates. We minimize this market risk by establishing and monitoring parameters that limit the types of, and degree to which we enter into, derivative instruments. We enter into derivative instruments for risk management purposes only. We do not enter into or issue derivatives for trading or speculative purposes. As of September 30, 2017 and 2016, we had no open foreign currency exchange rate contracts and all previous derivative instruments were settled or terminated. On September 23, 2016, Woodward and Woodward International Holding B.V., a wholly owned subsidiary of Woodward organized under the laws of The Netherlands (the “BV Subsidiary”), entered into note purchase agreements relating to the sale by Woodward and the BV Subsidiary of an aggregate principal amount of €160,000 of senior unsecured notes in a series of private placement transactions. Woodward issued €40,000 aggregate principal amount of Woodward’s Series M Senior Notes due September 23, 2026. Woodward designated the €40,000 Series M Notes as a hedge of a foreign currency exposure of Woodward’s net investment in its EUR denominated functional currency subsidiaries. Foreign exchange losses on the Series M Notes of $2,395 for the fiscal year ended September 30, 2017 and $47 for the fiscal year ended September 30, 2016 are included in foreign currency translation adjustments within total comprehensive earnings. In June 2015, Woodward designated an intercompany loan of 160,000 RMB between two wholly owned subsidiaries as a hedge of a foreign currency exposure of the net investment of the borrower in the lender. In June 2016, the intercompany loan was repaid, resulting in a realized foreign exchange gain of $1,484 that was recognized within total comprehensive earnings, of which $912 was recognized in fiscal year 2016 and $572 was recognized in fiscal year 2015. 48 In July 2016, Woodward designated a new intercompany loan of 160,000 RMB between the same two wholly owned subsidiaries as a hedge of a foreign currency exposure of the net investment of the borrower in the lender. In July 2017, the intercompany loan was repaid, resulting in a realized foreign exchange gain of $380 that was recognized within total comprehensive earnings, of which a gain of $453 was recognized in fiscal year 2017 and a loss of $73 was recognized in fiscal year 2016. For more information on derivative instruments, see Note 6, Derivative instruments and hedging activities, in the Notes to the Consolidated Financial Statements in “Item 8 – Financial Statements and Supplementary Data.” Our reported financial results of operations, including the reported value of our assets and liabilities, are also impacted by changes in foreign currency exchange rates. The assets and liabilities of substantially all of our subsidiaries outside the United States are translated at period end rates of exchange for each reporting period. Earnings and cash flow statements are translated at weighted-average rates of exchange. Although these translation changes have no immediate cash impact, the translation changes may impact future borrowing capacity, debt covenants, and the overall value of our net assets. In addition, we also have assets and liabilities, specifically accounts receivable, accounts payable and current inter-company receivables and payables, whose carrying amounts approximate their fair value, which are denominated in currencies other than their relevant functional currencies. Foreign currency exchange rate risk is reduced through several means, including the invoicing of customers in the same currency as the source of the products, and the prompt settlement of inter-company balances utilizing a global netting system. We recognized a net foreign currency loss of $651 in fiscal year 2017, a net foreign currency gain of $701 in fiscal year 2016, and a net foreign currency loss of $1,721 in fiscal year 2015 in “Selling, general, and administrative expenses” of our Consolidated Statements of Earnings related to these assets and liabilities. 49 Item 8.Financial Statements and Supplementary Data REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM  To the Board of Directors and Stockholders of Woodward, Inc. Fort Collins, Colorado  We have audited the accompanying consolidated balance sheets of Woodward, Inc. and subsidiaries (the "Company") as of September 30, 2017 and 2016, and the related consolidated statements of earnings, comprehensive earnings, stockholders' equity, and cash flows for each of the three years in the period ended September 30, 2017. Our audits also included the financial statement schedule listed in the Index at Item 15. These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Woodward, Inc. and subsidiaries as of September 30, 2017 and 2016, and the results of their operations and their cash flows for each of the three years in the period ended September 30, 2017, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of September 30, 2017, based on the criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated November 10, 2017 expressed an unqualified opinion on the Company's internal control over financial reporting.   /s/ DELOITTE & TOUCHE LLP Denver, Colorado November 10, 2017 50   PART I – FINANCIAL INFORMATION Item 1.Financial Statements  WOODWARD, INC. CONSOLIDATED STATEMENTS OF EARNINGS (In thousands, except per share amounts)        | | | | | | | --------------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+----------  | | | | | | | --------------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+----------  | Year Ended September 30, --------------------------------------------------------------+-------------------------  | 2017 | | 2016 | | 2015 --------------------------------------------------------------+--------------------------+-----------+------+---+----------  | | | | | | | --------------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Net sales | $ | 2,098,685 | | $ | 2,023,078 | $ | 2,038,303 --------------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Costs and expenses: | | | | | | | --------------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Cost of goods sold | | 1,526,126 | | | 1,483,960 | | 1,462,833 --------------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Selling, general and administrative expenses | | 176,633 | | | 174,017 | | 177,121 --------------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Research and development costs | | 126,519 | | | 126,170 | | 134,485 --------------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Interest expense | | 27,430 | | | 26,776 | | 24,864 --------------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Interest income | | (1,725) | | | (2,025) | | (787) --------------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Other (income) expense, net (Note 15) | | (9,045) | | | (12,306) | | (1,162) --------------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Total costs and expenses | | 1,845,938 | | | 1,796,592 | | 1,797,354 --------------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Earnings before income taxes | | 252,747 | | | 226,486 | | 240,949 --------------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Income tax expense | | 52,240 | | | 45,648 | | 59,497 --------------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Net earnings | $ | 200,507 | | $ | 180,838 | $ | 181,452 --------------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+----------  | | | | | | | --------------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Earnings per share (Note 3): | | | | | | | --------------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Basic earnings per share | $ | 3.27 | | $ | 2.92 | $ | 2.81 --------------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Diluted earnings per share | $ | 3.16 | | $ | 2.85 | $ | 2.75 --------------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+----------  | | | | | | | --------------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Weighted Average Common Shares Outstanding (Note 3): | | | | | | | --------------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Basic | | 61,366 | | | 61,893 | | 64,684 --------------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Diluted | | 63,512 | | | 63,556 | | 66,056 --------------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Cash dividends per share paid to Woodward common stockholders | $ | 0.485 | | $ | 0.430 | $ | 0.380 --------------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+----------  | | | | | | | --------------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+----------    See accompanying Notes to Consolidated Financial Statements 51  WOODWARD, INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE EARNINGS (In thousands)                     | | | | | | | -------------------------------------------------------------------------------------------------------------------+--------------------------+---------+------+---+----------+---+---------  | | | | | | | -------------------------------------------------------------------------------------------------------------------+--------------------------+---------+------+---+----------+---+---------  | Year Ended September 30, -------------------------------------------------------------------------------------------------------------------+-------------------------  | 2017 | | 2016 | | 2015 -------------------------------------------------------------------------------------------------------------------+--------------------------+---------+------+---+---------  | | | | | | | -------------------------------------------------------------------------------------------------------------------+--------------------------+---------+------+---+----------+---+--------- Net earnings | $ | 200,507 | | $ | 180,838 | $ | 181,452 -------------------------------------------------------------------------------------------------------------------+--------------------------+---------+------+---+----------+---+--------- Other comprehensive earnings: | | | | | | | -------------------------------------------------------------------------------------------------------------------+--------------------------+---------+------+---+----------+---+--------- Foreign currency translation adjustments | | 45 | | | (6,615) | | (34,989) -------------------------------------------------------------------------------------------------------------------+--------------------------+---------+------+---+----------+---+--------- Net gain (loss) on foreign currency transactions designated as hedges of net investments in a foreign subsidiaries | | (1,942) | | | 792 | | 572 -------------------------------------------------------------------------------------------------------------------+--------------------------+---------+------+---+----------+---+--------- Taxes on changes on foreign currency translation adjustments | | 588 | | | 1,462 | | 1,988 -------------------------------------------------------------------------------------------------------------------+--------------------------+---------+------+---+----------+---+---------  | | (1,309) | | | (4,361) | | (32,429) -------------------------------------------------------------------------------------------------------------------+--------------------------+---------+------+---+----------+---+--------- Reclassification of realized losses (gains) on derivatives to earnings | | (72) | | | 21 | | 99 -------------------------------------------------------------------------------------------------------------------+--------------------------+---------+------+---+----------+---+--------- Taxes on changes on derivative transactions | | 28 | | | (8) | | (38) -------------------------------------------------------------------------------------------------------------------+--------------------------+---------+------+---+----------+---+---------  | | (44) | | | 13 | | 61 -------------------------------------------------------------------------------------------------------------------+--------------------------+---------+------+---+----------+---+--------- Minimum retirement benefit liability adjustments (Note 17): | | | | | | | -------------------------------------------------------------------------------------------------------------------+--------------------------+---------+------+---+----------+---+--------- Net gain (loss) arising during the period | | 22,979 | | | (19,718) | | (26,866) -------------------------------------------------------------------------------------------------------------------+--------------------------+---------+------+---+----------+---+--------- Loss due to settlement or curtailment arising during the period | | - | | | 47 | | - -------------------------------------------------------------------------------------------------------------------+--------------------------+---------+------+---+----------+---+--------- Amortization of: | | | | | | | -------------------------------------------------------------------------------------------------------------------+--------------------------+---------+------+---+----------+---+--------- Prior service benefit | | (3,470) | | | 226 | | 225 -------------------------------------------------------------------------------------------------------------------+--------------------------+---------+------+---+----------+---+--------- Net loss | | 2,570 | | | 1,694 | | 513 -------------------------------------------------------------------------------------------------------------------+--------------------------+---------+------+---+----------+---+--------- Foreign currency exchange rate changes on minimum retirement benefit liabilities | | (43) | | | 2,239 | | 867 -------------------------------------------------------------------------------------------------------------------+--------------------------+---------+------+---+----------+---+--------- Taxes on changes on minimum retirement benefit liability adjustments | | (8,164) | | | 5,613 | | 9,704 -------------------------------------------------------------------------------------------------------------------+--------------------------+---------+------+---+----------+---+---------  | | 13,872 | | | (9,899) | | (15,557) -------------------------------------------------------------------------------------------------------------------+--------------------------+---------+------+---+----------+---+--------- Total comprehensive earnings | $ | 213,026 | | $ | 166,591 | $ | 133,527 -------------------------------------------------------------------------------------------------------------------+--------------------------+---------+------+---+----------+---+---------  See accompanying Notes to Consolidated Financial Statements  52 WOODWARD, INC. CONSOLIDATED BALANCE SHEETS (In thousands, except per share amounts)     | | | | | -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+----------  | | | | | -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+----------  | September 30, | | September 30, -------------------------------------------------------------------------------------------------+---------------+-----------+--------------  | 2017 | | 2016 -------------------------------------------------------------------------------------------------+---------------+-----------+-------------- ASSETS | | | | | -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Current assets: | | | | | -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Cash and cash equivalents | $ | 87,552 | | $ | 81,090 -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Accounts receivable, less allowance for uncollectible amounts of $3,776 and $2,540, respectively | | 402,182 | | | 343,768 -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Inventories | | 473,505 | | | 461,683 -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Income taxes receivable | | 19,376 | | | 20,358 -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Other current assets | | 38,574 | | | 37,525 -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Total current assets | | 1,021,189 | | | 944,424 -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Property, plant and equipment, net | | 922,043 | | | 876,350 -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Goodwill | | 556,545 | | | 555,684 -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Intangible assets, net | | 171,882 | | | 197,650 -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Deferred income tax assets | | 19,950 | | | 20,194 -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Other assets | | 65,500 | | | 48,060 -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Total assets | $ | 2,757,109 | | $ | 2,642,362 -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- LIABILITIES AND STOCKHOLDERS' EQUITY | | | | | -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Current liabilities: | | | | | -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Short-term borrowings and current portion of long-term debt | $ | 32,600 | | $ | 150,000 -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Accounts payable | | 232,788 | | | 169,439 -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Income taxes payable | | 6,774 | | | 4,547 -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Accrued liabilities | | 155,072 | | | 156,627 -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Total current liabilities | | 427,234 | | | 480,613 -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Long-term debt, less current portion | | 580,286 | | | 577,153 -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Deferred income tax liabilities | | 33,408 | | | 3,777 -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Other liabilities | | 344,798 | | | 368,224 -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Total liabilities | | 1,385,726 | | | 1,429,767 -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Commitments and contingencies (Note 19) | | | | | -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Stockholders' equity: | | | | | -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Preferred stock, par value $0.003 per share, 10,000 shares authorized, no shares issued | | - | | | - -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Common stock, par value $0.001455 per share, 150,000 shares authorized, 72,960 shares issued | | 106 | | | 106 -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Additional paid-in capital | | 163,836 | | | 141,570 -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Accumulated other comprehensive losses | | (53,186) | | | (65,705) -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Deferred compensation | | 7,135 | | | 5,089 -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Retained earnings | | 1,820,268 | | | 1,649,506 -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+----------  | | 1,938,159 | | | 1,730,566 -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Treasury stock at cost, 11,739 shares and 11,374 shares, respectively | | (559,641) | | | (512,882) -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Treasury stock held for deferred compensation, at cost, 186 shares and 157 shares, respectively | | (7,135) | | | (5,089) -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Total stockholders' equity | | 1,371,383 | | | 1,212,595 -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+---------- Total liabilities and stockholders' equity | $ | 2,757,109 | | $ | 2,642,362 -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+----------  | | | | | -------------------------------------------------------------------------------------------------+---------------+-----------+---------------+---+----------  See accompanying Notes to Consolidated Financial Statements. 53    WOODWARD, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands)     | | | | | | | ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+----------  | | | | | | | ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+----------  | Year Ended September 30, ----------------------------------------------------------------------------------------------+-------------------------  | 2017 | | 2016 | | 2015 ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+---------- Cash flows from operating activities: | | | | | | | ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Net earnings | $ | 200,507 | | $ | 180,838 | $ | 181,452 ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Adjustments to reconcile net earnings to net cash provided by operating activities: | | | | | | | ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Depreciation and amortization | | 80,917 | | | 69,036 | | 75,235 ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Loss due to settlements or curtailments of postretirement plan (Note 17) | | - | | | 47 | | - ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Net gain on sales of assets | | (3,604) | | | (4,431) | | (626) ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Stock-based compensation | | 17,282 | | | 15,122 | | 14,255 ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Deferred income taxes | | 22,772 | | | (52,744) | | 15,504 ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- (Gain) loss on derivatives reclassified from accumulated comprehensive earnings into earnings | | (72) | | | 21 | | 99 ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Proceeds from formation of joint venture (Note 4) | | - | | | 250,000 | | - ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Changes in operating assets and liabilities: | | | | | | | ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Accounts receivable | | (53,151) | | | (9,190) | | 14,845 ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Inventories | | (10,857) | | | (17,658) | | (8,824) ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Accounts payable and accrued liabilities | | 64,659 | | | 17,461 | | 3,029 ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Current income taxes | | 3,323 | | | (834) | | (7,487) ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Retirement benefit obligations | | (2,932) | | | (3,416) | | (4,537) ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Other | | (11,307) | | | (8,873) | | 13,045 ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Net cash provided by operating activities | | 307,537 | | | 435,379 | | 295,990 ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Cash flows from investing activities: | | | | | | | ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Payments for purchase of property, plant, and equipment | | (92,336) | | | (175,692) | | (286,612) ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Proceeds from sale of assets | | 3,743 | | | 6,664 | | 2,529 ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Proceeds from sales of short-term investments | | 5,313 | | | - | | - ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Purchases of short-term investments | | (8,586) | | | (4,918) | | - ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Net cash used in investing activities | | (91,866) | | | (173,946) | | (284,083) ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Cash flows from financing activities: | | | | | | | ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Cash dividends paid | | (29,745) | | | (26,606) | | (24,646) ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Proceeds from sales of treasury stock | | 14,195 | | | 15,892 | | 8,400 ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Payments for repurchases of common stock | | (71,751) | | | (125,541) | | (158,762) ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Borrowings on revolving lines of credit and short-term borrowings | | 1,506,000 | | | 695,000 | | 999,971 ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Payments on revolving lines of credit and short-term borrowings | | (1,630,100) | | | (890,896) | | (856,610) ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Proceeds from issuance of long-term debt | | - | | | 179,308 | | - ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Payments of long-term debt and capital lease obligations | | (412) | | | (107,287) | | - ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Payments of debt financing costs | | - | | | (863) | | (2,359) ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Net cash used in financing activities | | (211,813) | | | (260,993) | | (34,006) ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Effect of exchange rate changes on cash and cash equivalents | | 2,604 | | | (1,552) | | (10,986) ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Net change in cash and cash equivalents | | 6,462 | | | (1,112) | | (33,085) ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Cash and cash equivalents at beginning of year | | 81,090 | | | 82,202 | | 115,287 ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- Cash and cash equivalents at end of year | $ | 87,552 | | $ | 81,090 | $ | 82,202 ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+----------  | | | | | | | ----------------------------------------------------------------------------------------------+--------------------------+-------------+------+---+-----------+---+---------- See accompanying Notes to Consolidated Financial Statements  54 WOODWARD, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (In thousands)   | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+----------  | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+----------  | Number of shares | Stockholders' equity ------------------------------------------------------------------------+------------------+---------------------  | | | | | | | | | | Accumulated other comprehensive (loss) earnings | | | | | | | | | | | | | ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+--  | Preferred stock | Commonstock | Treasurystock | Treasury stock held for deferred compensation | Commonstock | | Additional paid-in capital | | Foreign currency translation adjustments | Unrealized derivative gains (losses) | | Minimum retirement benefit liabilityadjustments | | Total accumulated other comprehensive(loss) earnings | Deferred compensation | | Retainedearnings | | Treasury stock at cost | Treasury stock held for deferredcompensation | | Total stockholders' equity ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+----------------------------  | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Balances as of October 1, 2014 | - | 72,960 | (7,397) | (198) | $ | 106 | | $ | 112,491 | $ | 10,819 | | $ | 105 | $ | (14,457) | | $ | (3,533) | $ | 3,915 | | $ | 1,338,468 | $ | (286,588) | $ | (3,915) | $ | 1,160,944 ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Net earnings | - | - | - | - | | - | | | - | | - | | | - | | - | | | - | | - | | | 181,452 | | - | | - | | 181,452 ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Other comprehensive income (loss), net of tax | - | - | - | - | | - | | | - | | (32,429) | | | 61 | | (15,557) | | | (47,925) | | - | | | - | | - | | - | | (47,925) ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Cash dividends ($0.380 per share) | - | - | - | - | | - | | | - | | - | | | - | | - | | | - | | - | | | (24,646) | | - | | - | | (24,646) ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Purchases of treasury stock | - | - | (3,193) | - | | - | | | - | | - | | | - | | - | | | - | | - | | | - | | (160,294) | | - | | (160,294) ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Sales of treasury stock | - | - | 568 | - | | - | | | (6,817) | | - | | | - | | - | | | - | | - | | | - | | 16,749 | | - | | 9,932 ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Common shares issued from treasury stock for benefit plans | - | - | 259 | - | | - | | | 4,490 | | - | | | - | | - | | | - | | - | | | - | | 8,084 | | - | | 12,574 ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Tax benefit attributable to stock-based compensation | - | - | - | - | | - | | | 6,812 | | - | | | - | | - | | | - | | - | | | - | | - | | - | | 6,812 ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Stock-based compensation | - | - | - | - | | - | | | 14,255 | | - | | | - | | - | | | - | | - | | | - | | - | | - | | 14,255 ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Purchase of stock by deferred compensation plan | - | - | - | (18) | | - | | | - | | - | | | - | | - | | | - | | 893 | | | - | | - | | (893) | | - ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Distribution of stock from deferred compensation plan | - | - | - | 43 | | - | | | - | | - | | | - | | - | | | - | | (486) | | | - | | - | | 486 | | - ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Balances as of September 30, 2015 | - | 72,960 | (9,763) | (173) | $ | 106 | | $ | 131,231 | $ | (21,610) | | $ | 166 | $ | (30,014) | | $ | (51,458) | $ | 4,322 | | $ | 1,495,274 | $ | (422,049) | $ | (4,322) | $ | 1,153,104 ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Net earnings | - | - | - | - | | - | | | - | | - | | | - | | - | | | - | | - | | | 180,838 | | - | | - | | 180,838 ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Other comprehensive income (loss), net of tax | - | - | - | - | | - | | | - | | (4,361) | | | 13 | | (9,899) | | | (14,247) | | - | | | - | | - | | - | | (14,247) ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Cash dividends paid ($0.430 per share) | - | - | - | - | | - | | | - | | - | | | - | | - | | | - | | - | | | (26,606) | | - | | - | | (26,606) ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Purchases of treasury stock | - | - | (2,660) | - | | - | | | - | | - | | | - | | - | | | - | | - | | | - | | (126,295) | | - | | (126,295) ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Sales of treasury stock | - | - | 732 | - | | - | | | (10,137) | | - | | | - | | - | | | - | | - | | | - | | 26,782 | | - | | 16,645 ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Common shares issued from treasury stock for benefit plans | - | - | 317 | - | | - | | | 5,319 | | - | | | - | | - | | | - | | - | | | - | | 8,680 | | - | | 13,999 ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Tax benefit attributable to stock-based compensation | - | - | - | - | | - | | | 35 | | - | | | - | | - | | | - | | - | | | - | | - | | - | | 35 ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Stock-based compensation | - | - | - | - | | - | | | 15,122 | | - | | | - | | - | | | - | | - | | | - | | - | | - | | 15,122 ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Purchases of stock by deferred compensation plan | - | - | - | (25) | | - | | | - | | - | | | - | | - | | | - | | 1,269 | | | - | | - | | (1,269) | | - ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Distribution of stock from deferred compensation plan | - | - | - | 41 | | - | | | - | | - | | | - | | - | | | - | | (502) | | | - | | - | | 502 | | - ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Balances as of September 30, 2016 | - | 72,960 | (11,374) | (157) | $ | 106 | | $ | 141,570 | $ | (25,971) | | $ | 179 | $ | (39,913) | | $ | (65,705) | $ | 5,089 | | $ | 1,649,506 | $ | (512,882) | $ | (5,089) | $ | 1,212,595 ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Net earnings | - | - | - | - | | - | | | - | | - | | | - | | - | | | - | | - | | | 200,507 | | - | | - | | 200,507 ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Other comprehensive income (loss), net of tax | - | - | - | - | | - | | | - | | (1,309) | | | (44) | | 13,872 | | | 12,519 | | - | | | - | | - | | - | | 12,519 ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Cash dividends paid ($0.485 per share) | - | - | - | - | | - | | | - | | - | | | - | | - | | | - | | - | | | (29,745) | | - | | - | | (29,745) ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Purchases of treasury stock | - | - | (1,056) | - | | - | | | - | | - | | | - | | - | | | - | | - | | | - | | (73,224) | | - | | (73,224) ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Sales of treasury stock | - | - | 466 | - | | - | | | (2,257) | | - | | | - | | - | | | - | | - | | | - | | 17,925 | | - | | 15,668 ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Common shares issued from treasury stock for benefit plans | - | - | 199 | - | | - | | | 6,501 | | - | | | - | | - | | | - | | - | | | - | | 7,513 | | - | | 14,014 ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Common shares issued from treasury stock to settle employee liabilities | - | - | 26 | (26) | | - | | | 740 | | - | | | - | | - | | | - | | 1,767 | | | - | | 1,027 | | (1,767) | | 1,767 ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Stock-based compensation | - | - | - | - | | - | | | 17,282 | | - | | | - | | - | | | - | | - | | | - | | - | | - | | 17,282 ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Purchases and transfers of stock by/to deferred compensation plan | - | - | - | (3) | | - | | | - | | - | | | - | | - | | | - | | 298 | | | - | | - | | (298) | | - ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Distribution of stock from deferred compensation plan | - | - | - | - | | - | | | - | | - | | | - | | - | | | - | | (19) | | | - | | - | | 19 | | - ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+---------- Balances as of September 30, 2017 | - | 72,960 | (11,739) | (186) | $ | 106 | | $ | 163,836 | $ | (27,280) | | $ | 135 | $ | (26,041) | | $ | (53,186) | $ | 7,135 | | $ | 1,820,268 | $ | (559,641) | $ | (7,135) | $ | 1,371,383 ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+----------  | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | ------------------------------------------------------------------------+------------------+----------------------+---------------+------------------------------------------------+-------------+-----+-----------------------------+---+--------------------------------------------+-------------------------------------------------+----------+---------------------------------------------------+---+--------------------------------------------------------+-----------------------+----------+------------------+---+-------------------------+-----------------------------------------------+-------+-----------------------------+---+-----------+---+-----------+---+---------+---+----------   See accompanying Notes to Condensed Consolidated Financial Statements 55  WOODWARD, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share amounts) Note 1. Operations and summary of significant accounting policies Basis of presentation The Consolidated Financial Statements are prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) and include the accounts of Woodward, Inc. and its subsidiaries (collectively “Woodward” or “the Company”). Dollar amounts contained in these Consolidated Financial Statements are in thousands, except per share amounts. Nature of operations Woodward enhances the global quality of life, creating innovative energy control solutions that optimize the performance, efficiency and emissions of its customers’ products. Woodward is an independent designer, manufacturer, and service provider of energy control and optimization solutions. Woodward designs, produces and services reliable, efficient, low-emission, and high-performance energy control products for diverse applications in challenging environments. Woodward has significant production and assembly facilities in the United States, Europe and Asia, and promotes its products and services through its worldwide locations. Woodward’s strategic focus is providing energy control and optimization solutions for the aerospace and industrial markets. The precise and efficient control of energy, including motion, fluid, combustion and electrical energy, is a growing requirement in the markets it serves. Woodward’s customers look to it to optimize the efficiency, emissions and operation of power equipment in both commercial and defense operations. Woodward’s core technologies leverage well across its markets and customer applications, enabling it to develop and integrate cost-effective and state-of-the-art fuel, combustion, fluid, actuation and electronic systems. Woodward focuses its solutions and services primarily on serving original equipment manufacturers (“OEMs”) and equipment packagers, partnering with them to bring superior component and system solutions to their demanding applications. Woodward also provides aftermarket repair, maintenance, replacement and other service support for its installed products. Woodward’s components and integrated systems optimize performance of commercial aircraft, defense aircraft, military ground vehicles and other equipment, gas and steam turbines, wind turbines, including converters and power grid related equipment, industrial diesel, gas, bio-diesel and dual fuel reciprocating engines, and electrical power systems. Woodward’s innovative motion, fluid, combustion and electrical energy control systems help its customers offer more cost-effective, cleaner, and more reliable equipment. Summary of significant accounting policies Principles of consolidation: These Consolidated Financial Statements are prepared in accordance with U.S. GAAP and include the accounts of Woodward and its wholly and majority-owned subsidiaries. Transactions within and between these companies are eliminated. Use of estimates: The preparation of the Consolidated Financial Statements requires management to make use of estimates and assumptions that affect the reported amount of assets and liabilities, at the date of the financial statements and the reported revenues and expenses recognized during the reporting period, and certain financial statement disclosures. Significant estimates include allowances for uncollectible amounts, net realizable value of inventories, customer rebates earned, useful lives of property and identifiable intangible assets, the evaluation of impairments of property, identifiable intangible assets and goodwill, the provision for income tax and related valuation reserves, the valuation of assets and liabilities acquired in business combinations, assumptions used in the determination of the funded status and annual expense of pension and postretirement employee benefit plans, the valuation of stock compensation instruments granted to employees, and contingencies. Actual results could differ from those estimates. Foreign currency exchange rates: The assets and liabilities of substantially all subsidiaries outside the United States are translated at fiscal year-end rates of exchange, and earnings and cash flow statements are translated at weighted-average rates of exchange. Translation adjustments are accumulated with other comprehensive (losses) earnings as a separate component of stockholders’ equity and are presented net of tax effects in the Consolidated Statements of Stockholders’ Equity. The effects of changes in foreign currency exchange rates on loans between consolidated subsidiaries that are considered permanent in nature are also accumulated with other comprehensive earnings, net of tax. The Company is exposed to market risks related to fluctuations in foreign currency exchange rates because some sales transactions, and certain of the assets and liabilities of its domestic and foreign subsidiaries, are denominated in foreign 56 currencies. Selling, general, and administrative expenses include a net foreign currency loss of $651 in fiscal year 2017, net foreign currency gain of $701 in fiscal year 2016, and a net foreign currency loss of $1,721 in fiscal year 2015. Revenue recognition: Woodward recognizes revenue upon shipment or delivery of products or services and when collectability is reasonably assured. Delivery is upon completion of manufacturing, customer acceptance, and the transfer of the risks and rewards of ownership. In countries whose laws provide for retention of some form of title by sellers, enabling recovery of goods in the event of customer default on payment, product delivery is considered to have occurred when the customer has assumed the risks and rewards of ownership of the products. Occasionally, Woodward transfers title of product to customers, but retains substantive performance obligations such as completion of product testing, customer acceptance or in some instances regulatory acceptance. In addition, occasionally customers pay Woodward for products or services prior to Woodward satisfying its performance obligation. Under these circumstances, revenue is deferred until the performance obligations are satisfied. In addition, service revenue is also recognized upon completion of applicable performance obligations. Certain Woodward products include incidental software or firmware essential to the performance of the product as designed, which are treated as units of accounting associated with the related tangible product with which the software is included. Woodward does not generally sell software on a standalone basis, although software upgrades, if any, are generally paid for by the customer. Revenue for certain non-recurring engineering projects is recognized when contractually specified milestones are achieved. Product freight costs are included in cost of goods sold. Freight costs charged to customers are included in net sales. Taxes collected from customers and remitted to government authorities are excluded from revenue and are recorded as liabilities until the taxes are remitted to the appropriate U.S. or foreign government authority. Net sales generated through shipment of tangible products to customers represents more than 90% of total net sales for fiscal years 2017, 2016 and 2015. Customer payments: Woodward occasionally agrees to make payments to certain customers in order to participate in anticipated sales activity. Payments made to customers are accounted for as a reduction of revenue unless they are made in exchange for identifiable goods or services with fair values that can be reasonably estimated. Reductions in revenue associated with these customer payments are recognized immediately to the extent that the payments cannot be attributed to anticipated future sales, and are recognized in future periods to the extent that the payments relate to anticipated future sales. Such determinations are based on the facts and circumstances underlying each payment. Stock-based compensation: Compensation cost relating to stock-based payment awards made to employees and directors is recognized in the financial statements using a fair value method. Non-qualified stock option awards and restricted stock awards are issued under Woodward’s stock-based compensation plans. The cost of such awards, measured at the grant date, is based on the estimated fair value of the award. Forfeitures are estimated at the time of each grant in order to estimate the portion of the award that will ultimately vest. The estimate is based on Woodward’s historical rates of forfeitures and is updated periodically. The portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods, which is generally the vesting period of the awards. Research and development costs: Company funded expenditures related to new product development, and significant product enhancement and/or upgrade activities are expensed as incurred and are separately reported in the Consolidated Statements of Earnings. Income taxes: Deferred income taxes are provided for the temporary differences between the financial reporting basis and the tax basis of Woodward’s assets, liabilities, and certain unrecognized gains and losses recorded in accumulated other comprehensive (losses) earnings. Woodward provides for taxes that may be payable if undistributed earnings of overseas subsidiaries were to be remitted to the United States, except for those earnings that it considers to be indefinitely invested. Cash equivalents: Highly liquid investments purchased with an original maturity of three months or less are considered to be cash equivalents. Cash and cash equivalents are maintained with multiple financial institutions. Generally, these deposits may be redeemed upon demand and are maintained with financial institutions with reputable credit and therefore bear minimal credit risk. Woodward holds cash and cash equivalents at financial institutions in excess of amounts covered by the Federal Depository Insurance Corporation (the “FDIC”), sometimes invests excess cash in money market funds or other highly liquid investments not insured by the FDIC, and holds cash and cash equivalents outside the United States that are not insured by the FDIC. 57 Accounts receivable: Almost all of Woodward’s sales are made on credit and result in accounts receivable, which are recorded at the amount invoiced and are generally not collateralized. In the normal course of business, not all accounts receivable are collected and, therefore, an allowance for uncollectible amounts is provided equal to the amount that Woodward believes ultimately will not be collected. In establishing the amount of the allowance related to the credit risk of accounts receivable, customer-specific information is considered related to delinquent accounts, past loss experience, bankruptcy filings, deterioration in the customer’s operating results or financial position, and current economic conditions. Accounts receivable losses are deducted from the allowance, and the related accounts receivable balances are written off when the receivables are deemed uncollectible. Recoveries of accounts receivable previously written off are recognized when received. In addition, an allowance associated with anticipated future sales returns is also established and is included in the allowance for uncollectible amounts.  Consistent with common business practice in China, Woodward’s Chinese subsidiary accepts from Chinese customers, in settlement of certain customer accounts receivable, bankers’ acceptance notes issued by Chinese banks that are believed to be creditworthy. Bankers’ acceptance notes are financial instruments issued by Chinese financial institutions as part of financing arrangements between the financial institution and a customer of the financial institution. Bankers’ acceptance notes represent a commitment by the issuing financial institution to pay a certain amount of money at a specified future maturity date to the legal owner of the bankers’ acceptance note as of the maturity date. The maturity date of bankers’ acceptance notes varies, but it is Woodward’s policy to only accept bankers’ acceptance notes with maturity dates no more than 180 days from the date of Woodward’s receipt of such draft. The issuing financial institution is the obligor, not Woodward’s customers. Upon Woodward’s acceptance of a banker’s acceptance note from a customer, such customer has no further obligation to pay Woodward for the related accounts receivable balance. Woodward only accepts bankers’ acceptance notes issued by banks that are believed to be creditworthy and to which the credit risks associated with the bankers’ acceptance notes are believed to be minimal.  The composition of Woodward’s accounts receivable at September 30, 2017 and September 30, 2016 follows:      | | | | | ---------------------------------------------+---------------+---------+---------------+---+--------  | | | | | ---------------------------------------------+---------------+---------+---------------+---+--------  | September 30, | | September 30, ---------------------------------------------+---------------+---------+--------------  | 2017 | | 2016 ---------------------------------------------+---------------+---------+-------------- Accounts receivable from: | | | | | ---------------------------------------------+---------------+---------+---------------+---+-------- Customers | $ | 367,715 | | $ | 341,215 ---------------------------------------------+---------------+---------+---------------+---+-------- Other (Chinese financial institutions) | | 38,243 | | | 5,093 ---------------------------------------------+---------------+---------+---------------+---+-------- Allowance for uncollectible customer amounts | | (3,776) | | | (2,540) ---------------------------------------------+---------------+---------+---------------+---+--------  | $ | 402,182 | | $ | 343,768 ---------------------------------------------+---------------+---------+---------------+---+-------- Inventories: Inventories are valued at the lower of cost or net realizable value, with cost being determined using methods that approximate a first-in, first-out basis. Short-term investments: From time to time, certain of Woodward’s foreign subsidiaries will invest excess cash in short-term time deposits with a fixed maturity date of longer than three months but less than one year from the date the deposit. Woodward believes that the investments are with creditworthy financial institutions. Amounts with maturities of less than 365 days are classified as “Other current assets.” Property, plant, and equipment: Property, plant, and equipment are recorded at cost and are depreciated over the estimated useful lives of the assets. Assets are generally depreciated using the straight-line method. Assets are tested for recoverability whenever events or circumstances indicate the carrying value may not be recoverable. Estimated lives over which fixed assets are generally depreciated at September 30, 2017 were as follows:  | | | | -----------------------------------+---+---+----+------  | | | | -----------------------------------+---+---+----+------ Land improvements | 3 | - | 20 | years -----------------------------------+---+---+----+------ Buildings and improvements | 3 | - | 40 | years -----------------------------------+---+---+----+------ Leasehold improvements | 1 | - | 10 | years -----------------------------------+---+---+----+------ Machinery and production equipment | 3 | - | 20 | years -----------------------------------+---+---+----+------ Computer equipment and software | 3 | - | 10 | years -----------------------------------+---+---+----+------ Office furniture and equipment | 3 | - | 13 | years -----------------------------------+---+---+----+------ Other | 3 | - | 13 | years -----------------------------------+---+---+----+------ 58 Included in computer equipment and software are Woodward’s enterprise resource planning (“ERP”) systems, which have an estimated useful life of 10 years. All other computer equipment and software is generally depreciated over three to five years. Goodwill: Woodward tests goodwill for impairment at the reporting unit level on an annual basis and more often if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Based on the relevant U.S. GAAP authoritative guidance, Woodward aggregates components of a single operating segment into a reporting unit, if appropriate. The impairment tests consist of comparing the implied fair value of each reporting unit with its carrying amount that includes goodwill. If the carrying amount of the reporting unit exceeds its implied fair value, Woodward compares the implied fair value of goodwill with the recorded carrying amount of goodwill. If the carrying amount of goodwill exceeds the implied fair value of goodwill, an impairment loss would be recognized to reduce the carrying amount to its implied fair value. Based on the results of Woodward’s goodwill impairment testing it has recorded no impairment charges. Other intangibles: Other intangibles are recognized apart from goodwill whenever an acquired intangible asset arises from contractual or other legal rights, or whenever it is capable of being separated or divided from the acquired entity and sold, transferred, licensed, rented, or exchanged, either individually or in combination with a related contract, asset, or liability. All of Woodward’s intangibles have an estimated useful life and are being amortized using patterns that reflect the periods over which the economic benefits of the assets are expected to be realized. Amortization expense is allocated to cost of goods sold and selling, general, and administrative expenses based on the nature of the intangible asset. Impairment losses are recognized if the carrying amount of an intangible is both not recoverable and exceeds its fair value. Woodward has recorded no impairment charges on its other intangibles. Estimated lives over which intangible assets are amortized at September 30, 2017 were as follows:  | | | | -----------------------+----+---+----+------  | | | | -----------------------+----+---+----+------ Customer relationships | 9 | - | 30 | years -----------------------+----+---+----+------ Intellectual property | 10 | - | 17 | years -----------------------+----+---+----+------ Process technology | 8 | - | 30 | years -----------------------+----+---+----+------ Other | | | 15 | years -----------------------+----+---+----+------ Impairment of long-lived assets: Woodward reviews the carrying amount of its long-lived assets or asset groups to be used in operations whenever events or changes in circumstances indicate that the carrying amount of the assets might not be recoverable. Factors that would necessitate an impairment assessment include a significant adverse change in the extent or manner in which an asset is used, a significant adverse change in legal factors or the business climate that could affect the value of the asset, or a significant decline in the observable market value of an asset, among others. If such facts indicate a potential impairment, the Company would assess the recoverability of an asset group by determining if the carrying amount of the asset group exceeds the sum of the projected undiscounted cash flows expected to result from the use and eventual disposition of the assets over the remaining economic life of the primary asset in the asset group. If the recoverability test indicates that the carrying amount of the asset group is not recoverable, the Company will estimate the fair value of the asset group using appropriate valuation methodologies, which would typically include an estimate of discounted cash flows. Any impairment would be measured as the difference between the asset groups carrying amount and its estimated fair value. There were no impairment charges recorded in fiscal years 2017, 2016 or 2015. Investment in marketable equity securities: Woodward holds marketable equity securities related to its deferred compensation program. Based on Woodward’s intentions regarding these instruments, marketable equity securities are classified as trading securities. The trading securities are reported at fair value, with realized gains and losses recognized in “Other (income) expense, net.” The trading securities are included in “Other assets.” The associated obligation to provide benefits is included in “Other liabilities.” Investments in unconsolidated subsidiaries: Investments in, and operating results of, entities in which Woodward does not have a controlling financial interest or the ability to exercise significant influence over the operations are included in the financial statements using the cost method of accounting. Investments and operating results of entities in which Woodward does not have a controlling interest but does have the ability to exercise significant influence over operations are included in the financial statements using the equity method of accounting. Deferred compensation: The Company maintains a deferred compensation plan, or “rabbi trust,” as part of its overall compensation package for certain employees. Deferred compensation obligations will be settled either by delivery of a fixed number of shares of Woodward’s common stock (in accordance with certain eligible members’ irrevocable elections) or in cash. Woodward has contributed shares of its common stock into a trust established for the future settlement of deferred compensation obligations that are payable in shares of Woodward’s common stock. Common stock held by the trust is reflected in the Consolidated Balance 59 Sheet as “Treasury stock held for deferred compensation” and the related deferred compensation obligation is reflected as a separate component of equity in amounts equal to the fair value of the common stock at the dates of contribution. These accounts are not adjusted for subsequent changes in the fair value of the common stock. Deferred compensation obligations that will be settled in cash are accounted for on an accrual basis in accordance with the terms of the underlying contract and are reflected in the Consolidated Balance Sheet as “Other liabilities.” Derivatives: The Company is exposed to various market risks that arise from transactions entered into in the normal course of business. The Company has historically utilized derivative instruments, such as treasury lock agreements to lock in fixed rates on future debt issuances, which qualify as cash flow or fair value hedges to mitigate the risk of variability in cash flows related to future interest payments attributable to changes in the designated benchmark rate. The Company records all such interest rate hedge instruments on the balance sheet at fair value. Cash flows related to the instrument designated as a qualifying hedge are reflected in the accompanying Consolidated Statements of Cash Flows in the same categories as the cash flows from the items being hedged. Accordingly, cash flows relating to the settlement of interest rate derivatives hedging the forecasted future interest payments on debt have been reflected upon settlement as a component of financing cash flows. The resulting gain or loss from such settlement is deferred to other comprehensive income and reclassified to interest expense over the term of the underlying debt. This reclassification of the deferred gains and losses impacts the interest expense recognized on the underlying debt that was hedged and is therefore reflected as a component of operating cash flows in periods subsequent to settlement. The periodic settlement of interest rate derivatives hedging outstanding variable rate debt is recorded as an adjustment to interest expense and is therefore reflected as a component of operating cash flows. From time to time, in order to hedge against foreign currency exposure, Woodward designates certain non-derivative financial instrument loans as net investment hedges. Foreign exchange gains or losses on the loans are recognized in foreign currency translation adjustments within total comprehensive (losses) earnings. Further information on net investment hedges can be found at Note 6, Derivative instruments and hedging activities. Financial instruments: The Company’s financial instruments include cash and cash equivalents, short-term investments, investments in the deferred compensation program, notes receivable from municipalities, investments in term deposits and debt. Because of their short-term maturity, the carrying amount of cash and cash equivalents and short-term debt approximate fair value. The fair value of investments in the deferred compensation program are adjusted to fair value based on the quoted market prices for the investments in the various mutual funds owned. The fair value of the long-term notes from municipalities are estimated based on a model that discounts future principal and interest payments received at interest rates available to the Company at the end of the period for similarly rated municipality notes of similar maturity. The fair value of term deposits are estimated based on a model that discounts future principal and interest payments received at interest rates available to the Company at the end of the period for similar term deposits with the same maturity in the same jurisdictions. The fair value of long-term debt is estimated based on a model that discounts future principal and interest payments at interest rates available to the Company at the end of the period for similar debt with the same maturity. Further information on the fair value of financial instruments can be found at Note 5, Financial instruments and fair value measurements. Financial assets and liabilities recorded at fair value in the Consolidated Balance Sheets are categorized based upon a fair value hierarchy established by U.S. GAAP, which prioritizes the inputs used to measure fair value into the following levels: Level 1: Inputs based on quoted market prices in active markets for identical assets or liabilities at the measurement date. Level 2: Quoted prices included in Level 1, such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets and liabilities in markets that are not active; or other inputs that are observable and can be corroborated by observable market data. Level 3: Inputs reflect management’s best estimates and assumptions of what market participants would use in pricing the asset or liability at the measurement date. The inputs are unobservable in the market and significant to the valuation of the instruments. Postretirement benefits: The Company provides various benefits to certain current and former employees through defined benefit pension and postretirement plans. For financial reporting purposes, net periodic benefits expense and related obligations are calculated using a number of significant actuarial assumptions. Changes in net periodic expense and funding status may occur in the future due to changes in these assumptions. The funded status of defined pension and postretirement plans recognized in the statement of financial position is measured as the difference between the fair market value of the plan assets and the benefit obligation. For a defined benefit pension plan, the benefit obligation is the projected benefit obligation; for any other defined benefit postretirement plan, such as a retiree health care plan, the benefit obligation is the accumulated benefit obligation. Any over-funded status is recognized as an asset and any underfunded status is recognized as a liability. 60 Projected benefit obligation is the actuarial present value as of the measurement date of all benefits attributed by the plan benefit formula to employee service rendered before the measurement date using assumptions as to future compensation levels if the plan benefit formula is based on those future compensation levels. The accumulated benefit obligation is the actuarial present value of benefits (whether vested or unvested) attributed by the plan benefit formula to employee service rendered before the measurement date and based on employee service and compensation, if applicable, prior to that date. The accumulated benefit obligation differs from the projected benefit obligation in that it includes no assumption about future compensation levels. Reclassification In the Statements of Earnings for all periods presented amortization of intangible assets has been reclassified from a separate line to an allocated expense/cost component of cost of goods sold and selling, general and administrative expenses based on the nature of the intangible asset that is being amortized. Prior year amounts have been recast to reflect this reclassification. The following tables reflect the amounts reclassified.    | | | | | | | -----------------------------------------------------------+--------------------------+--------+------+---+--------+---+-------  | | | | | | | -----------------------------------------------------------+--------------------------+--------+------+---+--------+---+-------  | Year Ended September 30, -----------------------------------------------------------+-------------------------  | 2017 | | 2016 | | 2015 -----------------------------------------------------------+--------------------------+--------+------+---+-------  | | | | | | | -----------------------------------------------------------+--------------------------+--------+------+---+--------+---+------- Allocation to Cost of goods sold | $ | 7,800 | | $ | 8,420 | $ | 9,115 -----------------------------------------------------------+--------------------------+--------+------+---+--------+---+------- Allocation to Selling, general and administrative expenses | | 17,977 | | | 19,066 | | 20,126 -----------------------------------------------------------+--------------------------+--------+------+---+--------+---+------- Total amortization of intangible assets | $ | 25,777 | | $ | 27,486 | $ | 29,241 -----------------------------------------------------------+--------------------------+--------+------+---+--------+---+-------    | | | | | | | | | -----------------------------------------------------------+----------------------+-------+--------+---+-------+--------+-------+---+------  | | | | | | | | | -----------------------------------------------------------+----------------------+-------+--------+---+-------+--------+-------+---+------  | 2017 Fiscal Quarters -----------------------------------------------------------+---------------------  | First | | Second | | Third | Fourth -----------------------------------------------------------+----------------------+-------+--------+---+-------+-------  | | | | | | | | | -----------------------------------------------------------+----------------------+-------+--------+---+-------+--------+-------+---+------ Allocation to Cost of goods sold | $ | 1,954 | | $ | 1,943 | $ | 1,948 | $ | 1,955 -----------------------------------------------------------+----------------------+-------+--------+---+-------+--------+-------+---+------ Allocation to Selling, general and administrative expenses | | 4,504 | | | 4,488 | | 4,491 | | 4,494 -----------------------------------------------------------+----------------------+-------+--------+---+-------+--------+-------+---+------ Total amortization of intangible assets | $ | 6,458 | | $ | 6,431 | $ | 6,439 | $ | 6,449 -----------------------------------------------------------+----------------------+-------+--------+---+-------+--------+-------+---+------  | | | | | | | | | -----------------------------------------------------------+----------------------+-------+--------+---+-------+--------+-------+---+------  | 2016 Fiscal Quarters -----------------------------------------------------------+---------------------  | First | | Second | | Third | Fourth -----------------------------------------------------------+----------------------+-------+--------+---+-------+-------  | | | | | | | | | -----------------------------------------------------------+----------------------+-------+--------+---+-------+--------+-------+---+------ Allocation to Cost of goods sold | $ | 2,180 | | $ | 2,162 | $ | 2,117 | $ | 1,961 -----------------------------------------------------------+----------------------+-------+--------+---+-------+--------+-------+---+------ Allocation to Selling, general and administrative expenses | | 4,766 | | | 4,764 | | 4,770 | | 4,766 -----------------------------------------------------------+----------------------+-------+--------+---+-------+--------+-------+---+------ Total amortization of intangible assets | $ | 6,946 | | $ | 6,926 | $ | 6,887 | $ | 6,727 -----------------------------------------------------------+----------------------+-------+--------+---+-------+--------+-------+---+------  Note 2. New accounting standards From time to time, the Financial Accounting Standards Board (“FASB”) or other standards setting bodies issue new accounting pronouncements. Updates to the FASB Accounting Standards Codification (“ASC”) are communicated through issuance of an Accounting Standards Update (“ASU”). In August 2017, the FASB issued ASU 2017-12, “Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities.” ASU 2017-12 is intended to more closely align the financial statement reporting of hedging relationships with the economic results of an entity’s risk management activities and to make certain targeted improvements to simplify the application of hedge accounting guidance in current GAAP. ASU 2017-12 is also intended to increase standardization of financial statement disclosures including requiring a tabular disclosure of the income statement effects of fair value and cash flow hedges. ASU 2017-12 is effective for fiscal years beginning after December 15, 2018 (fiscal year 2020 for Woodward) and early adoption is permitted in any interim period. Upon adoption, an entity should apply a cumulative-effect adjustment to accumulated other comprehensive earnings with a corresponding adjustment to retained earnings to eliminate the separate measurement of ineffectiveness for cash flow and net investment hedges, if any. Also upon adoption, the amended presentation and disclosure guidance should be applied prospectively. Woodward has not determined in which period it will adopt the new guidance. Woodward does not believe the application of the new guidance will have any impact on its current hedging arrangements. In May 2017, the FASB issued ASU 2017-09, “Compensation – Stock Compensation (Topic 718): Scope of Modification Accounting.” ASU 2017-09 was issued to provide clarity and reduce both 1) diversity in practice and 2) cost 61 and complexity when applying the guidance in Topic 718 to a change in the terms or conditions of a share-based payment award. ASU 2017-09 provides guidance about which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting under Topic 718. The amendments in ASU 2017-09 are effective for fiscal years, and interim periods within those years, beginning after December 15, 2017 (fiscal year 2019 for Woodward). Early adoption is permitted, including adoption in any interim period. The amendments in ASU 2017-09 should be applied prospectively to an award modified on or after the adoption date. Woodward adopted the new guidance in its third quarter of fiscal year 2017 and will apply the guidance to any future changes to the terms or conditions of its share-based payment awards. In March 2017, the FASB issued ASU 2017-07, “Compensation – Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost.” ASU 2017-07 requires that the service cost component of net periodic benefit costs from defined benefit and other postretirement benefit plans be included in the same Statement of Earnings captions as other compensation costs arising from services rendered by the covered employees during the period. The other components of net benefit cost will be presented in the Statement of Earnings separately from service costs. ASU 2017-07 is effective for fiscal years beginning after December 31, 2017 (fiscal year 2019 for Woodward). Following adoption, only service costs will be eligible for capitalization into manufactured inventories, which should reduce diversity in practice. The amendments of ASU 2017-07 should be applied retrospectively for the presentation of the service cost component and the other components of net periodic benefit costs from defined benefit and other postretirement benefit plans in the earnings statement and prospectively, on and after the effective date, for the capitalization of the service cost component into manufactured inventories. Early adoption is permitted as of the beginning of Woodward’s fiscal year 2018. Woodward has not determined whether it will adopt the new guidance in fiscal year 2018 or fiscal year 2019, and expects changes to earnings before income taxes to be insignificant in the year of adoption. In January 2017, the FASB issued ASU 2017-04, “Intangibles – Goodwill and Other (Topic 350): Simplifying the Accounting for Goodwill Impairment,” to simplify financial reporting by eliminating the need to determine the fair value of individual assets and liabilities of a reporting unit to measure goodwill impairment. Under ASU 2017-04, an entity should perform its goodwill impairment test by comparing the fair value of the reporting unit with its carrying amount and recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value, up to the amount of goodwill allocated to that reporting unit. The new guidance effectively eliminates “Step 2” from the previous goodwill impairment test. ASU 2017-04 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2019 (fiscal year 2021 for Woodward). Early adoption is permitted for goodwill impairment tests performed on testing dates after January 1, 2017. Woodward adopted the new guidance in its fourth quarter of fiscal year 2017 when it performed its annual goodwill impairment test as of July 31, 2017. The adoption of ASU 2017-04 did not have a significant impact on the results of its goodwill impairment testing. In October 2016, the FASB issued ASU 2016-16, “Accounting for Income Taxes: Intra-Entity Asset Transfers of Assets Other than Inventory.” ASU 2016-16 eliminates the current U.S. GAAP exception deferring the tax effects of intercompany asset transfers (other than inventory) until the transferred asset is sold to a third party or otherwise recovered through use. After adoption of ASU 2016-16, Woodward will recognize the tax consequences of intercompany asset transfers in the buyer’s and seller’s tax jurisdictions when the transfer occurs, even though the pre-tax effects of these transactions are eliminated in consolidation. ASU 2016-16 is effective for fiscal years beginning after December 15, 2017 (fiscal year 2019 for Woodward), including interim periods within the year of adoption. Early adoption is allowed only in the first quarter of fiscal year 2017 or the first quarter of fiscal year 2018. Modified retrospective adoption is required with any cumulative-effect adjustment recorded to retained earnings as of the beginning of the period of adoption. Woodward has not determined in which period it will adopt the new guidance. Woodward currently anticipates the adoption of ASU 2016-16 will result in balance sheet reclassifications, but based on Woodward’s current transactional activity, such adjustments are not expected to be significant. In June 2016, the FASB issued ASU 2016-13, “Measurement of Credit Losses on Financial Instruments.” ASU 2016-13 adds a current expected credit loss (“CECL”) impairment model to U.S. GAAP that is based on expected losses rather than incurred losses. Modified retrospective adoption is required with any cumulative-effect adjustment recorded to retained earnings as of the beginning of the period of adoption. ASU 2016-13 is effective for fiscal years beginning after December 15, 2019 (fiscal year 2021 for Woodward), including interim periods within the year of adoption. Early adoption is permitted for fiscal years beginning after December 15, 2018 (fiscal year 2020 for Woodward), including interim periods within those fiscal years. Woodward has not determined in which period it will adopt the new guidance but does not expect the application of the CECL impairment model to have a significant impact on Woodward’s allowance for uncollectible amounts for accounts receivable and notes receivable from municipalities. In February 2016, the FASB issued ASU 2016-02, “Leases (Topic 842).” The purpose of ASU 2016-02 is to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. In addition, ASU 2016-02 modifies the definition of a lease to clarify 62 that an arrangement contains a lease when such arrangement conveys the right to control the use of an identified asset. ASU 2016-02 is effective for fiscal years beginning after December 15, 2018 (fiscal year 2020 for Woodward), including interim periods within the year of adoption. In transition, Woodward will be required to recognize and measure leases beginning in the earliest period presented using a modified retrospective approach; therefore, Woodward anticipates restating its Consolidated Financial Statements for the two fiscal years prior to the year of adoption. Early adoption is permitted. Woodward has not determined in which period it will adopt the new guidance. Woodward is currently assessing the impact this guidance may have on its Consolidated Financial Statements, including which of its existing lease arrangements will be impacted by the new guidance and whether other arrangements not currently classified as leases may become subject to the guidance of ASU 2016-02. Rent expense for all operating leases in fiscal year 2017, none of which was recognized on the balance sheet, was $8,302. As of September 30, 2017, future minimum rental payments required under operating leases, none of which were recognized on the balance sheet, were $23,215. In May 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers” and has subsequently issued several supplemental and/or clarifying ASUs (collectively “ASC 606”). ASC 606 prescribes a single common revenue standard that replaces most existing U.S. GAAP revenue recognition guidance. ASC 606 outlines a five-step model, under which Woodward will recognize revenue as performance obligations within a customer contract are satisfied. ASC 606 is intended to provide more consistent interpretation and application of the principles outlined in the standard across filers in multiple industries and within the same industries compared to current practices, which should improve comparability. Adoption of ASC 606 is required for annual reporting periods beginning after December 15, 2017 (fiscal year 2019 for Woodward), including interim periods within the reporting period. While Woodward could elect to adopt ASC 606 early, it will not be adopting the new standard in fiscal year 2018. Upon adoption, Woodward must elect to adopt either retrospectively to each prior reporting period presented or using the cumulative effect transition method with the cumulative effect of initial adoption recognized at the date of initial application. Woodward has not determined what transition method it will use. Woodward is currently assessing the impact that the future adoption of ASC 606 may have on its Consolidated Financial Statements by analyzing its current portfolio of customer contracts, including a review of historical accounting policies and practices to identify potential differences in applying the guidance of ASC 606. Woodward is also performing a comprehensive review of its current processes and systems to determine and implement changes required to support the adoption of ASC 606 on October 1, 2018, the first day of Woodward’s fiscal year 2019. As part of this review process, Woodward is implementing new software solutions to support revenue reporting after adoption. Based on Woodward’s review of its customer contracts, Woodward has determined that revenue on the majority of its customer contracts will continue to be recognized at a point in time, generally upon shipment of products, consistent with Woodward’s current revenue recognition model. Upon adoption of ASC 606, however, Woodward also believes some of its revenues from sales of products and services to customers will be recognized over time, rather than at a point in time, due primarily to the terms of certain customer contracts. As a result of recognizing some revenue over time, various balance sheet line items will be impacted. As such, Woodward believes the adoption of ASC 606 will have an impact on both the timing of revenue recognition and various line items within the Consolidated Balance Sheet. Woodward generally expenses costs as incurred for the engineering and development of new products. Customer funding received for such engineering and development efforts is currently recognized as revenue when earned, with the corresponding costs recognized as cost of sales. ASC 606 requires customer funding of product engineering and development to be deferred and recognized as revenue as the related products are delivered to the customer. ASC 606 also requires product engineering and development costs to be capitalized as contract fulfillment costs, to the extent recoverable from the deferred customer funding, and subsequently amortized as the related products are delivered to the customer. Therefore, under ASC 606, Woodward expects to record both contract assets and contract liabilities related to such funded engineering and development efforts, which are expected to become material over time. Recognized revenues and research and development costs are both expected to decrease in the year of adoption and for at least several years thereafter, due to the recognition of these contract assets and liabilities. However, recognition of these contract assets and liabilities are expected to have an immaterial impact on pre-tax earnings in future periods. In addition, ASC 606 will require more comprehensive disclosures about revenue streams and contracts with customers, including significant judgments required. Woodward is currently evaluating potential changes to its processes for preparing required disclosures and to information systems that support the financial reporting process. Woodward is also evaluating implications to the Company’s system of internal controls, relative to revenue recognition and the related revenue disclosures, which are based on the criteria outlined in the Committee of Sponsoring Organizations of the Treadway Commission’s 2013 Internal Control – Integrated Framework. 63 Note 3. Earnings per share Basic earnings per share is computed by dividing net earnings available to common stockholders by the weighted-average number of shares of common stock outstanding for the period. Diluted earnings per share reflects the weighted-average number of shares outstanding after consideration of the dilutive effect of stock options and restricted stock. The following is a reconciliation of net earnings to basic earnings per share and diluted earnings per share:   | | | | | | | ------------------------------------------------------+--------------------------+---------+------+---+---------+---+--------  | | | | | | | ------------------------------------------------------+--------------------------+---------+------+---+---------+---+--------  | Year Ended September 30, ------------------------------------------------------+-------------------------  | 2017 | | 2016 | | 2015 ------------------------------------------------------+--------------------------+---------+------+---+-------- Numerator: | | | | | | | ------------------------------------------------------+--------------------------+---------+------+---+---------+---+-------- Net earnings | $ | 200,507 | | $ | 180,838 | $ | 181,452 ------------------------------------------------------+--------------------------+---------+------+---+---------+---+-------- Denominator: | | | | | | | ------------------------------------------------------+--------------------------+---------+------+---+---------+---+-------- Basic shares outstanding | | 61,366 | | | 61,893 | | 64,684 ------------------------------------------------------+--------------------------+---------+------+---+---------+---+-------- Dilutive effect of stock options and restricted stock | | 2,146 | | | 1,663 | | 1,372 ------------------------------------------------------+--------------------------+---------+------+---+---------+---+-------- Diluted shares outstanding | | 63,512 | | | 63,556 | | 66,056 ------------------------------------------------------+--------------------------+---------+------+---+---------+---+-------- Income per common share: | | | | | | | ------------------------------------------------------+--------------------------+---------+------+---+---------+---+-------- Basic earnings per share | $ | 3.27 | | $ | 2.92 | $ | 2.81 ------------------------------------------------------+--------------------------+---------+------+---+---------+---+-------- Diluted earnings per share | $ | 3.16 | | $ | 2.85 | $ | 2.75 ------------------------------------------------------+--------------------------+---------+------+---+---------+---+-------- On June 2, 2015, Woodward entered into an accelerated share repurchase agreement (the “ASR Agreement”) with Goldman, Sachs & Co. (“Goldman”) under which Woodward repurchased shares of its common stock for an aggregate purchase price of $125,000. Upon execution of the ASR Agreement, Goldman initially delivered to Woodward 2,048 shares of common stock. Goldman completed the ASR Agreement on September 3, 2015 and delivered 458 additional shares to Woodward. The final number of shares delivered to Woodward was based generally on the average daily volume-weighted average price of Woodward stock during the term of the ASR Agreement of $49.89. The 2,506 shares of common stock delivered by Goldman to Woodward related to the ASR Agreement are reflected in the calculation of basic shares outstanding used in the calculation of earnings per share. The following stock option grants were outstanding during the fiscal years ended September 30, 2017, 2016 and 2015, but were excluded from the computation of diluted earnings per share because their inclusion would have been anti-dilutive.   | | | | | | | ------------------------------+--------------------------+-------+------+---+------+---+------  | | | | | | | ------------------------------+--------------------------+-------+------+---+------+---+------  | Year Ended September 30, ------------------------------+-------------------------  | 2017 | | 2016 | | 2015 ------------------------------+--------------------------+-------+------+---+----- Options | | 68 | | | - | | 697 ------------------------------+--------------------------+-------+------+---+------+---+------ Weighted-average option price | $ | 63.23 | | $ | n/a | $ | 46.55 ------------------------------+--------------------------+-------+------+---+------+---+------  The weighted-average shares of common stock outstanding for basic and diluted earnings per share included the weighted-average treasury stock shares held for deferred compensation obligations of the following:   | | | | | ----------------------------------------------------------------------------------+--------------------------+-----+------+------+----  | | | | | ----------------------------------------------------------------------------------+--------------------------+-----+------+------+----  | Year Ended September 30, ----------------------------------------------------------------------------------+-------------------------  | 2017 | | 2016 | 2015 ----------------------------------------------------------------------------------+--------------------------+-----+------+----- Weighted-average treasury stock shares held for deferred compensation obligations | | 180 | | 171 | 190 ----------------------------------------------------------------------------------+--------------------------+-----+------+------+---- Note 4. Joint venture On January 4, 2016, Woodward and General Electric Company (“GE”), acting through its GE Aviation business unit, consummated the formation of a strategic joint venture between Woodward and GE (the “JV”) to design, develop and source fuel systems for specified existing and all future GE commercial aircraft engines that produce thrust in excess of fifty thousand pounds. As part of the JV formation, Woodward contributed to the JV certain contractual rights and intellectual property applicable to the existing GE commercial aircraft engine programs within the scope of the JV. Woodward had no initial cost basis in the JV because Woodward had no cost basis in the contractual rights and intellectual property contributed to the JV. 64 GE purchased from Woodward a 50% ownership interest in the JV for a $250,000 cash payment to Woodward. In addition, GE will pay contingent consideration to Woodward consisting of fifteen annual payments of $4,894 per year which began on January 4, 2017 subject to certain claw-back conditions. Woodward received its first annual payment of $4,894 during the fiscal year ended September 30, 2017, which was recorded as deferred income and is included in Net cash provided by operating activities under the caption “Other” on the Condensed Consolidated Statement of Cash Flows. Neither Woodward nor GE contributed any tangible assets to the JV. Woodward determined that the JV formation was not the culmination of an earnings event because Woodward has significant performance obligations to support the future operations of the JV. Therefore, Woodward recorded the $250,000 consideration received from GE, in January of 2016, for its purchase of a 50% equity interest in the JV as deferred income. The $250,000 deferred income will be recognized as an increase to net sales in proportion to revenue realized on sales of applicable fuel systems within the scope of the JV in a particular period as a percentage of total revenue expected to be realized by Woodward over the estimated remaining lives of the underlying commercial aircraft engine programs assigned to the JV. Unamortized deferred income recorded in connection with the JV formation included accrued liabilities of $6,451 as of September 30, 2017 and $6,552 as of September 30, 2016, and other liabilities of $236,896 as of September 30, 2017 and $238,187 as of September 30, 2016. Amortization of the deferred income recognized as an increase to sales was $6,286 for the twelve months ended September 30, 2017, and $5,261 for the nine-months ended September 30, 2016. Woodward and GE jointly manage the JV and any significant decisions and/or actions of the JV require the mutual consent of both parties. Neither Woodward nor GE has a controlling financial interest in the JV, but both Woodward and GE do have the ability to significantly influence the operating and financial decisions of the JV. Therefore, Woodward is accounting for its 50% ownership interest in the JV using the equity method of accounting. The JV is a related party to Woodward. Other income includes income of $2,568 for the fiscal year ended September 30, 2017, and income of $6,204 for the nine-months ended September 30, 2016 related to Woodward’s equity interest in the earnings of the JV. During the fiscal year ended September 30, 2017, Woodward received a $2,500 cash distribution from the JV which is included in Net cash provided by operating activities under the caption “Other” on the Consolidated Statement of Cash Flows. Woodward received no cash distributions from the JV in the fiscal year ended September 30, 2016. Woodward’s net investment in the JV, which is included in other assets, was $6,272 as of September 30, 2017 and $6,204 as of September 30, 2016. Woodward’s net sales include $70,234 for the fiscal year ended September 30, 2017 of sales to the JV, compared to $46,973 for the nine-months ended September 30, 2016. Woodward recorded a reduction to sales of $26,133 for the fiscal year ended September 30, 2017 related to royalties paid to the JV by Woodward on sales by Woodward directly to third party aftermarket customers, compared to $21,391 for the nine-months ended September 30, 2016. The Consolidated Balance Sheets include “Accounts receivable” of $8,554 at September 30, 2017, and $5,326 at September 30, 2016 related to amounts the JV owed Woodward, and include “Accounts payable” of $6,741 at September 30, 2017, and $3,926 at September 30, 2016 related to amounts Woodward owed the JV.  Note 5. Financial instruments and fair value measurements Financial assets and liabilities recorded at fair value in the Consolidated Balance Sheets are categorized based upon a fair value hierarchy established by U.S. GAAP. The table below presents information about Woodward’s financial assets that are measured at fair value on a recurring basis and indicates the fair value hierarchy of the valuation techniques Woodward utilized to determine such fair value. Woodward had no financial liabilities required to be measured at fair value on a recurring basis as of September 30, 2017 or September 30, 2016.   | | | | | | | | | | | | | | | | | | | ------------------------------------------------+-----------------------+---------+-----------------------+---+---------+-------+---+---------+---+---------+---------+---------+-------+---+---+---+---+---+--------  | | | | | | | | | | | | | | | | | | | ------------------------------------------------+-----------------------+---------+-----------------------+---+---------+-------+---+---------+---+---------+---------+---------+-------+---+---+---+---+---+--------  | At September 30, 2017 | | At September 30, 2016 ------------------------------------------------+-----------------------+---------+----------------------  | Level 1 | | Level 2 | | Level 3 | Total | | Level 1 | | Level 2 | Level 3 | | Total ------------------------------------------------+-----------------------+---------+-----------------------+---+---------+-------+---+---------+---+---------+---------+---------+------ Financial assets: | | | | | | | | | | | | | | | | | | | ------------------------------------------------+-----------------------+---------+-----------------------+---+---------+-------+---+---------+---+---------+---------+---------+-------+---+---+---+---+---+-------- Cash | $ | 79,822 | | $ | - | $ | - | | $ | 79,822 | $ | 80,959 | | $ | - | $ | - | $ | 80,959 ------------------------------------------------+-----------------------+---------+-----------------------+---+---------+-------+---+---------+---+---------+---------+---------+-------+---+---+---+---+---+-------- Investments in money market funds | | - | | | - | | - | | | - | | 48 | | | - | | - | | 48 ------------------------------------------------+-----------------------+---------+-----------------------+---+---------+-------+---+---------+---+---------+---------+---------+-------+---+---+---+---+---+-------- Investments in reverse repurchase agreements | | 1 | | | - | | - | | | 1 | | 83 | | | - | | - | | 83 ------------------------------------------------+-----------------------+---------+-----------------------+---+---------+-------+---+---------+---+---------+---------+---------+-------+---+---+---+---+---+-------- Investments in term deposits with foreign banks | | 7,729 | | | - | | - | | | 7,729 | | 7,136 | | | - | | - | | 7,136 ------------------------------------------------+-----------------------+---------+-----------------------+---+---------+-------+---+---------+---+---------+---------+---------+-------+---+---+---+---+---+-------- Equity securities | | 16,600 | | | - | | - | | | 16,600 | | 12,491 | | | - | | - | | 12,491 ------------------------------------------------+-----------------------+---------+-----------------------+---+---------+-------+---+---------+---+---------+---------+---------+-------+---+---+---+---+---+-------- Total financial assets | $ | 104,152 | | $ | - | $ | - | | $ | 104,152 | $ | 100,717 | | $ | - | $ | - | $ | 100,717 ------------------------------------------------+-----------------------+---------+-----------------------+---+---------+-------+---+---------+---+---------+---------+---------+-------+---+---+---+---+---+--------  Investments in money market funds: Woodward sometimes invests excess cash in money market funds not insured by the FDIC. Woodward believes that the investments in money market funds are on deposit with creditworthy financial 65 institutions and that the funds are highly liquid. The investments in money market funds are reported in “Cash and cash equivalents” at fair value, with realized gains from interest income recognized in earnings. The fair values of Woodward’s investments in money market funds are based on the quoted market prices for the net asset value of the various money market funds. Investments in reverse repurchase agreements: Woodward sometimes invests excess cash in reverse repurchase agreements. Under the terms of Woodward’s reverse repurchase agreements, Woodward purchases an interest in a pool of securities and is granted a security interest in those securities by the counterparty to the reverse repurchase agreement. At an agreed upon date, generally the next business day, the counterparty repurchases Woodward’s interest in the pool of securities at a price equal to what Woodward paid to the counterparty plus a rate of return determined daily per the terms of the reverse repurchase agreement. Woodward believes that the investments in these reverse repurchase agreements are with creditworthy financial institutions and that the funds invested are highly liquid. The investments in reverse repurchase agreements are reported at fair value, with realized gains from interest income recognized in earnings, and are included in “Cash and cash equivalents.” Since the investments are generally overnight, the carrying value is considered to be equal to the fair value as the amount is deemed to be a cash deposit with no risk of change in value as of the end of each fiscal quarter. Investments in term deposits with foreign banks: Woodward’s foreign subsidiaries sometimes invest excess cash in various highly liquid financial instruments that Woodward believes are with creditworthy financial institutions. Such investments are reported in “Cash and cash equivalents” at fair value, with realized gains from interest income recognized in earnings. The carrying value of Woodward’s investments in term deposits with foreign banks are considered equal to the fair value given the highly liquid nature of the investments. Equity securities: Woodward holds marketable equity securities, through investments in various mutual funds, related to its deferred compensation program. Based on Woodward’s intentions regarding these instruments, marketable equity securities are classified as trading securities. The trading securities are reported at fair value, with realized gains and losses recognized in “Other (income) expense, net.” The trading securities are included in “Other assets.” The fair values of Woodward’s trading securities are based on the quoted market prices for the net asset value of the various mutual funds. Accounts receivable, accounts payable, the current portion of long-term debt, and short-term borrowings are not remeasured to fair value, as the carrying cost of each approximates its respective fair value. The estimated fair values and carrying costs of other financial instruments that are not required to be remeasured at fair value in the Condensed Consolidated Balance Sheets were as follows:    | | | | | | | | | | ------------------------------------------+----------------------------+-----------------------+-----------+-----------------------+---+----------------------+---------------+-----------+---+----------  | | | | | | | | | | ------------------------------------------+----------------------------+-----------------------+-----------+-----------------------+---+----------------------+---------------+-----------+---+----------  | | At September 30, 2017 | | At September 30, 2016 ------------------------------------------+----------------------------+-----------------------+-----------+----------------------  | Fair Value Hierarchy Level | Estimated Fair Value | | Carrying Cost | | Estimated Fair Value | Carrying Cost ------------------------------------------+----------------------------+-----------------------+-----------+-----------------------+---+----------------------+-------------- Assets: | | | | | | | | | | ------------------------------------------+----------------------------+-----------------------+-----------+-----------------------+---+----------------------+---------------+-----------+---+---------- Notes receivable from municipalities | 2 | $ | 15,848 | | $ | 14,507 | $ | 17,501 | $ | 15,849 ------------------------------------------+----------------------------+-----------------------+-----------+-----------------------+---+----------------------+---------------+-----------+---+---------- Investments in short-term time deposits | 2 | | 8,227 | | | 8,223 | | 4,882 | | 4,918 ------------------------------------------+----------------------------+-----------------------+-----------+-----------------------+---+----------------------+---------------+-----------+---+---------- Liabilities: | | | | | | | | | | ------------------------------------------+----------------------------+-----------------------+-----------+-----------------------+---+----------------------+---------------+-----------+---+---------- Long-term debt, excluding current portion | 2 | $ | (592,317) | | $ | (582,080) | $ | (617,857) | $ | (579,244) ------------------------------------------+----------------------------+-----------------------+-----------+-----------------------+---+----------------------+---------------+-----------+---+----------  In fiscal years 2014 and 2013, Woodward received long-term notes from municipalities within the states of Illinois and Colorado in connection with certain economic incentives related to Woodward’s development of a second campus in the greater-Rockford, Illinois area for its Aerospace segment and Woodward’s development of a new campus at its corporate headquarters in Fort Collins, Colorado. The fair value of the long-term notes was estimated based on a model that discounted future principal and interest payments received at an interest rate available to the Company at the end of the period for similarly rated municipal notes of similar maturity, which is a level 2 input as defined by the U.S. GAAP fair value hierarchy. The interest rates used to estimate the fair value of the long-term notes were 2.6% at September 30, 2017 and 2.2% at September 30, 2016. From time to time, certain of Woodward’s foreign subsidiaries will invest excess cash in short-term time deposits with a fixed maturity date of longer than three months but less than one year from the date of the deposit. Woodward believes that the investments are with creditworthy financial institutions. The fair value of the investments in short-term time deposits was estimated based on a model that discounted future principal and interest payments to be received at an interest rate available to the foreign subsidiary entering into the investment for similar short-term time deposits of similar maturity. This was determined to be a level 2 input as defined by the U.S. GAAP fair value hierarchy. The interest rate used to estimate the fair value of the short-term time deposits was 5.3% at September 30, 2017 and 6.9% at September 30, 2016. 66 The fair value of long-term debt was estimated based on a model that discounted future principal and interest payments at interest rates available to the Company at the end of the period for similar debt of the same maturity, which is a level 2 input as defined by the U.S. GAAP fair value hierarchy. The weighted-average interest rates used to estimate the fair value of long-term debt were 2.4% at September 30, 2017 and 1.9% at September 30, 2016. Note 6. Derivative instruments and hedging activities Woodward has exposures related to global market risks, including the effect of changes in interest rates, foreign currency exchange rates, changes in certain commodity prices and fluctuations in various producer indices. From time to time, Woodward enters into derivative instruments for risk management purposes only, including derivatives designated as accounting hedges and/or those utilized as economic hedges. Woodward uses interest rate related derivative instruments to manage its exposure to fluctuations of interest rates. Woodward does not enter into or issue derivatives for trading or speculative purposes. By using derivative and/or hedging instruments to manage its risk exposure, Woodward is subject, from time to time, to credit risk and market risk on those derivative instruments. Credit risk arises from the potential failure of the counterparty to perform under the terms of the derivative and/or hedging instrument. When the fair value of a derivative contract is positive, the counterparty owes Woodward, which creates credit risk for Woodward. Woodward mitigates this credit risk by entering into transactions with only counterparties that are believed to be creditworthy. Market risk arises from the potential adverse effects on the value of derivative and/or hedging instruments that result from a change in interest rates, commodity prices, or foreign currency exchange rates. Woodward minimizes this market risk by establishing and monitoring parameters that limit the types and degree of market risk that may be undertaken. Other than the net investment hedges discussed below, Woodward did not enter into any derivatives or hedging transactions during any of the fiscal years ended September 30, 2017, September 30, 2016, and September 30, 2015. Derivatives in cash flow hedging relationships In June 2013, in connection with Woodward’s expected refinancing of current maturities on its existing long-term debt, Woodward entered into a treasury lock agreement with a notional amount of $25,000 that qualified as a cash flow hedge under ASC Topic 815, “Derivatives and Hedging.” The objective of this derivative instrument was to hedge the risk of variability in cash flows attributable to changes in the designated benchmark interest rate over a seven-year period related to the future interest payments on a portion of anticipated future debt issuances. The treasury lock agreement was settled in August 2013 and the resulting gain of $507 is being recognized as a reduction of interest expense over a seven-year period. The unrecognized portion of the gain is recorded in accumulated other comprehensive (losses) earnings, net of tax. In March 2009, Woodward entered into LIBOR lock agreements that qualified as cash flow hedges under authoritative guidance for derivatives and hedging. The objective of this derivative instrument was to hedge the risk of variability in cash flows over a seven-year period related to future interest payments of a portion of anticipated future debt issuances attributable to changes in the designated benchmark interest rate associated with the then expected issuance of long-term debt to acquire HR Textron Inc. (“HRT”). The discontinuance of the LIBOR lock agreements resulted in a loss that was being recognized as an increase of interest expense over a seven-year period on the hedged Series E and F Notes, which were issued on April 3, 2009, using the effective interest method. The unrecognized portion of the loss was recorded in accumulated other comprehensive (losses) earnings, net of tax. The unrecognized portion of the loss was fully amortized to interest expense during the second quarter of fiscal year 2016, and as of September 30, 2016 there was no unrecognized loss associated with this cash flow hedge in Woodward’s Consolidated Balance Sheet. In September 2008, the Company entered into treasury lock agreements that qualified as cash flow hedges under authoritative guidance for derivatives and hedging. The objective of this derivative instrument was to hedge the risk of variability in cash flows related to future interest payments of a portion of the anticipated future debt issuances attributable to changes in the designated benchmark interest rate associated with the expected issuance of long-term debt to acquire Techni-Core, Inc. (“Techni-Core”) and MPC Products Corporation (“MPC Products” and, together with Techni-Core, “MPC”). The discontinuance of these treasury lock agreements resulted in a gain that was being recognized as a reduction of interest expense over a seven-year period on the hedged Series C and D Notes, which were issued on October 1, 2008, using the effective interest method. The unrecognized portion of the gain was recorded in accumulated other comprehensive (losses) earnings, net of tax. The unrecognized portion of the gain was fully amortized to interest expense during the fourth quarter of fiscal year 2015, and as of September 30, 2015 there was no unrecognized gain associated with this cash flow hedge in Woodward’s Consolidated Balance Sheet. 67 The remaining unrecognized gains and losses in Woodward’s Condensed Consolidated Balance Sheets associated with derivative instruments that were previously entered into by Woodward, which are classified in accumulated other comprehensive (losses) earnings (“accumulated OCI”), were net gains of $218 as of September 30, 2017 and $290 as of September 30, 2016. The following table discloses the impact of derivative instruments in cash flow hedging relationships on Woodward’s Consolidated Statements of Earnings, recognized in interest expense:   | | | | | | | ----------------------------------------------------------------------+--------------------------+------+------+---+------+---+---  | | | | | | | ----------------------------------------------------------------------+--------------------------+------+------+---+------+---+---  | Year Ended September 30, ----------------------------------------------------------------------+-------------------------  | 2017 | | 2016 | | 2015 ----------------------------------------------------------------------+--------------------------+------+------+---+----- Amount of (income) expense recognized in earnings on derivative | $ | (72) | | $ | 21 | $ | 99 ----------------------------------------------------------------------+--------------------------+------+------+---+------+---+--- Amount of (gain) loss recognized in accumulated OCI on derivative | | - | | | - | | - ----------------------------------------------------------------------+--------------------------+------+------+---+------+---+--- Amount of (gain) loss reclassified from accumulated OCI into earnings | | (72) | | | 21 | | 99 ----------------------------------------------------------------------+--------------------------+------+------+---+------+---+---  | | | | | | | ----------------------------------------------------------------------+--------------------------+------+------+---+------+---+---    Based on the carrying value of the realized but unrecognized gains on terminated derivative instruments designated as cash flow hedges as of September 30, 2017, Woodward expects to reclassify $72 of net unrecognized gains on terminated derivative instruments from accumulated other comprehensive (losses) earnings to earnings during the next twelve months.  Net investment hedges On September 23, 2016, Woodward and Woodward International Holding B.V., a wholly owned subsidiary of Woodward organized under the laws of The Netherlands (the “BV Subsidiary”), each entered into a note purchase agreement (the “2016 Note Purchase Agreement”) relating to the sale by Woodward and the BV Subsidiary of an aggregate principal amount of €160,000 of senior unsecured notes in a series of private placement transactions. Woodward issued €40,000 aggregate principal amount of Woodward’s Series M Senior Notes due September 23, 2026. Woodward designated the €40,000 Series M Notes as a hedge of a foreign currency exposure of Woodward’s net investment in its Euro denominated functional currency subsidiaries. Foreign exchange losses on the Series M Notes of $2,395 for the fiscal year ended September 30, 2017 and $47 for the fiscal year ended September 30, 2016 are included in foreign currency translation adjustments within total comprehensive (losses) earnings. In June 2015, Woodward designated an intercompany loan of 160,000 Renminbi (“RMB”) between two wholly owned subsidiaries as a hedge of a foreign currency exposure of the net investment of the borrower in the lender. In June 2016, the intercompany loan was repaid, resulting in a realized gain of $1,484 that was recognized within total comprehensive earnings, of which $912 was recognized in fiscal year 2016 and $572 was recognized in fiscal year 2015. In July 2016, Woodward designated a new intercompany loan of 160,000 RMB between two wholly owned subsidiaries as a hedge of a foreign currency exposure of the net investment of the borrower in the lender. In July 2017, the intercompany loan was repaid, resulting in a realized gain of $380 that was recognized within total comprehensive earnings, of which a gain of $453 was recognized in fiscal year 2017 and a loss of $73 was recognized in fiscal year 2016. Note 7. Supplemental statement of cash flows information    | | | | | ---------------------------------------------------------------------------+--------------------------+--------+------+---+-------  | Year Ended September 30, ---------------------------------------------------------------------------+-------------------------  | 2017 | | 2016 | | 2015 ---------------------------------------------------------------------------+--------------------------+--------+------+---+------- Interest paid, net of amounts capitalized | $ | 27,752 | | $ | 34,500 | $ | 32,608 ---------------------------------------------------------------------------+--------------------------+--------+------+---+--------+---+------- Income taxes paid | | 33,926 | | | 99,468 | | 51,218 ---------------------------------------------------------------------------+--------------------------+--------+------+---+--------+---+------- Income tax refunds received | | 997 | | | 2,350 | | 689 ---------------------------------------------------------------------------+--------------------------+--------+------+---+--------+---+------- Non-cash activities: | | | | | | | ---------------------------------------------------------------------------+--------------------------+--------+------+---+--------+---+------- Purchases of property, plant and equipment on account | | 17,327 | | | 10,705 | | 23,966 ---------------------------------------------------------------------------+--------------------------+--------+------+---+--------+---+------- Property, plant and equipment acquired by capital lease | | - | | | 1,653 | | - ---------------------------------------------------------------------------+--------------------------+--------+------+---+--------+---+------- Common shares issued from treasury to settle employee liabilities | | 1,767 | | | - | | - ---------------------------------------------------------------------------+--------------------------+--------+------+---+--------+---+------- Common shares issued from treasury to settle benefit obligations (Note 17) | | 14,014 | | | 13,999 | | 12,574 ---------------------------------------------------------------------------+--------------------------+--------+------+---+--------+---+------- Cashless exercise of stock options | | 1,473 | | | 753 | | 1,532 ---------------------------------------------------------------------------+--------------------------+--------+------+---+--------+---+-------   68 Note 8. Inventories    | | | | | --------------------+---------------+---------+---------------+---+--------  | | | | | --------------------+---------------+---------+---------------+---+--------  | September 30, | | September 30, --------------------+---------------+---------+--------------  | 2017 | | 2016 --------------------+---------------+---------+-------------- Raw materials | $ | 59,034 | | $ | 54,246 --------------------+---------------+---------+---------------+---+-------- Work in progress | | 103,790 | | | 109,756 --------------------+---------------+---------+---------------+---+-------- Component parts (1) | | 262,755 | | | 249,307 --------------------+---------------+---------+---------------+---+-------- Finished goods | | 47,926 | | | 48,374 --------------------+---------------+---------+---------------+---+--------  | $ | 473,505 | | $ | 461,683 --------------------+---------------+---------+---------------+---+-------- (1) | Component parts include items that can be sold separately as finished goods or included in the manufacture of other products. ----+------------------------------------------------------------------------------------------------------------------------------ Note 9. Property, plant, and equipment    | | | | | ------------------------------------+---------------+-----------+---------------+---+----------  | | | | | ------------------------------------+---------------+-----------+---------------+---+----------  | September 30, | | September 30, ------------------------------------+---------------+-----------+--------------  | 2017 | | 2016 ------------------------------------+---------------+-----------+-------------- Land and land improvements | $ | 88,326 | | $ | 87,696 ------------------------------------+---------------+-----------+---------------+---+---------- Buildings and building improvements | | 514,453 | | | 527,704 ------------------------------------+---------------+-----------+---------------+---+---------- Leasehold improvements | | 16,142 | | | 15,213 ------------------------------------+---------------+-----------+---------------+---+---------- Machinery and production equipment | | 543,641 | | | 484,315 ------------------------------------+---------------+-----------+---------------+---+---------- Computer equipment and software | | 124,723 | | | 117,984 ------------------------------------+---------------+-----------+---------------+---+---------- Office furniture and equipment | | 24,308 | | | 29,344 ------------------------------------+---------------+-----------+---------------+---+---------- Other | | 19,393 | | | 18,969 ------------------------------------+---------------+-----------+---------------+---+---------- Construction in progress | | 111,910 | | | 88,909 ------------------------------------+---------------+-----------+---------------+---+----------  | | 1,442,896 | | | 1,370,134 ------------------------------------+---------------+-----------+---------------+---+---------- Less accumulated depreciation | | (520,853) | | | (493,784) ------------------------------------+---------------+-----------+---------------+---+---------- Property, plant, and equipment, net | $ | 922,043 | | $ | 876,350 ------------------------------------+---------------+-----------+---------------+---+----------  Included in “Office furniture and equipment” and “Other” is $1,653 at each of September 30, 2017 and September 30, 2016, of gross assets acquired on capital leases, and accumulated depreciation included $739 at September 30, 2017 and $322 at September 30, 2016 of amortization associated with the capital lease assets. In fiscal year 2015, Woodward completed and placed into service a manufacturing and office building on a second campus in the greater-Rockford, Illinois area and has occupied the new facility for its Aerospace segment. This campus is intended to support Woodward’s expected growth in its Aerospace segment over the next ten years and beyond, required as a result of Woodward being awarded a substantial number of new system platforms, particularly on narrow-body aircraft. Included in “Construction in progress” are costs of $49,347 at September 30, 2017 and $26,741 at September 30, 2016 associated with new equipment purchases for the second campus. Concurrent with and in relation to Woodward’s significant investment in three new campuses and related equipment in the greater-Rockford, Illinois area, the new campus at its corporate headquarters in Fort Collins, Colorado (both discussed above), and the new campus in Niles, Illinois that was completed in fiscal year 2015, Woodward initiated a comprehensive review of its depreciation lives as required by U.S. GAAP to evaluate the estimates of the useful lives of Woodward assets. This review resulted in estimates of the useful lives of both existing and new assets generally in excess of those utilized prior to fiscal year 2016. The revised estimates were used in fiscal year 2016 and will be used going forward and result in a downward adjustment of depreciation on existing assets of approximately $12,000 for fiscal year 2016. For the fiscal years ended September 30, 2017, 2016, and 2015, Woodward had depreciation expense as follows:   | | | | | | | ---------------------+--------------------------+--------+------+---+--------+---+-------  | | | | | | | ---------------------+--------------------------+--------+------+---+--------+---+-------  | Year Ended September 30, ---------------------+-------------------------  | 2017 | | 2016 | | 2015 ---------------------+--------------------------+--------+------+---+------- Depreciation expense | $ | 55,140 | | $ | 41,550 | $ | 45,994 ---------------------+--------------------------+--------+------+---+--------+---+------- 69  For the fiscal years ended September 30, 2017, 2016, and 2015, Woodward capitalized interest that would have otherwise been included in interest expense of the following:   | | | | | | | ---------------------+--------------------------+-------+------+---+-------+---+------  | | | | | | | ---------------------+--------------------------+-------+------+---+-------+---+------  | Year Ended September 30, ---------------------+-------------------------  | 2017 | | 2016 | | 2015 ---------------------+--------------------------+-------+------+---+------ Capitalized interest | $ | 2,008 | | $ | 5,455 | $ | 8,995 ---------------------+--------------------------+-------+------+---+-------+---+------ Note 10. Goodwill   | | | | | | | -------------+--------------------+---------+-----------------------------------------+---+--------------------+---+--------  | | | | | | | -------------+--------------------+---------+-----------------------------------------+---+--------------------+---+--------  | September 30, 2016 | | Effects of Foreign Currency Translation | | September 30, 2017 -------------+--------------------+---------+-----------------------------------------+---+------------------- Aerospace | $ | 455,423 | | $ | - | $ | 455,423 -------------+--------------------+---------+-----------------------------------------+---+--------------------+---+-------- Industrial | | 100,261 | | | 861 | | 101,122 -------------+--------------------+---------+-----------------------------------------+---+--------------------+---+-------- Consolidated | $ | 555,684 | | $ | 861 | $ | 556,545 -------------+--------------------+---------+-----------------------------------------+---+--------------------+---+--------  | | | | | | | -------------+--------------------+---------+-----------------------------------------+---+--------------------+---+--------  | September 30, 2015 | | Effects of Foreign Currency Translation | | September 30, 2016 -------------+--------------------+---------+-----------------------------------------+---+------------------- Aerospace | $ | 455,423 | | $ | - | $ | 455,423 -------------+--------------------+---------+-----------------------------------------+---+--------------------+---+-------- Industrial | | 101,554 | | | (1,293) | | 100,261 -------------+--------------------+---------+-----------------------------------------+---+--------------------+---+-------- Consolidated | $ | 556,977 | | $ | (1,293) | $ | 555,684 -------------+--------------------+---------+-----------------------------------------+---+--------------------+---+--------  Woodward tests goodwill for impairment at the reporting unit level on an annual basis and more often if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Woodward completed its annual goodwill impairment test as of July 31, 2017 during the quarter ended September 30, 2017. At that date, Woodward determined it was appropriate to aggregate certain components of the same operating segment into a single reporting unit. The fair value of each of Woodward’s reporting units was determined using a discounted cash flow method. This method represents a level 3 input and incorporates various estimates and assumptions, the most significant being projected revenue growth rates, earnings margins, future tax rates, and the present value, based on an estimated weighted-average cost of capital (or the discount rate) and terminal growth rate, of forecasted cash flows. Management projects revenue growth rates, earnings margins and cash flows based on each reporting unit’s current operational results, expected performance and operational strategies over a ten-year period. These projections are adjusted to reflect current economic conditions and demand for certain products, and require considerable management judgment. Forecasted cash flows used in the July 31, 2017 impairment test were discounted using weighted-average cost of capital assumptions ranging from 9.57% to 13.86%. The terminal values of the forecasted cash flows were calculated using the Gordon Growth Model and assumed an annual compound growth rate after ten years of 3.39%. These inputs, which are unobservable in the market, represent management’s best estimate of what market participants would use in determining the present value of the Company’s forecasted cash flows. Changes in these estimates and assumptions can have a significant impact on the fair value of forecasted cash flows. Woodward evaluated the reasonableness of the reporting units’ resulting fair values utilizing a market multiple method. The results of Woodward’s goodwill impairment tests performed as of July 31, 2017 did not indicate impairment of any of Woodward’s reporting units. 70 Note 11. Intangible assets, net  | | | | | | | | | | | | | | --------------------------------------+----------------------+---------+--------------------------+---+---------------------+----------------------+---------+--------------------------+---+---------------------+---+-----------+---+--------  | | | | | | | | | | | | | | --------------------------------------+----------------------+---------+--------------------------+---+---------------------+----------------------+---------+--------------------------+---+---------------------+---+-----------+---+--------  | September 30, 2017 | | September 30, 2016 --------------------------------------+----------------------+---------+-------------------------  | Gross Carrying Value | | Accumulated Amortization | | Net Carrying Amount | Gross Carrying Value | | Accumulated Amortization | | Net Carrying Amount --------------------------------------+----------------------+---------+--------------------------+---+---------------------+----------------------+---------+--------------------------+---+-------------------- Customer relationships and contracts: | | | | | | | | | | | | | | --------------------------------------+----------------------+---------+--------------------------+---+---------------------+----------------------+---------+--------------------------+---+---------------------+---+-----------+---+-------- Aerospace | $ | 282,225 | | $ | (151,155) | $ | 131,070 | | $ | 282,225 | $ | (134,158) | $ | 148,067 --------------------------------------+----------------------+---------+--------------------------+---+---------------------+----------------------+---------+--------------------------+---+---------------------+---+-----------+---+-------- Industrial | | 40,962 | | | (34,407) | | 6,555 | | | 40,969 | | (33,509) | | 7,460 --------------------------------------+----------------------+---------+--------------------------+---+---------------------+----------------------+---------+--------------------------+---+---------------------+---+-----------+---+-------- Total | $ | 323,187 | | $ | (185,562) | $ | 137,625 | | $ | 323,194 | $ | (167,667) | $ | 155,527 --------------------------------------+----------------------+---------+--------------------------+---+---------------------+----------------------+---------+--------------------------+---+---------------------+---+-----------+---+--------  | | | | | | | | | | | | | | --------------------------------------+----------------------+---------+--------------------------+---+---------------------+----------------------+---------+--------------------------+---+---------------------+---+-----------+---+-------- Intellectual property: | | | | | | | | | | | | | | --------------------------------------+----------------------+---------+--------------------------+---+---------------------+----------------------+---------+--------------------------+---+---------------------+---+-----------+---+-------- Aerospace | $ | - | | $ | - | $ | - | | $ | - | $ | - | $ | - --------------------------------------+----------------------+---------+--------------------------+---+---------------------+----------------------+---------+--------------------------+---+---------------------+---+-----------+---+-------- Industrial | | 19,422 | | | (18,196) | | 1,226 | | | 19,435 | | (17,876) | | 1,559 --------------------------------------+----------------------+---------+--------------------------+---+---------------------+----------------------+---------+--------------------------+---+---------------------+---+-----------+---+-------- Total | $ | 19,422 | | $ | (18,196) | $ | 1,226 | | $ | 19,435 | $ | (17,876) | $ | 1,559 --------------------------------------+----------------------+---------+--------------------------+---+---------------------+----------------------+---------+--------------------------+---+---------------------+---+-----------+---+--------  | | | | | | | | | | | | | | --------------------------------------+----------------------+---------+--------------------------+---+---------------------+----------------------+---------+--------------------------+---+---------------------+---+-----------+---+-------- Process technology: | | | | | | | | | | | | | | --------------------------------------+----------------------+---------+--------------------------+---+---------------------+----------------------+---------+--------------------------+---+---------------------+---+-----------+---+-------- Aerospace | $ | 76,605 | | $ | (49,124) | $ | 27,481 | | $ | 76,605 | $ | (43,229) | $ | 33,376 --------------------------------------+----------------------+---------+--------------------------+---+---------------------+----------------------+---------+--------------------------+---+---------------------+---+-----------+---+-------- Industrial | | 22,950 | | | (17,756) | | 5,194 | | | 22,965 | | (16,200) | | 6,765 --------------------------------------+----------------------+---------+--------------------------+---+---------------------+----------------------+---------+--------------------------+---+---------------------+---+-----------+---+-------- Total | $ | 99,555 | | $ | (66,880) | $ | 32,675 | | $ | 99,570 | $ | (59,429) | $ | 40,141 --------------------------------------+----------------------+---------+--------------------------+---+---------------------+----------------------+---------+--------------------------+---+---------------------+---+-----------+---+--------  | | | | | | | | | | | | | | --------------------------------------+----------------------+---------+--------------------------+---+---------------------+----------------------+---------+--------------------------+---+---------------------+---+-----------+---+-------- Other intangibles: | | | | | | | | | | | | | | --------------------------------------+----------------------+---------+--------------------------+---+---------------------+----------------------+---------+--------------------------+---+---------------------+---+-----------+---+-------- Aerospace | $ | - | | $ | - | $ | - | | $ | - | $ | - | $ | - --------------------------------------+----------------------+---------+--------------------------+---+---------------------+----------------------+---------+--------------------------+---+---------------------+---+-----------+---+-------- Industrial | | 1,312 | | | (956) | | 356 | | | 1,246 | | (823) | | 423 --------------------------------------+----------------------+---------+--------------------------+---+---------------------+----------------------+---------+--------------------------+---+---------------------+---+-----------+---+-------- Total | $ | 1,312 | | $ | (956) | $ | 356 | | $ | 1,246 | $ | (823) | $ | 423 --------------------------------------+----------------------+---------+--------------------------+---+---------------------+----------------------+---------+--------------------------+---+---------------------+---+-----------+---+--------  | | | | | | | | | | | | | | --------------------------------------+----------------------+---------+--------------------------+---+---------------------+----------------------+---------+--------------------------+---+---------------------+---+-----------+---+-------- Total intangibles: | | | | | | | | | | | | | | --------------------------------------+----------------------+---------+--------------------------+---+---------------------+----------------------+---------+--------------------------+---+---------------------+---+-----------+---+-------- Aerospace | $ | 358,830 | | $ | (200,279) | $ | 158,551 | | $ | 358,830 | $ | (177,387) | $ | 181,443 --------------------------------------+----------------------+---------+--------------------------+---+---------------------+----------------------+---------+--------------------------+---+---------------------+---+-----------+---+-------- Industrial | | 84,646 | | | (71,315) | | 13,331 | | | 84,615 | | (68,408) | | 16,207 --------------------------------------+----------------------+---------+--------------------------+---+---------------------+----------------------+---------+--------------------------+---+---------------------+---+-----------+---+-------- Consolidated Total | $ | 443,476 | | $ | (271,594) | $ | 171,882 | | $ | 443,445 | $ | (245,795) | $ | 197,650 --------------------------------------+----------------------+---------+--------------------------+---+---------------------+----------------------+---------+--------------------------+---+---------------------+---+-----------+---+--------  For the fiscal years ended September 30, 2017, 2016, and 2015, Woodward recorded amortization expense associated with intangibles of the following:   | | | | | | | ---------------------+--------------------------+--------+------+---+--------+---+-------  | | | | | | | ---------------------+--------------------------+--------+------+---+--------+---+-------  | Year Ended September 30, ---------------------+-------------------------  | 2017 | | 2016 | | 2015 ---------------------+--------------------------+--------+------+---+------- Amortization expense | $ | 25,777 | | $ | 27,486 | $ | 29,241 ---------------------+--------------------------+--------+------+---+--------+---+-------  Future amortization expense associated with intangibles is expected to be:    | | --------------------------+---+--------  | | --------------------------+---+-------- Year Ending September 30: | | --------------------------+---+-------- 2018 | $ | 24,995 --------------------------+---+-------- 2019 | | 23,159 --------------------------+---+-------- 2020 | | 20,372 --------------------------+---+-------- 2021 | | 18,404 --------------------------+---+-------- 2022 | | 16,249 --------------------------+---+-------- Thereafter | | 68,703 --------------------------+---+--------  | $ | 171,882 --------------------------+---+--------   71 Note 12. Credit facilities, short-term borrowings and long-term debt As of September 30, 2017, Woodward’s short-term borrowings and availability under its various short-term credit facilities follows:   | | | | | | | | | -------------------------------------------------+--------------------+-----------+----------------------------------------------+---+------------------------+------------------------+----------+---+--------  | | | | | | | | | -------------------------------------------------+--------------------+-----------+----------------------------------------------+---+------------------------+------------------------+----------+---+--------  | Total availability | | Outstanding letters of credit and guarantees | | Outstanding borrowings | Remaining availability -------------------------------------------------+--------------------+-----------+----------------------------------------------+---+------------------------+----------------------- Revolving credit facility | $ | 1,000,000 | | $ | (10,621) | $ | (32,600) | $ | 956,779 -------------------------------------------------+--------------------+-----------+----------------------------------------------+---+------------------------+------------------------+----------+---+-------- Foreign lines of credit and overdraft facilities | | 7,530 | | | - | | - | | 7,530 -------------------------------------------------+--------------------+-----------+----------------------------------------------+---+------------------------+------------------------+----------+---+-------- Foreign performance guarantee facilities | | 10,058 | | | (351) | | - | | 9,707 -------------------------------------------------+--------------------+-----------+----------------------------------------------+---+------------------------+------------------------+----------+---+--------  | $ | 1,017,588 | | $ | (10,972) | $ | (32,600) | $ | 974,016 -------------------------------------------------+--------------------+-----------+----------------------------------------------+---+------------------------+------------------------+----------+---+-------- Revolving credit facility Woodward maintains a $1,000,000 revolving credit facility established under a revolving credit agreement among Woodward, a syndicate of lenders and Wells Fargo Bank, National Association, as administrative agent (the “Revolving Credit Agreement”). The Revolving Credit Agreement provides for the option to increase available borrowings to up to $1,200,000, subject to lenders’ participation. Borrowings under the Revolving Credit Agreement generally bear interest at LIBOR plus 0.85% to 1.65%. The Revolving Credit Agreement matures in April 2020. Under the Revolving Credit Agreement, there were $32,600 in principal amount of borrowings outstanding as of September 30, 2017, at an effective interest rate of 2.29%, and $156,700 in principal amount of borrowings outstanding as of September 30, 2016, at an effective interest rate of 1.77%. As of September 30, 2017, all of the borrowings under the Revolving Credit Agreement were classified as short-term based on Woodward’s intent and ability to pay this amount in the next twelve months. As of September 30, 2016, $150,000 of the borrowings under the Revolving Credit Agreement were classified as short-term debt. The Revolving Credit Agreement contains certain covenants customary with such agreements, which are generally consistent with the covenants applicable to Woodward’s long-term debt agreements, and contains customary events of default, including certain cross default provisions related to Woodward’s other outstanding debt arrangements in excess of $60,000, the occurrence of which would permit the lenders to accelerate the amounts due thereunder. In addition, the Revolving Credit Agreement includes the following financial covenants: (i) a maximum permitted leverage ratio of consolidated net debt to consolidated earnings before interest, taxes, depreciation, stock-based compensation, and amortization, plus any usual non-cash charges to the extent deducted in computing net income minus any usual non-cash gains to the extent added in computing net income (“Leverage Ratio”) for Woodward and its consolidated subsidiaries of 3.5 to 1.0, which ratio, subject to certain restrictions, may increase to 4.0 to 1.0 for the fiscal quarter (and the immediately following fiscal quarter) during which a permitted acquisition occurs and to 3.75 to 1.0 for the following two succeeding fiscal quarters, and (ii) a minimum consolidated net worth of $800,000 plus (a) 50% of Woodward’s positive net income for the prior fiscal year and (b) 50% of Woodward’s net cash proceeds resulting from certain issuances of stock, subject to certain adjustments. Woodward’s obligations under the Revolving Credit Agreement are guaranteed by Woodward FST, Inc., Woodward MPC, Inc., and Woodward HRT, Inc., each of which is a wholly owned subsidiary of Woodward. Short-term borrowings Woodward has other foreign lines of credit and foreign overdraft facilities at various financial institutions, which are generally reviewed annually for renewal and are subject to the usual terms and conditions applied by the financial institutions. Pursuant to the terms of the related facility agreements, Woodward’s foreign performance guarantee facilities are limited in use to providing performance guarantees to third parties. There were no borrowings outstanding as of September 30, 2017 and September 30, 2016 on Woodward’s foreign lines of credit and foreign overdraft facilities. 72 Long-term debt  | | | | | ------------------------------------------------------------------------------------------------+---------------+----------+---------------+---+----------  | | | | | ------------------------------------------------------------------------------------------------+---------------+----------+---------------+---+----------  | September 30, | | September 30, ------------------------------------------------------------------------------------------------+---------------+----------+--------------  | 2017 | | 2016 ------------------------------------------------------------------------------------------------+---------------+----------+-------------- Revolving credit facility - Floating rate (LIBOR plus 0.85% - 1.65%), due April 2020, unsecured | $ | 32,600 | | $ | 156,700 ------------------------------------------------------------------------------------------------+---------------+----------+---------------+---+---------- Series D notes – 6.39%, due October 2018; unsecured | | 100,000 | | | 100,000 ------------------------------------------------------------------------------------------------+---------------+----------+---------------+---+---------- Series F notes – 8.24%, due April 2019; unsecured | | 43,000 | | | 43,000 ------------------------------------------------------------------------------------------------+---------------+----------+---------------+---+---------- Series G notes – 3.42%, due November 2020; unsecured | | 50,000 | | | 50,000 ------------------------------------------------------------------------------------------------+---------------+----------+---------------+---+---------- Series H notes – 4.03%, due November 2023; unsecured | | 25,000 | | | 25,000 ------------------------------------------------------------------------------------------------+---------------+----------+---------------+---+---------- Series I notes – 4.18%, due November 2025; unsecured | | 25,000 | | | 25,000 ------------------------------------------------------------------------------------------------+---------------+----------+---------------+---+---------- Series J notes – Floating rate (LIBOR plus 1.25%), due November 2020; unsecured | | 50,000 | | | 50,000 ------------------------------------------------------------------------------------------------+---------------+----------+---------------+---+---------- Series K notes – 4.03%, due November 2023; unsecured | | 50,000 | | | 50,000 ------------------------------------------------------------------------------------------------+---------------+----------+---------------+---+---------- Series L notes – 4.18%, due November 2025; unsecured | | 50,000 | | | 50,000 ------------------------------------------------------------------------------------------------+---------------+----------+---------------+---+---------- Series M notes – 1.12% due September 2026; unsecured | | 47,270 | | | 44,886 ------------------------------------------------------------------------------------------------+---------------+----------+---------------+---+---------- Series N notes – 1.31% due September 2028; unsecured | | 90,995 | | | 86,406 ------------------------------------------------------------------------------------------------+---------------+----------+---------------+---+---------- Series O notes – 1.57% due September 2031; unsecured | | 50,815 | | | 48,252 ------------------------------------------------------------------------------------------------+---------------+----------+---------------+---+---------- Total debt | | 614,680 | | | 729,244 ------------------------------------------------------------------------------------------------+---------------+----------+---------------+---+---------- Less: Current portion of long-term debt | | (32,600) | | | (150,000) ------------------------------------------------------------------------------------------------+---------------+----------+---------------+---+---------- Unamortized debt issuance costs | | (1,794) | | | (2,091) ------------------------------------------------------------------------------------------------+---------------+----------+---------------+---+---------- Long-term debt, less current portion | $ | 580,286 | | $ | 577,153 ------------------------------------------------------------------------------------------------+---------------+----------+---------------+---+---------- The Notes In October 2008, Woodward entered into a note purchase agreement relating to the Series D Notes (the “2008 Notes”). In April 2009, Woodward entered into a note purchase agreement relating to the Series F Notes (the “2009 Notes”). On October 1, 2013, Woodward entered into a note purchase agreement relating to the sale by Woodward of an aggregate principal amount of $250,000 of its senior unsecured notes in a series of private placement transactions. Woodward issued the Series G, H and I Notes (the “First Closing Notes”) on October 1, 2013. Woodward issued the Series J, K and L Notes (the “Second Closing Notes,” and together with the 2008 Notes, 2009 Notes and the First Closing Notes, the “USD Notes”) on November 15, 2013. On September 23, 2016, Woodward and the BV Subsidiary each entered into note purchase agreements relating to the sale by Woodward and the BV Subsidiary of an aggregate principal amount of €160,000 of senior unsecured notes in a series of private placement transactions. Woodward issued €40,000 aggregate principal amount of Woodward’s Series M Senior Notes (the “Series M Notes”). The BV Subsidiary issued (a) €77,000 aggregate principal amount of the BV Subsidiary’s Series N Senior Notes (the “Series N Notes”) and (b) €43,000 aggregate principal amount of the BV Subsidiary’s Series O Senior Notes (the “Series O Notes” and together with the Series M Notes and the Series N Notes, the “2016 Notes,” and together with the USD Notes, collectively, the “Notes”). Interest on the 2008 Notes, the First Closing Notes, and the Series K and L Notes is payable semi-annually on April 1 and October 1 of each year until all principal is paid. Interest on the 2009 Notes is payable semi-annually on April 15 and October 15 of each year until all principal is paid. Interest on the 2016 Notes is payable semi-annually on March 23 and September 23 of each year, until all principal is paid. Interest on the Series J Notes is payable quarterly on January 1, April 1, July 1 and October 1 of each year until all principal is paid. As of September 30, 2017, the Series J Notes bore interest at an effective rate of 2.6%. None of the Notes were registered under the Securities Act of 1933 and they may not be offered or sold in the United States absent registration or an applicable exemption from registration requirements. Holders of the Notes do not have any registration rights. All of the issued Notes are held by multiple institutions. Woodward’s obligations under the Notes are guaranteed by (i) Woodward FST, Inc., Woodward MPC, Inc., and Woodward HRT, Inc., each of which is a wholly owned subsidiary of Woodward, and (ii) in the case of the BV Subsidiary’s Series N and O Notes, by Woodward. Woodward’s obligations under the Notes rank equal in right of payment with all of Woodward’s other unsecured unsubordinated debt, including its outstanding debt under its revolving credit facility. 73 The USD Notes and the 2016 Notes contain covenants customary for such financings, including, among other things, covenants that place limits on Woodward’s ability to incur liens on assets, incur additional debt (including a leverage or coverage based maintenance test), transfer or sell Woodward’s assets, merge or consolidate with other persons and enter into material transactions with affiliates. Under the financial covenants contained in the note purchase agreement governing the USD Notes, Woodward’s priority debt may not exceed, at any time, 25% of its consolidated net worth. Woodward’s Leverage Ratio cannot exceed 4.0 to 1.0 during any material acquisition period, or 3.5 to 1.0 at any other time on a rolling four quarter basis. In the event that Woodward’s Leverage Ratio exceeds 3.5 to 1.0 during any material acquisition period, the interest rate on each series of Notes will increase. Further for the Series D and F notes, Woodward’s consolidated net worth must at all times equal or exceed $485,940 plus 50% of Woodward’s consolidated net earnings for each fiscal year beginning with the fiscal year ending September 30, 2009. For the Series G, H, I, J, K, L, M, N, and O notes, Woodward’s consolidated net worth must at all times equal or exceed $1,046,619 plus 50% of Woodward’s positive net income for each completed fiscal year beginning with the fiscal year ending September 30, 2016. Woodward, at its option, is permitted at any time to prepay all, or any part of the then-outstanding principal amount of any series of the Notes at 100% of the principal amount of the series of Notes to be prepaid (but, in the case of partial prepayment, not less than $1,000 for the USD Notes and not less than €1,000 for the 2016 Notes), together with interest accrued on such amount to be prepaid to the date of payment, plus any applicable prepayment compensation amount. The prepayment compensation amount, as to the USD Notes other than the Series J Notes, is computed by discounting the remaining scheduled payments of interest and principal of the USD Notes being prepaid at a discount rate equal to the sum of 50 basis points and the yield to maturity of U.S. Treasury securities having a maturity equal to the remaining average life of the USD Notes being prepaid. The prepayment compensation amount, as to the Series J Notes, generally is computed as a percentage of the principal amount of the Series J Notes equal to (a) 2%, on or prior to November 15, 2014, (b) 1%, after November 15, 2014 and on or prior to November 15, 2015, and (c) 0% after November 15, 2015. The prepayment compensation amount as to the 2016 Notes that is not subject to a swap agreement is computed by discounting the remaining scheduled payments of interest and principal of such notes being prepaid at a discount rate equal to the sum of 50 basis points and the yield to maturity of the German Bund having a maturity equal to the remaining average life of the 2016 Notes being prepaid. The prepayment compensation amount as to a 2016 Note that is subject to a swap agreement entered into by the holder of such note under which the holder will receive payment in U.S. dollars in exchange for scheduled Euro payments of principal and interest on the Euro denominated 2016 Notes, adjusted for theoretical holder returns foregone on hypothetical reinvestments in U.S. Treasury securities (the “Swapped Notes”) is equal to the excess of an amount equal to the remaining scheduled payments to be paid in respect of such called principal under such swap agreement discounted at a rate equal to 50 basis points and the yield to maturity of U.S. Treasury securities having a maturity equal to the remaining average life of the Swapped Notes being prepaid over the amount of payments in U.S. dollars that would be paid to the holder of the Swapped Note in respect of the called principal under the swap agreement, which amount will be increased or reduced, as applicable, in an amount equal to any net gain or loss realized by the holder of such Swapped Note on swap transactions under such swap agreement as a result of such prepayment. Required future principal payments of the Notes as of September 30, 2017 are as follows:   | | --------------------------+---+--------  | | --------------------------+---+-------- Year Ending September 30: | | --------------------------+---+-------- 2018 | $ | - --------------------------+---+-------- 2019 | | 143,000 --------------------------+---+-------- 2020 | | - --------------------------+---+-------- 2021 | | 100,000 --------------------------+---+-------- 2022 | | - --------------------------+---+-------- Thereafter | | 339,080 --------------------------+---+--------  | $ | 582,080 --------------------------+---+-------- Certain financial and other covenants under Woodward's debt agreements contain customary restrictions on the operation of its business. Management believes that Woodward was in compliance with the covenants under the long-term debt agreements at September 30, 2017. 74 Debt Issuance Costs In connection with the 2016 Note Purchase Agreements, in fiscal year 2016, Woodward incurred $863 in financing costs, which are deferred and will be amortized using the straight-line method over the life of the agreement. In connection with the Revolving Credit Agreement, in fiscal year 2015, Woodward incurred $2,359 in financing costs, which are deferred and are being amortized using the straight-line method over the life of the agreement. As of April 28, 2015, Woodward also had $2,014 remaining of deferred financing costs incurred in connection with the prior revolving credit agreement, which have been combined with the financing costs associated with the Revolving Credit Agreement and are being amortized using the straight-line method over the life of the Revolving Credit Agreement. Amounts recognized as interest expense from the amortization of debt issuance costs were $1,130 in fiscal year 2017, $1,165 in fiscal year 2016, and $1,114 in fiscal year 2015. Unamortized debt issuance costs associated with the Notes of $1,794 as of September 30, 2017 and $2,091 as of September 30, 2016 have been recorded as a reduction in “Long-term debt, less current portion” in the Consolidated Balance Sheets. Unamortized debt issuance costs associated with the Revolving Credit Agreement of $2,259 as of September 30, 2017 and $3,134 as of September 30, 2016 have been recorded as “Other assets” in the Consolidated Balance Sheets. Amortization of debt issuance costs is included in operating activities in the Consolidated Statements of Cash Flows. Note 13. Accrued liabilities   | | | | | ----------------------------------------------------------------------------------+------------------+---------+------+---+--------  | | | | | ----------------------------------------------------------------------------------+------------------+---------+------+---+--------  | At September 30, ----------------------------------------------------------------------------------+-----------------  | 2017 | | 2016 ----------------------------------------------------------------------------------+------------------+---------+----- Salaries and other member benefits | $ | 91,285 | | $ | 87,197 ----------------------------------------------------------------------------------+------------------+---------+------+---+-------- Warranties | | 13,597 | | | 15,993 ----------------------------------------------------------------------------------+------------------+---------+------+---+-------- Interest payable | | 9,626 | | | 9,071 ----------------------------------------------------------------------------------+------------------+---------+------+---+-------- Current portion of acquired performance obligations and unfavorable contracts (1) | | 1,627 | | | 2,910 ----------------------------------------------------------------------------------+------------------+---------+------+---+-------- Accrued retirement benefits | | 2,413 | | | 2,505 ----------------------------------------------------------------------------------+------------------+---------+------+---+-------- Current portion of loss reserve on contractual lease commitments | | 1,343 | | | 1,840 ----------------------------------------------------------------------------------+------------------+---------+------+---+-------- Current portion of deferred income from JV formation (Note 4) | | 6,451 | | | 6,552 ----------------------------------------------------------------------------------+------------------+---------+------+---+-------- Deferred revenues | | 4,625 | | | 5,779 ----------------------------------------------------------------------------------+------------------+---------+------+---+-------- Taxes, other than income | | 14,401 | | | 14,580 ----------------------------------------------------------------------------------+------------------+---------+------+---+-------- Other | | 9,704 | | | 10,200 ----------------------------------------------------------------------------------+------------------+---------+------+---+--------  | $ | 155,072 | | $ | 156,627 ----------------------------------------------------------------------------------+------------------+---------+------+---+--------  (1) | In connection with Woodward’s acquisition of GE Aviation Systems LLC’s (the “Seller”) thrust reverser actuation systems business located in Duarte, California (the “Duarte Acquisition”) in fiscal year 2013, Woodward assumed current and long-term performance obligations for contractual commitments that are expected to result in future economic losses. In addition, Woodward assumed current and long-term performance obligations for services to be provided to the Seller and others, partially offset by current and long-term assets related to contractual payments due from the Seller. The current portion of both obligations is included in Accrued liabilities. ----+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 75  Warranties Provisions of Woodward’s sales agreements include product warranties customary to these types of agreements. Accruals are established for specifically identified warranty issues that are probable to result in future costs. Warranty costs are accrued on a non-specific basis whenever past experience indicates a normal and predictable pattern exists. Changes in accrued product warranties were as follows:   | | | | | | | ---------------------------------------+-----------------------------------+----------+------+---+---------+---+---------  | | | | | | | ---------------------------------------+-----------------------------------+----------+------+---+---------+---+---------  | Twelve-Months Ended September 30, ---------------------------------------+----------------------------------  | 2017 | | 2016 | | 2015 ---------------------------------------+-----------------------------------+----------+------+---+-------- Warranties, beginning of year | $ | 15,993 | | $ | 13,741 | $ | 16,916 ---------------------------------------+-----------------------------------+----------+------+---+---------+---+--------- Expense, net of recoveries | | 9,135 | | | 9,902 | | 10,117 ---------------------------------------+-----------------------------------+----------+------+---+---------+---+--------- Reductions for settling warranties | | (11,692) | | | (7,802) | | (12,416) ---------------------------------------+-----------------------------------+----------+------+---+---------+---+--------- Foreign currency exchange rate changes | | 161 | | | 152 | | (876) ---------------------------------------+-----------------------------------+----------+------+---+---------+---+--------- Warranties, end of year | $ | 13,597 | | $ | 15,993 | $ | 13,741 ---------------------------------------+-----------------------------------+----------+------+---+---------+---+---------    Loss reserve on contractual lease commitments In connection with the construction of a new production facility in Niles, Illinois, Woodward vacated a leased facility in Skokie, Illinois. During the first quarter of fiscal year 2016, Woodward fully vacated the Skokie facility and therefore recorded a charge of $8,165 to recognize a loss reserve against the estimated remaining contractual lease commitments, less anticipated sublease income. During the third quarter of fiscal year 2017, Woodward entered into an additional sublease agreement with a third party related to a portion of the vacated Skokie facility. Woodward recorded a reduction in the loss reserve associated with the vacated Skokie facility of $2,322 related to the anticipated sublease income it will receive. The summary for the activity in the loss reserve during the fiscal years ended September 30, 2017 and September 30, 2016 is as follows:   | | | | | | | | -----------------------------------------------------------------+-----------------------------------+---------+------+---+---------+------+---+------  | | | | | | | | -----------------------------------------------------------------+-----------------------------------+---------+------+---+---------+------+---+------  | Twelve-Months Ended September 30, -----------------------------------------------------------------+----------------------------------  | 2017 | | 2016 | | | 2015 -----------------------------------------------------------------+-----------------------------------+---------+------+---+---------+----- Loss reserve on contractual lease commitments, beginning of year | $ | 9,242 | | $ | 2,464 | | $ | 3,212 -----------------------------------------------------------------+-----------------------------------+---------+------+---+---------+------+---+------ Additions | | - | | | 8,165 | | | 39 -----------------------------------------------------------------+-----------------------------------+---------+------+---+---------+------+---+------ Payments | | (1,650) | | | (1,387) | | | (787) -----------------------------------------------------------------+-----------------------------------+---------+------+---+---------+------+---+------ Non-cash adjustments | | (2,322) | | | - | | | - -----------------------------------------------------------------+-----------------------------------+---------+------+---+---------+------+---+------ Loss reserve on contractual lease commitments, end of year | $ | 5,270 | | $ | 9,242 | | $ | 2,464 -----------------------------------------------------------------+-----------------------------------+---------+------+---+---------+------+---+------ Other liabilities included $3,927 of accrued loss reserve on contractual lease commitments that are not expected to be settled or paid within twelve months as of September 30, 2017. 76 Note 14. Other liabilities   | | | | | ------------------------------------------------------------------------------------+------------------+---------+------+---+--------  | | | | | ------------------------------------------------------------------------------------+------------------+---------+------+---+--------  | At September 30, ------------------------------------------------------------------------------------+-----------------  | 2017 | | 2016 ------------------------------------------------------------------------------------+------------------+---------+----- Net accrued retirement benefits, less amounts recognized within accrued liabilities | $ | 52,211 | | $ | 70,479 ------------------------------------------------------------------------------------+------------------+---------+------+---+-------- Noncurrent portion of deferred income from JV formation (1) | | 236,896 | | | 238,187 ------------------------------------------------------------------------------------+------------------+---------+------+---+-------- Total unrecognized tax benefits | | 20,949 | | | 17,239 ------------------------------------------------------------------------------------+------------------+---------+------+---+-------- Acquired unfavorable contracts (2) | | 2,076 | | | 3,148 ------------------------------------------------------------------------------------+------------------+---------+------+---+-------- Deferred economic incentives (3) | | 14,574 | | | 16,196 ------------------------------------------------------------------------------------+------------------+---------+------+---+-------- Loss reserve on contractual lease commitments (4) | | 3,927 | | | 7,402 ------------------------------------------------------------------------------------+------------------+---------+------+---+-------- Other | | 14,165 | | | 15,573 ------------------------------------------------------------------------------------+------------------+---------+------+---+--------  | $ | 344,798 | | $ | 368,224 ------------------------------------------------------------------------------------+------------------+---------+------+---+--------    (1) | See Note 4, Joint venture for more information on the deferred income from JV formation. ----+----------------------------------------------------------------------------------------- (2) | In connection with the Duarte Acquisition in fiscal year 2013, Woodward assumed current and long-term performance obligations for contractual commitments that are expected to result in future economic losses. The long-term portion of the acquired unfavorable contracts is included in Other liabilities. ----+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (3) | Woodward receives certain economic incentives from various state and local authorities related to capital expansion projects. Such amounts are initially recorded as deferred credits and are being recognized as a reduction to pre-tax expense over the economic lives of the related capital expansion projects. ----+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (4) | See Note 13, Accrued liabilities for more information on the loss reserve on contractual lease commitments. ----+-------------------------------------------------------------------------------------------------------------  Note 15. Other (income) expense, net   | | | | | | | ----------------------------------------------------------------+--------------------------+---------+------+---+----------+---+--------  | | | | | | | ----------------------------------------------------------------+--------------------------+---------+------+---+----------+---+--------  | Year Ended September 30, ----------------------------------------------------------------+-------------------------  | 2017 | | 2016 | | 2015 ----------------------------------------------------------------+--------------------------+---------+------+---+--------- Equity interest in the earnings of the JV (Note 4) | $ | (2,568) | | $ | (6,204) | $ | - ----------------------------------------------------------------+--------------------------+---------+------+---+----------+---+-------- Net gain on sales of assets | | (3,604) | | | (4,431) | | (626) ----------------------------------------------------------------+--------------------------+---------+------+---+----------+---+-------- Rent income | | (254) | | | (315) | | (485) ----------------------------------------------------------------+--------------------------+---------+------+---+----------+---+-------- Net (gain) loss on investments in deferred compensation program | | (1,833) | | | (1,062) | | 33 ----------------------------------------------------------------+--------------------------+---------+------+---+----------+---+-------- Other | | (786) | | | (294) | | (84) ----------------------------------------------------------------+--------------------------+---------+------+---+----------+---+--------  | $ | (9,045) | | $ | (12,306) | $ | (1,162) ----------------------------------------------------------------+--------------------------+---------+------+---+----------+---+-------- Note 16. Income taxes Income taxes consisted of the following:   | | | | | | | | ----------+---------+--------------------------+---------+------+---+----------+---+--------  | | | | | | | | ----------+---------+--------------------------+---------+------+---+----------+---+--------  | | Year Ended September 30, ----------+---------+-------------------------  | | 2017 | | 2016 | | 2015 ----------+---------+--------------------------+---------+------+---+--------- Current: | | | | | | | ----------+---------+--------------------------+---------+------+---+----------+--  | Federal | $ | 17,872 | | $ | 81,127 | $ | 23,923 ----------+---------+--------------------------+---------+------+---+----------+---+--------  | State | | 1,379 | | | 6,067 | | 3,108 ----------+---------+--------------------------+---------+------+---+----------+---+--------  | Foreign | | 15,118 | | | 9,689 | | 18,343 ----------+---------+--------------------------+---------+------+---+----------+---+-------- Deferred: | | | | | | | ----------+---------+--------------------------+---------+------+---+----------+--  | Federal | | 16,907 | | | (40,801) | | 19,236 ----------+---------+--------------------------+---------+------+---+----------+---+--------  | State | | (2,561) | | | (9,054) | | 751 ----------+---------+--------------------------+---------+------+---+----------+---+--------  | Foreign | | 3,525 | | | (1,380) | | (5,864) ----------+---------+--------------------------+---------+------+---+----------+---+--------  | | $ | 52,240 | | $ | 45,648 | $ | 59,497 ----------+---------+--------------------------+---------+------+---+----------+---+-------- 77 Earnings before income taxes by geographical area consisted of the following:   | | | | | | | ----------------+--------------------------+---------+------+---+---------+---+--------  | | | | | | | ----------------+--------------------------+---------+------+---+---------+---+--------  | Year Ended September 30, ----------------+-------------------------  | 2017 | | 2016 | | 2015 ----------------+--------------------------+---------+------+---+-------- United States | $ | 192,220 | | $ | 175,146 | $ | 172,315 ----------------+--------------------------+---------+------+---+---------+---+-------- Other countries | | 60,527 | | | 51,340 | | 68,634 ----------------+--------------------------+---------+------+---+---------+---+--------  | $ | 252,747 | | $ | 226,486 | $ | 240,949 ----------------+--------------------------+---------+------+---+---------+---+-------- Significant components of deferred income taxes presented in the Consolidated Balance Sheets are related to the following:   | | | | | | | --------------------------------------+-------------------------------------------------------+---+------------------+-----------+------+--------+----------  | | | | | | | --------------------------------------+-------------------------------------------------------+---+------------------+-----------+------+--------+----------  | | | At September 30, --------------------------------------+-------------------------------------------------------+---+-----------------  | | | 2017 | | 2016 --------------------------------------+-------------------------------------------------------+---+------------------+-----------+----- Deferred tax assets: | | | | | | --------------------------------------+-------------------------------------------------------+---+------------------+-----------+------+-------  | Defined benefit plans, other postretirement | | $ | 11,947 | | $ | 13,017 --------------------------------------+-------------------------------------------------------+---+------------------+-----------+------+--------+----------  | Foreign net operating loss carryforwards | | | 4,707 | | | 5,255 --------------------------------------+-------------------------------------------------------+---+------------------+-----------+------+--------+----------  | Inventory | | | 29,444 | | | 27,332 --------------------------------------+-------------------------------------------------------+---+------------------+-----------+------+--------+----------  | Deferred and stock-based compensation | | | 37,693 | | | 34,388 --------------------------------------+-------------------------------------------------------+---+------------------+-----------+------+--------+----------  | Defined benefit plans, pension | | | 1,148 | | | 8,955 --------------------------------------+-------------------------------------------------------+---+------------------+-----------+------+--------+----------  | Deferred revenue | | | 92,426 | | | 92,213 --------------------------------------+-------------------------------------------------------+---+------------------+-----------+------+--------+----------  | Other reserves | | | 10,850 | | | 13,968 --------------------------------------+-------------------------------------------------------+---+------------------+-----------+------+--------+----------  | Tax credits and incentives | | | 9,769 | | | 7,744 --------------------------------------+-------------------------------------------------------+---+------------------+-----------+------+--------+----------  | Other | | | 7,700 | | | 7,411 --------------------------------------+-------------------------------------------------------+---+------------------+-----------+------+--------+----------  | Valuation allowance | | | (3,714) | | | (3,317) --------------------------------------+-------------------------------------------------------+---+------------------+-----------+------+--------+----------  | Total deferred tax assets, net of valuation allowance | | | 201,970 | | | 206,966 --------------------------------------+-------------------------------------------------------+---+------------------+-----------+------+--------+---------- Deferred tax liabilities: | | | | | | --------------------------------------+-------------------------------------------------------+---+------------------+-----------+------+-------  | Goodwill and intangibles - net | | | (103,781) | | | (99,030) --------------------------------------+-------------------------------------------------------+---+------------------+-----------+------+--------+----------  | Property, plant and equipment | | | (109,229) | | | (88,986) --------------------------------------+-------------------------------------------------------+---+------------------+-----------+------+--------+----------  | Other | | | (2,418) | | | (2,533) --------------------------------------+-------------------------------------------------------+---+------------------+-----------+------+--------+----------  | Total deferred tax liabilities | | | (215,428) | | | (190,549) --------------------------------------+-------------------------------------------------------+---+------------------+-----------+------+--------+---------- Net deferred tax assets (liabilities) | | $ | (13,458) | | $ | 16,417 --------------------------------------+-------------------------------------------------------+---+------------------+-----------+------+------- Woodward has recorded a net operating loss (“NOL”) deferred tax asset of $4,707 as of September 30, 2017 and $5,255 as of September 30, 2016. A portion of these NOL carryforwards will start to expire in 2018 and is currently offset by a valuation allowance. We have placed valuation allowances against all other NOL carryforwards that are less than 50 percent likely to be realized. Deferred tax assets are reduced by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Both positive and negative evidence are considered in forming Woodward’s judgment as to whether a valuation allowance is appropriate, and more weight is given to evidence that can be objectively verified. Valuation allowances are reassessed whenever there are changes in circumstances that may cause a change in judgment. The change in the valuation allowance was primarily the result of new valuation allowances placed on two wholly owned subsidiaries with net operating losses and a reassessment of another valuation allowance based on a change in estimate of future earnings. At September 30, 2017, Woodward has not provided for taxes on undistributed foreign earnings of $405,286 that it considered indefinitely reinvested. These earnings could become subject to income taxes if they are remitted as dividends, are loaned to Woodward or any of Woodward’s subsidiaries located in the United States, or if Woodward sells its stock in the foreign subsidiaries. Any additional U.S. taxes could be offset, in part or in whole, by foreign tax credits. The amount of such taxes and application of tax credits would be dependent on the income tax laws and other circumstances at the time these amounts are repatriated. Based on these variables, it is impractical to determine the income tax liability that might be incurred if these funds were to be repatriated. 78 The following is a reconciliation of the U.S. Federal statutory tax rate of 35 percent to Woodward’s effective income tax rate:   | | | | | | | ------------------------------------------------------------+---------------------------+---+------+-------+------+-------+--  | | | | | | | ------------------------------------------------------------+---------------------------+---+------+-------+------+-------+--  | Year Ending September 30, ------------------------------------------------------------+-------------------------- Percent of pretax earnings | 2017 | | 2016 | | 2015 ------------------------------------------------------------+---------------------------+---+------+-------+----- Statutory tax rate | 35.0 | % | | 35.0 | % | 35.0 | % ------------------------------------------------------------+---------------------------+---+------+-------+------+-------+-- State income taxes, net of federal tax benefit | (0.3) | | | 0.4 | | 1.2 | ------------------------------------------------------------+---------------------------+---+------+-------+------+-------+-- Taxes on international activities | (7.6) | | | (2.2) | | (3.8) | ------------------------------------------------------------+---------------------------+---+------+-------+------+-------+-- Research credit | (3.2) | | | (3.6) | | (0.8) | ------------------------------------------------------------+---------------------------+---+------+-------+------+-------+-- Retroactive extension of research credit | - | | | (3.2) | | (2.4) | ------------------------------------------------------------+---------------------------+---+------+-------+------+-------+-- Net excess income tax benefit from stock-based compensation | (1.4) | | | (2.6) | | - | ------------------------------------------------------------+---------------------------+---+------+-------+------+-------+-- Domestic production activities deduction | (1.5) | | | (2.1) | | (1.6) | ------------------------------------------------------------+---------------------------+---+------+-------+------+-------+-- Adjustments of prior period tax items | (0.9) | | | (0.2) | | (2.1) | ------------------------------------------------------------+---------------------------+---+------+-------+------+-------+-- Other items, net | 0.6 | | | (1.3) | | (0.8) | ------------------------------------------------------------+---------------------------+---+------+-------+------+-------+-- Effective tax rate | 20.7 | % | | 20.2 | % | 24.7 | % ------------------------------------------------------------+---------------------------+---+------+-------+------+-------+-- In determining the tax amounts in Woodward’s financial statements, estimates are sometimes used that are subsequently adjusted in the actual filing of tax returns or by updated calculations. In addition, Woodward occasionally has resolutions of tax items with tax authorities related to prior years due to the conclusion of audits and the lapse of applicable statutes of limitations. Such adjustments are included in the “Adjustments of prior period tax items” line in the above table. The majority of these adjustments are related to the conclusion of audits, effective settlement, and lapse of applicable statutes of limitations in various tax jurisdictions. Income taxes for the fiscal year ended September 30, 2017 benefitted from impact of repatriation to the United States of certain net foreign profits and losses in the first quarter. The U.S. foreign tax credits available as a result of the repatriation of the foreign net earnings were greater than the U.S. taxes payable on these net foreign earnings. The excess U.S. foreign tax credit are expected to offset U.S. taxes on other foreign source income. On December 18, 2015, the Protecting Americans from Tax Hikes (“PATH”) Act of 2015 was enacted, which permanently extended the Research and Experimentation (“R&E”) Tax Credit. As a result, income taxes for the year ended September 30, 2016 included a net benefit related to the retroactive impact from the last three quarters of fiscal year 2015 of the R&E Credit pursuant to the PATH Act. In addition, income taxes for the year ended September 30, 2016 included a net benefit related to the full year impact of fiscal year 2016 of the R&E Credit. Woodward adopted ASU 2016-09, “Improvements to Employee Share-Based Payment Accounting,” in its second quarter of fiscal year 2016 resulting in the recognition through earnings of a net excess income tax benefit from stock-based compensation. On December 19, 2014, the Tax Increase Prevention Act of 2014 was enacted, which retroactively extended the R&E Credit through December 31, 2014. As a result, income taxes for the year ended September 30, 2015 included a net benefit related to the retroactive impact from the last three quarters of fiscal year 2014 of the R&E Credit pursuant to the Tax Increase Prevention Act. A reconciliation of the beginning and ending amounts of gross unrecognized tax benefits follows:   | | | | | | | -------------------------------------------+---------------------------+---------+------+---+---------+---+--------  | | | | | | | -------------------------------------------+---------------------------+---------+------+---+---------+---+--------  | Year Ending September 30, -------------------------------------------+--------------------------  | 2017 | | 2016 | | 2015 -------------------------------------------+---------------------------+---------+------+---+-------- Beginning balance | $ | 23,526 | | $ | 21,469 | $ | 22,687 -------------------------------------------+---------------------------+---------+------+---+---------+---+-------- Additions to current year tax positions | | 2,560 | | | 3,588 | | 2,234 -------------------------------------------+---------------------------+---------+------+---+---------+---+-------- Reductions to prior year tax positions | | (5,753) | | | (2,292) | | (7,785) -------------------------------------------+---------------------------+---------+------+---+---------+---+-------- Additions to prior year tax positions | | 3,501 | | | 761 | | 5,124 -------------------------------------------+---------------------------+---------+------+---+---------+---+-------- Lapse of applicable statute of limitations | | (3,702) | | | - | | (791) -------------------------------------------+---------------------------+---------+------+---+---------+---+-------- Ending balance | $ | 20,132 | | $ | 23,526 | $ | 21,469 -------------------------------------------+---------------------------+---------+------+---+---------+---+-------- Included in the balance of unrecognized tax benefits were $9,677 as of September 30, 2017 and $11,426 as of September 30, 2016 of tax benefits that, if recognized, would affect the effective tax rate. At this time, Woodward estimates that it is reasonably possible that the liability for unrecognized tax benefits will decrease by as much as $7,726 in the next twelve 79 months due to the completion of reviews by tax authorities, lapses of statutes, and the settlement of tax positions. Woodward accrues for potential interest and penalties related to unrecognized tax benefits and all other interest and penalties related to tax payments in tax expense. Woodward had accrued gross interest and penalties of $1,123 as of September 30, 2017 and $1,273 as of September 30, 2016. Woodward’s tax returns are subject to audits by U.S. federal, state, and foreign tax authorities, and these audits are at various stages of completion at any given time. Reviews of tax matters by authorities and lapses of the applicable statutes of limitations may result in changes to tax expense. Fiscal years remaining open to examination in significant foreign jurisdictions include 2008 and thereafter. Woodward’s fiscal years remaining open to examination in the United States include fiscal years 2014 and thereafter. Woodward is currently under examination by the Internal Revenue Service for fiscal year 2014. Woodward has concluded U.S. federal income tax examinations through fiscal year 2012. Woodward is generally subject to U.S. state income tax examinations for fiscal years 2012 and the periods thereafter. Note 17. Retirement benefits Woodward provides various retirement benefits to eligible members of the Company, including contributions to various defined contribution plans, pension benefits associated with defined benefit plans, postretirement medical benefits and postretirement life insurance benefits. Eligibility requirements and benefit levels vary depending on employee location. Defined contribution plans Most of the Company’s U.S. employees are eligible to participate in the U.S. defined contribution plan. The U.S. defined contribution plan allows employees to defer part of their annual income for income tax purposes into their personal 401(k) accounts. The Company makes matching contributions to eligible employee accounts, which are also deferred for employee personal income tax purposes. Certain foreign employees are also eligible to participate in similar foreign plans. Most of Woodward’s U.S. employees with at least two years of service receive an annual contribution of Woodward stock, equal to 5% of their eligible prior year wages, to their personal Woodward Retirement Savings Plan accounts. In the second quarter of fiscal years 2017, 2016, and 2015, Woodward fulfilled its annual Woodward stock contribution obligation using shares held in treasury stock by issuing 199 shares of common stock for a value of $14,014 in fiscal year 2017, 317 shares of common stock for a value of $13,999 in fiscal year 2016, and 259 shares of common stock for a value of $12,574 in fiscal year 2015. The Woodward Retirement Savings Plan (the “WRS Plan”) held 4,183 shares of Woodward stock as of September 30, 2017 and 4,488 shares as of September 30, 2016. The shares held in the WRS Plan participate in dividends and are considered issued and outstanding for purposes of calculating basic and diluted earnings per share. Accrued liabilities included obligations to contribute shares of Woodward common stock to the WRS Plan of $11,355 as of September 30, 2017 and $11,314 as of September 30, 2016. The amount of expense associated with defined contribution plans was as follows:   | | | | | | | --------------+------+--------------------------+------+---+--------+---+-------  | | | | | | | --------------+------+--------------------------+------+---+--------+---+-------  | | Year Ended September 30, --------------+------+-------------------------  | 2017 | | 2016 | | 2015 --------------+------+--------------------------+------+---+------- Company costs | $ | 32,008 | | $ | 31,893 | $ | 30,933 --------------+------+--------------------------+------+---+--------+---+-------  Defined benefit plans Woodward has defined benefit plans that provide pension benefits for certain retired employees in the United States, the United Kingdom, and Japan. Woodward also provides other postretirement benefits to its employees including postretirement medical benefits and life insurance benefits. Postretirement medical benefits are provided to certain current and retired employees and their covered dependents and beneficiaries in the United States and the United Kingdom. Life insurance benefits are provided to certain retirees in the United States under frozen plans, which are no longer available to current employees. A September 30 measurement date is utilized to value plan assets and obligations for all of Woodward’s defined benefit pension and other postretirement benefit plans. During the third quarter of fiscal year 2016, Woodward opened a lump-sum buy-out window, which closed in the fourth quarter of fiscal year 2016 and was fully settled during the first quarter of fiscal year 2017, for certain former U.S. employees and/or their dependents eligible to receive postretirement defined benefit pension payments for past employment services to the Company. Eligible pension plan participants were provided the opportunity to elect to receive a one-time lump-sum payment or an immediate annuity in lieu of future pension benefit payments. Pension benefit payments paid from available pension plan assets under the lump-sum buy-out options were $670 during fiscal year 2017. Woodward expects to make no further pension benefit payments under the lump-sum buy-out options. 80 Effective June 30, 2015, the Company terminated the defined benefit pension plan for employees at its Duarte, California manufacturing facility (the “Duarte Pension Plan”). The plan, which was established in fiscal year 2013 in connection with the December 2012 acquisition of the Duarte business, was amended in fiscal year 2013 to cease all future benefit accruals under the plan and was at that time closed to new entrants. Regulatory approval of the plan termination was received in the fourth quarter of fiscal year 2016. In exchange for the freeze and termination of the plan, which were agreed upon through negotiations with the applicable employee union, the employees were provided replacement benefits through full participation in the Woodward U.S. defined contribution plan. Woodward recorded settlement costs of $47 in fiscal year 2016 in connection with cash payouts to the beneficiaries of the plan and associated termination costs. As of September 30, 2017 and 2016, Woodward had no liability associated with the Duarte Pension Plan. In addition to the Duarte Pension Plan, excluding the Woodward HRT Plan, the defined benefit plans in the United States were frozen in fiscal year 2007 and no additional employees may participate in the U.S. plans and no additional service costs will be incurred. Pension plans The actuarial assumptions used in measuring the net periodic benefit cost and plan obligations of retirement pension benefits were as follows:     | | | | | | | -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+--  | | | | | | | -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+--  | 2017 | | 2016 | | 2015 -----------------------------------------------------------------------------------------------+------+---+------+------+----- United States: | | | | | | | -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+-- Weighted-average assumptions to determine benefit obligation at September 30: | | | | | | | -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+-- Discount rate | 3.80 | % | | 3.65 | % | 4.39 | % -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+-- Weighted-average assumptions to determine periodic benefit costs for years ended September 30: | | | | | | | -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+-- Discount rate | 3.65 | | | 4.39 | | 4.40 | -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+-- Long-term rate of return on plan assets | 7.38 | | | 7.62 | | 7.62 | -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+-- The discount rate assumption is intended to reflect the rate at which the retirement benefits could be effectively settled based upon the assumed timing of the benefit payments. In the United States, Woodward uses a bond portfolio matching analysis based on recently traded, non-callable bonds rated AA or better that have at least $50 million outstanding to determine the benefit obligations at year end.   | | | | | | | -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+--  | | | | | | | -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+--  | 2017 | | 2016 | | 2015 -----------------------------------------------------------------------------------------------+------+---+------+------+----- United Kingdom: | | | | | | | -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+-- Weighted-average assumptions to determine benefit obligation at September 30: | | | | | | | -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+-- Discount rate | 2.56 | % | | 2.28 | % | 3.75 | % -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+-- Rate of compensation increase | 3.60 | | | 3.40 | | 3.40 | -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+-- Weighted-average assumptions to determine periodic benefit costs for years ended September 30: | | | | | | | -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+-- Discount rate - service cost | 2.33 | | | 3.86 | | 4.10 | -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+-- Discount rate - interest cost | 2.24 | | | 3.63 | | 4.10 | -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+-- Rate of compensation increase | 3.40 | | | 3.40 | | 3.50 | -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+-- Long-term rate of return on plan assets | 4.75 | | | 5.00 | | 5.50 | -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+--  81   | | | | | | | -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+--  | | | | | | | -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+--  | 2017 | | 2016 | | 2015 -----------------------------------------------------------------------------------------------+------+---+------+------+----- Japan: | | | | | | | -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+-- Weighted-average assumptions to determine benefit obligation at September 30: | | | | | | | -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+-- Discount rate | 0.58 | % | | 0.46 | % | 0.97 | % -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+-- Rate of compensation increase | 2.00 | | | 2.02 | | 2.00 | -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+-- Weighted-average assumptions to determine periodic benefit costs for years ended September 30: | | | | | | | -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+-- Discount rate - service cost | 0.59 | | | 1.27 | | 1.10 | -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+-- Discount rate - interest cost | 0.45 | | | 0.59 | | 1.10 | -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+-- Rate of compensation increase | 2.02 | | | 2.00 | | 2.00 | -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+-- Long-term rate of return on plan assets | 2.50 | | | 3.00 | | 3.00 | -----------------------------------------------------------------------------------------------+------+---+------+------+------+------+--  In the United Kingdom and Japan, Woodward uses a high-quality corporate bond yield curve matched with separate cash flows to develop a single rate to determine the single rate equivalent to settle the entire benefit obligations in each jurisdiction. For the fiscal year ended September 30, 2017 and 2016, the discount rate used to determine periodic service cost and interest cost components of the overall benefit costs was based on spot rates derived from the same high-quality corporate bond yield curve used to determine the September 30, 2017 and 2016, respectively, benefit obligation matched with separate cash flows for each future year. Prior to this change in method, the discount rate used to determine the periodic benefit costs for the year ending September 30, 2015 was based on a single rate equivalent. Compensation increase assumptions, where applicable, are based upon historical experience and anticipated future management actions. In determining the long-term rate of return on plan assets, Woodward assumes that the historical long-term compound growth rates of equity and fixed-income securities will predict the future returns of similar investments in the plan portfolio. Investment management and other fees paid out of the plan assets are factored into the determination of asset return assumptions. Mortality assumptions are based on published mortality studies developed primarily based on past experience of the broad population and modified for projected longevity trends. The projected benefit obligations in the United States as of September 30, 2017 and September 30, 2016 and 2015 were based on the Society of Actuaries (“SOA”) RP-2014 Mortality Tables Report projected back to 2006 using the SOA’s Mortality Improvement Scale MP-2014 (“MP-2014”) and projected forward using a custom projection scale based on MP-2014 with a 10-year convergence period and a long-term rate of 0.75%. As of September 30, 2017, 2016, and 2015, mortality assumptions in Japan were based on the Standard rates 2014, and mortality assumptions for the United Kingdom pension scheme were based on the Self-administered pension scheme (“SAPS”) S2 “all” tables with a projected 1.5% annual improvement rate.  Net periodic benefit costs consist of the following components reflected as expense in Woodward’s Consolidated Statements of Earnings:   | | | | | | | | | | | | | | | | | | | | | ---------------------------------+--------------------------+----------+-----------------+---+----------+------+----------+------+---+---------+------+---------+------+---+---------+---+----------+---+----------+---+---------  | | | | | | | | | | | | | | | | | | | | | ---------------------------------+--------------------------+----------+-----------------+---+----------+------+----------+------+---+---------+------+---------+------+---+---------+---+----------+---+----------+---+---------  | Year Ended September 30, ---------------------------------+-------------------------  | United States | | Other Countries | | Total ---------------------------------+--------------------------+----------+-----------------+---+---------  | 2017 | | 2016 | | 2015 | 2017 | | 2016 | | 2015 | 2017 | | 2016 | | 2015 ---------------------------------+--------------------------+----------+-----------------+---+----------+------+----------+------+---+---------+------+---------+------+---+-------- Service cost | $ | 1,675 | | $ | 1,695 | $ | 2,018 | | $ | 1,133 | $ | 749 | | $ | 784 | $ | 2,808 | $ | 2,444 | $ | 2,802 ---------------------------------+--------------------------+----------+-----------------+---+----------+------+----------+------+---+---------+------+---------+------+---+---------+---+----------+---+----------+---+--------- Interest cost | | 5,757 | | | 5,236 | | 5,956 | | | 1,208 | | 1,637 | | | 2,128 | | 6,965 | | 6,873 | | 8,084 ---------------------------------+--------------------------+----------+-----------------+---+----------+------+----------+------+---+---------+------+---------+------+---+---------+---+----------+---+----------+---+--------- Expected return on plan assets | | (10,529) | | | (10,140) | | (10,647) | | | (2,605) | | (2,659) | | | (3,032) | | (13,134) | | (12,799) | | (13,679) ---------------------------------+--------------------------+----------+-----------------+---+----------+------+----------+------+---+---------+------+---------+------+---+---------+---+----------+---+----------+---+--------- Amortization of: | | | | | | | | | | | | | | | | | | | | | ---------------------------------+--------------------------+----------+-----------------+---+----------+------+----------+------+---+---------+------+---------+------+---+---------+---+----------+---+----------+---+--------- Net losses | | 1,854 | | | 1,292 | | 396 | | | 514 | | 246 | | | 190 | | 2,368 | | 1,538 | | 586 ---------------------------------+--------------------------+----------+-----------------+---+----------+------+----------+------+---+---------+------+---------+------+---+---------+---+----------+---+----------+---+--------- Net prior service (benefit) cost | | 383 | | | 384 | | 383 | | | - | | - | | | - | | 383 | | 384 | | 383 ---------------------------------+--------------------------+----------+-----------------+---+----------+------+----------+------+---+---------+------+---------+------+---+---------+---+----------+---+----------+---+--------- Settlement costs | | - | | | 47 | | - | | | - | | - | | | - | | - | | 47 | | - ---------------------------------+--------------------------+----------+-----------------+---+----------+------+----------+------+---+---------+------+---------+------+---+---------+---+----------+---+----------+---+--------- Net periodic (benefit) cost | $ | (860) | | $ | (1,486) | $ | (1,894) | | $ | 250 | $ | (27) | | $ | 70 | $ | (610) | $ | (1,513) | $ | (1,824) ---------------------------------+--------------------------+----------+-----------------+---+----------+------+----------+------+---+---------+------+---------+------+---+---------+---+----------+---+----------+---+---------  The settlement loss in “United States” in the year ended September 30, 2016 pertained to cash payouts to the beneficiaries of the Duarte Pension Plan and associated termination costs. 82 The following tables provide a reconciliation of the changes in the projected benefit obligation and fair value of assets for the defined benefit pension plans:   | | | | | | | | | | | | | | --------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+---------  | | | | | | | | | | | | | | --------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+---------  | At or for the Year Ended September 30, --------------------------------------------------+---------------------------------------  | United States | | Other Countries | | Total --------------------------------------------------+----------------------------------------+---------+-----------------+---+---------  | 2017 | | 2016 | | 2017 | 2016 | | 2017 | | 2016 --------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+-------- Changes in projected benefit obligation: | | | | | | | | | | | | | | --------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Projected benefit obligation at beginning of year | $ | 160,892 | | $ | 145,870 | $ | 72,057 | | $ | 62,231 | $ | 232,949 | $ | 208,101 --------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Service cost | | 1,675 | | | 1,695 | | 1,133 | | | 749 | | 2,808 | | 2,444 --------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Interest cost | | 5,757 | | | 5,236 | | 1,208 | | | 1,637 | | 6,965 | | 6,873 --------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Net actuarial (gains) losses | | (5,267) | | | 17,786 | | (6,188) | | | 17,190 | | (11,455) | | 34,976 --------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Contribution by participants | | 55 | | | 47 | | 14 | | | 20 | | 69 | | 67 --------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Benefits paid | | (5,676) | | | (9,789) | | (2,235) | | | (2,656) | | (7,911) | | (12,445) --------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Plan amendments | | 3,694 | | | - | | - | | | - | | 3,694 | | - --------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Settlements | | - | | | 47 | | - | | | - | | - | | 47 --------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Foreign currency exchange rate changes | | - | | | - | | 380 | | | (7,114) | | 380 | | (7,114) --------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Projected benefit obligation at end of year | $ | 161,130 | | $ | 160,892 | $ | 66,369 | | $ | 72,057 | $ | 227,499 | $ | 232,949 --------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+---------  | | | | | | | | | | | | | | --------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Changes in fair value of plan assets: | | | | | | | | | | | | | | --------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Fair value of plan assets at beginning of year | $ | 145,886 | | $ | 135,590 | $ | 62,926 | | $ | 60,663 | $ | 208,812 | $ | 196,253 --------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Actual return on plan assets | | 20,067 | | | 19,859 | | 2,542 | | | 10,202 | | 22,609 | | 30,061 --------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Contributions by the Company | | - | | | 226 | | 671 | | | 773 | | 671 | | 999 --------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Contributions by plan participants | | 55 | | | 47 | | 14 | | | 20 | | 69 | | 67 --------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Benefits paid | | (5,676) | | | (9,789) | | (2,235) | | | (2,656) | | (7,911) | | (12,445) --------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Settlements | | - | | | (47) | | - | | | - | | - | | (47) --------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Foreign currency exchange rate changes | | - | | | - | | 462 | | | (6,076) | | 462 | | (6,076) --------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Fair value of plan assets at end of year | $ | 160,332 | | $ | 145,886 | $ | 64,380 | | $ | 62,926 | $ | 224,712 | $ | 208,812 --------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Net underfunded status at end of year | $ | (798) | | $ | (15,006) | $ | (1,989) | | $ | (9,131) | $ | (2,787) | $ | (24,137) --------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+---------    During fiscal year 2017, a plan amendment was adopted for one of our U.S. pension plans as a result of scheduled collective bargaining contract negotiations. At September 30, 2017, the Company’s defined benefit pension plans in the United Kingdom represented $55,306 of the total projected benefit obligation and in Japan represented $11,063 of the total projected benefit obligation. At September 30, 2017, the United Kingdom represented $52,810 of the total fair value of plan assets and Japan represented $11,570 of the total fair value of plan assets. The accumulated benefit obligations of the Company’s defined benefit pension plans at September 30, 2017 was $161,130 in the United States, $10,007 in Japan and $53,628 in the United Kingdom, and at September 30, 2016 was $160,892 in the United States, $10,924 in Japan, and $57,877 in the United Kingdom. 83   | | | | | | | | | -------------------------------+--------------------------------------------------------------------+----------+-----------------------------------------------------------------+---+-----------+------+-----------+---+---------  | | | | | | | | | -------------------------------+--------------------------------------------------------------------+----------+-----------------------------------------------------------------+---+-----------+------+-----------+---+---------  | Plans with accumulated benefit obligation in excess of plan assets | | Plans with accumulated benefit obligation less than plan assets -------------------------------+--------------------------------------------------------------------+----------+----------------------------------------------------------------  | At September 30, | | At September 30, -------------------------------+--------------------------------------------------------------------+----------+----------------------------------------------------------------  | 2017 | | 2016 | | 2017 | 2016 -------------------------------+--------------------------------------------------------------------+----------+-----------------------------------------------------------------+---+-----------+----- Projected benefit obligation | $ | (82,447) | | $ | (220,788) | $ | (145,052) | $ | (12,161) -------------------------------+--------------------------------------------------------------------+----------+-----------------------------------------------------------------+---+-----------+------+-----------+---+--------- Accumulated benefit obligation | | (80,759) | | | (218,769) | | (144,006) | | (10,924) -------------------------------+--------------------------------------------------------------------+----------+-----------------------------------------------------------------+---+-----------+------+-----------+---+--------- Fair value of plan assets | | 77,036 | | | 196,800 | | 147,676 | | 12,012 -------------------------------+--------------------------------------------------------------------+----------+-----------------------------------------------------------------+---+-----------+------+-----------+---+--------- The following tables provide the amounts recognized in the statement of financial position and accumulated other comprehensive losses for the defined benefit pension plans:   | | | | | | | | | | | | | | -------------------------------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+---------  | | | | | | | | | | | | | | -------------------------------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+---------  | At or for the Year Ended September 30, -------------------------------------------------------------------------+---------------------------------------  | United States | | Other Countries | | Total -------------------------------------------------------------------------+----------------------------------------+---------+-----------------+---+---------  | 2017 | | 2016 | | 2017 | 2016 | | 2017 | | 2016 -------------------------------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+-------- Amounts recognized in statement of financial position consist of: | | | | | | | | | | | | | | -------------------------------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Other non-current assets | $ | 1,726 | | $ | - | $ | 897 | | $ | - | $ | 2,623 | $ | - -------------------------------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Accrued liabilities | | - | | | - | | (3) | | | - | | (3) | | - -------------------------------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Other non-current liabilities | | (2,524) | | | (15,006) | | (2,883) | | | (9,131) | | (5,407) | | (24,137) -------------------------------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Net over/(under)funded status at end of year | $ | (798) | | $ | (15,006) | $ | (1,989) | | $ | (9,131) | $ | (2,787) | $ | (24,137) -------------------------------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+---------  | | | | | | | | | | | | | | -------------------------------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Amounts recognized in accumulated other comprehensive income consist of: | | | | | | | | | | | | | | -------------------------------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Unrecognized net prior service (benefit) cost | $ | 7,169 | | $ | 3,857 | $ | - | | $ | - | $ | 7,169 | $ | 3,857 -------------------------------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Unrecognized net (gains) losses | | 17,023 | | | 33,682 | | 14,198 | | | 20,795 | | 31,221 | | 54,477 -------------------------------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Total amounts recognized | | 24,192 | | | 37,539 | | 14,198 | | | 20,795 | | 38,390 | | 58,334 -------------------------------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Deferred taxes | | (9,224) | | | (14,305) | | (5,016) | | | (7,303) | | (14,240) | | (21,608) -------------------------------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- Amounts recognized in accumulated other comprehensive income | $ | 14,968 | | $ | 23,234 | $ | 9,182 | | $ | 13,492 | $ | 24,150 | $ | 36,726 -------------------------------------------------------------------------+----------------------------------------+---------+-----------------+---+----------+------+---------+------+---+---------+---+----------+---+--------- The following table reconciles the changes in accumulated other comprehensive losses for the defined benefit pension plans:   | | | | | | | | | | | | | | ----------------------------------------------------------------+--------------------------+----------+-----------------+---+---------+------+---------+------+---+---------+---+----------+---+--------  | | | | | | | | | | | | | | ----------------------------------------------------------------+--------------------------+----------+-----------------+---+---------+------+---------+------+---+---------+---+----------+---+--------  | Year Ended September 30, ----------------------------------------------------------------+-------------------------  | United States | | Other Countries | | Total ----------------------------------------------------------------+--------------------------+----------+-----------------+---+--------  | 2017 | | 2016 | | 2017 | 2016 | | 2017 | | 2016 ----------------------------------------------------------------+--------------------------+----------+-----------------+---+---------+------+---------+------+---+-------- Accumulated other comprehensive losses at beginning of year | $ | 37,539 | | $ | 31,102 | $ | 20,795 | | $ | 13,618 | $ | 58,334 | $ | 44,720 ----------------------------------------------------------------+--------------------------+----------+-----------------+---+---------+------+---------+------+---+---------+---+----------+---+-------- Net (gain) loss | | (14,805) | | | 8,160 | | (6,125) | | | 9,646 | | (20,930) | | 17,806 ----------------------------------------------------------------+--------------------------+----------+-----------------+---+---------+------+---------+------+---+---------+---+----------+---+-------- Loss due to settlement or curtailment arising during the period | | - | | | (47) | | - | | | - | | - | | (47) ----------------------------------------------------------------+--------------------------+----------+-----------------+---+---------+------+---------+------+---+---------+---+----------+---+-------- Amortization of: | | | | | | | | | | | | | | ----------------------------------------------------------------+--------------------------+----------+-----------------+---+---------+------+---------+------+---+---------+---+----------+---+-------- Net losses | | (1,854) | | | (1,292) | | (515) | | | (246) | | (2,369) | | (1,538) ----------------------------------------------------------------+--------------------------+----------+-----------------+---+---------+------+---------+------+---+---------+---+----------+---+-------- Prior service benefit (cost) | | 3,312 | | | (384) | | - | | | - | | 3,312 | | (384) ----------------------------------------------------------------+--------------------------+----------+-----------------+---+---------+------+---------+------+---+---------+---+----------+---+-------- Foreign currency exchange rate changes | | - | | | - | | 43 | | | (2,223) | | 43 | | (2,223) ----------------------------------------------------------------+--------------------------+----------+-----------------+---+---------+------+---------+------+---+---------+---+----------+---+-------- Accumulated other comprehensive losses at end of year | $ | 24,192 | | $ | 37,539 | $ | 14,198 | | $ | 20,795 | $ | 38,390 | $ | 58,334 ----------------------------------------------------------------+--------------------------+----------+-----------------+---+---------+------+---------+------+---+---------+---+----------+---+-------- The amounts expected to be amortized from accumulated other comprehensive losses and reported as a component of net periodic benefit cost during fiscal year 2018 are as follows:   | | | | | | | ---------------------+---------------+-----+-----------------+---+-------+---+----  | | | | | | | ---------------------+---------------+-----+-----------------+---+-------+---+----  | United States | | Other Countries | | Total ---------------------+---------------+-----+-----------------+---+------ Prior service cost | $ | 709 | | $ | - | $ | 709 ---------------------+---------------+-----+-----------------+---+-------+---+---- Net actuarial losses | | 598 | | | 290 | | 888 ---------------------+---------------+-----+-----------------+---+-------+---+---- 84 Pension benefit payments are made from the assets of the pension plans. Using foreign exchange rates as of September 30, 2017 and expected future service assumptions, it is anticipated that the future benefit payments will be as follows:   | | | | | | | --------------------------+---------------+--------+-----------------+---+--------+---+-------  | | | | | | | --------------------------+---------------+--------+-----------------+---+--------+---+------- Year Ending September 30, | United States | | Other Countries | | Total --------------------------+---------------+--------+-----------------+---+------- 2018 | $ | 6,251 | | $ | 2,225 | $ | 8,476 --------------------------+---------------+--------+-----------------+---+--------+---+------- 2019 | | 6,911 | | | 2,578 | | 9,489 --------------------------+---------------+--------+-----------------+---+--------+---+------- 2020 | | 7,521 | | | 2,183 | | 9,704 --------------------------+---------------+--------+-----------------+---+--------+---+------- 2021 | | 8,065 | | | 2,396 | | 10,461 --------------------------+---------------+--------+-----------------+---+--------+---+------- 2022 | | 8,524 | | | 2,257 | | 10,781 --------------------------+---------------+--------+-----------------+---+--------+---+------- 2023 – 2027 | | 48,075 | | | 12,802 | | 60,877 --------------------------+---------------+--------+-----------------+---+--------+---+------- Woodward expects its pension plan contributions in fiscal year 2018 will be $397 in the United Kingdom and $217 in Japan. Woodward expects to have no pension plan contributions in fiscal year 2018 in the United States. Pension plan assets The overall investment objective of the pension plan assets is to earn a rate of return over time which, when combined with Company contributions, satisfies the benefit obligations of the pension plans and maintains sufficient liquidity to pay benefits. As the timing and nature of the plan obligations varies for each Company sponsored pension plan, investment strategies have been individually designed for each pension plan with a common focus on maintaining diversified investment portfolios that provide for long-term growth while minimizing the risk to principal associated with short-term market behavior. The strategy for each of the plans balances the requirements to generate returns, using investments expected to produce higher returns, such as equity securities, with the need to control risk within the pension plans using less volatile investment assets, such as debt securities. A strategy of more equity-oriented allocation is adopted for those plans which have a longer-term investment plan based on the timing of the associated benefit obligations. A pension oversight committee is assigned by the Company to each pension plan. Among other responsibilities, each committee is responsible for all asset class allocation decisions. Asset class allocations, which are reviewed by the respective pension committee on at least an annual basis, are designed to meet or exceed certain market benchmarks and align with each plan’s investment objectives. In evaluating the asset allocation choices, consideration is given to the proper long-term level of risk for each plan, particularly with respect to the long-term nature of each plan’s liabilities, the impact of asset allocation on investment results and the corresponding impact on the volatility and magnitude of plan contributions and expense and the impact certain actuarial techniques may have on the plans’ recognition of investment experience. From time to time, the plans may move outside the prescribed asset class allocation in order to meet significant liabilities with respect to one or more individuals approaching retirement. Risks associated with the plan assets include interest rate fluctuation risk, market fluctuation risk, risk of default by debt issuers and liquidity risk. To manage these risks, the assets are managed by established, professional investment firms and performance is evaluated regularly by the Company’s pension oversight committee against specific benchmarks and each plan’s investment objectives. Liability management and asset class diversification are central to the Company’s risk management approach and overall investment strategy. The assets of the U.S. plans are invested in actively managed mutual funds. The assets of the plans in Japan and the plan in the United Kingdom are invested in actively managed pooled investment funds. Each individual mutual fund or pooled investment fund has been selected based on the investment strategy of the related plan, which mirrors a specific asset class within the associated target allocation. Pension plan assets at September 30, 2017 and 2016 do not include any direct investment in Woodward’s common stock. 85 The asset allocations are monitored and rebalanced regularly by investment managers assigned to the individual pension plans. The actual allocations of pension plan assets and target allocation ranges by asset class, are as follows:   | | | | | | | | ------------------+---------------------------+--------------------------+---+---------------------------+--------------------------+-------+---+------  | | | | | | | | ------------------+---------------------------+--------------------------+---+---------------------------+--------------------------+-------+---+------  | At September 30, ------------------+--------------------------  | 2017 | 2016 ------------------+---------------------------+-------------------------  | Percentage of Plan Assets | Target Allocation Ranges | | Percentage of Plan Assets | Target Allocation Ranges ------------------+---------------------------+--------------------------+---+---------------------------+------------------------- United States: | | | | | | | | ------------------+---------------------------+--------------------------+---+---------------------------+--------------------------+-------+---+------ Asset Class | | | | | | | | ------------------+---------------------------+--------------------------+---+---------------------------+--------------------------+-------+---+------ Equity Securities | 64.6% | 41.2% | - | 81.2% | 56.4% | 40.8% | - | 80.8% ------------------+---------------------------+--------------------------+---+---------------------------+--------------------------+-------+---+------ Debt Securities | 35.2% | 28.8% | - | 48.8% | 39.0% | 29.2% | - | 49.2% ------------------+---------------------------+--------------------------+---+---------------------------+--------------------------+-------+---+------ Other | 0.2% | 0.0% | | 4.6% | 0.0% ------------------+---------------------------+--------------------------+---+---------------------------+-------------------------  | 100.0% | | | | 100.0% | | | ------------------+---------------------------+--------------------------+---+---------------------------+--------------------------+-------+---+------ United Kingdom: | | | | | | | | ------------------+---------------------------+--------------------------+---+---------------------------+--------------------------+-------+---+------ Asset Class | | | | | | | | ------------------+---------------------------+--------------------------+---+---------------------------+--------------------------+-------+---+------ Equity Securities | 46.1% | 30.0% | - | 60.0% | 34.7% | 25.0% | - | 45.0% ------------------+---------------------------+--------------------------+---+---------------------------+--------------------------+-------+---+------ Debt Securities | 53.8% | 45.0% | - | 70.0% | 65.2% | 40.0% | - | 80.0% ------------------+---------------------------+--------------------------+---+---------------------------+--------------------------+-------+---+------ Other | 0.1% | 0.0% | | 0.1% | 0.0% ------------------+---------------------------+--------------------------+---+---------------------------+-------------------------  | 100.0% | | | | 100.0% | | | ------------------+---------------------------+--------------------------+---+---------------------------+--------------------------+-------+---+------ Japan: | | | | | | | | ------------------+---------------------------+--------------------------+---+---------------------------+--------------------------+-------+---+------ Asset Class | | | | | | | | ------------------+---------------------------+--------------------------+---+---------------------------+--------------------------+-------+---+------ Equity Securities | 41.0% | 36.0% | - | 44.0% | 40.0% | 36.0% | - | 44.0% ------------------+---------------------------+--------------------------+---+---------------------------+--------------------------+-------+---+------ Debt Securities | 58.1% | 55.0% | - | 63.0% | 59.1% | 55.0% | - | 63.0% ------------------+---------------------------+--------------------------+---+---------------------------+--------------------------+-------+---+------ Other | 0.9% | 0.0% | - | 2.0% | 0.9% | 0.0% | - | 2.0% ------------------+---------------------------+--------------------------+---+---------------------------+--------------------------+-------+---+------  | 100.0% | | | | 100.0% | | | ------------------+---------------------------+--------------------------+---+---------------------------+--------------------------+-------+---+------ Actual allocations to each asset class can vary from target allocations due to periodic market value fluctuations, investment strategy changes, and the timing of benefit payments and contributions. 86 The following table presents Woodward’s pension plan assets using the fair value hierarchy established by U.S. GAAP as of September 30, 2017 and September 30, 2016.   | | | | | | | | | | | | | | | | -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+--------  | | | | | | | | | | | | | | | | -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+--------  | At September 30, 2017 -------------------------------------------------------+----------------------  | Level 1 | | Level 2 | | Level 3 | | -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+--  | United States | | Other Countries | | United States | Other Countries | | United States | | Other Countries | Total -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+------ Asset Category: | | | | | | | | | | | | | | | | -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- Cash and cash equivalents | $ | 291 | | $ | 167 | $ | - | | $ | - | $ | - | $ | - | $ | 458 -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- Mutual funds: | | | | | | | | | | | | | | | | -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- U.S. corporate bond fund | | 56,388 | | | - | | - | | | - | | - | | - | | 56,388 -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- U.S. equity large cap fund | | 54,140 | | | - | | - | | | - | | - | | - | | 54,140 -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- International equity large cap growth fund | | 49,513 | | | - | | - | | | - | | - | | - | | 49,513 -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- Pooled funds: | | | | | | | | | | | | | | | | -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- Japanese equity securities | | - | | | - | | - | | | 2,487 | | - | | - | | 2,487 -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- International equity securities | | - | | | - | | - | | | 2,260 | | - | | - | | 2,260 -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- Japanese fixed income securities | | - | | | - | | - | | | 4,987 | | - | | - | | 4,987 -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- International fixed income securities | | - | | | - | | - | | | 1,730 | | - | | - | | 1,730 -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- Global target return equity/bond fund | | - | | | - | | - | | | 13,103 | | - | | - | | 13,103 -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- Index linked U.K. equity fund | | - | | | - | | - | | | 4,940 | | - | | - | | 4,940 -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- Index linked international equity fund | | - | | | - | | - | | | 6,285 | | - | | - | | 6,285 -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- Index linked U.K. corporate bonds fund | | - | | | - | | - | | | 16,540 | | - | | - | | 16,540 -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- Index linked U.K. government securities fund | | - | | | - | | - | | | 4,980 | | - | | - | | 4,980 -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- Index linked U.K. long-term government securities fund | | - | | | - | | - | | | 6,901 | | - | | - | | 6,901 -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- Total assets | $ | 160,332 | | $ | 167 | $ | - | | $ | 64,213 | $ | - | $ | - | $ | 224,712 -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+--------  | | | | | | | | | | | | | | | | -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+--------  | At September 30, 2016 -------------------------------------------------------+----------------------  | Level 1 | | Level 2 | | Level 3 | | -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+--  | United States | | Other Countries | | United States | Other Countries | | United States | | Other Countries | Total -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+------ Asset Category: | | | | | | | | | | | | | | | | -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- Cash and cash equivalents | $ | 6,741 | | $ | 163 | $ | - | | $ | - | $ | - | $ | - | $ | 6,904 -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- Mutual funds: | | | | | | | | | | | | | | | | -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- U.S. corporate bond fund | | 56,813 | | | - | | - | | | - | | - | | - | | 56,813 -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- U.S. equity large cap fund | | 48,506 | | | - | | - | | | - | | - | | - | | 48,506 -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- International equity large cap growth fund | | 33,834 | | | - | | - | | | - | | - | | - | | 33,834 -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- Pooled funds: | | | | | | | | | | | | | | | | -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- Japanese equity securities | | - | | | - | | - | | | 2,536 | | - | | - | | 2,536 -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- International equity securities | | - | | | - | | - | | | 2,258 | | - | | - | | 2,258 -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- Japanese fixed income securities | | - | | | - | | - | | | 5,321 | | - | | - | | 5,321 -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- International fixed income securities | | - | | | - | | - | | | 1,777 | | - | | - | | 1,777 -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- Index linked U.K. equity fund | | - | | | - | | - | | | 7,982 | | - | | - | | 7,982 -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- Index linked international equity fund | | - | | | - | | - | | | 9,694 | | - | | - | | 9,694 -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- Index linked U.K. corporate bonds fund | | - | | | - | | - | | | 16,180 | | - | | - | | 16,180 -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- Index linked U.K. government securities fund | | - | | | - | | - | | | 5,009 | | - | | - | | 5,009 -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- Index linked U.K. long-term government securities fund | | - | | | - | | - | | | 11,998 | | - | | - | | 11,998 -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- Total assets | $ | 145,894 | | $ | 163 | $ | - | | $ | 62,755 | $ | - | $ | - | $ | 208,812 -------------------------------------------------------+-----------------------+---------+-----------------+---+---------------+-----------------+---+---------------+---+-----------------+-------+---+---+---+---+-------- 87 Cash and cash equivalents: Cash and cash equivalents held by the Company's pension plans are held on deposit with creditworthy financial institutions. The fair value of the cash and cash equivalents are based on the quoted market price of the respective currency in which the cash is maintained. Pension assets invested in mutual funds: The assets of the Company’s U.S. pension plans are invested in various mutual funds which invest in both equity and debt securities. The fair value of the mutual funds is determined based on the quoted market price of each fund. Pension assets invested in pooled funds: The assets of the Company’s Japan and United Kingdom pension plans are invested in pooled investment funds, which include both equity and debt securities. The assets of the United Kingdom pension plan are invested in index-linked pooled funds which aim to replicate the movements of an underlying market index to which the fund is linked. Fair value of the pooled funds is based on the net asset value of shares held by the plan as reported by the fund sponsors. All pooled funds held by plans outside of the United States are considered to be invested in international equity and debt securities. Although the underlying securities may be largely domestic to the plan holding the investment assets, the underlying assets are considered international from the perspective of the Company. There were no transfers into or out of Level 3 assets in fiscal years 2017 or 2016. Other postretirement benefit plans Woodward provides other postretirement benefits to its employees including postretirement medical benefits and life insurance benefits. Postretirement medical benefits are provided to certain current and retired employees and their covered dependents and beneficiaries in the United States and the United Kingdom. Benefits include the option to elect company provided medical insurance coverage to age 65 and a Medicare supplemental plan after age 65. Life insurance benefits are also provided to certain retirees in the United States under frozen plans which are no longer available to current employees. A September 30 measurement date is utilized to value plan assets and obligations for Woodward’s other postretirement benefit plans. The postretirement medical benefit plans, other than the plan assumed in an acquisition in fiscal year 2009, were frozen in fiscal year 2006 and no additional employees may participate in the plans. Generally, employees who had attained age 55 and had rendered 10 or more years of service before the plans were frozen were eligible for these postretirement medical benefits. Certain participating retirees are required to contribute to the plans in order to maintain coverage. The plans provide postretirement medical benefits for approximately 770 retired employees and their covered dependents and beneficiaries and may provide future benefits to 13 active employees and their covered dependents and beneficiaries, upon retirement, if the employees elect to participate. Six beneficiaries participate in the United Kingdom plan. All the postretirement medical plans are fully insured for retirees who have attained age 65. The actuarial assumptions used in measuring the net periodic benefit cost and plan obligations of postretirement benefits were as follows:   | | | | | | | --------------------------------------------------------------------------------------------------------+------+---+------+------+------+------+--  | | | | | | | --------------------------------------------------------------------------------------------------------+------+---+------+------+------+------+--  | 2017 | | 2016 | | 2015 --------------------------------------------------------------------------------------------------------+------+---+------+------+----- Weighted-average discount rate used to determine benefit obligation at September 30 | 3.78 | % | | 3.63 | % | 4.01 | % --------------------------------------------------------------------------------------------------------+------+---+------+------+------+------+-- Weighted-average discount rate used to determine net periodic benefit cost for years ended September 30 | 3.63 | | | 4.01 | | 4.40 | --------------------------------------------------------------------------------------------------------+------+---+------+------+------+------+-- The discount rate assumption is intended to reflect the rate at which the postretirement benefits could be effectively settled based upon the assumed timing of the benefit payments. In the United States, Woodward used a bond portfolio matching analysis based on recently traded, non-callable bonds rated AA or better that have at least $50 million outstanding to determine the benefit obligations at year end. In the United Kingdom, Woodward uses a high-quality corporate bond yield curve matched with separate cash flows to develop a single rate to determine the single rate equivalent to settle the entire benefit obligations in each jurisdiction. For the fiscal years ended September 30, 2017 and September 30, 2016, the discount rate used to determine periodic service cost and interest cost components of the overall benefit costs was based on spot rates derived from the same high-quality corporate bond yield curve used to determine the September 30, 2016 and 2015, respectively, benefit obligation matched with separate cash flows for each future year. 88 Mortality assumptions are based on published mortality studies developed primarily based on past experience of the broad population and modified for projected longevity trends. The projected benefit obligations in the United States as of September 30, 2017, 2016, and 2015 were based on the SOA’s RP-2014 Mortality Tables Report projected back to 2006 using the SOA’s MP-2014 and projected forward using a custom projection scale based on MP-2014 with a 10-year convergence period and a long-term rate of 0.75%. As of September 30, 2017 and September 30, 2016, mortality assumptions for the United Kingdom postretirement medical plan were based on the SAPS S2 “all” tables with a projected 1.5% annual improvement rate. Assumed healthcare cost trend rates at September 30, were as follows:   | | | | | --------------------------------------------------------+------+---+------+------+--  | | | | | --------------------------------------------------------+------+---+------+------+--  | 2017 | | 2016 --------------------------------------------------------+------+---+----- Health care cost trend rate assumed for next year | 6.75 | % | | 7.00 | % --------------------------------------------------------+------+---+------+------+-- Rate to which the cost trend rate is assumed to decline | | | | | --------------------------------------------------------+------+---+------+------+-- (the ultimate trend rate) | 5.00 | % | | 5.00 | % --------------------------------------------------------+------+---+------+------+-- Year that the rate reaches the ultimate trend rate | 2025 | | | 2025 | --------------------------------------------------------+------+---+------+------+-- Healthcare costs have generally trended upward in recent years, sometimes by amounts greater than 5%. Assumed health care cost trend rates have a significant effect on the amounts reported for postretirement medical plans. A one-percentage-point change in assumed health care cost trend rates would have the following effects:   | | | | | ------------------------------------------------------------------------------+---------------------------------------+-------+-------------+---+--------  | | | | | ------------------------------------------------------------------------------+---------------------------------------+-------+-------------+---+--------  | Change In Health Care Cost Trend Rate ------------------------------------------------------------------------------+--------------------------------------  | 1% increase | | 1% decrease ------------------------------------------------------------------------------+---------------------------------------+-------+------------ Effect on projected fiscal year 2018 service and interest cost | $ | 113 | | $ | (99) ------------------------------------------------------------------------------+---------------------------------------+-------+-------------+---+-------- Effect on accumulated postretirement benefit obligation at September 30, 2017 | | 2,960 | | | (2,605) ------------------------------------------------------------------------------+---------------------------------------+-------+-------------+---+-------- Net periodic benefit costs consist of the following components reflected as expense in Woodward’s Consolidated Statements of Earnings:   | | | | | | | --------------------------+--------------------------+-------+------+---+-------+---+------  | | | | | | | --------------------------+--------------------------+-------+------+---+-------+---+------  | Year Ended September 30, --------------------------+-------------------------  | 2017 | | 2016 | | 2015 --------------------------+--------------------------+-------+------+---+------ Service cost | $ | 14 | | $ | 22 | $ | 30 --------------------------+--------------------------+-------+------+---+-------+---+------ Interest cost | | 1,244 | | | 1,048 | | 1,233 --------------------------+--------------------------+-------+------+---+-------+---+------ Amortization of: | | | | | | | --------------------------+--------------------------+-------+------+---+-------+---+------ Net (gains) losses | | 201 | | | 156 | | (73) --------------------------+--------------------------+-------+------+---+-------+---+------ Net prior service benefit | | (158) | | | (158) | | (158) --------------------------+--------------------------+-------+------+---+-------+---+------ Net periodic cost | $ | 1,301 | | $ | 1,068 | $ | 1,032 --------------------------+--------------------------+-------+------+---+-------+---+------  89 The following table provides a reconciliation of the changes in the accumulated postretirement benefit obligation and fair value of assets for the postretirement benefits for the fiscal years ended September 30:   | | | | | -------------------------------------------------------------------+--------------------------+----------+------+---+---------  | | | | | -------------------------------------------------------------------+--------------------------+----------+------+---+---------  | Year Ended September 30, -------------------------------------------------------------------+-------------------------  | 2017 | | 2016 -------------------------------------------------------------------+--------------------------+----------+----- Changes in accumulated postretirement benefit obligation: | | | | | -------------------------------------------------------------------+--------------------------+----------+------+---+--------- Accumulated postretirement benefit obligation at beginning of year | $ | 35,630 | | $ | 34,927 -------------------------------------------------------------------+--------------------------+----------+------+---+--------- Service cost | | 14 | | | 22 -------------------------------------------------------------------+--------------------------+----------+------+---+--------- Interest cost | | 1,244 | | | 1,048 -------------------------------------------------------------------+--------------------------+----------+------+---+--------- Premiums paid by plan participants | | 1,365 | | | 1,299 -------------------------------------------------------------------+--------------------------+----------+------+---+--------- Net actuarial (gains) losses | | (2,049) | | | 1,912 -------------------------------------------------------------------+--------------------------+----------+------+---+--------- Benefits paid | | (3,964) | | | (3,503) -------------------------------------------------------------------+--------------------------+----------+------+---+--------- Foreign currency exchange rate changes | | 12 | | | (75) -------------------------------------------------------------------+--------------------------+----------+------+---+--------- Accumulated postretirement benefit obligation at end of year | $ | 32,252 | | $ | 35,630 -------------------------------------------------------------------+--------------------------+----------+------+---+--------- Changes in fair value of plan assets: | | | | | -------------------------------------------------------------------+--------------------------+----------+------+---+--------- Fair value of plan assets at beginning of year | $ | - | | $ | - -------------------------------------------------------------------+--------------------------+----------+------+---+--------- Contributions by the company | | 2,599 | | | 2,204 -------------------------------------------------------------------+--------------------------+----------+------+---+--------- Premiums paid by plan participants | | 1,365 | | | 1,299 -------------------------------------------------------------------+--------------------------+----------+------+---+--------- Benefits paid | | (3,964) | | | (3,503) -------------------------------------------------------------------+--------------------------+----------+------+---+--------- Fair value of plan assets at end of year | $ | - | | $ | - -------------------------------------------------------------------+--------------------------+----------+------+---+--------- Funded status at end of year | $ | (32,252) | | $ | (35,630) -------------------------------------------------------------------+--------------------------+----------+------+---+--------- The Company’s postretirement medical plan in the United Kingdom represents $409 of the total benefit obligation at September 30, 2017. The Company paid $21 in medical benefits to participants of the United Kingdom postretirement medical plan in fiscal year 2017. The following tables provide the amounts recognized in the statement of financial position and accumulated other comprehensive losses (earnings) for the postretirement plans:   | | | | | -------------------------------------------------------------------------+--------------------------+----------+------+---+---------  | | | | | -------------------------------------------------------------------------+--------------------------+----------+------+---+---------  | Year Ended September 30, -------------------------------------------------------------------------+-------------------------  | 2017 | | 2016 -------------------------------------------------------------------------+--------------------------+----------+----- Amounts recognized in statement of financial position consist of: | | | | | -------------------------------------------------------------------------+--------------------------+----------+------+---+--------- Accrued liabilities | $ | (2,410) | | $ | (2,505) -------------------------------------------------------------------------+--------------------------+----------+------+---+--------- Other non-current liabilities | | (29,842) | | | (33,125) -------------------------------------------------------------------------+--------------------------+----------+------+---+--------- Funded status at end of year | $ | (32,252) | | $ | (35,630) -------------------------------------------------------------------------+--------------------------+----------+------+---+---------  | | | | | -------------------------------------------------------------------------+--------------------------+----------+------+---+--------- Amounts recognized in accumulated other comprehensive income consist of: | | | | | -------------------------------------------------------------------------+--------------------------+----------+------+---+--------- Unrecognized net prior service benefit | $ | (160) | | $ | (318) -------------------------------------------------------------------------+--------------------------+----------+------+---+--------- Unrecognized net losses | | 3,234 | | | 5,484 -------------------------------------------------------------------------+--------------------------+----------+------+---+--------- Total amounts recognized | | 3,074 | | | 5,166 -------------------------------------------------------------------------+--------------------------+----------+------+---+--------- Deferred taxes | | (1,183) | | | (1,979) -------------------------------------------------------------------------+--------------------------+----------+------+---+--------- Amounts recognized in accumulated other comprehensive income | $ | 1,891 | | $ | 3,187 -------------------------------------------------------------------------+--------------------------+----------+------+---+--------- Woodward pays plan benefits from its general funds; therefore, there are no segregated plan assets as of September 30, 2017 or September 30, 2016. The accumulated benefit obligations of the Company’s postretirement plans were $32,252 at September 30, 2017 and $35,630 at September 30, 2016. 90 The following table reconciles the changes in accumulated other comprehensive losses (earnings) for the other postretirement benefit plans:   | | | | | ------------------------------------------------------------+--------------------------+---------+------+---+------  | | | | | ------------------------------------------------------------+--------------------------+---------+------+---+------  | Year Ended September 30, ------------------------------------------------------------+-------------------------  | 2017 | | 2016 ------------------------------------------------------------+--------------------------+---------+----- Accumulated other comprehensive losses at beginning of year | $ | 5,166 | | $ | 3,268 ------------------------------------------------------------+--------------------------+---------+------+---+------ Net (gain) loss | | (2,049) | | | 1,912 ------------------------------------------------------------+--------------------------+---------+------+---+------ Amortization of: | | | | | ------------------------------------------------------------+--------------------------+---------+------+---+------ Net losses | | (201) | | | (156) ------------------------------------------------------------+--------------------------+---------+------+---+------ Prior service benefit | | 158 | | | 158 ------------------------------------------------------------+--------------------------+---------+------+---+------ Foreign currency exchange rate changes | | - | | | (16) ------------------------------------------------------------+--------------------------+---------+------+---+------ Accumulated other comprehensive losses at end of year | $ | 3,074 | | $ | 5,166 ------------------------------------------------------------+--------------------------+---------+------+---+------ Using foreign currency exchange rates as of September 30, 2017 and expected future service, it is anticipated that the future Company contributions to pay benefits, excluding participate contributions, will be as follows:   | | --------------------------+---+-------  | | --------------------------+---+------- Year Ending September 30, | | --------------------------+---+------- 2018 | $ | 3,871 --------------------------+---+------- 2019 | | 3,890 --------------------------+---+------- 2020 | | 3,871 --------------------------+---+------- 2021 | | 3,852 --------------------------+---+------- 2022 | | 3,818 --------------------------+---+------- 2023 – 2027 | | 17,812 --------------------------+---+------- Multiemployer defined benefit plans Woodward operates two multiemployer defined benefit plans for certain employees in the Netherlands and Japan. The amounts of contributions associated with the multiemployer plans were as follows:   | | | | | | | ----------------------+------+--------------------------+------+---+------+---+----  | | | | | | | ----------------------+------+--------------------------+------+---+------+---+----  | | Year Ended September 30, ----------------------+------+-------------------------  | 2017 | | 2016 | | 2015 ----------------------+------+--------------------------+------+---+----- Company contributions | $ | 292 | | $ | 475 | $ | 600 ----------------------+------+--------------------------+------+---+------+---+---- The plan in the Netherlands is a quasi-mandatory plan that covers all of Woodward’s employees in the Netherlands and is part of the Dutch national pension system. The Company may elect to withdraw from its multiemployer plan in Japan, although it has no plans to do so. If the Company elects to withdraw from the Japanese plan, it would incur an immaterial one-time contribution cost. Changes in Japanese regulations could trigger reorganization of or abolishment of the Japanese multiemployer plan, which could impact future funding levels.  Note 18. Stockholders’ equity Common Stock Holders of Woodward’s common stock are entitled to receive dividends when and as declared by Woodward’s Board of Directors and have the right to one vote per share on all matters requiring stockholder approval. Dividends declared and paid during the 2017, 2016 and 2015 fiscal years were:   | | | | | | | ----------------------------+--------------------------+--------+------+---+--------+---+-------  | | | | | | | ----------------------------+--------------------------+--------+------+---+--------+---+-------  | Year Ended September 30, ----------------------------+-------------------------  | 2017 | | 2016 | | 2015 ----------------------------+--------------------------+--------+------+---+------- Dividends declared and paid | $ | 29,745 | | $ | 26,606 | $ | 24,646 ----------------------------+--------------------------+--------+------+---+--------+---+------- Dividend per share amount | | 0.485 | | | 0.430 | | 0.380 ----------------------------+--------------------------+--------+------+---+--------+---+------- 91 Stock repurchase program In the first quarter of fiscal year 2017, Woodward’s Board of Directors terminated the Company’s prior stock repurchase program (the “Prior Repurchase Program”) and replaced it with a new program for the repurchase of up to $500,000 of Woodward’s outstanding shares of common stock on the open market or in privately negotiated transactions over a three-year period that will end in 2019 (the “2016 Authorization”). Under the 2016 Authorization, in fiscal year 2017, Woodward purchased 1,027 shares of its common stock for $71,197, of which 491 shares were purchased pursuant to 10b5-1 plans and 536 shares were purchased pursuant to a 10b-18 plan. In the third quarter of fiscal year 2015, Woodward entered into an ASR Agreement with Goldman under which Woodward repurchased shares of its common stock for an aggregate purchase price of $125,000. A total of 2,506 shares of common stock were repurchased pursuant to the ASR Agreement under the Prior Repurchase Program. Under the Prior Repurchase Program, in the first quarter of fiscal year 2016, Woodward executed a 10b5-1 plan to repurchase up to $125,000 of its common stock for a period that ended on April 20, 2016. During fiscal year 2016, Woodward purchased 2,635 shares of its common stock for $125,000. Stock-based compensation Non-qualified stock option awards and restricted stock awards are granted to key management members and directors of the Company. The grant date for these awards is used for the measurement date. Vesting would be accelerated in the event of retirement, disability, or death of a participant, or change in control of the Company, as defined in the individual stock option agreements. These awards are valued as of the measurement date and are amortized on a straight-line basis over the requisite vesting period for all awards, including awards with graded vesting. Stock for exercised stock options and for restricted stock awards is issued from treasury stock shares. Provisions governing outstanding stock option awards are included in the 2006 Omnibus Incentive Plan (the “2006 Plan”) and the 2002 Stock Option Plan (the “2002 Plan”). The 2002 Plan provided that no further grants would be made after December 31, 2006. The 2006 Plan, which was approved by Woodward’s stockholders and became effective January 25, 2006, expired in fiscal year 2016, therefore, no further grants will be made under the 2006 Plan. The 2017 Omnibus Incentive Plan (the “2017 Plan”) was approved by Woodward’s stockholders in January 2017 and is a successor plan to the 2006 Plan. As of September 14, 2016, the effective date of the 2017 Plan, Woodward’s Board of Directors delegated authority to administer the 2017 Plan to the compensation committee of the board (the “Committee”), including, but not limited to, the power to determine the recipients of awards and the terms of those awards. The Committee approved issuance of options under the 2017 Plan, with an award date of October 3, 2016 conditional and subject to approval of the 2017 Plan by the stockholders. The stock options conditionally awarded under the 2017 Plan were not granted or outstanding for accounting purposes prior to stockholder approval of the 2017 Plan, and as such no stock-based compensation expense was recognized on these stock options during the three-months ended December 31, 2016. Stock-based compensation expense recognized on these stock options for the nine-months ended September 30, 2017 includes recognition of the elapsed service period of these stock options from October 3, 2016 through September 30, 2017. Stock-based compensation expense recognized was as follows:   | | | | | | | ------------------------------------------+--------------------------+--------+------+---+--------+---+-------  | | | | | | | ------------------------------------------+--------------------------+--------+------+---+--------+---+-------  | Year Ended September 30, ------------------------------------------+-------------------------  | 2017 | | 2016 | | 2015 ------------------------------------------+--------------------------+--------+------+---+------- Employee stock-based compensation expense | $ | 17,282 | | $ | 15,122 | $ | 14,255 ------------------------------------------+--------------------------+--------+------+---+--------+---+------- Stock options Woodward’s 2017 Plan, which was approved by Woodward’s stockholders, provides for the grant of up to 2,000 shares of Woodward’s common stock, including in the form of stock options to its employees and directors. To date, equity awards under the 2017 Plan have consisted of grants of stock options to Woodward employees and directors. Woodward believes that these stock options align the interests of its employees and directors with those of its stockholders. Stock option awards are granted with an exercise price equal to the market price of Woodward’s stock at the date of grant, a ten-year term, and generally a four-year vesting schedule at a rate of 25% per year. 92 The date of grant for stock options is the date when the grants become unconditionally awarded and an employer and grantee reach a mutual understanding of the key terms and conditions of the grant. Stock options awarded as of October 3, 2016 were conditional and subject to the approval of the 2017 Plan by the stockholders. As such, those awards have a date of grant for accounting purposes of January 25, 2017, the date the 2017 Plan was approved by stockholders. The fair value of options granted is estimated as of the grant date using the Black-Scholes-Merton option-valuation model using the assumptions in the following table. Woodward calculates the expected term, which represents the average period of time that stock options granted are expected to be outstanding, based upon historical experience of plan participants. Expected volatility is based on historical volatility using daily stock price observations. The estimated dividend yield is based upon Woodward’s historical dividend practice and the market value of its common stock. The risk-free rate is based on the U.S. treasury yield curve, for periods within the contractual life of the stock option, at the time of grant.     | | | | | | | | | | | -----------------------------------------------------------+--------------------------+-------+------+-------+-------+-------+-------+-------+-------+---+-----  | | | | | | | | | | | -----------------------------------------------------------+--------------------------+-------+------+-------+-------+-------+-------+-------+-------+---+-----  | Year Ended September 30, -----------------------------------------------------------+-------------------------  | 2017 | | 2016 | | 2015 -----------------------------------------------------------+--------------------------+-------+------+-------+------ Weighted-average exercise price per share | | 62.74 | | | 40.26 | | 46.55 | -----------------------------------------------------------+--------------------------+-------+------+-------+-------+-------+-------+------ Weighted-average grant date market value of Woodward stock | | 69.45 | | | 40.26 | | 46.55 | -----------------------------------------------------------+--------------------------+-------+------+-------+-------+-------+-------+------ Expected term (years) | | 6.0 | - | 8.7 | | 6.3 | - | 8.7 | 6.2 | - | 8.8 -----------------------------------------------------------+--------------------------+-------+------+-------+-------+-------+-------+-------+-------+---+----- Estimated volatility | | 30.6% | - | 33.7% | | 34.5% | | 35.1% | 36.5% | -----------------------------------------------------------+--------------------------+-------+------+-------+-------+-------+-------+-------+-------+-- Estimated dividend yield | | 0.7% | | | 1.0% | | 0.7% | -----------------------------------------------------------+--------------------------+-------+------+-------+-------+-------+-------+------ Risk-free interest rate | | 2.0% | - | 2.5% | | 1.7% | - | 2.0% | 2.0% | - | 2.3% -----------------------------------------------------------+--------------------------+-------+------+-------+-------+-------+-------+-------+-------+---+-----  The weighted average grant date fair value of options granted follows:   | | | | | | | --------------------------------------------------+--------------------------+-------+------+---+-------+---+------  | | | | | | | --------------------------------------------------+--------------------------+-------+------+---+-------+---+------  | Year Ended September 30, --------------------------------------------------+-------------------------  | 2017 | | 2016 | | 2015 --------------------------------------------------+--------------------------+-------+------+---+------ Weighted-average grant date fair value of options | $ | 24.98 | | $ | 13.39 | $ | 17.02 --------------------------------------------------+--------------------------+-------+------+---+-------+---+------  The following is a summary of the activity for stock option awards during the fiscal year ended September 30, 2017:   | | | | | ------------------------------+--------+-------+-------------------------------------------+---+------  | | | | | ------------------------------+--------+-------+-------------------------------------------+---+------  | Number | | Weighted-Average Exercise Price Per Share ------------------------------+--------+-------+------------------------------------------ Balance at September 30, 2016 | | 4,944 | | $ | 35.35 ------------------------------+--------+-------+-------------------------------------------+---+------ Options granted | | 791 | | | 62.74 ------------------------------+--------+-------+-------------------------------------------+---+------ Options exercised | | (466) | | | 33.65 ------------------------------+--------+-------+-------------------------------------------+---+------ Options forfeited | | (33) | | | 44.21 ------------------------------+--------+-------+-------------------------------------------+---+------ Balance at September 30, 2017 | | 5,236 | | | 39.58 ------------------------------+--------+-------+-------------------------------------------+---+------ Exercise prices of stock options outstanding as of September 30, 2017 range from $18.67 to $70.39. Changes in non-vested stock options during the fiscal year ended September 30, 2017 were as follows:   | | | | | ------------------------------+--------+-------+--------------------------------------------------+---+------  | | | | | ------------------------------+--------+-------+--------------------------------------------------+---+------  | Number | | Weighted-Average Grant Date Fair Value Per Share ------------------------------+--------+-------+------------------------------------------------- Balance at September 30, 2016 | | 2,075 | | $ | 14.90 ------------------------------+--------+-------+--------------------------------------------------+---+------ Options granted | | 791 | | | 24.98 ------------------------------+--------+-------+--------------------------------------------------+---+------ Options vested | | (763) | | | 15.26 ------------------------------+--------+-------+--------------------------------------------------+---+------ Options forfeited | | (31) | | | 15.40 ------------------------------+--------+-------+--------------------------------------------------+---+------ Balance at September 30, 2017 | | 2,072 | | | 18.61 ------------------------------+--------+-------+--------------------------------------------------+---+------  93  Information about stock options that have vested, or are expected to vest, and are exercisable at September 30, 2017 was as follows:   | | | | | | | | | ------------------------------------+--------+-------+--------------------------------------------+---+-------------------------------------------+---------------------------+-----+---+--------  | | | | | | | | | ------------------------------------+--------+-------+--------------------------------------------+---+-------------------------------------------+---------------------------+-----+---+--------  | Number | | Weighted- Average Exercise Price Per Share | | Weighted- Average Remaining Life in Years | Aggregate Intrinsic Value ------------------------------------+--------+-------+--------------------------------------------+---+-------------------------------------------+-------------------------- Options outstanding | | 5,236 | | $ | 39.58 | | 5.9 | $ | 199,098 ------------------------------------+--------+-------+--------------------------------------------+---+-------------------------------------------+---------------------------+-----+---+-------- Options vested and exercisable | | 3,164 | | | 32.80 | | 4.5 | | 141,785 ------------------------------------+--------+-------+--------------------------------------------+---+-------------------------------------------+---------------------------+-----+---+-------- Options vested and expected to vest | | 5,164 | | | 39.39 | | 5.9 | | 197,348 ------------------------------------+--------+-------+--------------------------------------------+---+-------------------------------------------+---------------------------+-----+---+-------- Other information follows:   | | | | | | | -----------------------------------------------------------+--------------------------+--------+------+---+--------+---+-------  | | | | | | | -----------------------------------------------------------+--------------------------+--------+------+---+--------+---+-------  | Year Ended September 30, -----------------------------------------------------------+-------------------------  | 2017 | | 2016 | | 2015 -----------------------------------------------------------+--------------------------+--------+------+---+------- Total fair value of stock options vested | $ | 11,639 | | $ | 10,374 | $ | 9,656 -----------------------------------------------------------+--------------------------+--------+------+---+--------+---+------- Total intrinsic value of options exercised | | 16,416 | | | 23,178 | | 18,876 -----------------------------------------------------------+--------------------------+--------+------+---+--------+---+------- Cash received from exercises of stock options | | 14,196 | | | 15,892 | | 8,400 -----------------------------------------------------------+--------------------------+--------+------+---+--------+---+------- Excess tax benefit realized from exercise of stock options | | 4,383 | | | 6,472 | | 6,959 -----------------------------------------------------------+--------------------------+--------+------+---+--------+---+------- Restricted Stock In the first quarter of fiscal year 2014, Woodward granted an award of 24 shares of restricted stock under the 2006 Plan to its Chief Executive Officer and President, Thomas A. Gendron, pursuant to a form restricted stock agreement approved by Woodward’s Compensation Committee of the Board of Directors. Subject to Mr. Gendron’s continued employment by the Company, 100% of these shares of restricted stock would have vested following the end of the Company’s fiscal year 2017 if a specified cumulative earnings per share (“EPS”) target was met or exceeded for fiscal years 2014 through 2017. The cumulative EPS target for fiscal years 2014 through 2017 was not met, and therefore the restricted stock was forfeited by Mr. Gendron as of September 30, 2017. A summary of the activity for restricted stock awards in the fiscal year ended September 30, 2017 follows:   | | | | | ------------------------------+--------+------+----------------------+---+------  | | | | | ------------------------------+--------+------+----------------------+---+------  | Number | | Fair Value per Share ------------------------------+--------+------+--------------------- Balance at September 30, 2016 | | 24 | | $ | 39.43 ------------------------------+--------+------+----------------------+---+------ Shares granted | | - | | | n/a ------------------------------+--------+------+----------------------+---+------ Shares vested | | - | | | n/a ------------------------------+--------+------+----------------------+---+------ Shares forfeited | | (24) | | | 39.43 ------------------------------+--------+------+----------------------+---+------ Balance at September 30, 2017 | | - | | | n/a ------------------------------+--------+------+----------------------+---+------  Stock-based compensation cost Woodward recognizes stock-based compensation expense on a straight-line basis over the requisite service period. Pursuant to form stock option agreements used by the Company, with terms approved by the administrator of the applicable plan, the requisite service period can be less than the four-year vesting period based on the grantee’s retirement eligibility. As such, the recognition of stock-based compensation expense associated with some stock option grants can be accelerated to a period of less than four years, including immediate recognition of stock-based compensation expense on the date of grant. At September 30, 2017, there was approximately $8,823 of total unrecognized compensation expense related to non-vested stock-based compensation arrangements, both stock options and restricted stock awards, granted under the 2006 Plan (for which no further grants will be made) and stock options granted under the 2017 Plan. The pre-vesting forfeiture rates for purposes of determining stock-based compensation expense recognized were estimated to be 0% for members of Woodward’s board of directors and 9% for all others. The remaining unrecognized compensation cost is expected to be recognized over a weighted-average period of approximately 2 years. Note 19. Commitments and contingencies Woodward has entered into operating leases for certain facilities, equipment, and software with terms in excess of one year under agreements that expire at various dates. Some leases require the payment of property taxes, insurance, and maintenance costs in addition to rental payments. Woodward has also entered into capital leases for equipment with terms in 94 excess of one year under agreements that expire at various dates. Future minimum payments required under these leases, excluding available option renewals, are as follows:   | | | | | --------------------------+------------------+--------+----------------+---+------  | | | | | --------------------------+------------------+--------+----------------+---+------ Year Ending September 30, | Operating Leases | | Capital Leases --------------------------+------------------+--------+--------------- 2018 | $ | 6,315 | | $ | 444 --------------------------+------------------+--------+----------------+---+------ 2019 | | 4,265 | | | 451 --------------------------+------------------+--------+----------------+---+------ 2020 | | 3,872 | | | 122 --------------------------+------------------+--------+----------------+---+------ 2021 | | 3,188 | | | - --------------------------+------------------+--------+----------------+---+------ 2022 | | 2,148 | | | - --------------------------+------------------+--------+----------------+---+------ Thereafter | | 3,427 | | | - --------------------------+------------------+--------+----------------+---+------ Total | $ | 23,215 | | $ | 1,017 --------------------------+------------------+--------+----------------+---+------ Rent expense for all operating leases totalled:   | | | | | | | -------------+--------------------------+-------+------+---+-------+---+------  | | | | | | | -------------+--------------------------+-------+------+---+-------+---+------  | Year Ended September 30, -------------+-------------------------  | 2017 | | 2016 | | 2015 -------------+--------------------------+-------+------+---+------ Rent expense | $ | 8,302 | | $ | 7,359 | $ | 7,299 -------------+--------------------------+-------+------+---+-------+---+------ Woodward enters into unconditional purchase obligation arrangements (i.e. issuance of purchase orders, obligations to transfer funds in the future for fixed or minimum quantities of goods or services at fixed or minimum prices, such as "take-or-pay" contracts) in the normal course of business to ensure that adequate levels of sourced product are available to Woodward. Future minimum unconditional purchase obligations are as follows:   | | --------------------------+---+--------  | | --------------------------+---+-------- Year Ending September 30, | | --------------------------+---+-------- 2018 | $ | 299,267 --------------------------+---+-------- 2019 | | 17,993 --------------------------+---+-------- 2020 | | 232 --------------------------+---+-------- 2021 | | 66 --------------------------+---+-------- 2022 | | - --------------------------+---+-------- Thereafter | | - --------------------------+---+-------- Total | $ | 317,558 --------------------------+---+--------  | | --------------------------+---+-------- The U.S. Government, and other governments, may terminate any of Woodward’s government contracts (and, in general, subcontracts) at their convenience, as well as for default based on specified performance measurements. If any of Woodward’s government contracts were to be terminated for convenience, the Company generally would be entitled to receive payment for work completed and allowable termination or cancellation costs. If any of Woodward’s government contracts were to be terminated for Woodward’s default, the U.S. Government generally would pay only for the work accepted, and could require Woodward to pay the difference between the original contract price and the cost to re-procure the contract items, net of the work accepted from the original contract. The U.S. Government could also hold Woodward liable for damages resulting from the default. Woodward is currently involved in claims, pending or threatened litigation or other legal proceedings, investigations and/or regulatory proceedings arising in the normal course of business, including, among others, those relating to product liability claims, employment matters, worker’s compensation claims, contractual disputes, product warranty claims and alleged violations of various laws and regulations. Woodward accrues for known individual matters where it believes that it is probable the matter will result in a loss when ultimately resolved using estimates of the most likely amount of loss. Legal costs are expensed as incurred and are classified in “Selling, general and administrative expenses” on the Consolidated Statements of Earnings. Woodward is partially self-insured in the United States for healthcare and worker’s compensation up to predetermined amounts, above which third party insurance applies. Management regularly reviews the probable outcome of these claims and proceedings, the expenses expected to be incurred, the availability and limits of the insurance coverage, and the established accruals for liabilities. 95 While the outcome of pending claims, legal and regulatory proceedings, and investigations cannot be predicted with certainty, management believes that any liabilities that may result from these claims, proceedings and investigations will not have a material effect on Woodward's liquidity, financial condition, or results of operations. In the event of a change in control of Woodward, as defined in change-in-control agreements with its current corporate officers, Woodward may be required to pay termination benefits to such officers. Note 20. Segment information Woodward serves the aerospace and industrial markets through its two reportable segments – Aerospace and Industrial. When appropriate, Woodward’s reportable segments are aggregations of Woodward’s operating segments. Woodward uses operating segment information internally to manage its business, including the assessment of operating segment performance and decisions for the allocation of resources between operating segments. The accounting policies of the reportable segments are the same as those of the Company. Woodward evaluates segment profit or loss based on internal performance measures for each segment in a given period. In connection with that assessment, Woodward generally excludes matters such as certain charges for restructuring costs, interest income and expense, certain gains and losses from asset dispositions, or other non-recurring and/or non-operationally related expenses. A summary of consolidated net sales and earnings by segment follows:   | | | | | | | ------------------------------------------+--------------------------+-----------+------+---+-----------+---+----------  | | | | | | | ------------------------------------------+--------------------------+-----------+------+---+-----------+---+----------  | Year Ended September 30, ------------------------------------------+-------------------------  | 2017 | | 2016 | | 2015 ------------------------------------------+--------------------------+-----------+------+---+---------- Segment external net sales: | | | | | | | ------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Aerospace | $ | 1,342,339 | | $ | 1,233,176 | $ | 1,160,883 ------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Industrial | | 756,346 | | | 789,902 | | 877,420 ------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Total consolidated net sales | $ | 2,098,685 | | $ | 2,023,078 | $ | 2,038,303 ------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Segment earnings: | | | | | | | ------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Aerospace | $ | 257,813 | | $ | 232,166 | $ | 187,747 ------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Industrial | | 78,991 | | | 82,237 | | 126,641 ------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Nonsegment expenses | | (58,352) | | | (63,166) | | (49,362) ------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Interest expense, net | | (25,705) | | | (24,751) | | (24,077) ------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Consolidated earnings before income taxes | $ | 252,747 | | $ | 226,486 | $ | 240,949 ------------------------------------------+--------------------------+-----------+------+---+-----------+---+----------  | | | | | | | ------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- 96 Segment assets consist of accounts receivable, inventories, property, plant, and equipment, net, goodwill, and other intangibles, net. A summary of consolidated total assets, consolidated depreciation and amortization and consolidated capital expenditures follows:   | | | | | | | ---------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+----------  | | | | | | | ---------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+----------  | Year Ended September 30, ---------------------------------------------------------+-------------------------  | 2017 | | 2016 | | 2015 ---------------------------------------------------------+--------------------------+-----------+------+---+---------- Segment assets: | | | | | | | ---------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Aerospace | $ | 1,722,789 | | $ | 1,637,522 | $ | 1,566,421 ---------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Industrial | | 695,264 | | | 705,169 | | 653,848 ---------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Unallocated corporate property, plant and equipment, net | | 104,755 | | | 89,988 | | 85,834 ---------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Other unallocated assets | | 234,301 | | | 209,683 | | 206,301 ---------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Consolidated total assets | $ | 2,757,109 | | $ | 2,642,362 | $ | 2,512,404 ---------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+----------  | | | | | | | ---------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Segment depreciation and amortization: | | | | | | | ---------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Aerospace | $ | 47,277 | | $ | 40,825 | $ | 46,488 ---------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Industrial | | 24,421 | | | 20,412 | | 20,768 ---------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Unallocated corporate amounts | | 9,219 | | | 7,799 | | 7,979 ---------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Consolidated depreciation and amortization | $ | 80,917 | | $ | 69,036 | $ | 75,235 ---------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+----------  | | | | | | | ---------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Segment capital expenditures: | | | | | | | ---------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Aerospace | $ | 62,812 | | $ | 90,749 | $ | 150,021 ---------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Industrial | | 12,189 | | | 62,065 | | 113,292 ---------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Unallocated corporate amounts | | 17,335 | | | 22,878 | | 23,299 ---------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Consolidated capital expenditures | $ | 92,336 | | $ | 175,692 | $ | 286,612 ---------------------------------------------------------+--------------------------+-----------+------+---+-----------+---+---------- Sales to General Electric Company were made by both of Woodward’s reportable segments and totaled approximately 16% of net sales in fiscal year 2017, 17% of net sales in fiscal year 2016, and 18% of net sales in fiscal year 2015. Sales to The Boeing Company were made by Woodward’s Aerospace segment and totaled approximately 11% of net sales in fiscal year 2017, 8% of net sales in fiscal year 2016, and 7% of net sales in fiscal year 2015. Accounts receivable from General Electric Company totaled approximately 10% of accounts receivable at September 30, 2017 and 14% of accounts receivable at September 30, 2016. Accounts receivable from Weichai Westport, Inc. totaled approximately 14% of accounts receivable at September 30, 2017 and 3% of accounts receivable at September 30, 2016. 97 U.S. Government related sales from Woodward’s reportable segments were as follows:   | | | | | | | -------------------------------------+------------------------------+---------+--------------------------------+---+-------------------------------------+---+--------  | | | | | | | -------------------------------------+------------------------------+---------+--------------------------------+---+-------------------------------------+---+--------  | Direct U.S. Government Sales | | Indirect U.S. Government Sales | | Total U.S. Government Related Sales -------------------------------------+------------------------------+---------+--------------------------------+---+------------------------------------ Fiscal year ended September 30, 2017 | | | | | | | -------------------------------------+------------------------------+---------+--------------------------------+---+-------------------------------------+---+-------- Aerospace | $ | 106,685 | | $ | 362,536 | $ | 469,221 -------------------------------------+------------------------------+---------+--------------------------------+---+-------------------------------------+---+-------- Industrial | | 3,726 | | | 10,814 | | 14,540 -------------------------------------+------------------------------+---------+--------------------------------+---+-------------------------------------+---+-------- Total net external sales | $ | 110,411 | | $ | 373,350 | $ | 483,761 -------------------------------------+------------------------------+---------+--------------------------------+---+-------------------------------------+---+-------- Percentage of total net sales | | 5% | | | 18% | | 23% -------------------------------------+------------------------------+---------+--------------------------------+---+-------------------------------------+---+--------  | | | | | | | -------------------------------------+------------------------------+---------+--------------------------------+---+-------------------------------------+---+-------- Fiscal year ended September 30, 2016 | | | | | | | -------------------------------------+------------------------------+---------+--------------------------------+---+-------------------------------------+---+-------- Aerospace | $ | 103,026 | | $ | 310,952 | $ | 413,978 -------------------------------------+------------------------------+---------+--------------------------------+---+-------------------------------------+---+-------- Industrial | | 6,550 | | | 9,845 | | 16,395 -------------------------------------+------------------------------+---------+--------------------------------+---+-------------------------------------+---+-------- Total net external sales | $ | 109,576 | | $ | 320,797 | $ | 430,373 -------------------------------------+------------------------------+---------+--------------------------------+---+-------------------------------------+---+-------- Percentage of total net sales | | 5% | | | 16% | | 21% -------------------------------------+------------------------------+---------+--------------------------------+---+-------------------------------------+---+--------  | | | | | | | -------------------------------------+------------------------------+---------+--------------------------------+---+-------------------------------------+---+-------- Fiscal year ended September 30, 2015 | | | | | | | -------------------------------------+------------------------------+---------+--------------------------------+---+-------------------------------------+---+-------- Aerospace | $ | 92,322 | | $ | 258,391 | $ | 350,713 -------------------------------------+------------------------------+---------+--------------------------------+---+-------------------------------------+---+-------- Industrial | | 4,836 | | | 8,839 | | 13,675 -------------------------------------+------------------------------+---------+--------------------------------+---+-------------------------------------+---+-------- Total net external sales | $ | 97,158 | | $ | 267,230 | $ | 364,388 -------------------------------------+------------------------------+---------+--------------------------------+---+-------------------------------------+---+-------- Percentage of total net sales | | 5% | | | 13% | | 18% -------------------------------------+------------------------------+---------+--------------------------------+---+-------------------------------------+---+--------  | | | | | | | -------------------------------------+------------------------------+---------+--------------------------------+---+-------------------------------------+---+-------- Accounts receivable from the U.S. Government totaled approximately 3% of accounts receivable at September 30, 2017 and 2% of accounts receivable at September 30, 2016. The customers who account for approximately 10% or more of sales to each of Woodward’s reportable segments for the fiscal year ended September 30, 2017 follow:   | -----------+------------------------------------------------------------------------------  | -----------+------------------------------------------------------------------------------  | Customer -----------+------------------------------------------------------------------------------ Aerospace | The Boeing Company, United Technologies Corporation, General Electric Company -----------+------------------------------------------------------------------------------ Industrial | General Electric Company -----------+------------------------------------------------------------------------------ Net sales by geographical area, as determined by the location of the customer invoiced, were as follows:  | | | | | | | -----------------------+--------------------------+-----------+------+---+-----------+---+----------  | | | | | | | -----------------------+--------------------------+-----------+------+---+-----------+---+----------  | Year Ended September 30, -----------------------+-------------------------  | 2017 | | 2016 | | 2015 -----------------------+--------------------------+-----------+------+---+---------- United States | $ | 1,211,902 | | $ | 1,118,833 | $ | 1,054,895 -----------------------+--------------------------+-----------+------+---+-----------+---+---------- Europe (1) | | 478,725 | | | 537,901 | | 569,322 -----------------------+--------------------------+-----------+------+---+-----------+---+---------- Asia | | 288,252 | | | 228,683 | | 241,875 -----------------------+--------------------------+-----------+------+---+-----------+---+---------- Other countries | | 119,806 | | | 137,661 | | 172,211 -----------------------+--------------------------+-----------+------+---+-----------+---+---------- Consolidated net sales | $ | 2,098,685 | | $ | 2,023,078 | $ | 2,038,303 -----------------------+--------------------------+-----------+------+---+-----------+---+----------  | | | | | | | -----------------------+--------------------------+-----------+------+---+-----------+---+---------- (1) | As a percentage of consolidated net sales, net sales to customers in Germany accounted for 8% for the year ended September 30, 2017, 10% for the year ended September 30, 2016 and 10% for the year ended September 30, 2015. ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 98 Property, plant, and equipment, net by geographical area, as determined by the physical location of the assets, were as follows:    | | | | | ------------------------------------------------+------------------+---------+------+---+--------  | | | | | ------------------------------------------------+------------------+---------+------+---+--------  | At September 30, ------------------------------------------------+-----------------  | 2017 | | 2016 ------------------------------------------------+------------------+---------+----- United States | $ | 872,947 | | $ | 826,225 ------------------------------------------------+------------------+---------+------+---+-------- Germany | | 24,541 | | | 24,468 ------------------------------------------------+------------------+---------+------+---+-------- Other countries | | 24,555 | | | 25,657 ------------------------------------------------+------------------+---------+------+---+-------- Consolidated property, plant and equipment, net | $ | 922,043 | | $ | 876,350 ------------------------------------------------+------------------+---------+------+---+--------  Note 21. Supplemental quarterly financial data (Unaudited) Quarterly results for the fiscal years ended September 30, 2017 and September 30, 2016 follow:   | | | | | | | | | -----------------------------+----------------------+---------+--------+---+---------+--------+---------+---+--------  | | | | | | | | | -----------------------------+----------------------+---------+--------+---+---------+--------+---------+---+--------  | 2017 Fiscal Quarters -----------------------------+---------------------  | First | | Second | | Third | Fourth -----------------------------+----------------------+---------+--------+---+---------+------- Net sales | $ | 442,894 | | $ | 500,381 | $ | 548,622 | $ | 606,788 -----------------------------+----------------------+---------+--------+---+---------+--------+---------+---+-------- Gross margin (1) (2) | | 113,746 | | | 133,282 | | 153,872 | | 171,659 -----------------------------+----------------------+---------+--------+---+---------+--------+---------+---+-------- Earnings before income taxes | | 47,059 | | | 50,236 | | 68,687 | | 86,765 -----------------------------+----------------------+---------+--------+---+---------+--------+---------+---+-------- Net earnings | | 46,548 | | | 38,105 | | 53,626 | | 62,228 -----------------------------+----------------------+---------+--------+---+---------+--------+---------+---+-------- Earnings per share | | | | | | | | | -----------------------------+----------------------+---------+--------+---+---------+--------+---------+---+-------- Basic earnings per share | | 0.76 | | | 0.62 | | 0.87 | | 1.02 -----------------------------+----------------------+---------+--------+---+---------+--------+---------+---+-------- Diluted earnings per share | | 0.73 | | | 0.60 | | 0.85 | | 0.98 -----------------------------+----------------------+---------+--------+---+---------+--------+---------+---+-------- Cash dividends per share | | 0.110 | | | 0.125 | | 0.125 | | 0.125 -----------------------------+----------------------+---------+--------+---+---------+--------+---------+---+--------  | | | | | | | | | -----------------------------+----------------------+---------+--------+---+---------+--------+---------+---+--------  | 2016 Fiscal Quarters -----------------------------+---------------------  | First (3) | | Second | | Third | Fourth -----------------------------+----------------------+---------+--------+---+---------+------- Net sales | $ | 445,110 | | $ | 479,382 | $ | 507,664 | $ | 590,922 -----------------------------+----------------------+---------+--------+---+---------+--------+---------+---+-------- Gross margin (1) (2) | | 109,553 | | | 131,081 | | 134,825 | | 163,659 -----------------------------+----------------------+---------+--------+---+---------+--------+---------+---+-------- Earnings before income taxes | | 27,956 | | | 54,366 | | 63,408 | | 80,756 -----------------------------+----------------------+---------+--------+---+---------+--------+---------+---+-------- Net earnings | | 25,820 | | | 40,824 | | 51,047 | | 63,147 -----------------------------+----------------------+---------+--------+---+---------+--------+---------+---+-------- Earnings per share | | | | | | | | | -----------------------------+----------------------+---------+--------+---+---------+--------+---------+---+-------- Basic earnings per share | | 0.41 | | | 0.66 | | 0.83 | | 1.03 -----------------------------+----------------------+---------+--------+---+---------+--------+---------+---+-------- Diluted earnings per share | | 0.40 | | | 0.65 | | 0.81 | | 0.99 -----------------------------+----------------------+---------+--------+---+---------+--------+---------+---+-------- Cash dividends per share | | 0.100 | | | 0.110 | | 0.110 | | 0.110 -----------------------------+----------------------+---------+--------+---+---------+--------+---------+---+-------- Notes: 1. | Gross margin represents net sales less cost of goods sold. ---+----------------------------------------------------------- 2. | Gross margin for all periods presented has been recast from previously reported quarterly results due to reclassification of amortization as a separate line to an allocated expense/cost component of cost of goods sold and selling, general and administrative expenses. See “Note 1 - Operations and summary of significant accounting policies” for further information on reclassification. ---+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3. | Results for the first quarter of fiscal year 2016 include special charges totaling approximately $16,100 related to Woodward's efforts to consolidate facilities, reduce costs and address current market conditions. ---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------  99 Quarterly results by segment for the fiscal years ended September 30, 2017 and September 30, 2016 follow:   | | | | | | | | | ------------------------------------------+----------------------+----------+--------+---+----------+--------+----------+---+---------  | | | | | | | | | ------------------------------------------+----------------------+----------+--------+---+----------+--------+----------+---+---------  | 2017 Fiscal Quarters ------------------------------------------+---------------------  | First | | Second | | Third | Fourth ------------------------------------------+----------------------+----------+--------+---+----------+------- Segment external net sales: | | | | | | | | | ------------------------------------------+----------------------+----------+--------+---+----------+--------+----------+---+--------- Aerospace | $ | 266,680 | | $ | 320,526 | $ | 355,992 | $ | 399,141 ------------------------------------------+----------------------+----------+--------+---+----------+--------+----------+---+--------- Industrial | | 176,214 | | | 179,855 | | 192,630 | | 207,647 ------------------------------------------+----------------------+----------+--------+---+----------+--------+----------+---+--------- Total | $ | 442,894 | | $ | 500,381 | $ | 548,622 | $ | 606,788 ------------------------------------------+----------------------+----------+--------+---+----------+--------+----------+---+--------- Segment earnings: | | | | | | | | | ------------------------------------------+----------------------+----------+--------+---+----------+--------+----------+---+--------- Aerospace | $ | 46,877 | | $ | 58,227 | $ | 67,173 | $ | 85,536 ------------------------------------------+----------------------+----------+--------+---+----------+--------+----------+---+--------- Industrial | | 17,998 | | | 17,089 | | 20,870 | | 23,034 ------------------------------------------+----------------------+----------+--------+---+----------+--------+----------+---+--------- Nonsegment expenses | | (11,381) | | | (18,764) | | (12,945) | | (15,262) ------------------------------------------+----------------------+----------+--------+---+----------+--------+----------+---+--------- Interest expense, net | | (6,435) | | | (6,316) | | (6,411) | | (6,543) ------------------------------------------+----------------------+----------+--------+---+----------+--------+----------+---+--------- Consolidated earnings before income taxes | $ | 47,059 | | $ | 50,236 | $ | 68,687 | $ | 86,765 ------------------------------------------+----------------------+----------+--------+---+----------+--------+----------+---+---------  | | | | | | | | | ------------------------------------------+----------------------+----------+--------+---+----------+--------+----------+---+---------  | 2016 Fiscal Quarters ------------------------------------------+---------------------  | First | | Second | | Third | Fourth ------------------------------------------+----------------------+----------+--------+---+----------+------- Segment external net sales: | | | | | | | | | ------------------------------------------+----------------------+----------+--------+---+----------+--------+----------+---+--------- Aerospace | $ | 268,599 | | $ | 290,690 | $ | 308,582 | $ | 365,305 ------------------------------------------+----------------------+----------+--------+---+----------+--------+----------+---+--------- Industrial | | 176,511 | | | 188,692 | | 199,082 | | 225,617 ------------------------------------------+----------------------+----------+--------+---+----------+--------+----------+---+--------- Total | $ | 445,110 | | $ | 479,382 | $ | 507,664 | $ | 590,922 ------------------------------------------+----------------------+----------+--------+---+----------+--------+----------+---+--------- Segment earnings: | | | | | | | | | ------------------------------------------+----------------------+----------+--------+---+----------+--------+----------+---+--------- Aerospace | $ | 43,486 | | $ | 50,578 | $ | 57,726 | $ | 80,376 ------------------------------------------+----------------------+----------+--------+---+----------+--------+----------+---+--------- Industrial | | 21,551 | | | 19,469 | | 21,963 | | 19,254 ------------------------------------------+----------------------+----------+--------+---+----------+--------+----------+---+--------- Nonsegment expenses (1) | | (30,620) | | | (9,888) | | (10,369) | | (12,289) ------------------------------------------+----------------------+----------+--------+---+----------+--------+----------+---+--------- Interest expense, net | | (6,461) | | | (5,793) | | (5,912) | | (6,585) ------------------------------------------+----------------------+----------+--------+---+----------+--------+----------+---+--------- Consolidated earnings before income taxes | $ | 27,956 | | $ | 54,366 | $ | 63,408 | $ | 80,756 ------------------------------------------+----------------------+----------+--------+---+----------+--------+----------+---+--------- Notes: 1. | The results for Nonsegment expenses for the first quarter of fiscal year 2016 include special charges totaling approximately $16,100 related to Woodward's efforts to consolidate facilities, reduce costs and address current market conditions. ---+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 100  Item 9.Changes in and Disagreements with Accountants on Accounting and Financial Disclosure There have been no disagreements or any reportable events requiring disclosure under Item 304(b) of Regulation S-K.    Item 9A.Controls and Procedures Evaluation of Disclosure Controls and Procedures We have established disclosure controls and procedures, which are designed to ensure that information required to be disclosed in reports filed or submitted under the Securities Exchange Act of 1934 (the “Act”) is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms. These disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in the reports that we file or submit under the Act is accumulated and communicated to management, including our Principal Executive Officer (Thomas A. Gendron, Chairman of the Board, Chief Executive Officer and President) and Principal Financial and Accounting Officer (Robert F. Weber, Jr., Vice Chairman, Chief Financial Officer and Treasurer), as appropriate, to allow timely decisions regarding required disclosures. Thomas A. Gendron and Robert F. Weber, Jr., evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Form 10-K. Based on their evaluations, they concluded that our disclosure controls and procedures were effective as of September 30, 2017.  Management’s Annual Report on Internal Control Over Financial Reporting We are responsible for establishing and maintaining adequate internal control over financial reporting for the Company. We have evaluated the effectiveness of internal control over financial reporting using the criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and, based on that evaluation, have concluded that the Company’s internal control over financial reporting was effective as of September 30, 2017, the end of the Company’s most recent fiscal year. Deloitte & Touche LLP, an independent registered public accounting firm, conducted an audit of Woodward’s internal control over financial reporting as of September 30, 2017, as stated in their report included in “Item 9A. – Controls and Procedures.” Internal control over financial reporting is a process designed by, or under the supervision of, our principal executive and principal financial officers, or persons performing similar functions, and effected by our Board of Directors, management, and other personnel, to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of our financial statements for external purposes in accordance with generally accepted accounting principles. Internal control over financial reporting includes those policies and procedures that: · | Pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; --+---------------------------------------------------------------------------------------------------------------------------------------------------------------- · | Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorization of management and directors of the Company; and --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- There have been no changes in our internal control over financial reporting during the fourth fiscal quarter ended September 30, 2017 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.    101 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders ofWoodward, Inc.Fort Collins, Colorado We have audited the internal control over financial reporting of Woodward, Inc. and subsidiaries (the "Company") as of September 30, 2017, based on criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit.  We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.  A company's internal control over financial reporting is a process designed by, or under the supervision of, the company's principal executive and principal financial officers, or persons performing similar functions, and effected by the company's board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.  Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.  In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of September 30, 2017, based on the criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.  We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements and financial statement schedule as of and for the year ended September 30, 2017 of the Company and our report dated November 10, 2017 expressed an unqualified opinion on those financial statements and financial statement schedule.   /s/ DELOITTE & TOUCHE LLP Denver, ColoradoNovember 10, 2017 102 Item 9B.Other Information  None. PART III Item 10.Directors, Executive Officers and Corporate Governance The information required by this item relating to our directors and nominees, regarding compliance with Section 16(a) of the Securities Act of 1934, and regarding our Audit Committee is included under the captions “Board of Directors,” “Board Meetings and Committees – Audit Committee” (including information with respect to audit committee financial experts), “Stock Ownership of Management,” and “Section 16(a) Beneficial Ownership Reporting Compliance” in our Proxy Statement related to the Annual Meeting of Stockholders to be held January 24, 2018 and is incorporated herein by reference. There have been no material changes to the procedures by which security holders may recommend nominees to our board of directors. The information required by this item relating to the identities and background of our executive officers and other corporate officers is included under the caption “Executive Officers of the Registrant” in Item 1 of this report. We have adopted a code of ethics that applies to all of our employees, including our principal executive officer and our principal financial and accounting officer. This code of ethics is posted on our Website. The Internet address for our Website is www.woodward.com, and the code of ethics may be found from our main Web page by clicking first on “Investors” and then on “Corporate Governance,” and then on “Woodward Codes of Business Conduct and Ethics.” We intend to satisfy any disclosure requirement under Item 5.05 of Form 8-K regarding an amendment to, or waiver from, a provision of this code of ethics by posting such information to our Website, at the address and location specified above. Item 11.Executive Compensation Information regarding executive compensation is under the captions “Board Meetings and Committees – Director Compensation,” “Board Meetings and Committees – Compensation Committee Interlocks and Insider Participation,” “Compensation Discussion and Analysis,” “Compensation Committee Report,” “Executive Compensation” and “Board Meetings and Committees – Compensation Committee – Risk Assessment” in our Proxy Statement, and is incorporated herein by reference, except the section captioned “Compensation Committee Report on Compensation Discussion and Analysis” is hereby “furnished” and not “filed” with this Form 10-K. Item 12.Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters Information regarding security ownership of certain beneficial owners and management and related stockholder matters is under the tables captioned “Stock Ownership of Management,” “Persons Owning More Than Five Percent of Woodward Stock,” and “Executive Compensation – Equity Compensation Plan Information” in our Proxy Statement, and is incorporated herein by reference. Item 13. Certain Relationships and Related Transactions, and Director Independence The information set forth under “Board Meetings and Committees – Related Person Transaction Policies and Procedures,” “Board of Directors” and “Audit Committee Report to Stockholders” in our Proxy Statement and is incorporated herein by reference except the section captioned “Audit Committee Report” is hereby “furnished” and not “filed” with this Form 10-K. Item 14.Principal Accountant Fees and Services Information regarding principal accountant fees and services is under the captions “Audit Committee Report to Stockholders – Audit Committee’s Policy on Pre-Approval of Services Provided by Independent Registered Public Accounting Firm” and “Audit Committee Report to Stockholders – Fees Paid to Independent Registered Public Accounting Firm” in our Proxy Statement, and is incorporated herein by reference. 103 Item 15.Exhibits and Financial Statement Schedules  | | | ----+-----+-----------------------------------------------------------------------------------------------------------------+-------------------------  | | | Page Number in Form 10-K ----+-----+-----------------------------------------------------------------------------------------------------------------+------------------------- (a) | (1) | Consolidated Financial Statements: | ----+-----+-----------------------------------------------------------------------------------------------------------------+-------------------------  | | Report of Independent Registered Public Accounting Firm | 50 ----+-----+-----------------------------------------------------------------------------------------------------------------+-------------------------  | | Consolidated Statements of Earnings for the fiscal years ended September 30, 2017, 2016, and 2015 | 51 ----+-----+-----------------------------------------------------------------------------------------------------------------+-------------------------  | | Consolidated Statements of Comprehensive Earnings for the fiscal years ended September 30, 2017, 2016, and 2015 | 52 ----+-----+-----------------------------------------------------------------------------------------------------------------+-------------------------  | | Consolidated Balance Sheets at September 30, 2017 and 2016 | 53 ----+-----+-----------------------------------------------------------------------------------------------------------------+-------------------------  | | Consolidated Statements of Cash Flows for the fiscal years ended September 30, 2017, 2016, and 2015 | 54 ----+-----+-----------------------------------------------------------------------------------------------------------------+-------------------------  | | Consolidated Statements of Stockholders’ Equity for the fiscal years ended September 30, 2017, 2016, and 2015 | 55 ----+-----+-----------------------------------------------------------------------------------------------------------------+-------------------------  | | Notes to Consolidated Financial Statements | 56 ----+-----+-----------------------------------------------------------------------------------------------------------------+-------------------------  | | | ----+-----+-----------------------------------------------------------------------------------------------------------------+------------------------- (a) | (2) | Consolidated Financial Statement Schedule: | ----+-----+-----------------------------------------------------------------------------------------------------------------+-------------------------  | | Valuation and Qualifying Accounts | 109 ----+-----+-----------------------------------------------------------------------------------------------------------------+-------------------------  Financial statements and schedules other than those listed above are omitted for the reason that they are not applicable, are not required, or the information is included in the financial statements or the footnotes.  | | ----+------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (a) | (3) | Exhibits Filed as Part of This Report: ----+------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ‡ | 3.1 | Restated Certificate of Incorporation, as amended October 3, 2007, filed as Exhibit 3(i)(a) to Annual Report on Form 10-K filed November 20, 2008 ----+------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ‡ | 3.2 | Bylaws of Woodward, Inc., as amended and restated on November 10, 2015, filed as Exhibit 3.2 to Annual Report on Form 10-K filed November 12, 2015 ----+------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ‡ | 3.3 | Certificate of Amendment of Certificate of Incorporation, dated January 23, 2008, filed as Exhibit 3(i)(b) to Annual Report on Form 10-K filed November 20, 2008 ----+------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ‡ | 3.4 | Certificate of Amendment of the Restated Certificate of Incorporation, dated January 26, 2011, filed as Exhibit 3.1 to Current Report on Form 8-K filed January 28, 2011 ----+------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------- †‡ | 10.1 | Long-Term Management Incentive Compensation Plan, filed as Exhibit 10(c) to Annual Report on Form 10-K filed December 22, 2000 ----+------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------- †‡ | 10.2 | Summary Description of the Woodward Variable Incentive Plan, filed as Exhibit 10.2 to Annual Report on Form 10-K filed November 16, 2016 ----+------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------- †‡ | 10.3 | 2002 Stock Option Plan, effective January 1, 2002, filed as Exhibit 10(iii) to Quarterly Report on Form 10-Q filed May 9, 2002 ----+------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------- †‡ | 10.4 | Form of Outside Director Stock Purchase Agreement with James L. Rulseh, filed as Exhibit 10(j) to Annual Report on Form 10-K filed December 9, 2002 ----+------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------- †‡ | 10.5 | 2006 Omnibus Incentive Plan, effective January 25, 2006, filed as Exhibit 4.1 to Registration Statement on Form S-8 filed April 28, 2006 ----+------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 104 †‡ | 10.6 | Amendment No. 1 to the Woodward, Inc. 2006 Omnibus Incentive Plan, effective as of January 26, 2011, filed as Exhibit 10.10 to Annual Report on Form 10-K filed November 16, 2011 ---+-------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- †‡ | 10.7 | Material Definitive Agreement with A. Christopher Fawzy, filed as Exhibit 10.12 to Quarterly Report on Form 10-Q filed July 25, 2007 ---+-------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- †‡ | 10.8 | Form of Non-Qualified Stock Option Agreement, filed as Exhibit 99.2 to Current Report on Form 8-K filed November 21, 2007 ---+-------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- †‡ | 10.9 | Form of Non-Qualified Stock Option Agreement, filed as Exhibit 10.12 to Annual Report on Form 10-K filed November 15, 2012 ---+-------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- †‡ | 10.10 | Form of Non-Qualified Stock Option Agreement, filed as Exhibit 10.13 to Annual Report on Form 10-K filed November 14, 2013 ---+-------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- †‡ | 10.11 | Form of Restricted Stock Agreement, filed as Exhibit 10.1 to Quarterly Report on Form 10-Q filed January 22, 2014 ---+-------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- †‡ | 10.12 | 2017 Omnibus Incentive Plan, effective September 14, 2016, filed as Exhibit 10.1 to Quarterly Report on Form 10-Q filed January 25, 2017 ---+-------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- †‡ | 10.13 | Form of Non-Qualified Stock Option Agreement, filed as Exhibit 10.2 to Quarterly Report on Form 10-Q filed January 25, 2017 ---+-------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ‡ | 10.14 | Credit Agreement, dated as of July 10, 2013, by and among the Company, the foreign subsidiary borrowers party thereto, the institutions party thereto as lenders, and Wells Fargo Bank, National Association, as administrative agent, filed as Exhibit 10.1 to Current Report on Form 8-K filed July 16, 2013 ---+-------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ‡ | 10.15 | Amendment No. 1 to Credit Agreement, dated April 28, 2015, and the conformed Credit Agreement by and among the Company, certain foreign subsidiary borrowers of the Company from time to time parties thereto, the institutions from time to time parties thereto, as lenders, Wells Fargo Bank, National Association, as administrative agent, filed as Exhibit 10.1 to Quarterly Report on Form 10-Q filed July 21, 2015 ---+-------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- †‡ | 10.16 | Chad Preiss Promotion Letter dated October 1, 2008, filed as Exhibit 10.19 to Annual Report on Form 10-K filed November 20, 2008 ---+-------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ‡ | 10.17 | Note Purchase Agreement, dated October 1, 2008, by and among the Company and the purchasers named therein, filed as Exhibit 10.2 to Current Report on Form 8-K filed October 7, 2008 ---+-------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ‡ | 10.18 | Amendment No. 1 to 2008 Note Purchase Agreement, dated as of October 1, 2013, by and among the Company and the noteholders named therein, filed as Exhibit 10.2 to Current Report on Form 8-K filed October 4, 2013 ---+-------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ‡ | 10.19 | Note Purchase Agreement, dated April 3, 2009, by and among the Company and the purchasers named therein, filed as Exhibit 10.2 to Current Report on Form 8-K filed April 8, 2009 ---+-------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ‡ | 10.20 | Amendment No. 1 to 2009 Note Purchase Agreement, dated as of October 1, 2013, by and among the Company and the noteholders named therein, filed as Exhibit 10.3 to Current Report on Form 8-K filed October 4, 2013 ---+-------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ‡ | 10.21 | Note Purchase Agreement, dated October 1, 2013, by and among the Company and the purchasers named therein, filed as Exhibit 10.1 to Current Report on Form 8-K filed October 4, 2013 ---+-------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 105 ‡ | 10.22 | Note Purchase Agreement, dated September 23, 2016, by and among the Company and the purchasers named therein, filed as Exhibit 10.20 to Annual Report on Form 10-K filed November 16, 2016 ---+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ‡ | 10.23 | Note Purchase Agreement, dated September 23, 2016, by and among Woodward International Holding B.V. and the purchasers named therein, filed as Exhibit 10.21 to Annual Report on Form 10-K filed November 16, 2016 ---+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- †‡ | 10.24 | Form of Change in Control Agreement for the Company’s principal executive officer and other executive officers other than the Company’s principal financial officer, filed as Exhibit 10.25 to Annual Report on Form 10-K filed November 12, 2014 ---+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- †‡ | 10.25 | Form of Change in Control Agreement for the Company’s principal financial officer, filed as Exhibit 10.26 to Annual Report on Form 10-K filed November 12, 2014 ---+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- †‡ | 10.26 | Executive Benefit Plan, as amended and restated as of September 18, 2013, filed as Exhibit 10.31 to Annual Report on Form 10-K filed November 14, 2013 ---+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- †‡ | 10.27 | James D. Rudolph Promotion Letter, dated February 10, 2011, filed as Exhibit 10.1 to Quarterly Report on Form 10-Q filed April 27, 2011 ---+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- †‡ | 10.28 | Mr. Martin V. Glass employment letter, dated April 27, 2011, filed as Exhibit 10.1 to Quarterly Report on Form 10-Q filed July 26, 2011 ---+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- †‡ | 10.29 | Sagar Patel employment letter, dated June 17, 2011, filed as Exhibit 10.2 to Quarterly Report on Form 10-Q filed July 26, 2011 ---+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- †‡ | 10.30 | Woodward Retirement Savings Plan, as amended and restated effective as of January 1, 2016, filed as Exhibit 10.1 to Quarterly Report on Form 10-Q filed February 9, 2016 ---+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ‡ | 10.31 | Purchase and Sale Agreement between Woodward, Inc. and General Electric Company dated January 4, 2016 filed as Exhibit 2.1 to Current Report on Form 8-K filed January 8, 2016 ---+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ‡ | 10.32 | Amended and Restated Limited Liability Company Agreement of Convergence Fuel Systems, LLC, dated January 4, 2016 filed as Exhibit 10.1 to Current Report on Form 8-K filed January 8, 2016 ---+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ‡ | 10.33 | Accelerated Share Repurchase (ASR) Master Confirmation Agreement dated June 2, 2015, filed as Exhibit 10.3 to Quarterly Report on Form 10-Q filed July 21, 2015 ---+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ‡ | 10.34 | Accelerated Share Repurchase (ASR) Supplemental Confirmation Agreement dated June 2, 2015, filed as Exhibit 10.4 to Quarterly Report on Form 10-Q filed July 21, 2015 ---+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- * | 21.1 | Subsidiaries ---+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- * | 23.1 | Consent of Independent Registered Public Accounting Firm ---+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- * | 31.1 | Rule 13a-14(a)/15d-14(a) certification of Thomas A. Gendron ---+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- * | 31.2 | Rule 13a-14(a)/15d-14(a) certification of Robert F. Weber, Jr. ---+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- * | 32.1 | Section 1350 certifications ---+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- * | 101.INS | XBRL Instance Document. ---+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- * | 101.SCH | XBRL Taxonomy Extension Schema Document ---+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- * | 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document ---+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- * | 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document ---+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- * | 101.LAB | XBRL Taxonomy Extension Label Linkbase Document ---+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 106 * | 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document -----+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------------------------------  | | -----+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------------------------------  | Attached as Exhibit 101 to this report are the following materials from Woodward, Inc.’s Annual Report on Form 10-K for the year ended September 30, 2017, formatted in XBRL (eXtensible Business Reporting Language): (i) the Consolidated Statements of Earnings, (ii) the Consolidated Statements of Comprehensive Earnings, (iii) the Consolidated Balance Sheets, (iv) the Consolidated Statements of Cash Flows, (v) the Consolidated Statements of Stockholders’ Equity, and (vi) the Notes to the Consolidated Financial Statements. -----+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------  | -----+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- † ‡ | Management contract or compensatory plan or arrangement. Incorporated by reference as an exhibit to this Report (file number 000-08408, unless otherwise indicated). -----+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- * | Filed as an exhibit to this Report. -----+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------   Item 16. Form 10-K Summary  Not applicable 107 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.  | -------------------------+---------------------------------------------------------------------------------------------------  | WOODWARD, INC. -------------------------+--------------------------------------------------------------------------------------------------- Date: November 13, 2017 | /s/ Thomas A. Gendron -------------------------+---------------------------------------------------------------------------------------------------  | Thomas A. Gendron -------------------------+---------------------------------------------------------------------------------------------------  | Chairman of the Board, Chief Executive Officer, and President (Principal Executive Officer) -------------------------+---------------------------------------------------------------------------------------------------  | -------------------------+--------------------------------------------------------------------------------------------------- Date: November 13, 2017 | /s/ Robert F. Weber, Jr. -------------------------+---------------------------------------------------------------------------------------------------  | Robert F. Weber, Jr. -------------------------+---------------------------------------------------------------------------------------------------  | Vice Chairman, Chief Financial Officer and Treasurer (Principal Financial and Accounting Officer) -------------------------+---------------------------------------------------------------------------------------------------  Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.  | | -----------------------+-----------------------+------------------ Signature | Title | Date -----------------------+-----------------------+------------------ /s/ John D. Cohn | Director | November 10, 2017 -----------------------+-----------------------+------------------ John D. Cohn | | -----------------------+-----------------------+------------------ /s/ Paul Donovan | Director | November 10, 2017 -----------------------+-----------------------+------------------ Paul Donovan | | -----------------------+-----------------------+------------------ /s/ Eileen P. Drake | Director | November 10, 2017 -----------------------+-----------------------+------------------ Eileen P. Drake | | -----------------------+-----------------------+------------------ /s/ Thomas A. Gendron | Chairman of the Board | November 10, 2017 -----------------------+-----------------------+------------------ Thomas A. Gendron | and Director | -----------------------+-----------------------+------------------ /s/ John A. Halbrook | Director | November 10, 2017 -----------------------+-----------------------+------------------ John A. Halbrook | | -----------------------+-----------------------+------------------ /s/ Daniel G. Korte | Director | November 10, 2017 -----------------------+-----------------------+------------------ Daniel G. Korte | | -----------------------+-----------------------+------------------ /s/ Mary L. Petrovich | Director | November 10, 2017 -----------------------+-----------------------+------------------ Mary L. Petrovich | | -----------------------+-----------------------+------------------ /s/ James R. Rulseh | Director | November 10, 2017 -----------------------+-----------------------+------------------ James R. Rulseh | | -----------------------+-----------------------+------------------ /s/ Ronald M. Sega | Director | November 10, 2017 -----------------------+-----------------------+------------------ Ronald M. Sega | | -----------------------+-----------------------+------------------ /s/ Gregg C. Sengstack | Director | November 10, 2017 -----------------------+-----------------------+------------------ Gregg C. Sengstack | | -----------------------+-----------------------+------------------ /s/ Jonathan W. Thayer | Director | November 10, 2017 -----------------------+-----------------------+------------------ Jonathan W. Thayer | | -----------------------+-----------------------+------------------  108  WOODWARD, INC. AND SUBSIDIARIES SCHEDULE II – VALUATION AND QUALIFYING ACCOUNTS For the years ended September 30, 2017, 2016, and 2015 (in thousands)    | | | | | | | | | | | | ---------------------------------------+------------------------------+-------+-------------------------------+-----------+-------------------------------+----------------+-----+------------------------+---+---------+---+------  | | | | | | | | | | | | ---------------------------------------+------------------------------+-------+-------------------------------+-----------+-------------------------------+----------------+-----+------------------------+---+---------+---+------ Column A | Column B | | Column C | | Column D | Column E ---------------------------------------+------------------------------+-------+-------------------------------+-----------+-------------------------------+---------------  | | | | Additions | | | | | ---------------------------------------+------------------------------+-------+-------------------------------+-----------+-------------------------------+----------------+-----+------------------------+-- Description | Balance at Beginning of Year | | Charged to Costs and Expenses | | Charged to Other Accounts (a) | Deductions (b) | | Balance at End of Year ---------------------------------------+------------------------------+-------+-------------------------------+-----------+-------------------------------+----------------+-----+----------------------- Fiscal year 2017 | | | | | | | | | | | | ---------------------------------------+------------------------------+-------+-------------------------------+-----------+-------------------------------+----------------+-----+------------------------+---+---------+---+------ Allowance for uncollectible accounts | $ | 2,540 | | $ | 1,063 | $ | 449 | | $ | (276) | $ | 3,776 ---------------------------------------+------------------------------+-------+-------------------------------+-----------+-------------------------------+----------------+-----+------------------------+---+---------+---+------ Deferred tax asset valuation allowance | | 3,317 | | | 77 | | - | | | 320 | | 3,714 ---------------------------------------+------------------------------+-------+-------------------------------+-----------+-------------------------------+----------------+-----+------------------------+---+---------+---+------ Fiscal year 2016 | | | | | | | | | | | | ---------------------------------------+------------------------------+-------+-------------------------------+-----------+-------------------------------+----------------+-----+------------------------+---+---------+---+------ Allowance for uncollectible accounts | | 3,841 | | | 255 | | 233 | | | (1,789) | | 2,540 ---------------------------------------+------------------------------+-------+-------------------------------+-----------+-------------------------------+----------------+-----+------------------------+---+---------+---+------ Deferred tax asset valuation allowance | | 6,804 | | | 53 | | - | | | (3,540) | | 3,317 ---------------------------------------+------------------------------+-------+-------------------------------+-----------+-------------------------------+----------------+-----+------------------------+---+---------+---+------ Fiscal year 2015 | | | | | | | | | | | | ---------------------------------------+------------------------------+-------+-------------------------------+-----------+-------------------------------+----------------+-----+------------------------+---+---------+---+------ Allowance for uncollectible accounts | | 7,078 | | | 364 | | 487 | | | (4,088) | | 3,841 ---------------------------------------+------------------------------+-------+-------------------------------+-----------+-------------------------------+----------------+-----+------------------------+---+---------+---+------ Deferred tax asset valuation allowance | | 9,486 | | | 209 | | - | | | (2,891) | | 6,804 ---------------------------------------+------------------------------+-------+-------------------------------+-----------+-------------------------------+----------------+-----+------------------------+---+---------+---+------    Notes: (a) | Includes recoveries of accounts previously written off. ----+--------------------------------------------------------  (b) | Represents accounts receivable written off against the allowance for collectible accounts and releases of valuation reserves to income tax expense. Also included are foreign currency exchange rate adjustments. Currency translation adjustments resulted in an increase in the reserves of $64 in fiscal year 2017, an increase in the reserve of $77 in fiscal year 2016, and a decrease in the reserve of $934 in fiscal year 2015. ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 109

1347 Property Insurance Holdings, Inc.

1591890

10-Q

0001387131-17-005432

UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) | -------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------- ☒ | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 -------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------- For the Quarterly Period Ended September 30, 2017 ------------------------------------------------------------------------------------------ Or ------------------------------------------------------------------------------------------ ☐ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 -------------------------------------------------------------------------------------------+--------------------------------------------------------------------------------------------- Commission File Number: 001-36366 1347 Property Insurance Holdings, Inc. (Exact name of registrant as specified in its charter) Delaware (State or other jurisdiction of incorporation or organization) | 46-1119100 (I.R.S. Employer Identification No.) ----------------------------------------------------------------------------------------+-------------------------------------------------------- 1511 N. Westshore Blvd., Suite 870, Tampa, FL 33607 -------------------------------------------------------- (Address of principal executive offices and zip code) -------------------------------------------------------- 813-579-6213 -------------------------------------------------------- (Registrant’s telephone number, including area code) -------------------------------------------------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No ☐ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large accelerated filer ☐ | Accelerated filer ☐ | Non-accelerated filer ☐ (Do not check if a smaller reporting company) | Smaller Reporting Company ☒ | Emerging Growth Company ☒ --------------------------+---------------------+------------------------------------------------------------------------------------------------------------------------+-----------------------------+-------------------------- If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒ The number of shares outstanding of the registrant’s common stock as of November 6, 2017 was 5,984,766. Table of Contents PART I. FINANCIAL INFORMATION | 3 --------------------------------------------------------------------------------------------------+--- ITEM 1. FINANCIAL STATEMENTS | 3 --------------------------------------------------------------------------------------------------+--- ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS | 26 --------------------------------------------------------------------------------------------------+--- ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK | 44 --------------------------------------------------------------------------------------------------+--- ITEM 4. CONTROLS AND PROCEDURES | 44 --------------------------------------------------------------------------------------------------+--- PART II. OTHER INFORMATION | 44 --------------------------------------------------------------------------------------------------+--- ITEM 1. LEGAL PROCEEDINGS | 44 --------------------------------------------------------------------------------------------------+--- ITEM 1A. RISK FACTORS | 45 --------------------------------------------------------------------------------------------------+--- ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS | 45 --------------------------------------------------------------------------------------------------+--- ITEM 3. DEFAULTS UPON SENIOR SECURITIES | 45 --------------------------------------------------------------------------------------------------+--- ITEM 4. MINE SAFETY DISCLOSURES | 45 --------------------------------------------------------------------------------------------------+--- ITEM 5. OTHER INFORMATION | 45 --------------------------------------------------------------------------------------------------+--- ITEM 6. EXHIBITS | 46 --------------------------------------------------------------------------------------------------+--- SIGNATURES | 46 --------------------------------------------------------------------------------------------------+--- 2 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS 1347 PROPERTY INSURANCE HOLDINGS INC. AND SUBSIDIARIES Consolidated Balance Sheets (in thousands, except share and per share data) | September 30, 2017 (unaudited) | | | December 31, 2016 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+-- ASSETS | | | | | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Investments: | | | | | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Fixed income securities, at fair value (amortized cost of $45,252 and $26,793, respectively) | $ | 45,207 | | | $ | 26,559 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Equity investments, at fair value (cost of $1,682 and $1,000, respectively) | | 1,771 | | | | 1,136 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Short-term investments, at cost | | 1,779 | | | | 196 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Other investments, at cost | | 945 | | | | 505 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Total investments | | 49,702 | | | | 28,396 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Cash and cash equivalents | | 25,679 | | | | 43,045 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Deferred policy acquisition costs, net | | 6,192 | | | | 4,389 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Premiums receivable, net of allowance for credit losses of $39 and $38, respectively | | 2,220 | | | | 2,923 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Ceded unearned premiums | | 3,836 | | | | 4,847 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Reinsurance recoverable on paid losses | | 7,767 | | | | 444 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Reinsurance recoverable on loss and loss adjustment expense reserves | | 17,560 | | | | 3,652 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Funds deposited with reinsured companies | | — | | | | 500 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Current income taxes recoverable | | 632 | | | | 1,195 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Deferred tax asset, net | | 855 | | | | 420 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Property and equipment, net | | 213 | | | | 250 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Other assets | | 867 | | | | 788 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Total assets | $ | 115,523 | | | $ | 90,849 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- LIABILITIES | | | | | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Loss and loss adjustment expense reserves | $ | 22,091 | | | $ | 6,971 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Unearned premium reserves | | 32,170 | | | | 25,821 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Ceded reinsurance premiums payable | | 5,786 | | | | 5,229 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Agency commissions payable | | 716 | | | | 497 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Premiums collected in advance | | 1,887 | | | | 1,128 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Funds held under reinsurance treaties | | 48 | | | | 73 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Accounts payable and other accrued expenses | | 4,483 | | | | 2,065 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Series B Preferred Shares, $25.00 par value, 1,000,000 shares authorized, 120,000 shares issued and outstanding for both periods | | 2,744 | | | | 2,708 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Total liabilities | $ | 69,925 | | | $ | 44,492 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Commitments and contingencies (Note 16) | | | | | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- SHAREHOLDERS’ EQUITY | | | | | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Common stock, $0.001 par value; 10,000,000 shares authorized; 6,136,125 and 6,108,125 shares issued and 5,984,766 and 5,956,766 shares outstanding as of September 30, 2017 and December 31, 2016, respectively | $ | 6 | | | $ | 6 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Additional paid-in capital | | 47,052 | | | | 46,809 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Retained (deficit) earnings | | (480 | ) | | | 616 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Accumulated other comprehensive income (loss) | | 29 | | | | (65 | ) ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- | | 46,607 | | | | 47,366 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Less: treasury stock at cost; 151,359 shares for both periods | | (1,009 | ) | | | (1,009 | ) ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Total shareholders’ equity | | 45,598 | | | | 46,357 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- Total liabilities and shareholders’ equity | $ | 115,523 | | | $ | 90,849 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------------------------------------+---------+---+----------------------------+---+--------+-- See accompanying notes to consolidated financial statements. 3 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES Consolidated Statements of Operations and Comprehensive Income (Loss) (in thousands, except share and per share data) (Unaudited) | Three months ended September 30, | | | Nine months ended September 30, | -------------------------------------------------------------------------------------+--------------------------------------+-----------+---+-------------------------------------+-- | 2017 | | | 2016 | | | 2017 | | 2016 | -------------------------------------------------------------------------------------+--------------------------------------+-----------+---+-------------------------------------+---+-----------+------+---+-----------+-- Revenue: | | | | | | | | | | -------------------------------------------------------------------------------------+--------------------------------------+-----------+---+-------------------------------------+---+-----------+------+---+-----------+-- Net premiums earned | $ | 8,632 | | | $ | 7,136 | | $ | 25,032 | | $ | 22,869 | -------------------------------------------------------------------------------------+--------------------------------------+-----------+---+-------------------------------------+---+-----------+------+---+-----------+---+---+-----------+-- Net investment income | | 248 | | | | 151 | | | 700 | | | 393 | -------------------------------------------------------------------------------------+--------------------------------------+-----------+---+-------------------------------------+---+-----------+------+---+-----------+---+---+-----------+-- Other income | | 474 | | | | 345 | | | 1,262 | | | 862 | -------------------------------------------------------------------------------------+--------------------------------------+-----------+---+-------------------------------------+---+-----------+------+---+-----------+---+---+-----------+-- Total revenue | | 9,354 | | | | 7,632 | | | 26,994 | | | 24,124 | -------------------------------------------------------------------------------------+--------------------------------------+-----------+---+-------------------------------------+---+-----------+------+---+-----------+---+---+-----------+-- Expenses: | | | | | | | | | | | | | -------------------------------------------------------------------------------------+--------------------------------------+-----------+---+-------------------------------------+---+-----------+------+---+-----------+---+---+-----------+-- Net losses and loss adjustment expenses | | 7,795 | | | | 6,443 | | | 13,809 | | | 14,917 | -------------------------------------------------------------------------------------+--------------------------------------+-----------+---+-------------------------------------+---+-----------+------+---+-----------+---+---+-----------+-- Amortization of deferred policy acquisition costs | | 2,755 | | | | 2,095 | | | 7,867 | | | 6,148 | -------------------------------------------------------------------------------------+--------------------------------------+-----------+---+-------------------------------------+---+-----------+------+---+-----------+---+---+-----------+-- General and administrative expenses | | 2,145 | | | | 1,658 | | | 6,535 | | | 4,982 | -------------------------------------------------------------------------------------+--------------------------------------+-----------+---+-------------------------------------+---+-----------+------+---+-----------+---+---+-----------+-- Accretion of discount on Series B Preferred Shares | | 93 | | | | 89 | | | 276 | | | 263 | -------------------------------------------------------------------------------------+--------------------------------------+-----------+---+-------------------------------------+---+-----------+------+---+-----------+---+---+-----------+-- Total expenses | | 12,788 | | | | 10,285 | | | 28,487 | | | 26,310 | -------------------------------------------------------------------------------------+--------------------------------------+-----------+---+-------------------------------------+---+-----------+------+---+-----------+---+---+-----------+-- Loss before income tax benefit | | (3,434 | ) | | | (2,653 | ) | | (1,493 | ) | | (2,186 | ) -------------------------------------------------------------------------------------+--------------------------------------+-----------+---+-------------------------------------+---+-----------+------+---+-----------+---+---+-----------+-- Income tax benefit | | (1,171 | ) | | | (847 | ) | | (397 | ) | | (605 | ) -------------------------------------------------------------------------------------+--------------------------------------+-----------+---+-------------------------------------+---+-----------+------+---+-----------+---+---+-----------+-- Net loss | $ | (2,263 | ) | | $ | (1,806 | ) | $ | (1,096 | ) | $ | (1,581 | ) -------------------------------------------------------------------------------------+--------------------------------------+-----------+---+-------------------------------------+---+-----------+------+---+-----------+---+---+-----------+-- Net loss per common share: | | | | | | | | | | | | | -------------------------------------------------------------------------------------+--------------------------------------+-----------+---+-------------------------------------+---+-----------+------+---+-----------+---+---+-----------+-- Basic and diluted | $ | (0.38 | ) | | $ | (0.30 | ) | $ | (0.18 | ) | $ | (0.26 | ) -------------------------------------------------------------------------------------+--------------------------------------+-----------+---+-------------------------------------+---+-----------+------+---+-----------+---+---+-----------+-- Weighted average common shares outstanding: | | | | | | | | | | | | | -------------------------------------------------------------------------------------+--------------------------------------+-----------+---+-------------------------------------+---+-----------+------+---+-----------+---+---+-----------+-- Basic and diluted | | 5,961,636 | | | | 6,022,983 | | | 5,958,407 | | | 6,076,838 | -------------------------------------------------------------------------------------+--------------------------------------+-----------+---+-------------------------------------+---+-----------+------+---+-----------+---+---+-----------+-- Consolidated Statements of Comprehensive Income (Loss) ------------------------------------------------------------------------------------ Net loss | $ | (2,263 | ) | | $ | (1,806 | ) | $ | (1,096 | ) | $ | (1,581 | ) -------------------------------------------------------------------------------------+--------------------------------------+-----------+---+-------------------------------------+---+-----------+------+---+-----------+---+---+-----------+-- Unrealized gains (losses) on investments available for sale, net of income taxes | | 25 | | | | (11 | ) | | 94 | | | 310 | -------------------------------------------------------------------------------------+--------------------------------------+-----------+---+-------------------------------------+---+-----------+------+---+-----------+---+---+-----------+-- Comprehensive loss | $ | (2,238 | ) | | $ | (1,817 | ) | $ | (1,002 | ) | $ | (1,271 | ) -------------------------------------------------------------------------------------+--------------------------------------+-----------+---+-------------------------------------+---+-----------+------+---+-----------+---+---+-----------+-- See accompanying notes to consolidated financial statements. 4 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES Consolidated Statement of Changes in Shareholders’ Equity (in thousands, except per share data) | Common Stock | | | Treasury Stock | | | | | | | | | | | | | ---------------------------------------------+------------------+-----------+---+--------------------+---+---+--------+----------+---+--------------------------------+--------+---+-----------------------+---+--------+---------------------------------------------------+-- | Shares | | | Amount | | | Shares | Amount | | Additional Paid-in Capital | | | Retained Earnings | | | Accumulated Other Comprehensive Income (Loss) | | Total Shareholders’ Equity | ---------------------------------------------+------------------+-----------+---+--------------------+---+---+--------+----------+---+--------------------------------+--------+---+-----------------------+---+--------+---------------------------------------------------+---+---------------------------------+-- Balance-January 1, 2016 | | 6,134,274 | | | $ | 6 | | 223,851 | | $ | (1,731 | ) | | $ | 48,688 | | $ | 605 | | $ | (62 | ) | $ | 47,506 | ---------------------------------------------+------------------+-----------+---+--------------------+---+---+--------+----------+---+--------------------------------+--------+---+-----------------------+---+--------+---------------------------------------------------+---+---------------------------------+---+---+-----+---+---+--------+-- Stock compensation expense | | — | | | | — | | — | | | — | | | | 38 | | | — | | | — | | | 38 | ---------------------------------------------+------------------+-----------+---+--------------------+---+---+--------+----------+---+--------------------------------+--------+---+-----------------------+---+--------+---------------------------------------------------+---+---------------------------------+---+---+-----+---+---+--------+-- Purchase of treasury stock | | (177,508 | ) | | | — | | 177,508 | | | (1,195 | ) | | | — | | | — | | | — | | | (1,195 | ) ---------------------------------------------+------------------+-----------+---+--------------------+---+---+--------+----------+---+--------------------------------+--------+---+-----------------------+---+--------+---------------------------------------------------+---+---------------------------------+---+---+-----+---+---+--------+-- Retirement of treasury shares | | — | | | | — | | (250,000 | ) | | 1,917 | | | | (1,917 | ) | | — | | | — | | | — | ---------------------------------------------+------------------+-----------+---+--------------------+---+---+--------+----------+---+--------------------------------+--------+---+-----------------------+---+--------+---------------------------------------------------+---+---------------------------------+---+---+-----+---+---+--------+-- Net income | | — | | | | — | | — | | | — | | | | — | | | 11 | | | — | | | 11 | ---------------------------------------------+------------------+-----------+---+--------------------+---+---+--------+----------+---+--------------------------------+--------+---+-----------------------+---+--------+---------------------------------------------------+---+---------------------------------+---+---+-----+---+---+--------+-- Other comprehensive loss | | — | | | | — | | — | | | — | | | | — | | | — | | | (3 | ) | | (3 | ) ---------------------------------------------+------------------+-----------+---+--------------------+---+---+--------+----------+---+--------------------------------+--------+---+-----------------------+---+--------+---------------------------------------------------+---+---------------------------------+---+---+-----+---+---+--------+-- Balance - December 31, 2016 | | 5,956,766 | | | $ | 6 | | 151,359 | | $ | (1,009 | ) | | $ | 46,809 | | $ | 616 | | $ | (65 | ) | $ | 46,357 | ---------------------------------------------+------------------+-----------+---+--------------------+---+---+--------+----------+---+--------------------------------+--------+---+-----------------------+---+--------+---------------------------------------------------+---+---------------------------------+---+---+-----+---+---+--------+-- Issuance of common shares | | 28,000 | | | | — | | — | | | — | | | | 224 | | | — | | | — | | | 224 | ---------------------------------------------+------------------+-----------+---+--------------------+---+---+--------+----------+---+--------------------------------+--------+---+-----------------------+---+--------+---------------------------------------------------+---+---------------------------------+---+---+-----+---+---+--------+-- Stock compensation expense | | — | | | | — | | — | | | — | | | | 19 | | | — | | | — | | | 19 | ---------------------------------------------+------------------+-----------+---+--------------------+---+---+--------+----------+---+--------------------------------+--------+---+-----------------------+---+--------+---------------------------------------------------+---+---------------------------------+---+---+-----+---+---+--------+-- Net loss | | — | | | | — | | — | | | — | | | | — | | | (1,096 | ) | | — | | | (1,096 | ) ---------------------------------------------+------------------+-----------+---+--------------------+---+---+--------+----------+---+--------------------------------+--------+---+-----------------------+---+--------+---------------------------------------------------+---+---------------------------------+---+---+-----+---+---+--------+-- Other comprehensive income | | — | | | | — | | — | | | — | | | | — | | | — | | | 94 | | | 94 | ---------------------------------------------+------------------+-----------+---+--------------------+---+---+--------+----------+---+--------------------------------+--------+---+-----------------------+---+--------+---------------------------------------------------+---+---------------------------------+---+---+-----+---+---+--------+-- Balance – September 30, 2017 (unaudited) | | 5,984,766 | | | $ | 6 | | 151,359 | | $ | (1,009 | ) | | $ | 47,052 | | $ | (480 | ) | $ | 29 | | $ | 45,598 | ---------------------------------------------+------------------+-----------+---+--------------------+---+---+--------+----------+---+--------------------------------+--------+---+-----------------------+---+--------+---------------------------------------------------+---+---------------------------------+---+---+-----+---+---+--------+-- See accompanying notes to consolidated financial statements. 5 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows (Unaudited) (in thousands) | Nine months ended September 30, | --------------------------------------------------------------------------------------+-------------------------------------+-------- | 2017 | | | 2016 | --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+-- Cash provided by: | | | | | | | --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Operating activities: | | | | | | | --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Net loss | $ | (1,096 | ) | | $ | (1,581 | ) --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Adjustments to reconcile net income to net cash provided by operating activities: | | | | | | | --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Accretion of discount on Series B Preferred Shares | | 276 | | | | 263 | --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Net deferred income taxes | | (483 | ) | | | (209 | ) --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Stock compensation expense | | 19 | | | | 30 | --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Depreciation expense | | 55 | | | | 49 | --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Changes in operating assets and liabilities: | | | | | | | --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Premiums receivable | | 703 | | | | 293 | --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Reinsurance recoverable on paid losses and loss reserves | | (21,231 | ) | | | (7,866 | ) --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Amounts held on deposit with reinsured companies | | 500 | | | | 725 | --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Ceded unearned premiums | | 1,011 | | | | (1,646 | ) --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Deferred policy acquisition costs, net | | (1,803 | ) | | | (339 | ) --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Loss and loss adjustment expense reserves | | 15,120 | | | | 6,504 | --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Premiums collected in advance | | 759 | | | | 819 | --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Unearned premium reserves | | 6,349 | | | | 2,902 | --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Ceded reinsurance premiums payable | | 557 | | | | 2,333 | --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Current income taxes recoverable | | 563 | | | | (606 | ) --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Other, net | | 2,533 | | | | (12 | ) --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Net cash provided by operating activities | | 3,832 | | | | 1,659 | --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Investing activities: | | | | | | | --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Purchases of furniture and equipment | | (18 | ) | | | (81 | ) --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Purchases of fixed income securities | | (18,459 | ) | | | (7,424 | ) --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Purchase of equity investments | | (682 | ) | | | (1,000 | ) --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Purchase of other investments | | (440 | ) | | | (139 | ) --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Net purchases of short-term investments | | (1,583 | ) | | | (784 | ) --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Net cash used in investing activities | | (21,182 | ) | | | (9,428 | ) --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Financing activities: | | | | | | | --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Payment of dividends on preferred shares | | (240 | ) | | | (240 | ) --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Proceeds from sale of common stock | | 224 | | | | — | --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Purchases of treasury stock | | — | | | | (1,022 | ) --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Net cash used in financing activities | | (16 | ) | | | (1,262 | ) --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Net decrease in cash and cash equivalents | | (17,366 | ) | | | (9,031 | ) --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Cash and cash equivalents at beginning of period | | 43,045 | | | | 47,957 | --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Cash and cash equivalents at end of period | $ | 25,679 | | | $ | 38,926 | --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Supplemental disclosure of cash flow information: | | | | | | | --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Cash paid during the period for: | | | | | | | --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Income taxes | $ | 35 | | | $ | 293 | --------------------------------------------------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- See accompanying notes to consolidated financial statements. 6 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ($ amounts in thousands, except share and per share data) 1. Nature of Business Maison Insurance Holdings, Inc. was incorporated on October 2, 2012 in the State of Delaware. On November 19, 2013, its legal name was changed from Maison Insurance Holdings, Inc. to 1347 Property Insurance Holdings, Inc. (“PIH”). PIH is a holding company and is engaged, through its subsidiaries, in the property and casualty insurance business. Unless context denotes otherwise, the terms “Company,” “we,” “us,” and “our” refer to 1347 Property Insurance Holdings, Inc., and its subsidiaries. Prior to March 31, 2014, PIH was a wholly owned subsidiary of Kingsway America Inc. (“KAI”). KAI, in turn, is a wholly owned subsidiary of Kingsway Financial Services Inc. (“KFSI”), a publicly owned holding company based in Toronto, Ontario, Canada. On March 31, 2014, PIH completed an initial public offering (“IPO”) of its common stock. On June 13, 2014, PIH completed a follow-on offering of its common stock to the public. Through the combination of the IPO and follow-on offering, PIH issued approximately five million shares of its common stock, while KAI, and entities affiliated with KAI retained one million shares of PIH. On October 25, 2017, KAI entered into a purchase agreement with Fundamental Global Investors, LLC (“FGI”) pursuant to which KAI agreed to sell 900,000 shares of our common stock to FGI or to one of FGI’s affiliate companies in two separate transactions. The first transaction, for the sale of 475,428 shares of our common stock, occurred on November 1, 2017. The second transaction, for the sale of 424,572 shares of our common stock is conditioned on approval of the transaction by both the LDI and FL OIR by January 23, 2018. FGI is affiliated with D. Kyle Cerminara, where he serves as Chief Executive Officer, Co-Founder and Partner, and Lewis M. Johnson, where he serves as President, Co-Founder and Partner. Messrs. Cerminara and Johnson are also members of our Board of Directors. Should the second transaction be consummated, FGI, and entities affiliated with FGI, would own 43% of our outstanding common shares. PIH has three wholly-owned subsidiaries; Maison Insurance Company (“Maison”), a Louisiana-domiciled property and casualty insurance company, Maison Managers, Inc. (“MMI”), a managing general agent, incorporated in the State of Delaware, and ClaimCor, LLC (“ClaimCor”), a Florida based claims solutions company. Maison processes claims made by its policyholders through ClaimCor, and also through various third-party claims adjusting companies. MMI has ultimate authority over the claims handling process, while the agencies that we appoint have no authority to settle our claims or otherwise exercise control over the claims process. Maison began providing homeowners insurance, manufactured home insurance and dwelling fire insurance to individuals in Louisiana in December 2012. Maison writes both full peril property policies as well as wind/hail only exposures in Louisiana and distributes its policies through a network of independent insurance agencies. Maison began assuming wind/hail only insurance for commercial properties in Texas beginning in June 2015. In September 2015, Maison began writing manufactured home policies in the State of Texas on a direct basis, and in March 2016, Maison began writing homeowner policies in Texas. In addition to the voluntary policies that Maison writes, Maison has participated in the last five rounds of take-outs from Louisiana Citizens Property Insurance Company (“LA Citizens”), occurring on December 1st of each year, as well as the inaugural depopulation of policies from the Texas Windstorm Insurance Association (“TWIA”), which occurred on December 1, 2016. Under these programs, state-approved insurance companies, such as Maison, have the opportunity to assume insurance policies written by both LA Citizens and TWIA. The majority of policies that we have obtained through LA Citizens as well as all of the policies we have obtained through TWIA cover losses arising only from wind and hail. Prior to our takeout, both LA Citizens and TWIA policyholders were not able to obtain such coverage from any other marketplace. On March 1, 2017, Maison received a certificate of authority from the Florida Office of Insurance Regulation (“FL OIR”) which authorizes Maison to write personal lines insurance in the State of Florida. Pursuant to the consent order issued, Maison has agreed to comply with certain requirements as outlined by the FL OIR until Maison can demonstrate three consecutive years of net income following the Company’s admission into Florida as evidenced by its Annual Statement filed with the FL OIR via the National Association of Insurance Commissioners electronic filing system. Among other requirements, the FL OIR requires the following as conditions related to the issuance of Maison’s certificate of authority: 7 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ($ amounts in thousands, except share and per share data) ● | Although domiciled in the State of Louisiana, Maison has agreed to comply with the Florida Insurance Code as if Maison were a domestic insurer within the State of Florida; --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ● | Maison has agreed to maintain capital and surplus as to policyholders of no less than $35,000; --+---------------------------------------------------------------------------------------------------------------------------------------- ● | Maison has agreed to receive prior approval from the FL OIR prior to the payment of any dividends; and --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ● | Maison has agreed to receive written approval from the FL OIR regarding any form of policy issued or rate charged to its policyholders prior to utilizing any such form or rate for policies written in the State of Florida. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- To comply with the consent order, on March 31, 2017, Maison received a capital contribution from PIH in the amount of $16,000. As of September 30, 2017, Maison has not written any insurance policies covering risks in the State of Florida. On September 29, 2017, Maison received authorization from the FL OIR to assume personal lines policies from Florida Citizens Property Insurance Corporation (“FL Citizens”) pursuant to a proposal of depopulation which Maison filed with FL Citizens on August 18, 2017. Accordingly, Maison plans to enter the Florida market via the assumption of policies from FL Citizens in December, 2017. The order approving Maison’s assumption of policies limits the number of policies which Maison may assume in 2017, and also stipulates that Maison maintain catastrophe reinsurance at such levels as deemed appropriate by the FL OIR. MMI serves as the Company’s management services subsidiary, known as a managing general agency, and provides underwriting, policy administration, claims administration, marketing, accounting, and other management services to Maison. MMI contracts primarily with independent agencies for policy sales and services, and also contracts with an independent third-party for policy administration services. As a managing general agency, MMI is licensed by and subject to the regulatory oversight of the Louisiana Department of Insurance (“LDI”), Texas Department of Insurance (“TDI”) and the FL OIR. 2. Significant Accounting Policies Basis of Presentation: These statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”). Principles of Consolidation: The accompanying consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany balances and transactions have been eliminated upon consolidation. The Use of Estimates in the Preparation of Consolidated Financial Statements: The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures about contingent assets and liabilities at the dates of the consolidated financial statements and the reported amounts of revenues and expenses during the period reported. Actual results could differ from those estimates. Changes in estimates are recorded in the accounting period in which the change is determined. The critical accounting estimates and assumptions in the accompanying consolidated financial statements include the provision for loss and loss adjustment expense reserves (as well as the associated reinsurance recoverable on those reserves), the valuation of fixed income and equity securities, the valuation of net deferred income taxes, the valuation of various securities that we have issued in conjunction with the termination of the management services agreement with 1347 Advisors, LLC, and the valuation of deferred policy acquisition costs. Investments: Investments in fixed income and equity securities are classified as available-for-sale and reported at estimated fair value. Unrealized gains and losses are included in accumulated other comprehensive income (loss), net of tax, until sold or an other-than-temporary impairment is recognized, at which point the cumulative unrealized gains or losses are transferred to the consolidated statement of operations. 8 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ($ amounts in thousands, except share and per share data) Other investments include investments in limited liability companies in which the Company’s interests are deemed minor and, therefore, are accounted for under the cost method of accounting, which approximates their fair value. Also included in other investments is a fixed rate certificate of deposit with an original maturity of 15 months. Short-term investments, which consist of investments with maturities between three months and one year, are reported at cost, which approximates fair value due to their short-term nature. Realized gains and losses on sales of investments are determined on a first-in, first-out basis, and are included in net investment income. Interest income is included in net investment income and is recorded as it accrues. The Company accounts for its investments using trade date accounting. The Company conducts a quarterly review to identify and evaluate investments that show objective indications of possible impairment. Impairment is charged to the statement of operations if the fair value of the instrument falls below its amortized cost and the decline is considered other-than-temporary. Factors considered in determining whether a loss is other-than-temporary include the length of time and extent to which fair value has been below cost, the financial condition and near-term prospects of the issuer, and the Company’s ability and intent to hold the investment for a period of time sufficient to allow for any anticipated recovery. Cash and Cash Equivalents: Cash and cash equivalents include cash and highly liquid investments with original maturities of 90 days or less. Premiums Receivable: Premiums receivable include premium balances due and uncollected as well as installment premiums not yet due from our independent agencies and insureds. Premiums receivable are reported net of an estimated allowance for credit losses. Reinsurance: Reinsurance premiums, losses, and loss adjustment expenses are accounted for on a basis consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. Premiums and losses ceded to other companies have been reported as a reduction of premium revenue and incurred net losses and loss adjustment expenses. A reinsurance recoverable is recorded for that portion of paid and unpaid losses and loss adjustment expenses that are ceded to other companies. Deferred Policy Acquisition Costs: The Company defers commissions, premium taxes, assessments and other underwriting and agency expenses that are directly related to successful efforts to acquire new or existing insurance policies to the extent they are considered recoverable. Costs deferred on insurance products are amortized over the period in which premiums are earned. Costs associated with unsuccessful efforts or costs that cannot be tied directly to a successful policy acquisition are expensed as incurred, as opposed to being deferred and amortized as the corresponding premium is earned. The method followed in determining the deferred policy acquisition costs limits the deferral to its realizable value by giving consideration to estimated future loss and loss adjustment expenses to be incurred as revenues are earned. Anticipated investment income is included in determining the realizable value of the deferred policy acquisition costs. Changes in estimates, if any, are recorded in the accounting period in which they are determined. 9 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ($ amounts in thousands, except share and per share data) Income Taxes: The Company follows the asset and liability method of accounting for income taxes, whereby deferred income tax assets and liabilities are recognized for (i) the differences between the financial statement carrying amount of existing assets and liabilities and their respective tax bases and (ii) loss and tax credit carry-forwards. Deferred income tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the date of enactment. Future tax benefits are recognized to the extent that realization of such benefits is more likely than not and a valuation allowance is established for any portion of a deferred tax asset that management believes will not be realized. Current federal income taxes are charged or credited to operations based upon amounts estimated to be payable or recoverable as a result of taxable operations for the current year. The Company recognizes interest and penalties, if any, related to unrecognized tax benefits in income tax expense (benefit). Property and Equipment: Property and equipment is reported at historical cost less accumulated depreciation. Depreciation of property and equipment is recorded on a straight-line basis over estimated useful life which range from seven years for furniture, five years for vehicles, three years for computer equipment, and the shorter of estimated useful life or the term of the lease for leasehold improvements. Property and equipment is estimated to have no salvage value at its useful life-end. Rent expense for the Company’s office leases is recognized on a straight-line basis over the term of the lease. Rent expense was $255 and $258 for the nine months ended September 30, 2017 and 2016, respectively. Loss and Loss Adjustment Expense Reserves: Loss and loss adjustment expense reserves represent the estimated liabilities for reported loss events, incurred but not yet reported loss events and the related estimated loss adjustment expenses. The Company performs a continuing review of its loss and loss adjustment expense reserves, including its reserving techniques as well as the impact of reinsurance on our loss reserves. The loss and loss adjustment expense reserves are also reviewed, at minimum, on an annual basis by qualified third party actuaries. Since the loss and loss adjustment expense reserves are based on estimates, the ultimate liability may be more or less than such reserves. The effects of changes in such estimated reserves are included in the results of income in the period in which the estimates are changed. Such changes in estimates could occur in a future period and may be material to the Company’s results of operations and financial position in such period. Concentration of Credit Risk: Financial instruments which potentially expose the Company to concentrations of credit risk include investments, cash, premiums receivable, and amounts due from reinsurers on losses incurred. The Company maintains its cash with two major U.S. domestic banking institutions and two regional banks headquartered in the Southeastern United States. Such amounts are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to $250 per institution. At September 30, 2017, the Company held funds on deposit at these institutions in excess of these FDIC insured amounts. The terms of these deposits are on demand to mitigate some of the associated risk. The Company has not incurred losses related to these deposits. The Company has not experienced significant losses related to premiums receivable from its policyholders and management believes that amounts provided as an allowance for credit losses is adequate. The Company has not experienced any losses on amounts due from reinsurers. In order to limit the credit risk associated with amounts potentially due from reinsurers, the Company uses several different reinsurers, all of which have an A.M. Best Rating of A- (Excellent) or better. Absent such rating, the Company has required its reinsurers to place collateral on deposit with an independent institution under a trust agreement for the Company’s benefit. The Company also has risk associated with the lack of geographic diversification due to the fact that through September 30, 2017, Maison exclusively underwrote policies in Louisiana and Texas. The Company insures personal property located in 63 of the 64 parishes in the State of Louisiana. As of September 30, 2017, these policies are concentrated within these parishes, presented as a percentage of our total policies in force in all states, as follows: Jefferson Parish 12.6%, Saint Tammany Parish 12.5%, East Baton Rouge Parish 7.2%, and Livingston Parish 5.1%. No other parish individually has over 5.0% of the policies in force as of September 30, 2017. On a direct basis, Maison writes in 150 of the 254 counties that comprise the State of Texas; however, no single county represents over 5.0% of the Company’s total policies in force as of September 30, 2017. 10 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ($ amounts in thousands, except share and per share data) Revenue Recognition: Premium revenue is recognized on a pro rata basis over the term of the respective policy contract. Unearned premium reserves represent the portion of premium written that is applicable to the unexpired term of policies in force. Service charges on installment premiums are recognized as income upon receipt of related installment payments and are reflected in other income. Revenue from other policy fees is deferred and recognized over the terms of the respective policy period, with revenue reflected in other income. Any customer payment received is applied first to any service charge or policy fee due, with the remaining amount applied toward any premium due. Ceded premiums are charged to income over the applicable term of the various reinsurance contracts with third party reinsurers. Ceded unearned premiums represent the unexpired portion of premiums ceded to reinsurers and are reported as an asset on the Company’s consolidated balance sheets. Premiums collected in advance occur when the policyholder premium is paid in advance of the effective commencement period of the policy and are recorded as a liability on the Company’s consolidated balance sheets. Stock-Based Compensation: The Company has accounted for stock-based compensation under the provisions of ASC Topic 718 – Stock Compensation, which requires the use of the fair-value based method to determine compensation for all arrangements under which employees and others receive shares of stock or equity instruments (stock options and common stock purchase warrants). The fair value of each stock option award is estimated on the date of grant using the Black-Scholes valuation model using assumptions for expected volatility, expected dividends, expected term, and the risk-free interest rate. The fair value of each stock option award is recorded as compensation expense on a straight-line basis over the requisite service period, which is generally the period in which the stock options vest, with a corresponding increase to additional paid-in capital. The Company has also issued restricted stock units (“RSUs”) to certain of its employees which have been accounted for as equity based awards since, upon vesting, they are required to be settled in the Company’s common shares. The Company used a Monte Carlo valuation model to estimate the fair value of these awards upon grant date as the vesting of these RSUs occurs solely upon market-based conditions. The fair value of each RSU is recorded as compensation expense over the derived service period, as determined by the valuation model. Should the market-based condition be achieved prior to the expiration of the derived service period, any unrecognized cost will be recorded as compensation expense in the period in which the RSUs actually vest. Fair Value of Financial Instruments: The carrying values of certain financial instruments, including cash, short-term investments, premiums receivable and accounts payable, approximate fair value due to their short-term nature. The Company measures the fair value of financial instruments in accordance with GAAP, which defines fair value as the exchange price that would be received for an asset (or paid to transfer a liability) in the principal or most advantageous market for the asset (or liability) in an orderly transaction between market participants on the measurement date. GAAP also establishes a fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. 11 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ($ amounts in thousands, except share and per share data) Earnings Per Common Share: Basic earnings per common share is computed using the weighted average number of shares outstanding during the respective period. Diluted earnings per common share assumes conversion of all potentially dilutive outstanding stock options, warrants or other convertible financial instruments. Potential common shares outstanding are excluded from the calculation of diluted earnings per share if their effect is anti-dilutive. Operating Segments: The Company operates in a single segment – property and casualty insurance. 3. Recently Issued Accounting Standards ASU 2014-09: Revenue from Contracts with Customers: The FASB has issued ASU No. 2014-09, “Revenue from Contracts with Customers”, and related amendments ASU 2015-14, ASU 2016-10, ASU 2016-12, ASU 2016-20, ASU 2017-05 and ASU 2017-13, (collectively, “Topic 606”). Topic 606 creates a new comprehensive revenue recognition standard that will serve as a single source of revenue guidance for all companies that either enter into contracts with customers to transfer goods or services or enter into contracts for the transfer of non-financial assets, unless those contracts are within the scope of other standards, such as insurance contracts. Topic 606 becomes effective for annual periods beginning after December 15, 2017, and interim periods within those fiscal years. The Company will adopt Topic 606 on the effective date and since virtually all of the Company’s revenues relate to insurance contracts and investment income, the adoption of Topic 606 is not expected to have a material impact on the Company’s revenues. The Company will continue to monitor and examine transactions that could potentially fall within the scope of Topic 606 as such are consummated. ASU 2016-01: Financial Instruments-Overall: In January 2016, the FASB issued ASU 2016-01: Financial Instruments-Overall: Recognition and Measurement of Financial Assets and Financial Liabilities. ASU 2016-01 amends various aspects of the recognition, measurement, presentation, and disclosure for financial instruments. Most significantly, ASU 2016-01 requires equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of an investee) to be measured at fair value with changes in fair value recognized in net income (loss). ASU 2016-01 is effective for fiscal years beginning after December 15, 2018, and interim periods within fiscal years beginning after December 15, 2019. ASU 2016-01 will be applied using a cumulative-effect adjustment to retained earnings as of the beginning of the fiscal year of adoption. Adoption of ASU 2016-01 is not expected to have a material impact on the Company’s financial position, cash flows, or total comprehensive income, but could impact the Company’s results of operations and earnings per share as changes in fair value will be presented in net income rather than other comprehensive income. ASU 2016-02: Leases: In February 2016, the FASB issued ASU 2016-02: Leases. ASU 2016-02 was issued to improve the financial reporting of leasing transactions. Under current guidance for lessees, leases are only included on the balance sheet if certain criteria, classifying the agreement as a capital lease, are met. This update will require the recognition of a right-of-use asset and a corresponding lease liability, discounted to present value, for all leases that extend beyond 12 months. For operating leases, the asset and liability will be expensed over the lease term on a straight-line basis, with all cash flows included in the operating section of the statement of cash flows. For finance leases, interest on the lease liability will be recognized separately from the amortization of the right-of-use asset in the statement of comprehensive income while the repayment of the principal portion of the lease liability will be classified as a financing activity and the interest component will be included in the operating section of the statement of cash flows. ASU 2016-02 is effective for annual reporting periods beginning after December 15, 2019, and interim periods within those fiscal years beginning after December 15, 2020. Early adoption is permitted. Upon adoption, leases will be recognized and measured at the beginning of the earliest period presented using a modified retrospective approach. The Company has reviewed its existing lessee obligations and has determined that ASU 2016-02 will apply should the Company renew its existing leases, or enter into any new lease agreements. 12 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ($ amounts in thousands, except share and per share data) ASU 2016-09: Stock Compensation: In March 2016, the FASB issued ASU 2016-09: Compensation – Stock Compensation: Improvement to Employee Share-Based Payment Accounting. ASU 2016-09 was issued to simplify the accounting for share-based payment awards. The guidance requires that all tax effects related to share-based payment be made through the statement of operations at the time of settlement as opposed to the current guidance that requires excess tax benefits to be recognized in additional paid-in-capital. ASU 2016-09 also removes the requirement to delay recognition of a tax benefit until it reduces current taxes payable. The change is required to be applied on a modified retrospective basis, with a cumulative effect adjustment to opening accumulated deficit. Additionally, all tax related cash flows resulting from share-based payments are to be reported as operating activities on the statement of cash flows, a departure from the current requirement which presents tax benefits as an inflow from financing activities and an outflow from operating activities. ASU 2016-09 is effective for annual and interim reporting periods beginning after December 15, 2017 and interim periods within annual periods beginning after December 15, 2018. Early adoption is permitted with any adjustments reflected as of the beginning of the fiscal year of adoption. The Company does not believe the adoption of ASU 2016-09 will have a material impact on its consolidated financial statements. ASU 2016-13: Financial Instruments – Credit Losses: In June 2016, the FASB issued ASU 2016-13: Financial Instruments – Credit Losses: Measurement of Credit Losses on Financial Instruments. ASU 2016-13 was issued to provide financial statement users with more useful information regarding the expected credit losses on financial instruments held as assets. Under current GAAP, financial statement recognition for credit losses on financial instruments was generally delayed until the loss was probable of occurring. The amendments of ASU 2016-13 eliminate this probable initial recognition threshold and instead reflect an entity’s current estimate of all expected credit losses. The amendments also broaden the information that an entity must consider in developing its expected credit loss estimates for those assets measured at amortized cost by using forecasted information instead of the current methodology which only considered past events and current conditions. Under ASU 2016-13, credit losses on available-for-sale debt securities will be measured in a manner similar to current GAAP; however, the amendments require that credit losses be presented as an allowance against the investment, rather than as a write-down. The amendments also allow the entity to record reversals of credit losses in current period net income, which is prohibited under current GAAP. The amendments in this update are effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years, with early adoption permitted. The Company is currently evaluating the impact of the adoption of ASU 2016-02 on its consolidated financial statements. 4. Investments A summary of the amortized cost, estimated fair value, and gross unrealized gains and losses on the Company’s investments in fixed income and equity securities at September 30, 2017 and December 31, 2016 is as follows. As of September 30, 2017 | Amortized Cost | | Gross Unrealized Gains | | | Gross Unrealized Losses | | Estimated Fair Value | --------------------------------------------------------------------+-------------------------+--------+----------------------------+---+-----+-----------------------------+---+--------------------------+-- Fixed income securities: | | | | | | | | | | | --------------------------------------------------------------------+-------------------------+--------+----------------------------+---+-----+-----------------------------+---+--------------------------+---+---+------- U.S. government | $ | 2,911 | | $ | 6 | | $ | (18 | ) | $ | 2,899 --------------------------------------------------------------------+-------------------------+--------+----------------------------+---+-----+-----------------------------+---+--------------------------+---+---+------- State municipalities and political subdivisions | | 5,379 | | | 12 | | | (26 | ) | | 5,365 --------------------------------------------------------------------+-------------------------+--------+----------------------------+---+-----+-----------------------------+---+--------------------------+---+---+------- Asset-backed securities and collateralized mortgage obligations | | 16,727 | | | 26 | | | (119 | ) | | 16,635 --------------------------------------------------------------------+-------------------------+--------+----------------------------+---+-----+-----------------------------+---+--------------------------+---+---+------- Corporate | | 20,235 | | | 113 | | | (40 | ) | | 20,308 --------------------------------------------------------------------+-------------------------+--------+----------------------------+---+-----+-----------------------------+---+--------------------------+---+---+------- Total fixed income securities | | 45,252 | | | 157 | | | (202 | ) | | 45,207 --------------------------------------------------------------------+-------------------------+--------+----------------------------+---+-----+-----------------------------+---+--------------------------+---+---+------- Equity securities: | | | | | | | | | | | --------------------------------------------------------------------+-------------------------+--------+----------------------------+---+-----+-----------------------------+---+--------------------------+---+---+------- Common stock | | 1,571 | | | 66 | | | (25 | ) | | 1,612 --------------------------------------------------------------------+-------------------------+--------+----------------------------+---+-----+-----------------------------+---+--------------------------+---+---+------- Warrants to purchase common stock | | 72 | | | 79 | | | (29 | ) | | 122 --------------------------------------------------------------------+-------------------------+--------+----------------------------+---+-----+-----------------------------+---+--------------------------+---+---+------- Rights to purchase common stock | | 39 | | | 3 | | | (5 | ) | | 37 --------------------------------------------------------------------+-------------------------+--------+----------------------------+---+-----+-----------------------------+---+--------------------------+---+---+------- Total equity securities | | 1,682 | | | 148 | | | (59 | ) | | 1,771 --------------------------------------------------------------------+-------------------------+--------+----------------------------+---+-----+-----------------------------+---+--------------------------+---+---+------- Total fixed income and equity securities | $ | 46,934 | | $ | 305 | | $ | (261 | ) | $ | 46,978 --------------------------------------------------------------------+-------------------------+--------+----------------------------+---+-----+-----------------------------+---+--------------------------+---+---+------- As of December 31, 2016 | | | | | | | | | | | --------------------------------------------------------------------+-------------------------+--------+----------------------------+---+-----+-----------------------------+---+--------------------------+---+---+------- Fixed income securities: | | | | | | | | | | | --------------------------------------------------------------------+-------------------------+--------+----------------------------+---+-----+-----------------------------+---+--------------------------+---+---+------- U.S. government | $ | 1,623 | | $ | 1 | | $ | (20 | ) | $ | 1,604 --------------------------------------------------------------------+-------------------------+--------+----------------------------+---+-----+-----------------------------+---+--------------------------+---+---+------- State municipalities and political subdivisions | | 2,271 | | | 2 | | | (27 | ) | | 2,246 --------------------------------------------------------------------+-------------------------+--------+----------------------------+---+-----+-----------------------------+---+--------------------------+---+---+------- Asset-backed securities and collateralized mortgage obligations | | 12,095 | | | 9 | | | (136 | ) | | 11,968 --------------------------------------------------------------------+-------------------------+--------+----------------------------+---+-----+-----------------------------+---+--------------------------+---+---+------- Corporate | | 10,804 | | | 28 | | | (91 | ) | | 10,741 --------------------------------------------------------------------+-------------------------+--------+----------------------------+---+-----+-----------------------------+---+--------------------------+---+---+------- Total fixed income securities | | 26,793 | | | 40 | | | (274 | ) | | 26,559 --------------------------------------------------------------------+-------------------------+--------+----------------------------+---+-----+-----------------------------+---+--------------------------+---+---+------- Equity securities: | | | | | | | | | | | --------------------------------------------------------------------+-------------------------+--------+----------------------------+---+-----+-----------------------------+---+--------------------------+---+---+------- Common stock | | 1,000 | | | 136 | | | — | | | 1,136 --------------------------------------------------------------------+-------------------------+--------+----------------------------+---+-----+-----------------------------+---+--------------------------+---+---+------- Total equity securities | | 1,000 | | | 136 | | | — | | | 1,136 --------------------------------------------------------------------+-------------------------+--------+----------------------------+---+-----+-----------------------------+---+--------------------------+---+---+------- Total fixed income and equity securities | $ | 27,793 | | $ | 176 | | $ | (274 | ) | $ | 27,695 --------------------------------------------------------------------+-------------------------+--------+----------------------------+---+-----+-----------------------------+---+--------------------------+---+---+------- 13 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ($ amounts in thousands, except share and per share data) The table below summarizes the Company’s fixed income securities at September 30, 2017 by contractual maturity periods. Actual results may differ as issuers may have the right to call or prepay obligations, with or without penalties, prior to the contractual maturity of these obligations. Matures in: | Amortized Cost | | Estimated Fair Value | --------------------------------+-------------------------+--------+--------------------------+-- One year or less | $ | 2,416 | | $ | 2,415 --------------------------------+-------------------------+--------+--------------------------+---+------- More than one to five years | | 19,759 | | | 19,757 --------------------------------+-------------------------+--------+--------------------------+---+------- More than five to ten years | | 11,780 | | | 11,804 --------------------------------+-------------------------+--------+--------------------------+---+------- More than ten years | | 11,297 | | | 11,231 --------------------------------+-------------------------+--------+--------------------------+---+------- Total | $ | 45,252 | | $ | 45,207 --------------------------------+-------------------------+--------+--------------------------+---+------- The following table highlights, by loss position and security type, those fixed income and equity securities in unrealized loss positions as of September 30, 2017 and December 31, 2016. The tables segregate the holdings based on the period of time the investments have been continuously held in unrealized loss positions. There were 149 and 122 fixed income investments that were in unrealized loss positions as of September 30, 2017 and December 31, 2016, respectively. The Company held 12 equity investments in unrealized loss positions as of September 30, 2017. | Less than 12 Months | | Greater than 12 Months | | | Total --------------------------------------------------------------------+--------------------------+--------+----------------------------+---+------+------------------------- As of September 30, 2017 | Estimated Fair Value | | Unrealized Loss | | | Estimated Fair Value | | Unrealized Loss | Estimated Fair Value | | | Unrealized Loss | --------------------------------------------------------------------+--------------------------+--------+----------------------------+---+------+--------------------------+---+---------------------+--------------------------+-----+---+---------------------+-- Fixed income securities: | | | | | | | | | | | | | | | | | --------------------------------------------------------------------+--------------------------+--------+----------------------------+---+------+--------------------------+---+---------------------+--------------------------+-----+---+---------------------+---+--------+---+------+-- U.S. government | $ | 2,041 | | $ | (18 | ) | $ | 175 | $ | — | | | $ | 2,216 | $ | (18 | ) --------------------------------------------------------------------+--------------------------+--------+----------------------------+---+------+--------------------------+---+---------------------+--------------------------+-----+---+---------------------+---+--------+---+------+-- State municipalities and political subdivisions | | 2,357 | | | (13 | ) | | 589 | | (13 | ) | | | 2,946 | | (26 | ) --------------------------------------------------------------------+--------------------------+--------+----------------------------+---+------+--------------------------+---+---------------------+--------------------------+-----+---+---------------------+---+--------+---+------+-- Asset-backed securities and collateralized mortgage obligations | | 11,682 | | | (83 | ) | | 1,675 | | (36 | ) | | | 13,357 | | (119 | ) --------------------------------------------------------------------+--------------------------+--------+----------------------------+---+------+--------------------------+---+---------------------+--------------------------+-----+---+---------------------+---+--------+---+------+-- Corporate | | 6,568 | | | (23 | ) | | 556 | | (16 | ) | | | 7,124 | | (39 | ) --------------------------------------------------------------------+--------------------------+--------+----------------------------+---+------+--------------------------+---+---------------------+--------------------------+-----+---+---------------------+---+--------+---+------+-- Total fixed income securities | | 22,648 | | | (137 | ) | | 2,995 | | (65 | ) | | | 25,643 | | (202 | ) --------------------------------------------------------------------+--------------------------+--------+----------------------------+---+------+--------------------------+---+---------------------+--------------------------+-----+---+---------------------+---+--------+---+------+-- Equity securities: | | | | | | | | — | | — | | | | | | | --------------------------------------------------------------------+--------------------------+--------+----------------------------+---+------+--------------------------+---+---------------------+--------------------------+-----+---+---------------------+---+--------+---+------+-- Common stock | | 237 | | | (25 | ) | | — | | — | | | | 237 | | (25 | ) --------------------------------------------------------------------+--------------------------+--------+----------------------------+---+------+--------------------------+---+---------------------+--------------------------+-----+---+---------------------+---+--------+---+------+-- Warrants to purchase common stock | | 23 | | | (29 | ) | | — | | — | | | | 23 | | (29 | ) --------------------------------------------------------------------+--------------------------+--------+----------------------------+---+------+--------------------------+---+---------------------+--------------------------+-----+---+---------------------+---+--------+---+------+-- Rights to purchase common stock | | 18 | | | (5 | ) | | — | | — | | | | 18 | | (5 | ) --------------------------------------------------------------------+--------------------------+--------+----------------------------+---+------+--------------------------+---+---------------------+--------------------------+-----+---+---------------------+---+--------+---+------+-- Total equity securities | | 278 | | | (59 | ) | | — | | | | | | 278 | | (59 | ) --------------------------------------------------------------------+--------------------------+--------+----------------------------+---+------+--------------------------+---+---------------------+--------------------------+-----+---+---------------------+---+--------+---+------+-- Total fixed income and equity securities | $ | 22,926 | | $ | (196 | ) | $ | 2,995 | $ | (65 | ) | | $ | 25,921 | $ | (261 | ) --------------------------------------------------------------------+--------------------------+--------+----------------------------+---+------+--------------------------+---+---------------------+--------------------------+-----+---+---------------------+---+--------+---+------+-- As of December 31, 2016 | | | | | | | | | | | | | | | | | --------------------------------------------------------------------+--------------------------+--------+----------------------------+---+------+--------------------------+---+---------------------+--------------------------+-----+---+---------------------+---+--------+---+------+-- Fixed income securities: | | | | | | | | | | | | | | | | | --------------------------------------------------------------------+--------------------------+--------+----------------------------+---+------+--------------------------+---+---------------------+--------------------------+-----+---+---------------------+---+--------+---+------+-- U.S. government | $ | 1,303 | | $ | (20 | ) | $ | — | $ | — | | | $ | 1,303 | $ | (20 | ) --------------------------------------------------------------------+--------------------------+--------+----------------------------+---+------+--------------------------+---+---------------------+--------------------------+-----+---+---------------------+---+--------+---+------+-- State municipalities and political subdivisions | | 1,537 | | | (27 | ) | | — | | — | | | | 1,537 | | (27 | ) --------------------------------------------------------------------+--------------------------+--------+----------------------------+---+------+--------------------------+---+---------------------+--------------------------+-----+---+---------------------+---+--------+---+------+-- Asset-backed securities and collateralized mortgage obligations | | 9,552 | | | (133 | ) | | 460 | | (3 | ) | | | 10,012 | | (136 | ) --------------------------------------------------------------------+--------------------------+--------+----------------------------+---+------+--------------------------+---+---------------------+--------------------------+-----+---+---------------------+---+--------+---+------+-- Corporate | | 5,952 | | | (91 | ) | | — | | — | | | | 5,952 | | (91 | ) --------------------------------------------------------------------+--------------------------+--------+----------------------------+---+------+--------------------------+---+---------------------+--------------------------+-----+---+---------------------+---+--------+---+------+-- Total fixed income securities | $ | 18,344 | | $ | (271 | ) | $ | 460 | $ | (3 | ) | | $ | 18,804 | $ | (274 | ) --------------------------------------------------------------------+--------------------------+--------+----------------------------+---+------+--------------------------+---+---------------------+--------------------------+-----+---+---------------------+---+--------+---+------+-- Under the terms of the certificate of authority granted to Maison by the Texas Department of Insurance, Maison is required to pledge securities totaling at least $2,000 with the State of Texas. Maison deposited the required securities with the State of Texas on May 13, 2015. These securities consist of various fixed income securities listed in the preceding tables which have an amortized cost basis of $2,001 and estimated fair value of $1,998 as of September 30, 2017. 14 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ($ amounts in thousands, except share and per share data) The Company’s other investments are comprised of investments in two limited partnerships which seek to provide equity and asset-backed debt investment in a variety of privately-owned companies. The Company has committed to a total investment of $1,000, of which the limited partnerships have drawn down approximately $645 through September 30, 2017. One of these limited partnerships is managed by Argo Management Group, LLC, an entity which, as of April 21, 2016 is wholly owned by KFSI (see Note 12 – Related Party Transactions). The Company has accounted for its investments under the cost method as the instruments do not have readily determinable fair values and the Company does not exercise significant influence over the operations of the limited partnerships or the underlying privately-owned companies. Also included in other investments is a certificate of deposit in the amount of $300 with an original term of 18 months deposited with the State of Florida pursuant to the terms of the certificate of authority issued to Maison from the FL OIR. Other-than-Temporary Impairment: The establishment of an other-than-temporary impairment on an investment requires a number of judgments and estimates. The Company performs a quarterly analysis of the individual investments to determine if declines in market value are other-than-temporary. The analysis includes some or all of the following procedures as deemed appropriate by the Company: ● | considering the extent and length of time during which the market value has been below cost; --+-------------------------------------------------------------------------------------------------------------------------------------- ● | identifying any circumstances which management believes may impact the recoverability of the unrealized loss positions; --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ● | obtaining a valuation analysis from a third-party investment manager regarding the intrinsic value of these investments based upon their knowledge and experience combined with market-based valuation techniques; --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ● | reviewing the historical trading volatility and trading range of the investment and certain other similar investments; --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ● | assessing if declines in market value are other-than-temporary for debt instruments based upon the investment grade credit ratings from third-party credit rating agencies; --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ● | assessing the timeliness and completeness of principal and interest payment due from the investee; and --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ● | assessing the Company’s ability and intent to hold these investments until the impairment may be recovered. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- The risks and uncertainties inherent in the assessment methodology used to determine declines in market value that are other-than-temporary include, but may not be limited to, the following: ● | the opinions of professional investment managers could be incorrect; --+-------------------------------------------------------------------------------------------------------------- ● | the past trading patterns of investments may not reflect their future valuation trends; --+--------------------------------------------------------------------------------------------------------------------------------- ● | the credit ratings assigned by credit rating agencies may be incorrect due to unforeseen events or unknown facts related to the investee company’s financial situation; and --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ● | the historical debt service record of an investment may not be indicative of future performance and may not reflect a company’s unknown underlying financial problems. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- The Company has reviewed currently available information regarding the investments it holds which have estimated fair values that are less than their carrying amounts and believes that these unrealized losses are primarily due to temporary market and sector-related factors rather than to issuer-specific factors. The Company does not intend to sell these investments in the short term, and it is not likely that it will be required to sell these investments before the recovery of their amortized cost. Accordingly, all of the Company’s investments were in good standing and there were no write-downs for other-than-temporary impairments on the Company’s investments for the nine months ended September 30, 2017 and 2016. 15 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ($ amounts in thousands, except share and per share data) The Company does not have any exposure to subprime mortgage-backed investments. Net investment income for the three and nine months ended September 30, 2017 and 2016 was as follows: | Three months ended September 30, | | | Nine months ended September 30, | ------------------------------------------+---------------------------------------------------------------------------------------------------------------------+-----+---+------------------------------------------+-- | 2017 | | | 2016 | | | 2017 | | 2016 | ------------------------------------------+---------------------------------------------------------------------------------------------------------------------+-----+---+------------------------------------------+---+-----+------+---+------+-- Investment income: | | | | | | | | | | | | | ------------------------------------------+---------------------------------------------------------------------------------------------------------------------+-----+---+------------------------------------------+---+-----+------+---+------+---+---+-----+-- Interest on fixed income securities | $ | 231 | | | $ | 123 | | $ | 548 | | $ | 332 | ------------------------------------------+---------------------------------------------------------------------------------------------------------------------+-----+---+------------------------------------------+---+-----+------+---+------+---+---+-----+-- Interest on cash and cash equivalents | | 30 | | | | 34 | | | 126 | | | 89 | ------------------------------------------+---------------------------------------------------------------------------------------------------------------------+-----+---+------------------------------------------+---+-----+------+---+------+---+---+-----+-- Realized gain upon sale of securities | | 4 | | | | — | | | 68 | | | — | ------------------------------------------+---------------------------------------------------------------------------------------------------------------------+-----+---+------------------------------------------+---+-----+------+---+------+---+---+-----+-- Other | | — | | | | 5 | | | — | | | 7 | ------------------------------------------+---------------------------------------------------------------------------------------------------------------------+-----+---+------------------------------------------+---+-----+------+---+------+---+---+-----+-- Gross investment income | | 265 | | | | 162 | | | 742 | | | 428 | ------------------------------------------+---------------------------------------------------------------------------------------------------------------------+-----+---+------------------------------------------+---+-----+------+---+------+---+---+-----+-- Investment expenses | | (17 | ) | | | (11 | ) | | (42 | ) | | (35 | ) ------------------------------------------+---------------------------------------------------------------------------------------------------------------------+-----+---+------------------------------------------+---+-----+------+---+------+---+---+-----+-- Net investment income | $ | 248 | | | $ | 151 | | $ | 700 | | $ | 393 | ------------------------------------------+---------------------------------------------------------------------------------------------------------------------+-----+---+------------------------------------------+---+-----+------+---+------+---+---+-----+-- 5. Reinsurance The Company reinsures, or cedes, a portion of its written premiums on a per risk and excess of loss basis to non-affiliated insurers in order to limit its loss exposure. Although reinsurance is intended to reduce the Company’s exposure risk, the ceding of insurance does not legally discharge the Company from its primary liability for the full amount of coverage under its policies. If our reinsurers fail to meet their obligations under the applicable reinsurance agreements, the Company would still be required to pay the insured for the loss. Under the Company’s per-risk treaty, reinsurance recoveries are received for up to $1,750 in excess of a retention of $250 for each loss occurring prior to June 1, 2017. Effective June 1, 2017, the Company amended its per-risk treaty such that recoveries are received for up to $1,600 in excess of a retention of $400 for each loss occurring on June 1, 2017 or thereafter. The Company has ceded $405 and $438 in written premiums under its per-risk treaties for the nine months ended September 30, 2017 and 2016, respectively. The Company’s excess of loss treaties are based upon a treaty year beginning on June 1st of each year and expiring on May 31st of the following year. Thus, the financial statements for the nine month periods ended September 30, 2017 and 2016 contain premiums ceded under three separate excess of loss treaties. Under the Company’s 2015/2016 excess of loss treaty which expired on May 31, 2016, for each catastrophic event occurring within a 144-hour period, the Company receives reinsurance recoveries of up to $121,000 in excess of a retention of $4,000 per event. The Company had also procured a “top, drop and aggregate” layer of reinsurance protection that may be used for any event above $125,000, up to a maximum recovery of $15,000. This $15,000 second layer of coverage applied in total to all events occurring during the treaty year of June 1, 2015 through May 31, 2016. For both the treaty years beginning June 1, 2016 and June 1, 2017, the Company’s excess of loss treaties cover losses of up to $170,000 in excess of a $5,000 retention per event. For any event above $175,000, the Company again purchased top, drop and aggregate coverage, with an additional limit of $25,000. The $25,000 aggregate coverage applies in total to all events occurring during each of the treaty years. The Company has ceded $16,021 and $14,976 in written premiums under its excess of loss treaties for the nine months ended September 30, 2017 and 2016, respectively. In June 2015, we began writing business through a quota-share agreement with Brotherhood Mutual Insurance Company (“Brotherhood”). Through this agreement, we act as a reinsurer, and have assumed wind/hail only exposures on certain churches and related structures that Brotherhood insures throughout the State of Texas. Our quota-share percentage varies from 25%-100% of the wind/hail premium written by Brotherhood, dependent upon the geographic location (coastal areas versus non-coastal areas) within the State of Texas. For the nine months ended September 30, 2017, we have written $1,427 in assumed premiums through our agreement with Brotherhood, compared to $1,367 in assumed premiums for the same period in 2016. 16 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ($ amounts in thousands, except share and per share data) On December 1, 2016, we participated TWIA’s inaugural depopulation program whereby Maison assumed personal lines policies for wind and hail only exposures along the Gulf Coast area of Texas. The depopulation program was structured such that Maison reinsures TWIA under a 100% quota share agreement. For the nine months ended September 30, 2017, we have written $1,401 in assumed premiums through the TWIA quota share agreement. The impact of reinsurance treaties on the Company’s financial statements is as follows: | Three months ended September 30, | | | Nine months ended September 30, | --------------------------------+--------------------------------------+---------+---+---------------------------------+-- | 2017 | | | 2016 | | | 2017 | | 2016 | --------------------------------+--------------------------------------+---------+---+---------------------------------+---+--------+------+---+---------+-- Premium written: | | | | | | | | | | | | | --------------------------------+--------------------------------------+---------+---+---------------------------------+---+--------+------+---+---------+---+---+---------+-- Direct | $ | 16,533 | | | $ | 13,457 | | $ | 45,989 | | $ | 38,117 | --------------------------------+--------------------------------------+---------+---+---------------------------------+---+--------+------+---+---------+---+---+---------+-- Assumed | | 630 | | | | 509 | | | 2,828 | | | 1,367 | --------------------------------+--------------------------------------+---------+---+---------------------------------+---+--------+------+---+---------+---+---+---------+-- Ceded | | (6,051 | ) | | | (5,973 | ) | | (16,426 | ) | | (15,414 | ) --------------------------------+--------------------------------------+---------+---+---------------------------------+---+--------+------+---+---------+---+---+---------+-- Net premium written | $ | 11,112 | | | $ | 7,993 | | $ | 32,391 | | $ | 24,070 | --------------------------------+--------------------------------------+---------+---+---------------------------------+---+--------+------+---+---------+---+---+---------+-- Premium earned: | | | | | | | | | | | | | --------------------------------+--------------------------------------+---------+---+---------------------------------+---+--------+------+---+---------+---+---+---------+-- Direct | $ | 14,056 | | | $ | 12,037 | | $ | 40,015 | | $ | 34,455 | --------------------------------+--------------------------------------+---------+---+---------------------------------+---+--------+------+---+---------+---+---+---------+-- Assumed | | 851 | | | | 509 | | | 2,454 | | | 1,367 | --------------------------------+--------------------------------------+---------+---+---------------------------------+---+--------+------+---+---------+---+---+---------+-- Ceded | | (6,275 | ) | | | (5,410 | ) | | (17,437 | ) | | (12,953 | ) --------------------------------+--------------------------------------+---------+---+---------------------------------+---+--------+------+---+---------+---+---+---------+-- Net premium earned | $ | 8,632 | | | $ | 7,136 | | $ | 25,032 | | $ | 22,869 | --------------------------------+--------------------------------------+---------+---+---------------------------------+---+--------+------+---+---------+---+---+---------+-- Losses and LAE incurred: | | | | | | | | | | | | | --------------------------------+--------------------------------------+---------+---+---------------------------------+---+--------+------+---+---------+---+---+---------+-- Direct | $ | 20,451 | | | $ | 12,529 | | $ | 31,297 | | $ | 25,985 | --------------------------------+--------------------------------------+---------+---+---------------------------------+---+--------+------+---+---------+---+---+---------+-- Assumed | | 5,734 | | | | 562 | | | 8,937 | | | 2,340 | --------------------------------+--------------------------------------+---------+---+---------------------------------+---+--------+------+---+---------+---+---+---------+-- Ceded | | (18,390 | ) | | | (6,648 | ) | | (26,425 | ) | | (13,408 | ) --------------------------------+--------------------------------------+---------+---+---------------------------------+---+--------+------+---+---------+---+---+---------+-- Net losses and LAE incurred | $ | 7,795 | | | $ | 6,443 | | $ | 13,809 | | $ | 14,917 | --------------------------------+--------------------------------------+---------+---+---------------------------------+---+--------+------+---+---------+---+---+---------+-- 6. Deferred Policy Acquisition Costs Deferred policy acquisition costs (“DPAC”) consist primarily of commissions, premium taxes, assessments and other policy processing fees incurred which are related to successful efforts to acquire new or renewal insurance contracts. Acquisition costs deferred on insurance products are amortized over the period in which the related revenues are earned. Costs associated with unsuccessful efforts or costs that cannot be tied directly to a successful policy acquisition are expensed as incurred. DPAC as well as the related amortization expense associated with DPAC for the three and nine months ended September 30, 2017 and 2016, is as follows: | Three months ended September 30, | | | Nine months ended September 30, | --------------------------------------+----------------------------------+--------+---+---------------------------------+-- | 2017 | | | 2016 | | | 2017 | | 2016 | --------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+-- Balance, beginning of period, net | $ | 5,545 | | | $ | 4,139 | | $ | 4,389 | | $ | 4,030 | --------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Additions | | 3,402 | | | | 2,325 | | | 9,670 | | | 6,487 | --------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Amortization | | (2,755 | ) | | | (2,095 | ) | | (7,867 | ) | | (6,148 | ) --------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Balance, September 30, net | $ | 6,192 | | | $ | 4,369 | | $ | 6,192 | | $ | 4,369 | --------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- 7. Loss and Loss Adjustment Expense Reserves The Company continually revises its estimates of the ultimate financial impact of claims made. A significant degree of judgment is required to determine amounts recorded in the consolidated financial statements for the provision for loss and loss adjustment expense (“LAE”) reserves. The process for establishing this provision reflects the uncertainties and significant judgmental factors inherent in predicting future results of both known and unknown loss events. The process of establishing the provision for loss and LAE reserves relies on the judgment and opinions of a large number of individuals, including the opinions of the Company’s independent actuaries. 17 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ($ amounts in thousands, except share and per share data) The Company’s evaluation of the adequacy of loss and loss adjustment expense reserves includes a re-estimation of the liability for loss and LAE reserves relating to each preceding financial year compared to the liability that was previously established. The results of this comparison and the changes in the provision, net of amounts recoverable from reinsurers, for the nine months ended September 30, 2017 and 2016 were as follows: | Three months ended September 30, | | | Nine months ended September 30, | --------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------+--------+---+--------------------------------------------------------------------------------------------------------------------+-- | 2017 | | | 2016 | | | 2017 | | 2016 | --------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------+--------+---+--------------------------------------------------------------------------------------------------------------------+---+--------+------+---+---------+-- Balance, beginning of period, gross of reinsurance | $ | 9,583 | | | $ | 5,884 | | $ | 6,971 | | $ | 2,123 | --------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------+--------+---+--------------------------------------------------------------------------------------------------------------------+---+--------+------+---+---------+---+---+---------+-- Less reinsurance recoverable on loss and LAE expense reserves | | (6,012 | ) | | | (3,431 | ) | | (3,652 | ) | | (120 | ) --------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------+--------+---+--------------------------------------------------------------------------------------------------------------------+---+--------+------+---+---------+---+---+---------+-- Balance, beginning of period, net of reinsurance | | 3,571 | | | | 2,453 | | | 3,319 | | | 2,003 | --------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------+--------+---+--------------------------------------------------------------------------------------------------------------------+---+--------+------+---+---------+---+---+---------+-- Incurred related to: | | | | | | | | | | | | | --------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------+--------+---+--------------------------------------------------------------------------------------------------------------------+---+--------+------+---+---------+---+---+---------+-- Current year | | 8,717 | | | | 6,487 | | | 15,953 | | | 15,090 | --------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------+--------+---+--------------------------------------------------------------------------------------------------------------------+---+--------+------+---+---------+---+---+---------+-- Prior years | | (922 | ) | | | (44 | ) | | (2,144 | ) | | (173 | ) --------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------+--------+---+--------------------------------------------------------------------------------------------------------------------+---+--------+------+---+---------+---+---+---------+-- Paid related to: | | | | | | | | | | | | | --------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------+--------+---+--------------------------------------------------------------------------------------------------------------------+---+--------+------+---+---------+---+---+---------+-- Current year | | (7,246 | ) | | | (5,671 | ) | | (12,060 | ) | | (12,719 | ) --------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------+--------+---+--------------------------------------------------------------------------------------------------------------------+---+--------+------+---+---------+---+---+---------+-- Prior years | | 411 | | | | 36 | | | (537 | ) | | (940 | ) --------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------+--------+---+--------------------------------------------------------------------------------------------------------------------+---+--------+------+---+---------+---+---+---------+-- Balance, September 30, net of reinsurance | | 4,531 | | | | 3,261 | | | 4,531 | | | 3,261 | --------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------+--------+---+--------------------------------------------------------------------------------------------------------------------+---+--------+------+---+---------+---+---+---------+-- Plus reinsurance recoverable related to loss and LAE expense reserves | | 17,560 | | | | 5,366 | | | 17,560 | | | 5,366 | --------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------+--------+---+--------------------------------------------------------------------------------------------------------------------+---+--------+------+---+---------+---+---+---------+-- Balance, September 30, gross of reinsurance | $ | 22,091 | | | $ | 8,627 | | $ | 22,091 | | $ | 8,627 | --------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------+--------+---+--------------------------------------------------------------------------------------------------------------------+---+--------+------+---+---------+---+---+---------+-- 8. Income Taxes Actual income tax expense for the three and nine months ended September 30, 2017 and 2016 varies from the amount that would result by applying the applicable statutory federal income tax rate of 34% to income before income taxes as summarized in the following table: | Three months ended September 30, | | | Nine months ended September 30, | ----------------------------------------------------+---------------------------------------------------------------------------------------------------------------------+--------+---+--------------------------------------------------------------------------------------------------------------------+-- | 2017 | | | 2016 | | | 2017 | | 2016 | ----------------------------------------------------+---------------------------------------------------------------------------------------------------------------------+--------+---+--------------------------------------------------------------------------------------------------------------------+---+------+------+---+------+-- Income tax benefit at statutory income tax rate | $ | (1,168 | ) | | $ | (902 | ) | $ | (508 | ) | $ | (743 | ) ----------------------------------------------------+---------------------------------------------------------------------------------------------------------------------+--------+---+--------------------------------------------------------------------------------------------------------------------+---+------+------+---+------+---+---+------+-- State income tax (net of federal tax benefit) | | (5 | ) | | | 54 | | | 104 | | | 131 | ----------------------------------------------------+---------------------------------------------------------------------------------------------------------------------+--------+---+--------------------------------------------------------------------------------------------------------------------+---+------+------+---+------+---+---+------+-- Other | | 2 | | | | 1 | | | 7 | | | 7 | ----------------------------------------------------+---------------------------------------------------------------------------------------------------------------------+--------+---+--------------------------------------------------------------------------------------------------------------------+---+------+------+---+------+---+---+------+-- Income tax benefit | $ | (1,171 | ) | | $ | (847 | ) | $ | (397 | ) | $ | (605 | ) ----------------------------------------------------+---------------------------------------------------------------------------------------------------------------------+--------+---+--------------------------------------------------------------------------------------------------------------------+---+------+------+---+------+---+---+------+-- The Company carries a net deferred income tax asset of $855 and $420 as of September 30, 2017 and December 31, 2016, respectively, all of which the Company believes is more likely than not to be fully realized based upon management’s assessment of future taxable income. Significant components of the Company’s net deferred tax assets are as follows: | September 30, 2017 | | December 31, 2016 | ----------------------------------------------+------------------------+-------+-----------------------+-- Deferred income tax assets: | | | | | ----------------------------------------------+------------------------+-------+-----------------------+---+------ Loss and loss adjustment expense reserves | $ | 49 | | $ | 35 ----------------------------------------------+------------------------+-------+-----------------------+---+------ Unearned premium reserves | | 2,055 | | | 1,503 ----------------------------------------------+------------------------+-------+-----------------------+---+------ Net operating loss carryforwards | | 736 | | | 235 ----------------------------------------------+------------------------+-------+-----------------------+---+------ Share-based compensation | | 335 | | | 316 ----------------------------------------------+------------------------+-------+-----------------------+---+------ Other | | 308 | | | 270 ----------------------------------------------+------------------------+-------+-----------------------+---+------ Deferred income tax assets | $ | 3,483 | | $ | 2,359 ----------------------------------------------+------------------------+-------+-----------------------+---+------ Deferred income tax liabilities: | | | | | ----------------------------------------------+------------------------+-------+-----------------------+---+------ Deferred policy acquisition costs | $ | 2,105 | | $ | 1,492 ----------------------------------------------+------------------------+-------+-----------------------+---+------ State deferred taxes | | 444 | | | 397 ----------------------------------------------+------------------------+-------+-----------------------+---+------ Other | | 79 | | | 50 ----------------------------------------------+------------------------+-------+-----------------------+---+------ Deferred income tax liabilities | $ | 2,628 | | $ | 1,939 ----------------------------------------------+------------------------+-------+-----------------------+---+------ Net deferred income tax assets | $ | 855 | | $ | 420 ----------------------------------------------+------------------------+-------+-----------------------+---+------ As of September 30, 2017, the Company had no unrecognized tax benefits. The Company analyzed its tax positions in accordance with the provisions of Accounting Standards Codification Topic 740, Income Taxes, and has determined that there are currently no uncertain tax positions. The Company generally recognizes interest and penalties, if any, related to unrecognized tax benefits in income tax expense (benefit). 18 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ($ amounts in thousands, except share and per share data) 9. Net Loss Per Share Net loss per share is computed by dividing net loss by the weighted average number of common shares and common share equivalents outstanding during the periods presented. In calculating diluted loss per share, those potential common shares that are found to be anti-dilutive are excluded from the calculation. The table below provides a summary of the numerators and denominators used in determining basic and diluted loss per share for the three and nine months ended September 30, 2017 and 2016. | Three months ended September 30, | | | Nine months ended September 30, | -----------------------------------------------+--------------------------------------+-----------+---+-------------------------------------+-- | 2017 | | | 2016 | | | 2017 | | 2016 | -----------------------------------------------+--------------------------------------+-----------+---+-------------------------------------+---+-----------+------+---+-----------+-- Basic and Diluted: | | | | | | | | | | | | | -----------------------------------------------+--------------------------------------+-----------+---+-------------------------------------+---+-----------+------+---+-----------+---+---+-----------+-- Net loss | $ | (2,263 | ) | | $ | (1,806 | ) | $ | (1,096 | ) | $ | (1,581 | ) -----------------------------------------------+--------------------------------------+-----------+---+-------------------------------------+---+-----------+------+---+-----------+---+---+-----------+-- Weighted average common shares outstanding | | 5,961,636 | | | | 6,022,983 | | | 5,958,407 | | | 6,076,838 | -----------------------------------------------+--------------------------------------+-----------+---+-------------------------------------+---+-----------+------+---+-----------+---+---+-----------+-- Loss per common share | $ | (0.38 | ) | | $ | (0.30 | ) | $ | (0.18 | ) | $ | (0.26 | ) -----------------------------------------------+--------------------------------------+-----------+---+-------------------------------------+---+-----------+------+---+-----------+---+---+-----------+-- The following potentially dilutive securities outstanding as of September 30, 2017 and 2016 have been excluded from the computation of diluted weighted-average shares outstanding as their effect would be anti-dilutive. | As of September 30, | --------------------------------------+-------------------------+---------- | 2017 | | 2016 --------------------------------------+-------------------------+-----------+----- Options to purchase common stock | | 177,456 | | 210,489 --------------------------------------+-------------------------+-----------+------+---------- Warrants to purchase common stock | | 1,906,875 | | 1,906,875 --------------------------------------+-------------------------+-----------+------+---------- Restricted stock units | | 20,500 | | 20,500 --------------------------------------+-------------------------+-----------+------+---------- Performance shares | | 475,000 | | 475,000 --------------------------------------+-------------------------+-----------+------+---------- | | 2,579,831 | | 2,612,864 --------------------------------------+-------------------------+-----------+------+---------- 10. Options, Warrants, and Restricted Stock Units The Company has established an equity incentive plan for employees and directors of the Company (the “Plan”). The purpose of the Plan is to create incentives designed to motivate recipients to contribute toward the Company’s growth and success, and also to attract and retain persons of outstanding competence, and provide such persons with an opportunity to acquire an equity interest in the Company. The types of awards available for issuance under the Plan include non-qualified stock options, restricted stock, restricted stock units (“RSUs”), performance shares, performance cash awards, and other stock-based awards. The Plan provides for the issuance of 354,912 shares of common stock. As of September 30, 2017, both stock options and RSUs had been issued to the Company’s employees under the Plan resulting in 156,956 shares available for future issuance under the Plan. There were no grants, exercises, or cancellations of the Company’s stock options for the nine months ended September 30, 2017. The following table summarizes the Company’s stock options outstanding as of September 30, 2017. Stock Options Outstanding as of September 30, 2017 ------------------------------------------------------ Date of Grant | Exercise Price ($) | | Expiration Date | | Remaining Contractual Life (Years) | | Number Outstanding | Number Exercisable -------------------------------------------------------+--------------------+------+---------------------+------------+----------------------------------------+-------+------------------------+----------------------- 03/31/2014 | | 8.00 | | 03/31/2019 | | 1.50 | | 163,301 | 143,704 -------------------------------------------------------+--------------------+------+---------------------+------------+----------------------------------------+-------+------------------------+------------------------+-------- 04/04/2014 | | 8.69 | | 04/04/2019 | | 1.51 | | 14,155 | 12,456 -------------------------------------------------------+--------------------+------+---------------------+------------+----------------------------------------+-------+------------------------+------------------------+-------- | | | | | | Total | | 177,456 | 156,160 -------------------------------------------------------+--------------------+------+---------------------+------------+----------------------------------------+-------+------------------------+------------------------+-------- On May 29, 2015, the Compensation Committee of the Company’s Board of Directors granted RSUs to certain of its executive officers under the Plan. Each RSU granted entitles the grantee to one share of the Company’s common stock upon the vesting date of the RSU. The RSUs vest as follows: (i) 50% upon the date that the closing price of the Company’s common stock equals or exceeds $10.00 per share; and (ii) 50% upon the date that the closing price of the Company’s common stock equals or exceeds $12.00 per share. Prior to the vesting of the RSUs, the grantee will not be entitled to any dividends declared on the Company’s common stock. The RSUs do not expire; however, should the grantee discontinue employment with the Company for any reason other than death or disability, all unvested RSUs will be deemed forfeited on the date employment is discontinued. 19 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ($ amounts in thousands, except share and per share data) On May 23, 2017, the Compensation Committee of the Company’s Board of Directors approved the potential issuance of RSUs to the Company’s Chief Operating Officer, Mr. Case. Mr. Case will be awarded two matching RSUs for each share of the Company’s common stock that he purchases on the open market or directly from the Company during the period beginning May 23, 2017 and ending November 23, 2017, up to a maximum of 136,054 RSUs. Each RSU will entitle Mr. Case to one share of the Company’s common stock upon the vesting date of the RSU, which shall vest 20% per year over a period of five years following the date granted, subject to Mr. Case’s continued employment with the Company. Mr. Case will also be required to maintain ownership of the shares purchased through the full five-year vesting period. The RSUs will be issued to Mr. Case outside of the Plan as an inducement grant material to Mr. Case entering into employment with the Company. Through September 30, 2017, Mr. Case had purchased 50,092 shares of the Company’s common stock, of which 28,000 restricted common shares were purchased directly from the Company. On May 31, 2017, the Compensation Committee of the Company’s Board of Directors approved the potential issuance of additional RSUs to the Company’s Officers and Directors under the Plan. The number of RSUs to be granted will be based upon the number of shares of the Company’s common stock that each participating Officer and Director purchases in open market transactions, independently, and without assistance from the Company, during the period beginning May 31, 2017 and ending November 30, 2017 (the “Purchase Period”). At the end of the Purchase Period, the Company will issue to each participating Officer and Director a total of two RSUs for each share of the Company’s common stock purchased during the Purchase Period, subject to a maximum of 40,000 RSUs for the Company’s Chief Executive Officer, Mr. Raucy, 40,000 RSUs for the Company’s Chief Financial Officer, Mr. Hill, 20,000 RSUs for the Company’s Chief Underwriting Officer, Mr. Stroud, and 6,666 RSUs for each of the Company’s non-employee Directors. Each RSU will entitle the grantee to one share of the Company’s common stock upon the vesting date of the RSU, which shall vest 20% per year over a period of five years following the date granted, subject to each Officer’s continued employment with the Company and each Director’s continued service on the Board, provided that if a Director makes himself available and consents to be nominated by the Company for continued service but is not nominated by the Board for election by the shareholders, other than for good reason as determined by the Board in its discretion, then such director’s RSUs shall vest in full as of his last date of service as a director with the Company. Participating Officers and Directors will be required to maintain ownership of the shares purchased through the full five-year vesting period. Pursuant to the arrangement, a maximum number of 139,996 RSUs may be granted to the Company’s Officers and Directors at the end of the Purchase Period under the Plan. Through September 30, 2017, the Company’s Officers and Directors had purchased 41,565 shares of the Company’s common stock. The following table summarizes RSU activity for the nine months ended September 30, 2017. Restricted Stock Units | Number of Units | | Weighted Average Grant Date Fair Value | -----------------------------------------+---------------------+--------+--------------------------------------------+-- Non-vested units, December 31, 2016 | | 20,500 | | $ | 1.34 -----------------------------------------+---------------------+--------+--------------------------------------------+---+----- Granted | | — | | | — -----------------------------------------+---------------------+--------+--------------------------------------------+---+----- Vested | | — | | | — -----------------------------------------+---------------------+--------+--------------------------------------------+---+----- Forfeited | | — | | | — -----------------------------------------+---------------------+--------+--------------------------------------------+---+----- Non-vested units, September 30, 2017 | | 20,500 | | $ | 1.34 -----------------------------------------+---------------------+--------+--------------------------------------------+---+----- Total stock based compensation expense for the nine months ended September 30, 2017 and 2016 was $19 and $30, respectively. As of September 30, 2017, total unrecognized stock compensation expense of $11 remained, which will be recognized through March 31, 2018. There were no grants, exercises, or cancellations of the Company’s common stock warrants for the nine months ended September 30, 2017. The following table summarizes the Company’s warrants outstanding as of September 30, 2017. Date of Grant | Exercise Price ($) | | Expiration Date | | Remaining Contractual Life (Years) | | Number Outstanding and Exercisable ------------------+--------------------+-------+---------------------+------------+----------------------------------------+-------+--------------------------------------- 03/31/2014 | | 9.60 | | 03/31/2019 | | 1.50 | | 312,500 ------------------+--------------------+-------+---------------------+------------+----------------------------------------+-------+----------------------------------------+---------- 03/31/2014 | | 10.00 | | 03/31/2019 | | 1.50 | | 94,375 ------------------+--------------------+-------+---------------------+------------+----------------------------------------+-------+----------------------------------------+---------- 02/24/2015 | | 15.00 | | 02/24/2022 | | 4.41 | | 1,500,000 ------------------+--------------------+-------+---------------------+------------+----------------------------------------+-------+----------------------------------------+---------- | | | | | | Total | | 1,906,875 ------------------+--------------------+-------+---------------------+------------+----------------------------------------+-------+----------------------------------------+---------- 20 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ($ amounts in thousands, except share and per share data) 11. Shareholders’ Equity Treasury Shares On December 1, 2014, the Company’s Board of Directors authorized a share repurchase program for up to 500,000 shares of the Company’s common stock, which expired on December 31, 2016. Through December 31, 2016, the Company has repurchased an aggregate 401,359 shares at an aggregate purchase price of $2,927, or $7.29 per share, including all fees and commissions. On January 29, 2016, the Company retired 250,000 of its treasury shares, resulting in a reclassification of the purchase price of $1,917 to additional paid in capital. 12. Related Party Transactions Related party transactions are carried out in the normal course of operations and are measured in part by the amount of consideration paid or received as established and agreed by the parties. Management believes that consideration paid for such services in each case approximates fair value. Except where disclosed elsewhere in these consolidated financial statements, the following is a summary of related party transactions. Performance Share Grant Agreement On March 26, 2014, the Company entered into a Performance Share Grant Agreement (“PSGA”) with KAI, whereby KAI will be entitled to receive up to an aggregate of 375,000 shares of PIH common stock upon achievement of certain milestones regarding the Company’s stock price. Pursuant to the terms of the PSGA, if at any time the last sales price of the Company’s common stock equals or exceeds: (i) $12.00 per share (as adjusted for stock splits, stock dividends, reorganizations, recapitalizations and the like) for any 20 trading days within any 30-trading day period, KAI will receive 125,000 shares of the Company’s common stock; (ii) $15.00 per share (as adjusted for stock splits, stock dividends, reorganizations, recapitalizations and the like) for any 20 trading days within any 30-trading day period, KAI will receive 125,000 shares of the Company’s common stock (in addition to the 125,000 shares of common stock earned pursuant to clause (i) herein); and (iii) $18.00 per share (as adjusted for stock splits, stock dividends, reorganizations, recapitalizations and the like) for any 20 trading days within any 30-trading day period, KAI will receive 125,000 shares of the Company’s common stock (in addition to the 250,000 shares of common stock earned pursuant to clauses (i) and (ii) herein). The shares of common stock granted to KAI will have a valuation equal to the last sales price of PIH common stock on the day prior to such grant. As of September 30, 2017, the Company has not issued any shares under the PSGA. Termination of Management Services Agreement As a result of the termination of the Management Services Agreement (“MSA”), which occurred on February 24, 2015, the Company has issued the following securities to 1347 Advisors, LLC (“Advisors”), a wholly owned subsidiary of KFSI: ● | 100,000 shares of the Company’s common stock issuable pursuant to the Performance Shares Grant Agreement dated February 24, 2015, and subject to the achievement of the Milestone Event; --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ● | 120,000 shares of Series B Preferred Stock of the Company (the “Preferred Shares”); and --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ● | A warrant (the “Warrant”) to purchase 1,500,000 shares of the Company’s common stock at an exercise price of $15.00 per share. The Warrant expires on February 24, 2022. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- The Performance Shares Grant Agreement grants Advisors 100,000 shares of the Company’s common stock issuable upon the date that the last sales price of the Company’s common stock equals or exceeds $10.00 per share for any 20 trading days within any 30-day trading period (the “Milestone Event”). Advisors will not be entitled to any dividends declared or paid on the Company’s stock prior to the Milestone Event having been achieved. 21 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ($ amounts in thousands, except share and per share data) The Preferred Shares have a par value of $25.00 and pay annual cumulative dividends at a rate of eight percent per annum. Cumulative dividends shall accrue, whether or not declared by the Board and irrespective of whether there are funds legally available for the payment of dividends. Accrued dividends shall be paid in cash only when, as, and if declared by the Board out of funds legally available therefor or upon a liquidation or redemption of the Preferred Shares. In the event of any voluntary of involuntary liquidation, dissolution, or winding up of the Company, the holders of the Preferred Shares then outstanding shall be entitled to be paid out of the assets of the Company available for distributions to its shareholders, before any payment shall be made to holders of securities junior in preference to the Preferred Shares. The Preferred Shares rank senior to the Company’s common stock, and the Company is not permitted to issue any other series of preferred stock that ranks equal or senior to the Preferred Shares while the Preferred Shares are outstanding. On both February 24, 2017 and 2016, the Company issued a cash payment of $240 to Advisors representing annual dividend payments due on the Preferred Shares. Unless redeemed earlier by the Company as discussed below, with the written consent of the holders of the majority of the Preferred Shares then outstanding, the Company will be required to redeem the Preferred Shares then outstanding on February 24, 2020 (the “Mandatory Redemption Date”), for a redemption amount equal to $25.00 per share plus all accrued and unpaid dividends on such shares. The Company has the option to redeem the Preferred Shares prior to the Mandatory Redemption Date immediately prior to the consummation of any change in control of the Company that may occur. Since the Preferred Shares have a mandatory redemption provision requiring redemption on February 24, 2020, the Company was required to classify the Preferred Shares as a liability on the balance sheet instead of recording the value of these shares in equity. The resulting liability was recorded at a discount to the ultimate redemption amount of the Preferred Shares based upon an analysis of the cash payments expected to occur under the terms of the Preferred Shares discounted for the Company’s estimated cost of equity (13.9%). As a result, amortization in the amount of $1,889 will be charged to operations during the period the Preferred Shares are outstanding using the effective interest method. For the nine months ended September 30, 2017 and 2016, amortization of the discount on the Preferred Shares totaled $276 and $263, respectively. Investment in Limited Liability Company On April 21, 2016, KFSI completed the acquisition of Argo Management Group LLC (“Argo”). Argo’s primary business is to act as the Managing Member of Argo Holdings Fund I, LLC, an investment fund in which the Company has committed to invest $500, of which the Company has invested $211 as of September 30, 2017. The managing member of Argo, Mr. John T. Fitzgerald, was also appointed to KFSI’s board of directors on April 21, 2016. 13. Accumulated Other Comprehensive Income (Loss) The table below details the change in the balance of each component of accumulated other comprehensive income (loss), net of tax, for the three and nine months ended September 30, 2017 and 2016. | Three months ended September 30, | | | Nine month ended September 30, | ----------------------------------------------------------------------------+----------------------------------+-----+---+--------------------------------+-- | 2017 | | | 2016 | | | 2017 | | 2016 | ----------------------------------------------------------------------------+----------------------------------+-----+---+--------------------------------+---+-----+------+---+------+-- Unrealized gains (losses) on available-for-sale securities: | | | | | | | | | | | | | ----------------------------------------------------------------------------+----------------------------------+-----+---+--------------------------------+---+-----+------+---+------+---+---+------+-- Balance, beginning of period | $ | 4 | | | $ | 259 | | $ | (65 | ) | $ | (62 | ) ----------------------------------------------------------------------------+----------------------------------+-----+---+--------------------------------+---+-----+------+---+------+---+---+------+-- Other comprehensive income (loss) before reclassifications | | 40 | | | | (10 | ) | | 187 | | | 478 | ----------------------------------------------------------------------------+----------------------------------+-----+---+--------------------------------+---+-----+------+---+------+---+---+------+-- Amounts reclassified from accumulated other comprehensive income (loss) | | (3 | ) | | | (6 | ) | | (45 | ) | | (8 | ) ----------------------------------------------------------------------------+----------------------------------+-----+---+--------------------------------+---+-----+------+---+------+---+---+------+-- Income taxes | | (12 | ) | | | 5 | | | (48 | ) | | (160 | ) ----------------------------------------------------------------------------+----------------------------------+-----+---+--------------------------------+---+-----+------+---+------+---+---+------+-- Net current-period other comprehensive income (loss) | | 25 | | | | (11 | ) | | 94 | | | 310 | ----------------------------------------------------------------------------+----------------------------------+-----+---+--------------------------------+---+-----+------+---+------+---+---+------+-- Balance, September 30 | $ | 29 | | | $ | 248 | | $ | 29 | | $ | 248 | ----------------------------------------------------------------------------+----------------------------------+-----+---+--------------------------------+---+-----+------+---+------+---+---+------+-- 22 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ($ amounts in thousands, except share and per share data) 14. Fair Value of Financial Instruments Fair value is best evidenced by quoted bid or ask price, as appropriate, in an active market. Where bid or ask prices are not available, such as in an illiquid or inactive market, the closing price of the most recent transaction of that instrument subject to appropriate adjustments as required is used. Where quoted market prices are not available, the quoted prices of similar financial instruments or valuation models with observable market based inputs are used to estimate the fair value. These valuation models may use multiple observable market inputs, including observable interest rates, foreign exchange rates, index levels, credit spreads, equity prices, counterparty credit quality, corresponding market volatility levels and option volatilities. Minimal management judgment is required for fair values calculated using quoted market prices or observable market inputs for models. Greater subjectivity is required when making valuation adjustments for financial instruments in inactive markets or when using models where observable parameters do not exist. Also, the calculation of estimated fair value is based on market conditions at a specific point in time and may not be reflective of future fair values. For the Company’s financial instruments carried at cost or amortized cost, the book value is not adjusted to reflect increases or decreases in fair value due to market fluctuations, including those due to interest rate changes, as it is the Company’s intention to hold them until there is a recovery of fair value, which may be to maturity. The Company classifies its investments in fixed income and equity securities as available-for-sale and reports these investments at fair value. Fair values of fixed income securities for which no active market exists are derived from quoted market prices of similar instruments or other third-party evidence. The FASB has issued guidance that defines fair value as the exchange price that would be received for and asset (or paid to transfer a liability) in the principal, or most advantageous market in an orderly transaction between market participants. This guidance also establishes a fair value hierarchy that requires and entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The guidance categorizes assets and liabilities at fair value into one of three different levels depending on the observation of the inputs employed in the measurements, as follows: ● | Level 1 – inputs to the valuation methodology are quoted prices for identical assets or liabilities in active markets providing the most reliable measurement of fair value since it is directly observable. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ● | Level 2 – inputs to the valuation methodology which include quoted prices for similar assets or liabilities in active markets. These inputs are observable, either directly or indirectly, for substantially the full-term of the financial instrument. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ● | Level 3 – inputs to the valuation methodology which are unobservable and significant to the measurement of fair value. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Financial instruments measured at fair value as of September 30, 2017 and December 31, 2016 in accordance with this guidance are as follows. September 30, 2017 | Level 1 | | | Level 2 | | | Level 3 | | Total | --------------------------------------------------------------------+-------------+-------+---+-------------+---+--------+-------------+---+-------+-- Fixed income securities: | | | | | | | | | | | | | --------------------------------------------------------------------+-------------+-------+---+-------------+---+--------+-------------+---+-------+---+---+--------+------- U.S. government | $ | — | | | $ | 2,899 | | $ | — | | $ | 2,899 | --------------------------------------------------------------------+-------------+-------+---+-------------+---+--------+-------------+---+-------+---+---+--------+------- State municipalities and political subdivisions | | — | | | | 5,365 | | | — | | | 5,365 | --------------------------------------------------------------------+-------------+-------+---+-------------+---+--------+-------------+---+-------+---+---+--------+------- Asset-backed securities and collateralized mortgage obligations | | | — | | | | 16,635 | | | — | | | 16,635 --------------------------------------------------------------------+-------------+-------+---+-------------+---+--------+-------------+---+-------+---+---+--------+------- Corporate | | — | | | | 20,308 | | | — | | | 20,308 | --------------------------------------------------------------------+-------------+-------+---+-------------+---+--------+-------------+---+-------+---+---+--------+------- Total fixed income securities | | — | | | | 45,207 | | | — | | | 45,207 | --------------------------------------------------------------------+-------------+-------+---+-------------+---+--------+-------------+---+-------+---+---+--------+------- Equity securities: | | | | | | | | | | | | | --------------------------------------------------------------------+-------------+-------+---+-------------+---+--------+-------------+---+-------+---+---+--------+------- Common stock | | 1,612 | | | | — | | | — | | | 1,612 | --------------------------------------------------------------------+-------------+-------+---+-------------+---+--------+-------------+---+-------+---+---+--------+------- Warrants to purchase common stock | | 122 | | | | — | | | — | | | 122 | --------------------------------------------------------------------+-------------+-------+---+-------------+---+--------+-------------+---+-------+---+---+--------+------- Rights to purchase common stock | | 37 | | | | — | | | — | | | 37 | --------------------------------------------------------------------+-------------+-------+---+-------------+---+--------+-------------+---+-------+---+---+--------+------- Total equity securities | | 1,771 | | | | — | | | — | | | 1,771 | --------------------------------------------------------------------+-------------+-------+---+-------------+---+--------+-------------+---+-------+---+---+--------+------- Total fixed income and equity securities | $ | 1,771 | | | $ | 45,207 | | $ | — | | $ | 46,978 | --------------------------------------------------------------------+-------------+-------+---+-------------+---+--------+-------------+---+-------+---+---+--------+------- December 31, 2016 | | | | | | | | | | | | | --------------------------------------------------------------------+-------------+-------+---+-------------+---+--------+-------------+---+-------+---+---+--------+------- Fixed income securities: | | | | | | | | | | | | | --------------------------------------------------------------------+-------------+-------+---+-------------+---+--------+-------------+---+-------+---+---+--------+------- U.S. government | $ | — | | | $ | 1,604 | | $ | — | | $ | 1,604 | --------------------------------------------------------------------+-------------+-------+---+-------------+---+--------+-------------+---+-------+---+---+--------+------- State municipalities and political subdivisions | | — | | | | 2,246 | | | — | | | 2,246 | --------------------------------------------------------------------+-------------+-------+---+-------------+---+--------+-------------+---+-------+---+---+--------+------- Asset-backed securities and collateralized mortgage obligations | | | — | | | | 11,968 | | | — | | | 11,968 --------------------------------------------------------------------+-------------+-------+---+-------------+---+--------+-------------+---+-------+---+---+--------+------- Corporate | | — | | | | 10,741 | | | — | | | 10,741 | --------------------------------------------------------------------+-------------+-------+---+-------------+---+--------+-------------+---+-------+---+---+--------+------- Total fixed income securities | $ | — | | | $ | 26,559 | | $ | — | | $ | 26,559 | --------------------------------------------------------------------+-------------+-------+---+-------------+---+--------+-------------+---+-------+---+---+--------+------- Equity securities: | | | | | | | | | | | | | --------------------------------------------------------------------+-------------+-------+---+-------------+---+--------+-------------+---+-------+---+---+--------+------- Common stock | | 1,136 | | | | — | | | — | | | 1,136 | --------------------------------------------------------------------+-------------+-------+---+-------------+---+--------+-------------+---+-------+---+---+--------+------- Total equity securities | | 1,136 | | | | — | | | — | | | 1,136 | --------------------------------------------------------------------+-------------+-------+---+-------------+---+--------+-------------+---+-------+---+---+--------+------- Total fixed income and equity securities | $ | 1,136 | | | $ | 26,559 | | $ | — | | $ | 27,695 | --------------------------------------------------------------------+-------------+-------+---+-------------+---+--------+-------------+---+-------+---+---+--------+------- 23 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ($ amounts in thousands, except share and per share data) 15. Statutory Requirements The Company’s insurance subsidiary, Maison, prepares statutory basis financial statements in accordance with accounting practices prescribed or permitted by the LDI. Prescribed statutory accounting practices include state laws, rules and regulations as well as accounting practices and rules as outlined in a variety of publications of the National Association of Insurance Commissioners (“NAIC”). Permitted statutory accounting practices encompass all accounting practices that are not prescribed, but instead have been specifically requested by an insurer and allowed by the state in which the insurer is domiciled (in Maison’s case, Louisiana). Permitted practices may differ from state to state, company to company within a state, and may change in the future. In converting from statutory accounting basis to U.S. GAAP, typical adjustments include the deferral of acquisition costs (which are all charged to operations as incurred on a statutory basis), the inclusion of statutorily non-admitted assets on the balance sheet, the inclusion of net unrealized holding gains or losses related to investments included on the balance sheet, as well as the inclusion of changes in deferred tax assets and liabilities in the statement of operations. Statutory Surplus and Capital Requirements In order to retain its certificate of authority in the States of Louisiana and Florida, Maison is required to maintain a minimum capital surplus of $5,000 and $35,000, respectively. As of September 30, 2017, Maison’s capital surplus was $35,962. The LDI employs risk-based capital (“RBC”) reports to monitor Maison’s financial condition. Risk-based capital is determined in accordance with a formula adopted by the NAIC which takes into consideration the covariance between asset risk, credit risk, underwriting risk, and other business risks. The RBC report determines whether Maison falls into the “no action” level or one of the four action levels set forth in the Louisiana Insurance Code. Furthermore, in order to retain its certificate of authority in the State of Texas, Maison is required to maintain an RBC ratio of 300% or more. As of September 30, 2017, Maison’s RBC ratio was above 300%. States routinely require deposits of assets for the protection of policyholders. As of September 30, 2017, Maison held certificates of deposit with an estimated fair value of approximately $100 and $300 as a deposit with the LDI and FL OIR, respectively. Maison also held investment securities with an estimated fair value of approximately $2,000 as a deposit with the TDI. Surplus Notes PIH, as the parent company of Maison, is subject to the insurance holding company laws of the State of Louisiana, which, among other things, regulate the terms of surplus notes issued by insurers to their parent company. Maison’s capital is comprised of six surplus notes issued to PIH for the total principal amount of $9,000, all of which have been approved by the LDI prior to their issuance. Notes accrue interest at 10% per annum. Interest payments on the notes are due annually, and are also subject to prior approval by the LDI. The Company’s surplus notes, as of September 30, 2017, are as follows. Date of Issuance | Maturity Date | Principal Amount | -----------------------+------------------------+---------------------------+------ October 22, 2013 | October 22, 2017 | $ | 650 -----------------------+------------------------+---------------------------+------ December 21, 2015 | December 21, 2017 | | 850 -----------------------+------------------------+---------------------------+------ March 31, 2016 | March 31, 2018 | | 550 -----------------------+------------------------+---------------------------+------ September 29, 2016 | September 29, 2018 | | 3,450 -----------------------+------------------------+---------------------------+------ November 14, 2016 | November 14, 2018 | | 550 -----------------------+------------------------+---------------------------+------ September 28, 2017 | September 28, 2019 | | 2,950 -----------------------+------------------------+---------------------------+------ | | $ | 9,000 -----------------------+------------------------+---------------------------+------ 24 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ($ amounts in thousands, except share and per share data) Dividend Restrictions As a Louisiana domiciled insurer, the payment of dividends from our insurance subsidiary is restricted by the Louisiana Insurance Code. Dividends can only be paid if an insurer’s paid-in capital and surplus exceed the minimum required by the Louisiana Insurance Code. Any dividend or distribution that when aggregated with any other dividends or distributions made within the preceding twelve months exceeds the lesser of (a) ten percent of the insurer’s surplus as regards policyholders as of the thirty-first day of December next preceding; or (b) the net income of the insurer, not including realized capital gains, for the twelve month period ending the thirty-first day of December next preceding; is considered to be extra-ordinary and shall not be paid until thirty days after the LDI has received notice of the declaration thereof and has not within that period disapproved the payment, or until the LDI has approved the payment within the thirty-day period. In determining whether a dividend or distribution is extra-ordinary, an insurer may carry forward net income from the previous two calendar years that has not already been paid out in dividends. Furthermore, pursuant to the consent order issued to Maison by the FL OIR, Maison is restricted from paying dividends which have not been approved in advance by the FL OIR. As of September 30, 2017, Maison had not paid any dividends to its sole shareholder, PIH. 16. Commitments and Contingencies Legal Proceedings: From time to time, we are involved in legal proceedings and litigation arising in the ordinary course of business. Currently, it is not possible to predict legal outcomes and their impact on the future development of claims. Any such development will be affected by future court decisions and interpretations. Because of these uncertainties, additional liabilities may arise for amounts in excess of the Company’s current reserves. In addition, the Company’s estimate of ultimate loss and loss adjustment expenses may change. These additional liabilities, or increases in estimates, or a range of either, cannot be reasonably estimated, and could result in income statement charges that could be material to the Company’s results of operations in future periods. Operating Lease Commitments: As of September 30, 2017, the Company had the following amounts due under its operating leases for facilities leased in Baton Rouge, Louisiana, and Tampa, Florida. Year ending September 30, | | ------------------------------+---+---- 2018 | $ | 303 ------------------------------+---+---- 2019 | | 298 ------------------------------+---+---- 2020 | | 25 ------------------------------+---+---- 2021 and thereafter | | — ------------------------------+---+---- | $ | 626 ------------------------------+---+---- 25 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES ($ amounts in thousands, except share and per share data) ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS You should read the following discussion in conjunction with our consolidated financial statements and notes thereto included in this Quarterly Report on Form 10-Q and in our Annual Report on form 10-K for the year ended December 31, 2016 filed with the Securities and Exchange Commission (the “SEC”) on March 16, 2017. Unless context denotes otherwise, the terms “Company,” “we,” “us,” and “our” refer to 1347 Property Insurance Holdings, Inc., and its subsidiaries. Cautionary Note about Forward-Looking Statements This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Sections 27A of the Securities Act of 1933, as amended, and 21E of the Securities Exchange Act of 1934, as amended. We use words such as “anticipate,” “estimate,” “plan,” “project,” “continuing,” “ongoing,” “expect,” “believe,” “intend,” “may,” “will,” “should,” “could,” and other similar expressions to identify forward-looking statements. Such forward-looking statements relate to future events or future performance, but reflect management’s current beliefs, based on information currently available. Although we believe that the plans, objectives, expectations, and prospects reflected in or suggested by our forward-looking statements are reasonable, those statements involve risks, uncertainties, and other factors that may cause our actual results, performance, or achievements to be materially different from any future results, performance, or achievements express or implied by these forward-looking statements, and we can give no assurance that our plans, objectives, expectations, and prospects will be achieved. Important factors that may cause our actual results to differ materially from the results contemplated by the forward looking statements are contained in Item 1A. Risk Factors and elsewhere on the Company’s Form 10-K for the year ended December 31, 2016 and in our subsequent filings with the SEC, and include, among others, the following: (i) our limited operating history and status as an emerging growth company; (ii) lack of future opportunities to participate in take-out programs; (iii) the level of demand for our coverage and the incidence of catastrophic events related to such coverage, including the impact of climate change and our lack of geographic diversification; (iv) our ability to successfully implement our business strategy and expand our operations, including through acquisitions and development of new products; (v) changes in general economic, business, and industry conditions, including cyclical changes in the insurance industry; (vi) our ability to grow and remain profitable in the competitive insurance industry, including our lack of a rating from A.M. Best; (vii) legal, regulatory, and tax developments, including the effects of emerging claim and coverage issues and increased litigation against the insurance industry; (viii) legal actions brought against us; (ix) damage to our reputation; (x) adequacy of our insurance reserves; (xi) availability of reinsurance and ability of reinsurers to pay their obligations; (xii) the failure of our risk mitigation strategies or loss limitation methods; (xiii) our reliance on independent agents to write our insurance and other third parties; (xiv) our ability to maintain our public company status, exchange listing and effective internal control systems; (xv) data security breaches and other factors affecting our information technology systems; (xvi) our ability to attract and retain qualified employees, independent agents and brokers; (xvii) our ability to meet our obligations or obtain additional capital on favorable terms, or at all; (xviii) our ability to accurately price the risks that we underwrite; and (xix) restrictions on the use of our net operating loss carryforwards. We disclaim any obligation to update or revise any forward-looking statements as a result of new information, future events, or for any other reason. Overview Maison Insurance Holdings, Inc. was incorporated on October 2, 2012 in the State of Delaware. On November 19, 2013, the Company changed its legal name from Maison Insurance Holdings, Inc. to 1347 Property Insurance Holdings, Inc. (“PIH”). PIH is a holding company and is engaged, through its subsidiaries, in the property and casualty insurance business. 26 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES ($ amounts in thousands, except share and per share data) Prior to March 31, 2014, the Company operated as a wholly owned subsidiary of Kingsway America, Inc. (“KAI”). KAI, in turn, is a wholly owned subsidiary of Kingsway Financial Services, Inc. (“KFSI”), a publicly owned holding company based in Toronto, Ontario, Canada. On March 31, 2014, the Company completed an initial public offering of its common stock and then on June 13, 2014, the Company completed a follow-on offering. Through the combination of the IPO and follow-on offering, the Company issued approximately five million shares of its common stock, while KAI, and entities affiliated with KAI retained one million shares of PIH. On October 25, 2017, KAI entered into a purchase agreement with Fundamental Global Investors, LLC (“FGI”) pursuant to which KAI agreed to sell 900,000 shares of our common stock to FGI or to one of FGI’s affiliate companies in two separate transactions. The first transaction, for the sale of 475,428 shares of our common stock, occurred on November 1, 2017. The second transaction, for the sale of 424,572 shares of our common stock is conditioned on approval of the transaction by both the LDI and FL OIR by January 23, 2018. FGI is affiliated with D. Kyle Cerminara, where he serves as Chief Executive Officer, Co-Founder and Partner, and Lewis M. Johnson, where he serves as President, Co-Founder and Partner. Messrs. Cerminara and Johnson are also members of our Board of Directors. Should the second transaction be consummated, FGI, and entities affiliated with FGI, would own 43% of our outstanding common shares. PIH has three wholly-owned subsidiaries; Maison Insurance Company (“Maison”), a Louisiana-domiciled property and casualty insurance company, Maison Managers, Inc. (“MMI”), a managing general agent, incorporated in the State of Delaware on October 2, 2012, and ClaimCor, LLC (“ClaimCor”), a Florida based claims solutions company. Maison writes personal property and casualty insurance in Louisiana and both personal and commercial property and casualty insurance in Texas. Maison provides dwelling policies for wind and hail only, and dwelling, homeowner and mobile home/manufactured home policies for multi-peril property risks. Maison distributes its insurance policies through a network of independent agencies in Louisiana and Texas. These agencies typically represent several insurance companies in order to provide various insurance product lines to their clients. The Company refers to these policies as voluntary policies. In addition to the voluntary policies that Maison writes, Maison has participated in the last five rounds of take-outs from Louisiana Citizens Property Insurance Company (“LA Citizens”), occurring on December 1st of each year, as well as the inaugural depopulation of policies from the Texas Windstorm Insurance Association (“TWIA”), which occurred on December 1, 2016. Under these programs, state-approved insurance companies, such as Maison, have the opportunity to assume insurance policies written by both LA Citizens and TWIA. The majority of policies that we have obtained through LA Citizens as well as all of the policies we have obtained through TWIA cover losses arising only from wind and hail. Prior to our takeout, both LA Citizens and TWIA policyholders were not able to obtain such coverage from any other marketplace. On March 1, 2017, Maison received a certificate of authority from the Florida Office of Insurance Regulation (“FL OIR”) which authorizes Maison to write personal lines insurance in the State of Florida. Pursuant to the consent order issued, Maison has agreed to comply with certain requirements as outlined by the FL OIR until Maison can demonstrate three consecutive years of net income following the Company’s admission into Florida as evidenced by its Annual Statement filed with the FL OIR via the National Association of Insurance Commissioners electronic filing system. Among other requirements, the FL OIR requires the following as conditions related to the issuance of Maison’s certificate of authority: ● | Although domiciled in the State of Louisiana, Maison has agreed to comply with the Florida Insurance Code as if Maison were a domestic insurer within the State of Florida; --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ● | Maison has agreed to maintain capital and surplus as to policyholders of no less than $35,000; --+---------------------------------------------------------------------------------------------------------------------------------------- ● | Maison has agreed to receive prior approval from the FL OIR prior to the payment of any dividends; and --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ● | Maison has agreed to receive written approval from the FL OIR regarding any form of policy issued or rate charged to its policyholders prior to utilizing any such form or rate for policies written in the State of Florida. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- To comply with the consent order, on March 31, 2017, Maison received a capital contribution from PIH in the amount of $16,000. As of September 30, 2017, Maison has not written any insurance policies covering risks in the State of Florida. 27 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES ($ amounts in thousands, except share and per share data) Our direct in-force policy counts as well as assumed policies as of September 30, 2017 and December 31, 2016 were as follows: | Policies in-force as of | ------------------------------------------------------+-----------------------------+------- Source of Policies | September 30, 2017 | | December 31, 2016 ------------------------------------------------------+-----------------------------+--------+---------------------- Total LA Citizens Takeout Policies in Force | | 8,224 | | 8,892 ------------------------------------------------------+-----------------------------+--------+-----------------------+------- Homeowners | | 21,465 | | 17,685 ------------------------------------------------------+-----------------------------+--------+-----------------------+------- Manufactured Homes | | 4,816 | | 4,694 ------------------------------------------------------+-----------------------------+--------+-----------------------+------- Other Dwellings | | 5,036 | | 2,568 ------------------------------------------------------+-----------------------------+--------+-----------------------+------- Total Voluntary Policies in Force | | 31,317 | | 24,947 ------------------------------------------------------+-----------------------------+--------+-----------------------+------- Total Direct Policies in Force | | 39,541 | | 33,839 ------------------------------------------------------+-----------------------------+--------+-----------------------+------- Assumed through Brotherhood Quota-Share Agreement | | 766 | | 522 ------------------------------------------------------+-----------------------------+--------+-----------------------+------- Assumed through TWIA Quota-Share Agreement(1) | | 623 | | 1,251 ------------------------------------------------------+-----------------------------+--------+-----------------------+------- Total Assumed Policies | | 1,389 | | 1,773 ------------------------------------------------------+-----------------------------+--------+-----------------------+------- (1) | The decrease in policies assumed through the TWIA quota share agreement from December 1, 2016 to September 30, 2017 is attributable to the fact that policyholders had a six month period (until May 31, 2017) to opt-out of the assumption process. Upon opt-out, policies are removed from the Company’s listing of assumed policies back to the original date of takeout, December 1, 2016 (as if the Company had never assumed the policy). Furthermore, pursuant to the quota share agreement, any policies which had been assumed through TWIA and had reached their expiration are renewed by Maison directly (are no longer considered an assumed policy and are instead reflected Voluntary Policies in Force in the table above). ----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- On September 29, 2017, Maison received authorization from the FL OIR to assume personal lines policies from Florida Citizens Property Insurance Corporation (“FL Citizens”) pursuant to a proposal of depopulation which Maison filed with FL Citizens on August 18, 2017. Accordingly, Maison plans to enter the Florida market via the assumption of policies from FL Citizens in December, 2017. The order approving Maison’s assumption of policies limits the number of policies which Maison may assume in 2017, and also stipulates that Maison maintain catastrophe reinsurance at such levels as deemed appropriate by the FL OIR. MMI serves as the Company’s management services subsidiary and provides underwriting, policy administration, claims administration, marketing, accounting and other management services to Maison. MMI contracts with independent agencies for policy sales and services, and contracts with an independent third-party for policy administration services. As a managing general agency, MMI is licensed by and subject to the regulatory oversight of the Louisiana and Texas Departments of Insurance (“LDI” and “TDI”, respectively) as well as the Florida Office of Insurance Regulation (“FL OIR”). ClaimCor serves as the Company’s claims and underwriting technical solutions company. Maison processes claims made by our policyholders through ClaimCor, and also through various third-party claims adjusting companies. We have the ultimate authority over the claims handling process, while the agencies that we appoint have no authority to settle our claims or otherwise exercise control over the claims process. The Company operates in in a single segment – property and casualty insurance. Non U.S.-GAAP Financial Measures The Company assesses its results of operations using certain non-U.S. GAAP financial measures, in addition to U.S. GAAP financial measures. These non-U.S. GAAP financial measures are defined below. The Company believes these non-U.S. GAAP financial measures provide useful information to investors and others in understanding and evaluating our operating performance in the same manner as management does. The non-U.S. GAAP financial measures should be considered in addition to, and not as a substitute for or superior to, any financial measures prepared in accordance with U.S. GAAP. The Company’s non-U.S. GAAP financial measures may be defined differently from time to time and may be defined differently than similar terms used by other companies, and accordingly, care should be exercised in understanding how we define our non-U.S. GAAP financial measures. 28 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES ($ amounts in thousands, except share and per share data) Underwriting Ratios The Company, like many insurance companies, analyzes performance based on underwriting ratios such as loss ratio, expense ratio and combined ratio. The loss ratio is derived by dividing the amount of net losses and loss adjustment expenses by net premiums earned. The expense ratio is derived by dividing the sum of amortization of deferred policy acquisition costs and general and administrative expenses by net premiums earned. All items included in the loss and expense ratios are presented in the Company’s U.S. GAAP financial statements. The combined ratio is the sum of the loss ratio and the expense ratio. A combined ratio below 100% demonstrates underwriting profit whereas a combined ratio over 100% demonstrates an underwriting loss. Critical Accounting Policies The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the application of policies and the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses for the reporting period. Actual results could differ from these estimates. Estimates and their underlying assumptions are reviewed on an ongoing basis. Changes in estimates are recorded in the accounting period in which they are determined. The critical accounting estimates and assumptions in the accompanying consolidated financial statements include the provision for loss and loss adjustment expense reserves (as well as the reinsurance recoverable on those reserves), the valuation of fixed income and equity securities, the valuation of net deferred income taxes, the valuation of various securities that we have issued in conjunction with the termination of the management services agreement with 1347 Advisors, LLC, and the valuation of deferred policy acquisition costs. Adoption of Accounting Standards Due to Status as an Emerging Growth Company Section 107 of the JOBS act provides that an emerging growth company can take advantage of the exemption from complying with new or revised accounting standards provided in Section 7(a)(2)(B) of the Securities Act of 1933, as amended, as long as we are an emerging growth company. An emerging growth company can therefore delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have elected to take advantage of these benefits until we are no longer an emerging growth company or until we affirmatively and irrevocably opt out of this exemption. Our financial statements may therefore not be comparable to those of companies that comply with such new or revised accounting standards. Provision for Loss and Loss Adjustment Expense Reserves A significant degree of judgment is required to determine amounts recorded in the consolidated financial statements for the provision for loss and loss adjustment expense reserves. The process for establishing the provision for loss and loss adjustment expense reserves reflects the uncertainties and significant judgmental factors inherent in predicting future results of both known and unknown loss events. As such, the process is inherently complex and imprecise and estimates are constantly refined. The process of establishing the provision for loss and loss adjustment expense reserves relies on the judgment and opinions of a large number of individuals, including the opinions of the Company’s independent actuaries. Factors affecting the provision for loss and loss adjustment expense reserves include the continually evolving and changing regulatory and legal environment, actuarial studies, professional experience and expertise of the Company’s claims departments’ personnel and independent adjusters retained to handle individual claims, the quality of the data used for projection purposes, existing claims management practices including claims handling and settlement practices, the effect of inflationary trends on future loss settlement costs, court decisions, economic conditions and public attitudes. In the actuarial review process, an analysis of the provision for loss and loss adjustment expense reserves is completed for the Company’s insurance subsidiary. Unpaid losses, allocated loss adjustment expenses and unallocated loss adjustment expenses are separately analyzed by line of business or coverage by accident year. A wide range of actuarial methods are utilized in order to appropriately measure ultimate loss and loss adjustment expense costs. These methods include paid loss development, incurred loss development and frequency-severity method. Reasonability tests such as ultimate loss ratio trends and ultimate allocated loss adjustment expense to ultimate loss are also performed prior to selection of the final provision. The provision is indicated by line of business or coverage and is separated into case reserves, reserves for losses incurred but not reported (“IBNR”) and a provision for loss adjustment expenses (“LAE”). 29 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES ($ amounts in thousands, except share and per share data) Because the establishment of the provision for loss and loss adjustment expense reserves is an inherently uncertain process involving estimates, current provisions may need to be updated. Adjustments to the provision, both favorable and unfavorable, are reflected in the consolidated statements of operations and comprehensive income (loss) for the periods in which such estimates are updated. Management determines the loss and loss adjustment expense reserves as recorded on the Company’s financial statements, while the Company’s independent actuaries develop a range of reasonable estimates and a point estimate of loss and loss adjustment expense reserves. The actuarial point estimate is intended to represent the actuaries’ best estimate and will not necessarily be at the mid-point of the high and low estimates of the range. Valuation of Fixed Income and Equity Securities The Company’s fixed income and equity securities are recorded at fair value using observable inputs such as quoted prices in inactive markets, quoted prices in active markets for similar instruments, benchmark interest rates, broker quotes and other relevant inputs. The Company does not have any fixed income or equity investments in its portfolio which require the Company to use unobservable inputs. Any change in the estimated fair value of its investments could impact the amount of unrealized gain or loss the Company has recorded, which could change the amount the Company has recorded for its investments and other comprehensive loss on its consolidated balance sheets and statements of comprehensive income (loss). Gains and losses realized on the disposition of investments are determined on the first-in, first-out basis and credited or charged to the consolidated statements of operations and comprehensive income (loss). Premium and discount on investments are amortized and accreted using the interest method and charged or credited to net investment income. The Company performs a quarterly analysis of its investment portfolio to determine if declines in market value are other-than-temporary. Further information regarding its detailed analysis and factors considered in establishing an other-than-temporary impairment on an investment is discussed within Note 4 - Investments, to the consolidated financial statements. Valuation of Net Deferred Income Taxes The provision for income taxes is calculated based on the expected tax treatment of transactions recorded in the Company’s consolidated financial statements. In determining its provision for income taxes, the Company interprets tax legislation in a variety of jurisdictions and makes assumptions about the expected timing of the reversal of deferred income tax assets and liabilities and the valuation of net deferred income taxes. The ultimate realization of the deferred income tax asset balance is dependent upon the generation of future taxable income during the periods in which the Company’s temporary differences reverse and become deductible. A valuation allowance is established when it is more likely than not that all or a portion of the deferred income tax asset balance will not be realized. In determining whether a valuation allowance is needed, management considers all available positive and negative evidence affecting specific deferred income tax asset balances, including the Company’s past and anticipated future performance, the reversal of deferred income tax liabilities, and the availability of tax planning strategies. To the extent a valuation allowance is established in a period, an expense must be recorded within the income tax provision in the consolidated statements of operations and comprehensive income. 30 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES ($ amounts in thousands, except share and per share data) Securities issued to 1347 Advisors, LLC Pursuant to the termination of the Management Services Agreement with 1347 Advisors LLC (“Advisors,” a wholly-owned subsidiary of KFSI), the Company issued Preferred Shares, Warrants, and entered into a Performance Share Grant Agreement with Advisors on February 24, 2015. Because the Preferred Shares have a provision requiring mandatory redemption on February 24, 2020, the Company was required to classify the Preferred Shares as a liability on its balance sheet. The resulting liability was recorded at a discount to the $4,200 ultimate amount of payments required to be made under the Preferred Shares which includes all periodic dividends to be paid on the Preferred Shares based upon an analysis of the timing and amounts of cash payments expected to occur under the terms of the Preferred Shares discounted for the Company’s estimated cost of equity (13.9%). The Company has estimated the fair value of the Warrants on grant date based upon the Black-Scholes option pricing model while it utilized a Monte Carlo model to determine the fair value of the Performance Share Grant Agreement due to the fact that the underlying shares are only issuable based upon the achievement of certain market conditions. Deferred Policy Acquisition Costs Deferred policy acquisition costs represent the deferral of expenses that the Company incurs related to successful efforts to acquire new business or renew existing business. Acquisition costs, which consist of commissions, premium taxes and underwriting and agency expenses related to issuing insurance policies are deferred, and charged against income ratably over the terms of the related insurance policies. Management regularly reviews the categories of acquisition costs that are deferred and assesses the recoverability of this asset. Costs associated with unsuccessful efforts or costs that cannot be tied directly to a successful policy acquisition are expensed as incurred, as opposed to being deferred and amortized as the premium is earned. New Accounting Pronouncements See Note 3 – “Recently Issued Accounting Standards” in the Notes to our consolidated financial statements included in Item 1 of the Quarterly Report on Form 10-Q for a discussion of the recent accounting pronouncements and their effect, if any, on the Company. Analysis of Financial Condition As of September 30, 2017 compared to December 31, 2016 Investments The Company’s investments in fixed income and equity securities are classified as available-for-sale and are reported at estimated fair value. The Company held an investment portfolio comprised primarily of fixed income securities issued by the U.S. government, government agencies and high quality corporate issuers. The fixed income portfolio is managed by a third-party investment management firm in accordance with the investment policies and guidelines approved by the Company’s Board of Directors. These guidelines stress the preservation of capital, market liquidity and the diversification of risk. Additionally, an investment committee comprised of a portion of the Company’s directors is in place to identify, evaluate and approve suitable investment opportunities for the Company. This has resulted in a number of equity investments managed by the committee that represent approximately 3.6% of the Company’s total investment portfolio as of September 30, 2017. Investments held by the Company’s insurance subsidiary must also comply with applicable domiciliary state regulations that prescribe the type, quality and concentration of investments. 31 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES ($ amounts in thousands, except share and per share data) The table below summarizes, by type, the Company’s investments as of September 30, 2017 and December 31, 2016. | September 30, 2017 | | December 31, 2016 --------------------------------------------------------------------+--------------------------+--------+-------------------------- Type of Investment | Carrying Amount | | Percent of Total | | Carrying Amount | | Percent of Total --------------------------------------------------------------------+--------------------------+--------+---------------------------+-------+--------------------------+---+-------------------------- Fixed income securities: | | | | | | | | | --------------------------------------------------------------------+--------------------------+--------+---------------------------+-------+--------------------------+---+---------------------------+-------+-- U.S. government | $ | 2,899 | | 5.8 | % | $ | 1,604 | 5.6 | % --------------------------------------------------------------------+--------------------------+--------+---------------------------+-------+--------------------------+---+---------------------------+-------+-- State municipalities and political subdivisions | | 5,365 | | 10.8 | % | | 2,246 | 7.9 | % --------------------------------------------------------------------+--------------------------+--------+---------------------------+-------+--------------------------+---+---------------------------+-------+-- Asset-backed securities and collateralized mortgage obligations | | 16,635 | | 33.5 | % | | 11,968 | 42.2 | % --------------------------------------------------------------------+--------------------------+--------+---------------------------+-------+--------------------------+---+---------------------------+-------+-- Corporate | | 20,308 | | 40.9 | % | | 10,741 | 37.8 | % --------------------------------------------------------------------+--------------------------+--------+---------------------------+-------+--------------------------+---+---------------------------+-------+-- Total fixed income securities | | 45,207 | | 91.0 | % | | 26,559 | 93.5 | % --------------------------------------------------------------------+--------------------------+--------+---------------------------+-------+--------------------------+---+---------------------------+-------+-- Equity securities: | | | | | | | | | --------------------------------------------------------------------+--------------------------+--------+---------------------------+-------+--------------------------+---+---------------------------+-------+-- Common stock | | 1,612 | | 3.2 | % | | 1,136 | 4.0 | % --------------------------------------------------------------------+--------------------------+--------+---------------------------+-------+--------------------------+---+---------------------------+-------+-- Warrants to purchase common stock | | 122 | | 0.2 | % | | — | — | % --------------------------------------------------------------------+--------------------------+--------+---------------------------+-------+--------------------------+---+---------------------------+-------+-- Rights to purchase common stock | | 37 | | 0.1 | % | | — | — | % --------------------------------------------------------------------+--------------------------+--------+---------------------------+-------+--------------------------+---+---------------------------+-------+-- Total equity securities | | 1,771 | | 3.5 | % | | 1,136 | 4.0 | % --------------------------------------------------------------------+--------------------------+--------+---------------------------+-------+--------------------------+---+---------------------------+-------+-- Short-term investments | | 1,779 | | 3.6 | % | | 196 | 0.7 | % --------------------------------------------------------------------+--------------------------+--------+---------------------------+-------+--------------------------+---+---------------------------+-------+-- Other investments | | 945 | | 1.9 | % | | 505 | 1.8 | % --------------------------------------------------------------------+--------------------------+--------+---------------------------+-------+--------------------------+---+---------------------------+-------+-- Total investments | $ | 49,702 | | 100.0 | % | $ | 28,396 | 100.0 | % --------------------------------------------------------------------+--------------------------+--------+---------------------------+-------+--------------------------+---+---------------------------+-------+-- Pursuant to the certificate of authority that we received from the TDI, we are required to deposit securities with the State of Texas. These securities consist of fixed income securities listed in the table above having an amortized cost basis of $2,001 and an estimated fair value of $1,998 as of September 30, 2017. The Company’s other investments are comprised of equity investments in two limited partnerships which seek to provide equity and asset-backed debt investment in a variety of privately-owned companies. The Company has committed to a total investment of $1,000, of which the limited partnerships have drawn down approximately $645 through September 30, 2017. One of these limited partnerships is managed by Argo Management Group, LLC, an entity which, as of April 21, 2016 is wholly owned by KFSI. The Company has accounted for its investments under the cost method as the instruments do not have readily determinable fair values and the Company does not exercise significant influence over the operations of the limited partnerships or the underlying privately-owned companies. Also included in other investments is a $300 certificate of deposit with an original term of 18 months deposited with the State of Florida pursuant to the terms of the certificate of authority issued to Maison from the FL OIR. Liquidity and Cash Flow Risk The table below summarizes the fair value of the Company’s fixed income securities by contractual maturity as of September 30, 2017 and December 31, 2016. Actual results may differ as issuers may have the right to call or prepay obligations, with or without penalties, prior to the contractual maturity of these obligations. | September 30, 2017 | | December 31, 2016 --------------------------------+--------------------------+--------+-------------------------- Matures in: | Carrying Amount | | Percent of Total | | Carrying Amount | | Percent of Total --------------------------------+--------------------------+--------+---------------------------+-------+--------------------------+---+-------------------------- One year or less | $ | 2,415 | | 5.3 | % | $ | 1,828 | 6.9 | % --------------------------------+--------------------------+--------+---------------------------+-------+--------------------------+---+---------------------------+-------+-- More than one to five years | | 19,757 | | 43.7 | % | | 12,678 | 47.7 | % --------------------------------+--------------------------+--------+---------------------------+-------+--------------------------+---+---------------------------+-------+-- More than five to ten years | | 11,804 | | 26.1 | % | | 3,918 | 14.8 | % --------------------------------+--------------------------+--------+---------------------------+-------+--------------------------+---+---------------------------+-------+-- More than ten years | | 11,231 | | 24.9 | % | | 8,135 | 30.6 | % --------------------------------+--------------------------+--------+---------------------------+-------+--------------------------+---+---------------------------+-------+-- Total | $ | 45,207 | | 100.0 | % | $ | 26,559 | 100.0 | % --------------------------------+--------------------------+--------+---------------------------+-------+--------------------------+---+---------------------------+-------+-- The Company holds cash and high-grade short-term assets which, along with fixed income and equity securities, management believes are sufficient in amount for the payment of loss and loss adjustment expense reserves and other operating subsidiary obligations on a timely basis. The Company may not be able to liquidate its investments in the event that additional cash is required to meet obligations to its policyholders; however, the Company believes that the high-quality, liquid investments in its portfolio provide it with sufficient liquidity. Market Risk Market risk is the risk that the Company will incur losses due to adverse changes in interest or currency exchange rates and equity prices. Given the Company’s operations only invest in U.S. dollar denominated instruments and maintains a relatively insignificant investment in equity instruments, its primary market risk exposures in the investments portfolio are to changes in interest rates. Because the investments portfolio is comprised of primarily fixed maturity instruments that are usually held to maturity, periodic changes in interest rate levels generally impact the Company’s financial results to the extent that the investments are recorded at market value and reinvestment yields are different than the original yields on maturing instruments. During periods of rising interest rates, the market values of the existing fixed income securities will generally decrease. The reverse is true during periods of declining interest rates. 32 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES ($ amounts in thousands, except share and per share data) Credit Risk Credit risk is defined as the risk of financial loss due to failure of the other party to a financial instrument to discharge an obligation. Credit risk arises from the Company’s positions in short-term investments, corporate debt instruments and government and government agency bonds. At September 30, 2017 and December 31, 2016, the Company’s debt securities had the following quality ratings as assigned by Standard and Poor’s (“S&P”) or Moody’s Investors Service (“Moody’s”). | September 30, 2017 | | December 31, 2016 ----------------------------------+--------------------------+--------+-------------------------- Rating (S&P/Moody’s) | Carrying Amount | | Percent of Total | | Carrying Amount | | Percent of Total ----------------------------------+--------------------------+--------+---------------------------+-------+--------------------------+---+-------------------------- AAA/Aaa | $ | 22,345 | | 49.4 | % | $ | 14,995 | 56.4 | % ----------------------------------+--------------------------+--------+---------------------------+-------+--------------------------+---+---------------------------+-------+-- Aa/Aa | | 5,551 | | 12.3 | % | | 2,627 | 9.9 | % ----------------------------------+--------------------------+--------+---------------------------+-------+--------------------------+---+---------------------------+-------+-- A/A | | 11,735 | | 26.0 | % | | 5,516 | 20.8 | % ----------------------------------+--------------------------+--------+---------------------------+-------+--------------------------+---+---------------------------+-------+-- BBB | | 5,576 | | 12.3 | % | | 3,421 | 12.9 | % ----------------------------------+--------------------------+--------+---------------------------+-------+--------------------------+---+---------------------------+-------+-- Total fixed income securities | $ | 45,207 | | 100.0 | % | $ | 26,559 | 100.0 | % ----------------------------------+--------------------------+--------+---------------------------+-------+--------------------------+---+---------------------------+-------+-- Other-Than-Temporary Impairment The length of time an individual investment may be held in an unrealized loss position may vary based on the opinion of the investment manager and their respective analyses related to valuation and to the various credit risks that may prevent the Company from recapturing the principal investment. In the case of an individual investment where the investment manager determines that there is little or no risk of default prior to maturity, the Company would elect to hold the investment in an unrealized loss position until the price recovers or the investment matures. In situations where facts emerge that might increase the risk associated with recapture of principal, the Company may elect to sell the investment at a loss. The Company performs a quarterly analysis of its investment portfolio to determine if declines in market value are other-than-temporary. Further information regarding the Company’s detailed analysis and factors considered in establishing an other-than-temporary impairment on an investment is discussed within Note 4 - “Investments,” to the consolidated financial statements in Item 1 of this report. As a result of the analysis performed by the Company, there were no write-downs for other-than-temporary impairments related to investments for the nine months ended September 30, 2017 and 2016. As of September 30, 2017, the gross unrealized losses for fixed income and equity securities amounted to $202 and $59, respectively, and there were no unrealized losses attributable to non-investment grade securities. At both September 30, 2017 and December 31, 2016, all unrealized losses on individual investments were considered temporary. Fixed income securities in unrealized loss positions continued to pay interest and were not subject to material changes in their respective debt ratings. The Company concluded the declines in value were considered temporary. As the Company has the capacity to hold these investments to maturity, no impairment provision was considered necessary. Deferred Policy Acquisition Costs The Company’s deferred policy acquisition costs (“DPAC”) include commissions, premium taxes, assessments and policy processing fees that are directly related to successful efforts to acquire new or existing insurance policies to the extent they are considered recoverable and represent those costs related to acquiring the premiums the Company has yet to earn (the unearned premium reserve). DPAC increased $1,803, to $6,192 as of September 30, 2017 from $4,389 as of December 31, 2016. DPAC expressed as a percentage of unearned premium reserves was 19.2% as of September 30, 2017, compared to 17.0% as of December 31, 2016. This increase results from an increase in the effective rate on premium taxes that we pay in Louisiana and Texas due to a change in Louisiana statute whereby the Company no longer qualifies for certain credits on its premium taxes which were related to the value of investments held in the State of Louisiana. 33 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES ($ amounts in thousands, except share and per share data) Premiums Receivable, Net of Allowance for Doubtful Accounts Premiums receivable, net of allowances for credit losses, decreased by $703 to $2,220 as of September 30, 2017 from $2,923 as of December 31, 2016. Due to our participation in the Citizens take-out program on December 1, 2016, we had a balance due from Citizens for approximately $800 as of December 31, 2016, most of which had been collected as of September 30, 2017. Ceded Unearned Premiums Ceded unearned premiums represents the unexpired portion of premiums which have been paid to the Company’s reinsurers. Ceded unearned premiums are charged to income over the terms of the respective reinsurance treaties. Ceded unearned premiums decreased $1,011 to $3,836 as of September 30, 2017 from $4,847 as of December 31, 2016 due predominantly to the amount and timing of installment payments due under our excess of loss catastrophe treaties. Reinsurance Recoverable Reinsurance recoverable on both paid losses and loss and LAE reserves represents amounts due to the Company, or expected to be due to the Company, from its reinsurers, based upon claims paid as well as claims reserves which have exceeded the retention amount under our reinsurance treaties. As of September 30, 2017, we have recorded expected recoveries from our reinsurers of $7,767 on paid losses and $17,560 on loss and LAE reserves, resulting primarily from recoveries due under our catastrophe excess of loss treaty for Hurricane Harvey, which affected the Gulf Coast of Texas in late August, 2017. See “Loss and Loss Adjustment Expense Reserves” in Item 2 of this report for further discussion on the Company’s claims reserves and expected recoveries. Funds Deposited with Reinsured Companies Funds deposited with reinsured companies represents collateral that we had placed on deposit with Brotherhood based upon our quota-share agreement to reinsure a portion of Brotherhood’s business for wind/hail coverage only. Pursuant to the agreement, we were required to fund our pro-rata portion of reserves that Brotherhood had established for losses and loss adjustments expenses, and any other amounts for which Brotherhood had not been able to take credit for on its annual statutory financial statements. As of December 31, 2016, we had funded this obligation via a deposit of $500 made to Brotherhood under a trust agreement. This collateral was returned to the Company in March 2017. Current Income Taxes Recoverable Current income taxes recoverable were $632 as of September 30, 2017 compared to $1,195 as of December 31, 2016, which represent the estimate of both the Company’s state and federal income taxes paid in excess of amounts due as of September 30, 2017 and December 31, 2016, respectively. Net Deferred Income Taxes Net deferred income taxes increased $435 to $855 as of September 30, 2017 compared to $420 as of December 31, 2016. Net deferred income taxes are comprised of approximately $3,483 and $2,359 of deferred tax assets, net of approximately $2,628 and $1,939 of deferred tax liabilities as of September 30, 2017 and December 31, 2016, respectively. The change in the net deferred tax asset is primarily due to an increase in deferred tax assets associated with our increase in unearned premium reserves as well as an increase in net operating loss carryforwards due to our net loss for the nine months ended September 30, 2017. Property and Equipment Property and equipment was $213 and $250 as of September 30, 2017 and December 31, 2016, respectively, and consists of computers, office equipment, and improvements at our leased facilities in Tampa, Florida and Baton Rouge, Louisiana, shown net of accumulated depreciation. Also included in these balances are vehicles that we have purchased for the use of our sales representatives in Texas, Florida and Louisiana. Our policy for the capitalization and depreciation of these assets can be found in Note 2 – Significant Accounting Policies in Item 1 of this report. 34 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES ($ amounts in thousands, except share and per share data) Other Assets Other assets increased $79, to $867 as of September 30, 2017 from $788 as of December 31, 2016. The major components of other assets, and the change therein, are shown below. Other Assets | September 30, 2017 | | December 31, 2016 | | | Change ------------------------------------------+------------------------+-----+-----------------------+---+-----+------- Accrued interest on investments | $ | 233 | | $ | 117 | | $ | 116 | ------------------------------------------+------------------------+-----+-----------------------+---+-----+--------+---+------+-- Security deposits for facility leases | | 38 | | | 38 | | | — | ------------------------------------------+------------------------+-----+-----------------------+---+-----+--------+---+------+-- Prepaid expenses | | 481 | | | 616 | | | (135 | ) ------------------------------------------+------------------------+-----+-----------------------+---+-----+--------+---+------+-- Other | | 115 | | | 17 | | | 98 | ------------------------------------------+------------------------+-----+-----------------------+---+-----+--------+---+------+-- Total | $ | 867 | | $ | 788 | | $ | 79 | ------------------------------------------+------------------------+-----+-----------------------+---+-----+--------+---+------+-- Loss and Loss Adjustment Expense Reserves Loss and loss adjustment expense reserves represent the estimated liabilities for reported loss events, incurred and but not reported (“IBNR”) loss events, as well as the related estimated loss adjustment expenses (“LAE”). The table below separates our loss reserves and LAE between IBNR and case specific estimates as of September 30, 2017 and December 31, 2016, and also shows the expected reinsurance recoverable on those reserves. | Case Loss Reserves | | Case LAE Reserves | | | Total Case Reserves | | IBNR Reserves (including LAE) | Total Reserves | | Reinsurance Recoverable on Reserves | ------------------------+------------------------+--------+-----------------------+---+-----+-------------------------+---+-----------------------------------+--------------------+-------+-----------------------------------------+-- September 30, 2017 | | | | | | | | | | | | | | | ------------------------+------------------------+--------+-----------------------+---+-----+-------------------------+---+-----------------------------------+--------------------+-------+-----------------------------------------+---+--------+---+------- Homeowners(1) | $ | 3,348 | | $ | 347 | | $ | 3,695 | $ | 3,065 | | $ | 6,760 | $ | 3,254 ------------------------+------------------------+--------+-----------------------+---+-----+-------------------------+---+-----------------------------------+--------------------+-------+-----------------------------------------+---+--------+---+------- Special Property(2) | | 10,372 | | | 600 | | | 10,972 | | 4,359 | | | 15,331 | | 14,306 ------------------------+------------------------+--------+-----------------------+---+-----+-------------------------+---+-----------------------------------+--------------------+-------+-----------------------------------------+---+--------+---+------- Total | $ | 13,720 | | $ | 947 | | $ | 14,667 | $ | 7,424 | | $ | 22,091 | $ | 17,560 ------------------------+------------------------+--------+-----------------------+---+-----+-------------------------+---+-----------------------------------+--------------------+-------+-----------------------------------------+---+--------+---+------- December 31, 2016 | | | | | | | | | | | | | | | ------------------------+------------------------+--------+-----------------------+---+-----+-------------------------+---+-----------------------------------+--------------------+-------+-----------------------------------------+---+--------+---+------- Homeowners | $ | 1,523 | | $ | 463 | | $ | 1,986 | $ | 3,302 | | $ | 5,288 | $ | 2,565 ------------------------+------------------------+--------+-----------------------+---+-----+-------------------------+---+-----------------------------------+--------------------+-------+-----------------------------------------+---+--------+---+------- Special Property | | 697 | | | 88 | | | 785 | | 898 | | | 1,683 | | 1,087 ------------------------+------------------------+--------+-----------------------+---+-----+-------------------------+---+-----------------------------------+--------------------+-------+-----------------------------------------+---+--------+---+------- Total | $ | 2,220 | | $ | 551 | | $ | 2,771 | $ | 4,200 | | $ | 6,971 | $ | 3,652 ------------------------+------------------------+--------+-----------------------+---+-----+-------------------------+---+-----------------------------------+--------------------+-------+-----------------------------------------+---+--------+---+------- (1) | Homeowners refers to our multi-peril policies for traditional dwellings as well as mobile and manufactured homes. ----+------------------------------------------------------------------------------------------------------------------ (2) | Special property includes both our fire and allied lines of business, which are primarily wind/hail only products, and also includes the commercial lines wind/hail only business that we have assumed through our quota-share agreement with Brotherhood and our personal lines wind/hail only business that we have assumed through our quota-share agreement with TWIA. ----+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Gross reserves as of September 30, 2017 were $22,091, an increase of $15,120 from December 31, 2016. Gross reserves in the approximate amount of $14,200 have been established for PCS Catastrophe 1743, or Harvey, a major storm which made initial landfall in the U.S. as a Category 4 hurricane near Rockport, Texas. As of September 30, 2017, we anticipate our total incurred losses from Harvey to be $23,000 on a gross basis, or $5,000 on a net basis after recoveries under our catastrophe excess of loss reinsurance program. The reinsurance recoverable on reserves as of September 30, 2017 was $17,560, an increase of $13,908 from December 31, 2016, due, in large part, to the anticipated recoveries due to the Company from Harvey losses. As a result of the foregoing, net loss reserves were $4,531 and $3,319 as of September 30, 2017 and December 31, 2016, respectively. We cannot predict whether loss and loss adjustment expense reserves will develop favorably or unfavorably from the amounts reported in our consolidated financial statements. Any such development could have a material effect on our consolidated financial results for a given period. Furthermore, while we use, and expect to continue to use, reinsurance to help manage our exposure to catastrophic losses, the availability and cost of reinsurance are each subject to prevailing market conditions beyond our control which can affect business volume and profitability. We may be unable to maintain our current reinsurance coverage, to obtain additional reinsurance coverage in the event our current reinsurance coverage is exhausted by a catastrophic event, or to obtain other reinsurance coverage in adequate amounts or at acceptable rates. Similar risks exist whether we are seeking to replace coverage terminated during the applicable coverage period or to renew or replace coverage upon its expiration. 35 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES ($ amounts in thousands, except share and per share data) Unearned Premium Reserves Unearned premium reserves increased to $32,170 as of September 30, 2017 compared to $25,821 as of December 31, 2016. The following table outlines the change in unearned premium reserves by state and line of business. | September 30, 2017 | | December 31, 2016 | | | Change --------------------------+------------------------+--------+--------------------------------------------------------------+---+--------+------- Homeowners - LA | $ | 17,725 | | $ | 16,644 | | $ | 1,081 --------------------------+------------------------+--------+--------------------------------------------------------------+---+--------+--------+---+------ Special Property - LA | | 7,379 | | | 7,113 | | | 266 --------------------------+------------------------+--------+--------------------------------------------------------------+---+--------+--------+---+------ Total Louisiana | | 25,104 | | | 23,757 | | | 1,347 --------------------------+------------------------+--------+--------------------------------------------------------------+---+--------+--------+---+------ Homeowners – TX | | 3,439 | | | 822 | | | 2,617 --------------------------+------------------------+--------+--------------------------------------------------------------+---+--------+--------+---+------ Special Property – TX | | 3,627 | | | 1,242 | | | 2,385 --------------------------+------------------------+--------+--------------------------------------------------------------+---+--------+--------+---+------ Total Texas | | 7,066 | | | 2,064 | | | 5,002 --------------------------+------------------------+--------+--------------------------------------------------------------+---+--------+--------+---+------ Grand Total | $ | 32,170 | | $ | 25,821 | | $ | 6,349 --------------------------+------------------------+--------+--------------------------------------------------------------+---+--------+--------+---+------ Ceded Reinsurance Premiums Payable Ceded reinsurance premiums payable increased $557 to $5,786 as of September 30, 2017 compared to $5,229 as of December 31, 2016. The bulk of the balance payable as of September 30, 2017 represents a quarterly installment payment due under our catastrophe reinsurance program, which was paid in October, 2017. Agency Commissions Payable Agency commissions payable increased $219 to $716 as of September 30, 2017 compared to $497 as of December 31, 2016. As agency commissions are paid one month in arrears, this balance represents commissions owed to the Company’s independent agencies on policies written throughout the months ended September 30, 2017 and December 31, 2016, respectively. Since the commissions that we pay to our independent agencies are based upon a percentage of the premium written by our agencies, the balance due will vary directly with the volume of premium written in the month. Premiums Collected in Advance Premium deposits were $1,887 and $1,128 and represent cash that the Company has received for policies which were not yet in-force as of September 30, 2017 and December 31, 2016, respectively. Upon the effective date of coverage, advance premiums are reclassified to the unearned premium reserve account. Funds held under Reinsurance Treaties Funds held under reinsurance treaties represents collateral that we have received on deposit from our reinsurers under our catastrophe excess of loss treaties and is intended to fund those reinsurers pro-rata portion of reserves that we have established for losses and loss adjustment expenses. As of December 31, 2016, we had received cash deposits of $73 from our reinsurers. This balance was reduced to $48 as of September 30, 2017 as a portion of the balance was applied to reinsurance recoveries due to us on paid losses during the nine months ended September 30, 2017. Accounts Payable and Other Accrued Expenses Accounts payable and other accrued expenses increased $2,418, to $4,483 as of September 30, 2017 from $2,065 as of December 31, 2016. The major components of accrued expenses and other liabilities, as well as the change therein, are shown below. | September 30, 2017 | | December 31, 2016 | | | Change ------------------------------------------+------------------------+-------+-------------------+---+-------+------- Accrued employee compensation | $ | 128 | | $ | 95 | | $ | 33 ------------------------------------------+------------------------+-------+-------------------+---+-------+--------+---+------ Accrued professional fees | | 763 | | | 509 | | | 254 ------------------------------------------+------------------------+-------+-------------------+---+-------+--------+---+------ Unearned policy fees | | 386 | | | 204 | | | 182 ------------------------------------------+------------------------+-------+-------------------+---+-------+--------+---+------ Accrued premium taxes and assessments | | 2,108 | | | 1,193 | | | 915 ------------------------------------------+------------------------+-------+-------------------+---+-------+--------+---+------ Funds due to settle bond trades | | 1,031 | | | — | | | 1,031 ------------------------------------------+------------------------+-------+-------------------+---+-------+--------+---+------ Other accounts payable | | 67 | | | 64 | | | 3 ------------------------------------------+------------------------+-------+-------------------+---+-------+--------+---+------ Total | $ | 4,483 | | $ | 2,065 | | $ | 2,418 ------------------------------------------+------------------------+-------+-------------------+---+-------+--------+---+------ 36 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES ($ amounts in thousands, except share and per share data) Related Party Transactions As a result of the termination of the Management Services Agreement (“MSA”), which occurred on February 24, 2015, the Company has issued the following securities to 1347 Advisors, LLC (“Advisors”), a wholly owned subsidiary of KFSI. ● | 100,000 shares of the Company’s common stock issuable pursuant to the Performance Shares Grant Agreement dated February 24, 2015, and subject to the achievement of the Milestone Event; --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ● | 120,000 shares of Series B Preferred Stock of the Company (the “Preferred Shares”); and --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ● | A warrant (the “Warrant”) to purchase 1,500,000 shares of the Company’s common stock at an exercise price of $15.00 per share. The Warrant expires on February 24, 2022. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- The Performance Shares Grant Agreement grants Advisors 100,000 shares of the Company’s common stock issuable upon the date that the last sales price of the Company’s common stock equals or exceeds $10.00 per share for any 20 trading days within any 30-day trading period (the “Milestone Event”). Advisors will not be entitled to any dividends declared or paid on the Company’s stock prior to the Milestone Event having been achieved. The Preferred Shares have a par value of $25.00 dollars and pay annual cumulative dividends at a rate of eight percent per annum. Cumulative dividends shall accrue, whether or not declared by the Board and irrespective of whether there are funds legally available for the payment of dividends. Accrued dividends shall be paid in cash only when, as, and if declared by the Board out of funds legally available therefor or upon a liquidation or redemption of the Preferred Shares. In the event of any voluntary of involuntary liquidation, dissolution, or winding up of the Company, the holders of the Preferred Shares then outstanding shall be entitled to be paid out of the assets of the Company available for distributions to its shareholders, before any payment shall be made to holders of securities junior in preference to the Preferred Shares. The Preferred Shares rank senior to the Company’s common stock, and the Company is not permitted to issue any other series of preferred stock that ranks equal or senior to the Preferred Shares while the Preferred Shares are outstanding. On both February 24, 2017 and 2016, the Company issued a cash payment of $240 to Advisors representing annual dividend payments due on the Preferred Shares. Unless redeemed earlier by the Company as discussed below, with the written consent of the holders of the majority of the Preferred Shares then outstanding, the Company will be required to redeem the Preferred Shares then outstanding on February 24, 2020 (the “Mandatory Redemption Date”), for a redemption amount equal to $25.00 dollars per share outstanding plus all accrued and unpaid dividends on such shares. The Company has the option to redeem the Preferred Shares prior to the Mandatory Redemption Date immediately prior to the consummation of any change in control of the Company that may occur. Since the Preferred Shares have a mandatory redemption provision requiring redemption on February 24, 2020, the Company was required to classify the Preferred Shares as a liability on the balance sheet instead of recording the value of these shares in equity. The resulting liability was recorded at a discount to the ultimate redemption amount of the Preferred Shares based upon an analysis of the cash payments expected to occur under the terms of the Preferred Shares discounted for the Company’s estimated cost of equity (13.9%). As a result, amortization in the amount of $1,889 will be charged to operations during the period the Preferred Shares are outstanding using the effective interest method. For the nine months ended September 30, 2017 and 2016, amortization of the discount on the Preferred Shares totaled $276 and $263, respectively. Investment in Limited Liability Company On April 21, 2016, KFSI completed the acquisition of Argo Management Group LLC (“Argo”). Argo’s primary business is to act as the Managing Member of Argo Holdings Fund I, LLC, an investment fund in which the Company has committed to invest $500, of which the Company has invested $211 as of September 30, 2017. The managing member of Argo, Mr. John T. Fitzgerald, was also appointed to KFSI’s board of directors on April 21, 2016. 37 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES ($ amounts in thousands, except share and per share data) Contractual Obligations As of September 30, 2017, the Company had the following amounts due under its operating leases for facilities leased in Baton Rouge, Louisiana, and Tampa, Florida. Year ending September 30, | | ------------------------------+---+---- 2018 | $ | 303 ------------------------------+---+---- 2019 | | 298 ------------------------------+---+---- 2020 | | 25 ------------------------------+---+---- 2021 and thereafter | | — ------------------------------+---+---- Total | $ | 626 ------------------------------+---+---- Shareholders’ Equity The primary drivers behind the changes to total shareholders’ equity for the nine months ended September 30, 2017 were the Company’s net loss as well as net unrealized gains on its investment portfolio as shown in the table below. Furthermore, on September 14, 2017, the Company sold 28,000 restricted common shares to its Chief Operating Officer, Mr. Case, at a price of $8.00 per share. | Common Shares Outstanding | | Treasury Shares | | Total Shareholders’ Equity -------------------------------------------------------------------+-------------------------------+-----------+--------------------------+---------+--------------------------------------------------------------------- Balance, January 1, 2017 | | 5,956,766 | | 151,359 | | $ | 46,357 | -------------------------------------------------------------------+-------------------------------+-----------+--------------------------+---------+----------------------------------------------------------------------+---+--------+-- Issuance of common shares | | 28,000 | | — | | | 224 | -------------------------------------------------------------------+-------------------------------+-----------+--------------------------+---------+----------------------------------------------------------------------+---+--------+-- Stock compensation expense | | — | | — | | | 19 | -------------------------------------------------------------------+-------------------------------+-----------+--------------------------+---------+----------------------------------------------------------------------+---+--------+-- Net loss | | — | | — | | | (1,096 | ) -------------------------------------------------------------------+-------------------------------+-----------+--------------------------+---------+----------------------------------------------------------------------+---+--------+-- Unrealized gains on investment portfolio (net of income taxes) | | — | | — | | | 94 | -------------------------------------------------------------------+-------------------------------+-----------+--------------------------+---------+----------------------------------------------------------------------+---+--------+-- Balance, September 30, 2017 | | 5,984,766 | | 151,359 | | $ | 45,598 | -------------------------------------------------------------------+-------------------------------+-----------+--------------------------+---------+----------------------------------------------------------------------+---+--------+-- Results of Operations Three and Nine Months Ended September 30, 2017 Compared with Three and Nine Months Ended September 30, 2016 Gross Premiums Written The following table shows our gross premiums written by line of business for the three and nine months ended September 30, 2017 and 2016. | Three months ended September 30, | | Nine months ended September 30, | --------------------------+--------------------------------------+--------+-------------------------------------+-- Line of Business | 2017 | | 2016 | | | Change | | 2017 | 2016 | | Change | --------------------------+--------------------------------------+--------+-------------------------------------+---+--------+--------+---+-------+------+--------+--------+-- Homeowners | $ | 11,275 | | $ | 9,402 | | $ | 1,873 | $ | 30,474 | | $ | 25,577 | $ | 4,897 --------------------------+--------------------------------------+--------+-------------------------------------+---+--------+--------+---+-------+------+--------+--------+---+--------+---+------ Special Property | | 5,888 | | | 4,564 | | | 1,324 | | 18,343 | | | 13,907 | | 4,436 --------------------------+--------------------------------------+--------+-------------------------------------+---+--------+--------+---+-------+------+--------+--------+---+--------+---+------ Gross Premium Written | $ | 17,163 | | $ | 13,966 | | $ | 3,197 | $ | 48,817 | | $ | 39,484 | $ | 9,333 --------------------------+--------------------------------------+--------+-------------------------------------+---+--------+--------+---+-------+------+--------+--------+---+--------+---+------ 38 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES ($ amounts in thousands, except share and per share data) Gross premiums written were $17,163 for the quarter ended September 30, 2017, up 22.9% from $13,966 for the quarter ended September 30, 2016. This increase was largely due to organic growth in voluntary production from the Company’s independent agents, particularly in Texas where the Company is reporting solid growth across all of its product lines with homeowner’s policies especially strong. For the nine months ended September 30, 2017, gross premiums written in the State of Louisiana represented approximately 74% of total gross written premiums, with the remaining 26% written in Texas. For the same period in the preceding year, gross premiums written in Louisiana and Texas represented 91% and 9%, respectively, as we continue to expand our network in Texas. Ceded Premiums Written Ceded premiums written increased to $16,426 for the nine months ended September 30, 2017, compared to $15,414 for the same period 2016. The increase in ceded premiums written is primarily due to an increase in the total insured value of the Company’s book of business year over year as well as the change in the geographic mix of coverage that we provide. While the limits purchased under our catastrophe excess of loss reinsurance (“CAT XOL”) and aggregate programs did not change year over year, our treaty years run from June 1st through May 31st of each year, thus the nine month periods ended September 30, 2017 and 2016 are covered by ceded premiums written under three separate reinsurance treaties. Therefore, the increase in ceded premiums written for the nine month period can also be attributed to the increase in limits purchased when comparing our 2015/2016 treaty with the Company’s two most recent treaties. The following table is a summary of the key provisions under each of our treaties. | 2015/2016 CAT XOL Treaty 06/01/15 – 05/31/16 | | 2016/2017 CAT XOL Treaty 06/01/16 – 05/31/17 | | | 2017/2018 CAT XOL Treaty 06/01/17 – 05/31/18 ------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------+---+----------------------------------------------------+------------------------------------------------- Wind/Hail loss occurrence clause(1) | | 144 hours | | | 144 hours | | | 144 hours ------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------+---+----------------------------------------------------+--------------------------------------------------+---+--------------------------------------------------- Retention on first occurrence | $ | 4,000 | | $ | 5,000 | | $ | 5,000 ------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------+---+----------------------------------------------------+--------------------------------------------------+---+--------------------------------------------------- Retention on second occurrence | $ | 1,000 | | $ | 2,000 | | $ | 2,000 ------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------+---+----------------------------------------------------+--------------------------------------------------+---+--------------------------------------------------- Limit of coverage including first event retention | $ | 140,000 | | $ | 200,000 | | $ | 200,000 ------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------+---+----------------------------------------------------+--------------------------------------------------+---+--------------------------------------------------- Franchise deductible(2) | $ | — | | $ | 125 | | $ | 250 ------------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------+---------------------------------------------------------------------------------------------------------------------------------+---+----------------------------------------------------+--------------------------------------------------+---+--------------------------------------------------- (1) | Specifies the time period during which our losses from the same occurrence may be aggregated and applied to our retention and limits. We may pick the date and time when the period of consecutive hours begin in order to maximize our recovery. ----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (2) | Specifies the gross incurred losses by which each 144 hour loss occurrence must exceed before recoveries are generated under our aggregate treaty. Once the franchise deductible is met, all losses under the loss occurrence qualify for recovery, not just those losses which exceed the franchise deductible amount. ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ The total cost of our CAT XOL and aggregate coverage is estimated to be approximately $24,700 for the 2017/2018 treaty year, compared to $21,200 for the 2016/2017 treaty year. Net Premium Earned The following table shows our net premiums earned by line of business. | Three months ended September 30, | | Nine months ended September 30, | -----------------------+--------------------------------------+-------+-------------------------------------+-- Line of Business | 2017 | | 2016 | | | Change | | 2017 | | 2016 | | Change | -----------------------+--------------------------------------+-------+-------------------------------------+---+-------+--------+---+-------+---+------+--------+--------+-- Homeowners | $ | 6,494 | | $ | 4,996 | | $ | 1,498 | | $ | 17,410 | | $ | 15,792 | $ | 1,618 -----------------------+--------------------------------------+-------+-------------------------------------+---+-------+--------+---+-------+---+------+--------+--------+---+--------+---+------ Special Property | | 2,138 | | | 2,140 | | | (2 | ) | | 7,622 | | | 7,077 | | 545 -----------------------+--------------------------------------+-------+-------------------------------------+---+-------+--------+---+-------+---+------+--------+--------+---+--------+---+------ Net premium earned | $ | 8,632 | | $ | 7,136 | | $ | 1,496 | | $ | 25,032 | | $ | 22,869 | $ | 2,163 -----------------------+--------------------------------------+-------+-------------------------------------+---+-------+--------+---+-------+---+------+--------+--------+---+--------+---+------ Premium earned on a gross and ceded basis is as shown in the following table. | Three months ended September 30, | | Nine months ended September 30, | -------------------------+--------------------------------------+--------+-------------------------------------+-- | 2017 | | 2016 | | | Change | | 2017 | 2016 | | Change | -------------------------+--------------------------------------+--------+-------------------------------------+---+--------+--------+---+-------+------+--------+--------+-- Gross premium earned | $ | 14,907 | | $ | 12,546 | | $ | 2,361 | $ | 42,469 | | $ | 35,822 | $ | 6,647 -------------------------+--------------------------------------+--------+-------------------------------------+---+--------+--------+---+-------+------+--------+--------+---+--------+---+------ Ceded premium earned | | 6,275 | | | 5,410 | | | 865 | | 17,437 | | | 12,953 | | 4,484 -------------------------+--------------------------------------+--------+-------------------------------------+---+--------+--------+---+-------+------+--------+--------+---+--------+---+------ Net premium earned | $ | 8,632 | | $ | 7,136 | | $ | 1,496 | $ | 25,032 | | $ | 22,869 | $ | 2,163 -------------------------+--------------------------------------+--------+-------------------------------------+---+--------+--------+---+-------+------+--------+--------+---+--------+---+------ 39 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES ($ amounts in thousands, except share and per share data) Other Income Other income increased $400 to $1,262 for the nine months ended September 30, 2017, compared to $862 for the same period in 2016. Comparing the three month periods ended September 30, 2017 and 2016, other income increased $129 to $474 from $345. Other income is comprised of policy fee income charged to our policyholders for property inspections, premium financing fees for those policyholders which elect to pay their premiums on an installment basis, and commission revenue resulting from a brokerage sharing agreement between our insurance subsidiary, Maison, and the intermediary Maison uses to place its CAT XOL reinsurance program. The growth in our book of business is the main driver behind the increase in other income when comparing the three and nine month periods ended September 30, 2017 to 2016. Net losses and loss adjustment expenses Net losses and LAE represent both actual payments made and changes in estimated future payments to be made to our policyholders. The following table sets forth the components of our losses and loss ratios for the three and nine months ended September 30, 2017 and 2016. 40 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES ($ amounts in thousands, except share and per share data) | Three months ended September 30, | | | Nine months ended September 30, -----------------------------------------------+--------------------------------------+-------+---+------------------------------------ | 2017 | | | 2016 | | 2017 | | 2016 | -----------------------------------------------+--------------------------------------+-------+---+-------------------------------------+-------+------------+---+----------------+-- | Losses ($) | | | Loss Ratio (%) | | Losses ($) | | Loss Ratio (%) | | Losses ($) | | | Loss Ratio (%) | | | Losses ($) | Loss Ratio (%) | -----------------------------------------------+--------------------------------------+-------+---+-------------------------------------+-------+------------+---+----------------+---+------------------------------------------------------+------+----+---------------------------------------------------------+---+--------+------------------------------------------------------+---------------------------------------------------------+--- Non-catastrophe weather losses | $ | 881 | | | 10.2 | % | $ | 51 | | | 0.7 | % | | $ | 2,753 | | 11.0 | % | $ | 430 | | 1.9 | % -----------------------------------------------+--------------------------------------+-------+---+-------------------------------------+-------+------------+---+----------------+---+------------------------------------------------------+------+----+---------------------------------------------------------+---+--------+------------------------------------------------------+---------------------------------------------------------+----+---+--------+---+------+--- Non-weather losses | | 2,836 | | | 32.9 | % | | 1,648 | | | 23.1 | % | | | 6,500 | | 26.0 | % | | 4,876 | | 21.3 | % -----------------------------------------------+--------------------------------------+-------+---+-------------------------------------+-------+------------+---+----------------+---+------------------------------------------------------+------+----+---------------------------------------------------------+---+--------+------------------------------------------------------+---------------------------------------------------------+----+---+--------+---+------+--- Core loss(1) | | 3,717 | | | 43.1 | % | | 1,699 | | | 23.8 | % | | | 9,253 | | 37.0 | % | | 5,306 | | 23.2 | % -----------------------------------------------+--------------------------------------+-------+---+-------------------------------------+-------+------------+---+----------------+---+------------------------------------------------------+------+----+---------------------------------------------------------+---+--------+------------------------------------------------------+---------------------------------------------------------+----+---+--------+---+------+--- Catastrophe loss(2) | | 5,000 | | | 57.9 | % | | 4,798 | | | 67.2 | % | | | 6,700 | | 26.7 | % | | 9,784 | | 42.8 | % -----------------------------------------------+--------------------------------------+-------+---+-------------------------------------+-------+------------+---+----------------+---+------------------------------------------------------+------+----+---------------------------------------------------------+---+--------+------------------------------------------------------+---------------------------------------------------------+----+---+--------+---+------+--- Prior period (redundancy) development(3) | | (922 | ) | | (10.7 | )% | | (54 | ) | | (0.7 | )% | | | (2,144 | ) | (8.5 | )% | | (173 | ) | (0.8 | )% -----------------------------------------------+--------------------------------------+-------+---+-------------------------------------+-------+------------+---+----------------+---+------------------------------------------------------+------+----+---------------------------------------------------------+---+--------+------------------------------------------------------+---------------------------------------------------------+----+---+--------+---+------+--- Net losses and LAE incurred | $ | 7,795 | | | 90.3 | % | $ | 6,443 | | | 90.3 | % | | $ | 13,809 | | 55.2 | % | $ | 14,917 | | 65.2 | % -----------------------------------------------+--------------------------------------+-------+---+-------------------------------------+-------+------------+---+----------------+---+------------------------------------------------------+------+----+---------------------------------------------------------+---+--------+------------------------------------------------------+---------------------------------------------------------+----+---+--------+---+------+--- (1) | We define Core Loss as net losses and LAE less the sum of catastrophe losses and prior period development/redundancy. ----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (2) | Property Claims Services (PCS) defines a catastrophic event as an event where the insurance industry is estimated to incur over $25,000 of insured property damage that also impacts a significant number of insureds. For purposes of the above table, we have defined a catastrophe as a PCS event where the Company’s estimated gross incurred cost (before recovery from reinsurance) exceeds $1,500. ----+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (3) | Prior period development is the amount of ultimate actual loss settlement value which is more than the estimated reserves recorded for a particular liability or loss, while redundancy represents the ultimate actual loss settlement value which is less than the estimated and determined reserves recorded for a particular liability or loss. ----+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Our net loss ratio (net losses and LAE divided by net premiums earned) for the nine months ended September 30, 2017 was 55.2%, compared to a net loss ratio of 65.2% for the nine months ended September 30, 2016. While we experienced an increase in our core loss ratio, this was offset by a decrease in our catastrophe loss ratio when comparing periods. Although Hurricane Harvey was a significant event for us, as we expect our total gross incurred losses to be approximately $23,000 for this storm, due to our reinsurance program, our net incurred losses from Harvey are limited to $5,000. Furthermore, PCS event 1714 was a series of wind/hail storms which impacted our policyholders in both Louisiana and Texas in early February, 2017, resulting in $1,700 in net incurred catastrophe losses for the nine months ended September 30, 2017. These net losses from event 1714, along with $5,000 in net incurred losses from Hurricane Harvey, represent the extent of our catastrophe losses for the nine months ended September 30, 2017 as shown in the preceding table. In comparison, for the nine months ended September 30, 2016, we experienced three catastrophe events: PCS event 1616 in February, PCS event 1617 in March, and PCS event 1644 in August. These three events resulted in $9,784 in net incurred losses for prior year. Our net loss ratio for the current year was further reduced due to redundancy in the amount of $2,144 due to the release of reserves relating to prior accident years. Our net loss ratio for the three months ended September 30, 2017 was 90.3% and was marked by the impact of Harvey, which resulted in $5,000 in net incurred catastrophe losses for the quarter and accounted for over half of the quarter’s net loss ratio. Non-weather losses also accounted for approximately one-third of the quarter’s net loss ratio as we experienced approximately $1,500 in net losses from fire claims and $1,336 from all other non-weather related causes of loss. Amortization of Deferred Policy Acquisition Costs Amortization of deferred acquisition costs for the three months ended September 30, 2017 were $2,755 compared to $2,095 for the three months ended September 30, 2016, and include items such as commissions earned by our agencies, premium taxes, assessments, and policy processing fees. Expressed as a percentage of gross earned premiums, amortization was 18.5% in the current quarter, compared to 16.7% in the same quarter last year. For the nine month periods ended September 30, amortization as a percentage of gross earned premiums was 18.5% and 16.7% in 2017 and 2016, respectively. The increase in amortization of deferred acquisition costs as a percentage of gross earned premiums can be attributed to an increase in the effective rate of the premium taxes that we pay due to the loss of an investment credit received on our premium taxes in previous years. Effective January 1, 2017, the State of Louisiana amended this credit such that certain assets such as cash and money market funds held in the state of Louisiana would no longer qualify as a tax credit on the Company’s premium taxes. 41 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES ($ amounts in thousands, except share and per share data) General and Administrative Expenses General and administrative expenses were $2,145 for the quarter ended September 30, 2017, compared to $1,658 for the quarter ended September 30, 2016. For the nine month periods ended September 30, 2017 and 2016, general and administrative expenses were $6,535 and $4,982, respectively. Expressed as a percentage of gross premium earned, general and administrative expenses were 15.4% and 13.9%, for the nine month periods of 2017 and 2016, respectively. The largest drivers in the increase in general and administrative expense over both the three and nine month periods include employee costs and professional fees. Employee costs accounted for approximately 35% of the nine month increase as we have increased staffing to support our growth in Texas and Florida while professional fees accounted for approximately 50% of the nine month increase as we have initiated a review of the rates that we charge on our risks in Louisiana and also have initiated filings for the new products that we plan to offer in Florida. Income Tax Benefit Income tax benefit for the three and nine months ended September 30, 2017 was $1,171 and $397, respectively, on pre-tax losses of $3,434 and 1,493, respectively. This resulted in an effective tax rate of 34% and 27%, respectively. For the three and nine month periods ended September 30, 2016, our effective income tax rate was 32% and 28%, respectively. The variances to the effective income tax rate between periods is due, in large, to state income taxes charged to the Company’s subsidiaries. Net Loss As a result of the foregoing, the Company’s net loss for the third quarter 2017 was $2,263, or $0.38 per diluted share, compared to a net loss of $1,806, or $0.30 per diluted share for the third quarter of 2016. For the nine months ended September 30, 2017, the Company’s net loss was $1,096, or $0.18 per diluted share, compared to a net loss of $1,581 or $0.26 per diluted share for the nine months ended September 30, 2016. Liquidity and Capital Resources The purpose of liquidity management is to ensure that there is sufficient cash to meet all financial commitments and obligations as they become due. The liquidity requirements for the Company and its subsidiaries have been met primarily by funds generated from operations, and from the proceeds from the sales of its common and preferred stock. Cash provided from these sources is used primarily for loss and LAE payments as well as other operating expenses. The timing and amount of payments for net losses and loss adjustment expenses may differ materially from the Company’s provisions for loss and loss adjustment expense reserves, which may create increased liquidity requirements. Cash Flows The following table summarizes the Company’s consolidated cash flows for the nine months ended September 30, 2017 and 2016. | Nine months ended September 30, | ----------------------------------------------+-------------------------------------+-------- Summary of Cash Flows | 2017 | | | 2016 | ----------------------------------------------+-------------------------------------+---------+---+------+-- Net cash provided by operating activities | $ | 3,832 | | | $ | 1,659 | ----------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Net cash used in investing activities | | (21,182 | ) | | | (9,428 | ) ----------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Net cash used in financing activities | | (16 | ) | | | (1,262 | ) ----------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Net decrease in cash and cash equivalents | $ | (17,366 | ) | | $ | (9,031 | ) ----------------------------------------------+-------------------------------------+---------+---+------+---+--------+-- Nine months ended September 30, 2017 For the nine months ended September 30, 2017, net cash provided by operating activities as reported on our consolidated statement of cash flows was $3,832, driven, in large, by our collection of approximately $34,411 in premiums for the period (net of the amounts that we have ceded to our reinsurers), less the payment of approximately $19,920 in loss and LAE expenses (net of ceded recoveries collected from our reinsurers). We also paid approximately $6,830 in commissions to our agencies, Brotherhood and Citizens (as ceding commissions), as well as cash payments in the approximate amount of $3,829 for taxes, assessments and general and administrative expenses. 42 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES ($ amounts in thousands, except share and per share data) Net cash used in investing activities as reported on our consolidated statement of cash flows was $21,182, driven primarily by the net purchases of fixed income and equity securities as well as short term investments for our investment portfolio. Net cash used in financing activities was $16, as a result of a dividend payment of $240 made to Advisors as holders of the Preferred Shares issued in the MSA termination transaction, net of $224 in proceeds from the sale of our common stock. As a result of the foregoing, cash and cash equivalents decreased from $43,045 as of December 31, 2016 to $25,679 as of September 30, 2017. Nine months ended September 30, 2016 For the nine months ended September 30, 2016, the net cash provided by operating activities as reported on our consolidated statement of cash flows was $1,659, resulting from our collection of approximately $27,500 in premiums for the year (net of the amounts we have ceded to our reinsurers), less the payment of approximately $13,700 in loss and LAE expenses (net of ceded recoveries collected from our reinsurers). We also paid approximately $5,300 in commissions to our agencies, as well as to Brotherhood and Citizens as ceding commissions. Lastly, cash payments in the approximate amount of $6,800 were made for taxes, assessments and general and administrative expenses. The net cash used by investing activities as reported on our consolidated statement of cash flows was $9,428, resulting from the net purchases of fixed income, equity securities and short term investments for our investment portfolio. Net cash used by financing activities was $1,262, which resulted from a dividend payment of $240 to Advisors as holders of the Preferred Shares issued in the MSA termination transaction, as well as the payment of $1,022 for the repurchase of 153,905 shares of our common stock pursuant to our share buyback program. As a result of the foregoing, cash and cash equivalents decreased from $47,957 as of December 31, 2015 to $38,926 as of September 30, 2016. Regulatory Capital In the United States, a risk-based capital (“RBC”) formula is used by the National Association of Insurance Commissioners (“NAIC”) to identify property and casualty insurance companies that may not be adequately capitalized. Most states, including Louisiana, the domiciliary state of our insurance subsidiary, Maison, as well as Texas, where Maison began writing business in June 2015, have adopted the NAIC RBC requirements. In general, insurers reporting surplus with respect to policyholders below 200% of the authorized control level, as defined by the NAIC, on December 31st of the previous year are subject to varying levels of regulatory action, which may include discontinuation of operations. As of September 30, 2017, Maison’s reported surplus was considered to be in the “no action” level by the Louisiana Department of Insurance. 43 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES ($ amounts in thousands, except share and per share data) Furthermore, pursuant to the consent order approving Maison’s admission into the State of Texas, Maison has agreed to: ● | Establish a deposit of $2,000 for the benefit of Texas policyholders. The Company has fulfilled this obligation by depositing fixed income securities, having an estimated fair value of $1,998 as of September 30, 2017, with the State of Texas. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ ● | Maintain a Risk-Based-Capital (“RBC”) ratio of 300% or more, and provide calculation of such ratio to the TDI on a periodic basis. Maison has fulfilled this obligation by maintaining an RBC ratio over 300% through September 30, 2017. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Similarly, although Maison has not yet written any insurance policies in the State of Florida, pursuant to the consent order approving Maison’s admission into the State of Florida, Maison has agreed to: ● | Maintain a Risk-Based-Capital (“RBC”) ratio of 300% or more. --+------------------------------------------------------------------------------------------------------ ● | Maintain minimum capital and surplus as to policyholders of $35,000. --+-------------------------------------------------------------------------------------------------------------- ● | Restrict the payment of dividends to only those which have been approved in advance by the FL OIR. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- As of September 30, 2017, Maison has fulfilled these obligations as its RBC ratio exceeded 300% and its capital surplus was $35,962. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not applicable. ITEM 4. CONTROLS AND PROCEDURES The Company’s management performed an evaluation under the supervision and with the participation of the Company’s principal executive officer and the principal financial officer, and completed an evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as that term is defined in Rules 13a-15(e) and 15d-15(e), as adopted by the Securities and Exchange Commission (“SEC”) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as of September 30, 2017. Disclosure controls and procedures are the controls and other procedures that are designed to ensure that information required to be disclosed in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Exchange Act is accumulated and communicated to management, including the principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosures. Based on that evaluation, the Company’s principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures are effective as of September 30, 2017. During the quarter ended September 30, 2017, there were no changes in internal control over financial reporting that materially affected, or are reasonably likely to materially affect the Company’s internal control over financial reporting. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS From time to time, we are involved in legal proceedings and litigation arising in the ordinary course of business. Currently, it is not possible to predict legal outcomes and their impact on the future development of claims. Any such development will be affected by future court decisions and interpretations. Because of these uncertainties, additional liabilities may arise for amounts in excess of the Company’s current reserves. In addition, the Company’s estimate of ultimate loss and loss adjustment expenses may change. These additional liabilities, or increases in estimates, or a range of either, cannot be reasonably estimated, and could result in income statement charges that could be material to the Company’s results of operations in future periods. 44 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES ($ amounts in thousands, except share and per share data) ITEM 1A. RISK FACTORS There have been no material changes to the risk factors previously disclosed in Part I, Item 1A. “Risk Factors” to our annual report on Form 10-K for the year ended December 31, 2016 filed with the SEC on March 16, 2017. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS On May 23, 2017, the Company announced that Dan Case has been appointed to the position of Chief Operating Officer. In connection with Mr. Case’s new employment, Mr. Case has the opportunity to purchase up to 68,027 shares of the Company’s common stock on the open market or in direct purchases from the Company during his first six months of employment with the Company, and at the end of the six-month purchase period, the Company will match any such shares purchased by Mr. Case with a grant of restricted stock units (“RSUs”) of the Company equal to two RSUs for each share purchased by Mr. Case. The RSUs will vest 20% per year over five years following the date granted, subject to continued employment through such vesting date. The aggregate maximum number of shares of the Company’s common stock that may be acquired pursuant to this arrangement, including through open market purchases, purchases from the Company and grants from the Company, is 204,081. Any shares purchased directly from the Company will be made at a price equal to the closing price of the Company’s common stock on the prior trading day, but not less than the latest quarter end published book value per share. This arrangement was entered into outside of the Company’s existing shareholder approved equity plans and was approved by the Compensation Committee of the Company’s Board of Directors as an inducement material to Mr. Case entering into employment with the Company in reliance on Nasdaq Listing Rule 5635(c)(4). As of November 1, 2017, Mr. Case had purchased 50,092 shares of the Company’s common stock pursuant to this arrangement, 28,000 of which shares were purchased directly from the Company at a purchase price of $8.00 per share on September 14, 2017. The shares of the Company’s common stock issued under this arrangement were issued pursuant to an exemption from registration under Section 4(a)(2) of the Securities Act of 1933, as amended. ITEM 3. DEFAULTS UPON SENIOR SECURITIES None. ITEM 4. MINE SAFETY DISCLOSURES Not applicable. ITEM 5. OTHER INFORMATION None. 45 1347 PROPERTY INSURANCE HOLDINGS, INC. AND SUBSIDIARIES ITEM 6. EXHIBITS Exhibit | Description --------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.1 | Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 --------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.2 | Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 --------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 32.1 | Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (furnished) --------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 32.2 | Certification of Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (furnished) --------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.INS | XBRL Instance Document --------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.SCH | XBRL Taxonomy Extension Schema --------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.CAL | XBRL Taxonomy Extension Calculation Linkbase --------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.DEF | XBRL Taxonomy Extension Definition Linkbase --------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.LAB | XBRL Taxonomy Extension Label Linkbase --------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.PRE | XBRL Taxonomy Extension Presentation Linkbase --------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------- SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. | | | 1347 PROPERTY INSURANCE HOLDINGS, INC. ------+-----------------------+-----+------------------------------------------------------------------------- Date: | November 13, 2017 | By: | /s/ Douglas N. Raucy ------+-----------------------+-----+------------------------------------------------------------------------- | | | Douglas N. Raucy, President, Chief Executive Officer and Director ------+-----------------------+-----+------------------------------------------------------------------------- | | | (principal executive officer) ------+-----------------------+-----+------------------------------------------------------------------------- Date: | November 13, 2017 | By: | /s/ John S. Hill ------+-----------------------+-----+------------------------------------------------------------------------- | | | John S. Hill, Vice President, Chief Financial Officer, and Secretary ------+-----------------------+-----+------------------------------------------------------------------------- | | | (principal financial and accounting officer) ------+-----------------------+-----+------------------------------------------------------------------------- 46

3PEA INTERNATIONAL, INC.

1496443

10-Q

0001683168-17-002938

UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-Q (Mark One) x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2017 or o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ___________ to __________ Commission file number 000-54123 3PEA INTERNATIONAL, INC. (Exact name of small business issuer as specified in its charter) Nevada | 95-4550154 ---------------------------------------------------------------+---------------------------------- (State or other jurisdiction of incorporation or organization) | (IRS Employer Identification No.) ---------------------------------------------------------------+---------------------------------- 1700 W Horizon Ridge Parkway, Suite 201, Henderson, Nevada 89012 (Address of principal executive offices) (702) 453-2221 (Issuer’s telephone number, including area code) _______________________________________________________ (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). x Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer”, “smaller reporting company”, and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one) Large accelerated filer o | Accelerated filer o ---------------------------+----------------------------- Non-accelerated filer o | Smaller reporting company x ---------------------------+----------------------------- Emerging growth company x | ---------------------------+----------------------------- If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x State the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date: 43,660,765 shares as of November 1, 2017. 3PEA INTERNATIONAL, INC. FORM 10-Q REPORT INDEX PART I. FINANCIAL INFORMATION | 3 ----------------------------------------------------------------------------------------------+--- Item 1. Financial Statements | 3 ----------------------------------------------------------------------------------------------+--- Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations | 14 ----------------------------------------------------------------------------------------------+--- Item 3. Quantitative and Qualitative Disclosures about Market Risk | 18 ----------------------------------------------------------------------------------------------+--- Item 4. Controls and Procedures | 18 ----------------------------------------------------------------------------------------------+--- PART II. OTHER INFORMATION | 19 ----------------------------------------------------------------------------------------------+--- Item 1. Legal Proceedings | 19 ----------------------------------------------------------------------------------------------+--- Item 1A. Risk Factors | 19 ----------------------------------------------------------------------------------------------+--- Item 2. Unregistered Sales of Equity Securities and Use of Proceeds | 19 ----------------------------------------------------------------------------------------------+--- Item 3. Defaults upon Senior Securities | 19 ----------------------------------------------------------------------------------------------+--- Item 4. Mine Safety Disclosures | 19 ----------------------------------------------------------------------------------------------+--- Item 5. Other Information | 19 ----------------------------------------------------------------------------------------------+--- Item 6. Exhibits | 19 ----------------------------------------------------------------------------------------------+--- SIGNATURES | 20 ----------------------------------------------------------------------------------------------+--- 2 - PART I. FINANCIAL INFORMATION Item 1. Financial Statements 3PEA INTERNATIONAL, INC. CONSOLIDATED BALANCE SHEETS SEPTEMBER 30, 2017 AND DECEMBER 31, 2016 | September 30, 2017 (Unaudited) | | | December 31, 2016 (Audited) | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+-- ASSETS | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Current assets | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Cash | $ | 1,916,736 | | | $ | 1,631,943 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Cash Restricted | | 12,498,529 | | | | 10,002,505 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Accounts Receivable | | 183,521 | | | | 110,269 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Prepaid Expenses and other assets | | 521,895 | | | | 270,634 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Total current assets | | 15,120,681 | | | | 12,015,531 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Fixed assets, net | | 852,136 | | | | 300,761 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Intangible and other assets | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Deposits | | 5,551 | | | | 5,551 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Intangible assets, net | | 1,524,063 | | | | 1,550,044 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Total assets | $ | 17,502,431 | | | $ | 13,871,707 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- LIABILITIES AND STOCKHOLDERS' EQUITY | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Current liabilities | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Accounts payable and accrued liabilities | $ | 806,454 | | | $ | 765,596 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Customer card funding | | 12,498,529 | | | | 10,002,505 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Legal settlement payable – current portion | | – | | | | 254,900 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Notes payable | | – | | | | 124,168 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Total current liabilities | | 13,304,983 | | | | 11,147,169 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Long-term liabilities | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Notes payable | | – | | | | 27,892 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Total long-term liabilities | | – | | | | 27,892 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Total liabilities | | 13,304,983 | | | | 11,175,061 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Stockholders' equity | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Common stock; $0.001 par value; 150,000,000 shares authorized, 43,660,765 and 43,185,765 issued and outstanding at September 30, 2017 and December 31, 2016, respectively | | 43,661 | | | | 43,186 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Additional paid-in capital | | 7,085,324 | | | | 6,797,759 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Treasury stock at cost, 303,450 shares at September 30, 2017 and December 31, 2016 | | (150,000 | ) | | | (150,000 | ) --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Accumulated deficit | | (2,545,609 | ) | | | (3,799,613 | ) --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Total 3Pea International, Inc.'s stockholders' equity | | 4,433,376 | | | | 2,891,332 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Noncontrolling interest | | (235,928 | ) | | | (194,686 | ) --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Total stockholders' equity | | 4,197,448 | | | | 2,696,646 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- Total liabilities and stockholders' equity | $ | 17,502,431 | | | $ | 13,871,707 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------------------------------+---+------------+-- See accompanying notes to consolidated financial statements. 3 - 3PEA INTERNATIONAL, INC. CONSOLIDATED STATEMENTS OF INCOME FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2017 AND 2016 (UNAUDITED) | For the three months ended September 30, | ---------------------------------------------------------------------+-------------------------------------------+----------- | 2017 | | 2016 | ---------------------------------------------------------------------+-------------------------------------------+------------+------+-- Revenues | $ | 4,001,991 | | $ | 2,812,536 | ---------------------------------------------------------------------+-------------------------------------------+------------+------+---+------------+-- Cost of revenues (excluding depreciation and amortization) | | 2,145,621 | | | 1,522,458 | ---------------------------------------------------------------------+-------------------------------------------+------------+------+---+------------+-- Gross profit | | 1,856,370 | | | 1,290,078 | ---------------------------------------------------------------------+-------------------------------------------+------------+------+---+------------+-- Operating expenses | | | | | | ---------------------------------------------------------------------+-------------------------------------------+------------+------+---+------------+-- Depreciation and amortization | | 276,533 | | | 149,342 | ---------------------------------------------------------------------+-------------------------------------------+------------+------+---+------------+-- Selling, general and administrative | | 1,104,280 | | | 660,556 | ---------------------------------------------------------------------+-------------------------------------------+------------+------+---+------------+-- Total operating expenses | | 1,380,813 | | | 809,898 | ---------------------------------------------------------------------+-------------------------------------------+------------+------+---+------------+-- Income from operations | | 475,557 | | | 480,180 | ---------------------------------------------------------------------+-------------------------------------------+------------+------+---+------------+-- Other income (expense) | | | | | | ---------------------------------------------------------------------+-------------------------------------------+------------+------+---+------------+-- Other income | | 14,398 | | | 4,986 | ---------------------------------------------------------------------+-------------------------------------------+------------+------+---+------------+-- Interest expense | | – | | | (20,483 | ) ---------------------------------------------------------------------+-------------------------------------------+------------+------+---+------------+-- Total other income (expense) | | 14,398 | | | (15,497 | ) ---------------------------------------------------------------------+-------------------------------------------+------------+------+---+------------+-- Income before provision for income taxes and noncontrolling interest | | 489,955 | | | 464,683 | ---------------------------------------------------------------------+-------------------------------------------+------------+------+---+------------+-- Provision for income taxes | | 3,000 | | | – | ---------------------------------------------------------------------+-------------------------------------------+------------+------+---+------------+-- Net income before noncontrolling interest | | 486,955 | | | 464,683 | ---------------------------------------------------------------------+-------------------------------------------+------------+------+---+------------+-- Net loss attributable to noncontrolling interest | | 13,213 | | | 15,746 | ---------------------------------------------------------------------+-------------------------------------------+------------+------+---+------------+-- Net income attributable to 3Pea International, Inc. | $ | 500,168 | | $ | 480,429 | ---------------------------------------------------------------------+-------------------------------------------+------------+------+---+------------+-- Net income per common share - basic | $ | 0.01 | | $ | 0.01 | ---------------------------------------------------------------------+-------------------------------------------+------------+------+---+------------+-- Net income per common share - fully diluted | $ | 0.01 | | $ | 0.01 | ---------------------------------------------------------------------+-------------------------------------------+------------+------+---+------------+-- Weighted average common shares outstanding - basic | | 43,474,895 | | | 42,948,265 | ---------------------------------------------------------------------+-------------------------------------------+------------+------+---+------------+-- Weighted average common shares outstanding - fully diluted | | 44,544,895 | | | 43,138,279 | ---------------------------------------------------------------------+-------------------------------------------+------------+------+---+------------+-- See accompanying notes to consolidated financial statements. 4 - 3PEA INTERNATIONAL, INC. CONSOLIDATED STATEMENTS OF INCOME FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2017 AND 2016 (UNAUDITED) | For the nine months ended September 30, | ---------------------------------------------------------------------+------------------------------------------+----------- | 2017 | | | 2016 | ---------------------------------------------------------------------+------------------------------------------+------------+---+------+-- Revenues | $ | 10,621,055 | | | $ | 7,369,540 | ---------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Cost of revenues (excluding depreciation and amortization) | | 5,834,709 | | | | 4,062,062 | ---------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Gross profit | | 4,786,346 | | | | 3,307,478 | ---------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Operating expenses | | | | | | | ---------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Depreciation and amortization | | 725,401 | | | | 406,328 | ---------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Selling, general and administrative | | 2,847,955 | | | | 2,054,351 | ---------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Total operating expenses | | 3,573,356 | | | | 2,460,679 | ---------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Income from operations | | 1,212,990 | | | | 846,799 | ---------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Other income (expense) | | | | | | | ---------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Other income | | 40,395 | | | | 10,900 | ---------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Interest expense | | (31,623 | ) | | | (58,748 | ) ---------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Total other income (expense) | | 8,772 | | | | (47,848 | ) ---------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Income before provision for income taxes and noncontrolling interest | | 1,221,762 | | | | 798,951 | ---------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Provision for income taxes | | 9,000 | | | | – | ---------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Net income before noncontrolling interest | | 1,212,762 | | | | 798,951 | ---------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Net loss attributable to noncontrolling interest | | 41,242 | | | | 99,097 | ---------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Net income attributable to 3Pea International, Inc. | $ | 1,254,004 | | | $ | 898,048 | ---------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Net income per common share - basic | $ | 0.03 | | | $ | 0.02 | ---------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Net income per common share - fully diluted | $ | 0.03 | | | $ | 0.02 | ---------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Weighted average common shares outstanding - basic | | 43,308,750 | | | | 42,844,570 | ---------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Weighted average common shares outstanding - fully diluted | | 44,378,750 | | | | 42,991,542 | ---------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- See accompanying notes to consolidated financial statements. 5 - 3PEA INTERNATIONAL, INC. CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2017 | Stockholders' Equity Attributable to 3Pea International, Inc. | | | | | ------------------------------------------------+-------------------------------------------------------------------+------------+------------+---+--------+--------- | | | Additional | | | Treasury | | | Non- | | | Total | ------------------------------------------------+-------------------------------------------------------------------+------------+------------+---+--------+----------+---+-------------+-------------+----------+---+---------------+-- | Common Stock | | Paid-in | | | Stock | | Accumulated | controlling | | | Stockholders' | ------------------------------------------------+-------------------------------------------------------------------+------------+------------+---+--------+----------+---+-------------+-------------+----------+---+---------------+-- | Shares | | Amount | | | Capital | | Amount | Deficit | | | Interest | | | Equity ------------------------------------------------+-------------------------------------------------------------------+------------+------------+---+--------+----------+---+-------------+-------------+----------+---+---------------+---+------------+------- Balance, December 31, 2016 (Audited) | | 43,185,765 | | $ | 43,186 | | $ | 6,797,759 | $ | (150,000 | ) | | $ | (3,799,613 | ) | $ | (194,686 | ) | $ | 2,696,646 ------------------------------------------------+-------------------------------------------------------------------+------------+------------+---+--------+----------+---+-------------+-------------+----------+---+---------------+---+------------+--------+---+----------+---+---+---------- Issuance of stock for services (Unaudited) | | 75,000 | | | 75 | | | 12,807 | | – | | | | – | | | – | | | 12,882 ------------------------------------------------+-------------------------------------------------------------------+------------+------------+---+--------+----------+---+-------------+-------------+----------+---+---------------+---+------------+--------+---+----------+---+---+---------- Stock issued for employee bonus (Unaudited) | | 200,000 | | | 200 | | | 84,200 | | – | | | | – | | | – | | | 84,400 ------------------------------------------------+-------------------------------------------------------------------+------------+------------+---+--------+----------+---+-------------+-------------+----------+---+---------------+---+------------+--------+---+----------+---+---+---------- Stock Based Compensation (Unaudited) | | – | | | – | | | 140,758 | | – | | | | – | | | – | | | 140,758 ------------------------------------------------+-------------------------------------------------------------------+------------+------------+---+--------+----------+---+-------------+-------------+----------+---+---------------+---+------------+--------+---+----------+---+---+---------- Exercise of Warrants (Unaudited) | | 200,000 | | | 200 | | | 49,800 | | – | | | | – | | | – | | | 50,000 ------------------------------------------------+-------------------------------------------------------------------+------------+------------+---+--------+----------+---+-------------+-------------+----------+---+---------------+---+------------+--------+---+----------+---+---+---------- Net income (loss) (Unaudited) | | – | | | – | | | – | | – | | | | 1,254,004 | | | (41,242 | ) | | 1,212,762 ------------------------------------------------+-------------------------------------------------------------------+------------+------------+---+--------+----------+---+-------------+-------------+----------+---+---------------+---+------------+--------+---+----------+---+---+---------- Balance, September 30, 2017 (Unaudited) | | 43,660,765 | | $ | 43,661 | | $ | 7,085,324 | $ | (150,000 | ) | | $ | (2,545,609 | ) | $ | (235,928 | ) | $ | 4,197,448 ------------------------------------------------+-------------------------------------------------------------------+------------+------------+---+--------+----------+---+-------------+-------------+----------+---+---------------+---+------------+--------+---+----------+---+---+---------- See accompanying notes to consolidated financial statements. 6 - 3PEA INTERNATIONAL, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2017 AND 2016 (UNAUDITED) | For the nine months ended September 30, | ----------------------------------------------------------------------------------+------------------------------------------+----------- | 2017 | | | 2016 | ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+-- Cash flows from operating activities: | | | | | | | ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Net income | $ | 1,254,004 | | | $ | 898,048 | ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Adjustments to reconcile net income to net cash provided by operating activities: | | | | | | | ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Change in noncontrolling interest | | (41,242 | ) | | | (99,097 | ) ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Depreciation and amortization | | 725,401 | | | | 406,328 | ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Stock based compensation | | 238,040 | | | | 40,091 | ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Changes in operating assets and liabilities: | | | | | | | ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Change in accounts receivable | | (73,252 | ) | | | (93,531 | ) ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Change in prepaid expenses | | (251,261 | ) | | | 4,028 | ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Change in other assets | | – | | | | (2,000 | ) ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Change in accounts payable and accrued liabilities | | 40,858 | | | | 237,511 | ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Change in customer card funding | | 2,496,024 | | | | 1,726,127 | ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Change in legal settlement payable | | (254,900 | ) | | | (746,954 | ) ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Net cash provided by operating activities | | 4,133,672 | | | | 2,370,551 | ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Cash flows from investing activities: | | | | | | | ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Purchase of fixed assets | | (649,260 | ) | | | (52,111 | ) ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Purchase of intangible assets | | (601,535 | ) | | | (551,448 | ) ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Net cash used in investing activities | | (1,250,795 | ) | | | (603,559 | ) ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Cash flows from financing activities: | | | | | | | ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Proceeds from borrowing on note payable | | – | | | | 29,053 | ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Proceeds from exercise of warrants | | 50,000 | | | | – | ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Payments on notes payable | | (152,060 | ) | | | (126,308 | ) ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Net cash used in financing activities | | (102,060 | ) | | | (97,255 | ) ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Net change in cash and restricted cash | | 2,780,817 | | | | 1,669,737 | ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Cash and restricted cash, beginning of period | | 11,634,448 | | | | 8,453,439 | ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Cash and restricted cash, end of period | $ | 14,415,265 | | | $ | 10,123,176 | ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Supplemental cash flow information: | | | | | | | ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Non-cash financing activities: | | | | | | | ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Transfer of accrued interest from accrued liabilities to notes payable | $ | – | | | $ | 115,227 | ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Interest paid | $ | 46,663 | | | $ | 58,748 | ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- Income taxes paid | $ | 16,200 | | | $ | – | ----------------------------------------------------------------------------------+------------------------------------------+------------+---+------+---+------------+-- See accompanying notes to consolidated financial statements. 7 - 3PEA INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT POLICIES The foregoing unaudited consolidated interim financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions for Form 10-Q and Regulation S-X as promulgated by the Securities and Exchange Commission (“SEC”). Accordingly, these financial statements do not include all of the disclosures required by generally accepted accounting principles in the United States of America for complete financial statements. These unaudited interim financial statements should be read in conjunction with the audited financial statements and the notes thereto included on Form 10-K for the year ended December 31, 2016. In the opinion of management, the unaudited interim financial statements furnished herein include all adjustments, all of which are of a normal recurring nature, necessary for a fair statement of the results for the interim period presented. The preparation of financial statements in accordance with generally accepted accounting principles in the United States of America requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities known to exist as of the date the financial statements are published, and the reported amounts of revenues and expenses during the reporting period. Uncertainties with respect to such estimates and assumption are inherent in the preparation of the Company’s financial statements; accordingly, it is possible that the actual results could differ from these estimates and assumptions that could have a material effect on the reported amounts of the Company’s financial position and results of operations. Operating results for the three and nine months ended September 30, 2017 are not necessarily indicative of the results that may be expected for the year ending December 31, 2017. About 3PEA International, Inc. 3PEA International, Inc. is a vertically integrated provider of innovative prepaid card programs and processing services for corporate, consumer and government applications. Our payment solutions are utilized by our customers as a means to increase customer loyalty, reduce administration costs and streamline operations. Public sector organizations can utilize our solutions to disburse public benefits or for internal payments. We market our prepaid debit card solutions under our PaySign® brand. As we are a payment processor and debit card program manager, we derive our revenue from all stages of the debit card lifecycle. We provide a card processing platform consisting of proprietary systems and innovative software applications based on the unique needs of our programs. We have extended our processing business capabilities through our proprietary PaySign platform. We provide a variety of services including transaction processing, cardholder enrollment, value loading, cardholder account management, reporting, and customer service. We have developed prepaid card programs for healthcare reimbursement payments, pharmaceutical co-pay assistance, donor compensation and corporate incentive and rewards. We plan to expand our product offering to include payroll cards, general purpose re-loadable cards, travel cards, and expense reimbursement and per diem cards. Our cards are offered to end users through our relationships with bank issuers. Our proprietary PaySign® platform was built on modern cross-platform architecture and designed to be highly flexible, scalable and customizable. The platform allows 3PEA to significantly expand its operational capabilities by facilitating our entry into new markets within the payments space through its flexibility and ease of customization. The PaySign platform delivers cost benefits and revenue building opportunities to our partners. We manage all aspects of the debit card lifecycle, from managing the card design and approval processes with partners and associations, to production, packaging, distribution, and personalization. We also oversee inventory and security controls, renewals, lost and stolen card management and replacement. We deploy a fully staffed, in-house customer service department which utilizes bi-lingual customer service agents, Interactive Voice Response, (IVR), SMS alerts and two way SMS messaging. Principles of consolidation – The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany balances and transactions have been eliminated. Use of estimates – The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. 8 - Restricted cash – Restricted cash is a cash account controlled by the Company which funds are received related to the card programs from our customers. The Company has recorded a corresponding customer card funding liability. Restricted cash is not available to the company for corporate use. Goodwill and intangible assets - Goodwill is the purchase premium after adjusting for the fair value of net assets acquired. Goodwill is not amortized but is reviewed for potential impairment on an annual basis, or when events or circumstances indicate a potential impairment, at the reporting unit level. A reporting unit, as defined under applicable accounting guidance, is a business segment or one level below a business segment. We may in any given period bypass the qualitative assessment and proceed directly to a two-step method to assess and measure impairment of the reporting unit’s goodwill. We first assess qualitative factors to determine whether it is more likely-than-not (i.e., a likelihood of more than 50 percent) that the fair value of a reporting unit is less than its carrying value. This step serves as the basis for determining whether it is necessary to perform the two-step quantitative impairment test. The first step of the quantitative impairment test involves a comparison of the estimated fair value of each reporting unit to its carrying amount, including goodwill. If the estimated fair value of the reporting unit exceeds its carrying amount, goodwill of the reporting unit is not impaired; however, if the carrying amount of the reporting unit exceeds its estimated fair value, then the second step of the quantitative impairment test must be performed. The second step compares the implied fair value of the reporting unit’s goodwill with its carrying amount to measure the amount of impairment loss, if any. The implied fair value of goodwill is determined in the same manner as the amount of goodwill recognized in a business combination. If the carrying amount of the reporting unit’s goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. For intangible assets, we recognize an impairment loss if the carrying amount of the intangible asset is not recoverable and exceeds fair value. The carrying amount of the intangible asset is considered not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use of the asset. No impairment was deemed necessary in the three and nine month period ended September 30,2017. Intangible assets with finite lives are amortized on a straight-line basis over their estimated useful lives. Platform and Licenses are comprised of costs associated with our development and continual development of our platform which includes direct development costs, software and licenses. Revenue and expense recognition – We recognize revenue when (1) there is persuasive evidence of an arrangement existing, (2) delivery has occurred, (3) our price to the buyer is fixed or determinable and (4) collectability of the receivables is reasonably assured. We recognize the costs of these revenues at the time revenue is recognized. Any fees paid up front are deferred until such time such services have been considered rendered. As of September 30, 2017 and December 31, 2016, there were no deferred revenues recorded. We generate the following types of revenues: · | Administration and usage fees, charged to our prepaid card clients when our programs are created, distributed or reloaded. Such revenues are recognized when such services are performed. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ · | Transaction fees, paid by the applicable networks and passed through by our card issuing banks when our SVCs (Stored Value Cards) are used in a purchase or ATM transaction. Such revenues are recognized when such services are performed. --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | Maintenance, administration, transaction fees, charged to an SVC and not under any multiple element arrangements. Such revenues are recognized when such services are performed. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | Program maintenance management fees charged to our clients. Such revenues are not under any multiple element arrangements and are recognized when such services are performed. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | Software development and consulting services to our clients. Such revenues are recognized in accordance with ASC 985-605. --+-------------------------------------------------------------------------------------------------------------------------- The Company records all revenues on gross basis in accordance with ASC 605-45 since it is the primary obligor and establishes the price in the revenue arrangement. The Company is currently under no obligation for refunding any fees or has any obligations for disputed claim settlements. Earnings (loss) per share - Basic earnings (loss) per share exclude any dilutive effects of options, warrants and convertible securities. Basic earnings (loss) per share is computed using the weighted-average number of outstanding common stocks during the applicable period. Diluted earnings per share is computed using the weighted-average number of common and common stock equivalent shares outstanding during the period. Common stock equivalent shares are excluded from the computation if their effect is antidilutive. 9 - Reclassification of prior year presentation - Certain prior year amounts have been reclassified for consistency with the current period presentation. These reclassifications had no effect on the reported results of operations or cash flows. During the first quarter of 2017, the Company concluded that it was appropriate to reclassify its customer service center costs from general and administration expense to cost of sales for the three and nine months ended September 30, 2016. In the second quarter of 2017, the company concluded that it was appropriate to reclassify stock payable from liabilities to additional paid in capital for the three and nine month period ended September 30, 2017. These changes in classification does not affect previously reported cash flows from operations in the Consolidated Statement of Cash Flows, and had no effect on the previously reported net income of the Consolidated Statement of Income for any period. Recent Accounting Pronouncements – In November 2016, the FASB issued Accounting Standards Update 2016-18, “Statement of Cash Flows – Restricted Cash a consensus of the FASB Emerging Issues Task Force.” This standard requires restricted cash and cash equivalents to be included with cash and cash equivalents on the statement of cash flows under a retrospective transition approach. The guidance became effective for fiscal years beginning December 15, 2017 and interim periods within those fiscal years. The Company has retrospectively adopted ASU 2016-18. In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606) ("ASU 2014-09"), which supersedes nearly all existing revenue recognition guidance under GAAP. The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, more judgment and estimates may be required within the revenue recognition process than are required under existing GAAP. ASU 2014-09, as amended by ASU 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date, is effective for annual periods beginning after December 15, 2017, including interim periods within those annual periods, with early adoption permitted for annual reporting periods beginning after December 15, 2016. The FASB has also issued a number of additional technical corrections since the initial ASU, all of which follow the effective dates of the new revenue recognition guidance under Topic 606. The amendment allows companies to use either a full retrospective or a modified retrospective approach to adopt this ASU. We have formed a project team and are currently assessing the impact of the adoption of this principle on our consolidated financial statements. We anticipate adopting this ASU on January 1, 2018 using the modified retrospective approach, however, may opt for the full retrospective method depending on the final outcome of our evaluation. In February 2016, the FASB issued Accounting Standards Update No. 2016-02, Leases. The new standard establishes a right-of-use (ROU) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. Management is currently assessing the impact of this pronouncement on the Company’s financial statements. 2. FIXED ASSETS Fixed assets consist of the following: | September 30, 2017 | | | December 31, 2016 | -------------------------------+---------------------+-----------+---+-------------------+-- Equipment | $ | 1,343,717 | | | $ | 746,117 | -------------------------------+---------------------+-----------+---+-------------------+---+-----------+-- Software | | 120,795 | | | | 117,163 | -------------------------------+---------------------+-----------+---+-------------------+---+-----------+-- Furniture and fixtures | | 119,550 | | | | 107,141 | -------------------------------+---------------------+-----------+---+-------------------+---+-----------+-- Website Costs | | 21,117 | | | | – | -------------------------------+---------------------+-----------+---+-------------------+---+-----------+-- Leasehold improvements | | 50,999 | | | | 36,499 | -------------------------------+---------------------+-----------+---+-------------------+---+-----------+-- | | 1,656,178 | | | | 1,006,920 | -------------------------------+---------------------+-----------+---+-------------------+---+-----------+-- Less: accumulated depreciation | | (804,042 | ) | | | (706,159 | ) -------------------------------+---------------------+-----------+---+-------------------+---+-----------+-- Fixed assets, net | $ | 852,136 | | | $ | 300,761 | -------------------------------+---------------------+-----------+---+-------------------+---+-----------+-- Fixed assets are depreciated over their useful lives ranging from periods of 3 to 7 years. 10 -- 3. INTANGIBLE ASSETS Intangible assets consist of the following: | September 30, 2017 | | | December 31, 2016 | -------------------------------+--------------------+------------+---+-------------------+-- Patents and trademarks | $ | 34,940 | | | $ | 34,771 | -------------------------------+--------------------+------------+---+-------------------+---+-----------+-- Platform and licenses | | 2,602,924 | | | | 2,008,307 | -------------------------------+--------------------+------------+---+-------------------+---+-----------+-- Kiosk development | | 64,802 | | | | 64,802 | -------------------------------+--------------------+------------+---+-------------------+---+-----------+-- Licenses | | 389,165 | | | | 382,414 | -------------------------------+--------------------+------------+---+-------------------+---+-----------+-- | | 3,091,831 | | | | 2,490,294 | -------------------------------+--------------------+------------+---+-------------------+---+-----------+-- Less: accumulated amortization | | (1,567,768 | ) | | | (940,250 | ) -------------------------------+--------------------+------------+---+-------------------+---+-----------+-- Intangible assets, net | $ | 1,524,063 | | | $ | 1,550,044 | -------------------------------+--------------------+------------+---+-------------------+---+-----------+-- Intangible assets are amortized over their useful lives ranging from periods of 3 to 5 years. 4. NOTES PAYABLE Notes payable consist of the following: | September 30, 2017 | | December 31, 2016 | -----------------------------------------------------------------------------------------------------------------------------------+---------------------+---+-------------------+-- Note payable due to a shareholder of the Company, bearing fixed interest at 8%, at December 31, 2016 due on demand and unsecured. | $ | – | | $ | 102,613 | -----------------------------------------------------------------------------------------------------------------------------------+---------------------+---+-------------------+---+----------+-- Notes payable due to various equipment finance companies bearing interest from 12.89% to 15.14% at December 31, 2016. | | – | | | 49,447 | -----------------------------------------------------------------------------------------------------------------------------------+---------------------+---+-------------------+---+----------+-- | | – | | | 152,060 | -----------------------------------------------------------------------------------------------------------------------------------+---------------------+---+-------------------+---+----------+-- Less: current portion | | – | | | (124,168 | ) -----------------------------------------------------------------------------------------------------------------------------------+---------------------+---+-------------------+---+----------+-- Notes payable – long term portion | $ | – | | $ | 27,892 | -----------------------------------------------------------------------------------------------------------------------------------+---------------------+---+-------------------+---+----------+-- 5. COMMON STOCK At September 30, 2017, the Company's authorized capital stock was 150,000,000 shares of common stock, par value $0.001 per share, and 10,000,000 shares of preferred stock, par value $0.001 per share. On that date, the Company had outstanding 43,660,765 shares of common stock, and no shares of preferred stock. 2017 Transactions: During the nine months ended September 30, 2017, the Company issued shares of common stock as follows: · | 75,000 shares of common stock for current services rendered totaling $12,882 or $0.17 per share (average cost). --+----------------------------------------------------------------------------------------------------------------------------------------------------- · | 200,000 shares of common stock issued to an employee as a bonus totaling $84,400 or $0.42 per share (average cost) --+----------------------------------------------------------------------------------------------------------------------------------------------------- · | 200,000 shares of common stock were issued related to exercise of a warrant with an exercise price of $0.25 for a total of $50,000 in cash proceeds. --+----------------------------------------------------------------------------------------------------------------------------------------------------- 11 -- 2016 Transactions: During the nine months ended September 30, 2016, the Company issued shares of common stock as follows: · | 437,500 shares of common stock for current services rendered and prior services which had previously been recorded as accrued liability totaling $98,810 or $0.23 per share (average cost). --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Stock and Warrant Grants: In July 2017 the Company granted 200,000 shares of restricted common stock to an employee of the Company with a total value of $84,400 or $0.422 per share. These shares have been issued. Concurrently, the Company also granted the employee four equal tranches of 200,000 restricted common shares, each valued at $84,400 which will vest in equal amounts over a four year period on the last day of each quarter, commencing December 31, 2017. None of these shares have been issued. In November 2016, the Company granted a total of 5,000,000 shares to certain officers and directors of the Company with a total value of $787,950 or $0.15759 per share (including a 15% discount of fair market value due to these shares being restricted and lacking market liquidity). The 5,000,000 shares have a quarterly vesting period of five years with the first vesting period occurring on December 31, 2016. The approximate value vested for the three and nine months ended September 30, 2017 was $39,397 and $118,191 respectively. As of September 30, 2017, none of the shares have been issued. In November 2016, the Company granted 210,000 shares to a consultant. The shares were valued at $33,094 or $0.15759 per share (including a 15% discount of fair market value due to these shares being restricted and lacking market liquidity). The 210,000 shares have a quarterly vesting period of three years with the first vesting period occurring on December 31, 2016. The approximate value vested for the three and nine months ended September 30, 2017 was $2,758 and $8,274, respectively. The approximate value vested for 2016 is $2,758. As of September 30, 2017, none of the shares have been issued. In March 2015, the Company granted 200,000 shares of common stock along with 200,000 warrants to a consultant. The shares were valued at $30,600 or $0.16 per share (including a 15% discount of fair market value due to these shares being restricted and lacking market liquidity). The warrants were valued at $34,611, using the Black-Scholes options pricing model under the following assumptions: stock price at issuance of $0.18 per share; exercise price of $0.50, 3 year life; discount rate of 2.00%; and volatility rate of 245%. The 200,000 shares and 200,000 warrants granted have a vesting period of six months, and were fully vested as of March 31, 2016. As of March 31, 2017, the 200,000 shares have been issued and the warrants for 200,000 shares were granted. In August 2014, the Company granted 150,000 shares of common stock to a consultant with a total value of $25,500 or $0.17 per share (including a 15% discount of fair market value due to these shares being restricted and lacking market liquidity). The 150,000 shares granted have a vesting period of three years and is fully vested as of September 30, 2017. The approximate value vested for the three and nine months ended September 30, 2017 and 2016 was $2,100, and $6,300, respectively. As of September 30, 2017, 100,000 shares granted have been issued. In September 2014, the Company granted 150,000 shares of common stock along with 150,000 Class A warrants and 150,000 Class B warrants to an advisory board member. The shares were valued at $19,250 or $0.13 per share (including a 15% discount of fair market value due to these shares being restricted and lacking market liquidity. The warrants were valued at $42,761, using the Black-Scholes options pricing model under the following assumptions: stock price at issuance of $0.15 per share; exercise price of $0.25 for the Class A warrants and $0.50 for the Class B warrants; 3 year life; discount rate of 2.00%; and volatility rate of 245%. The 150,000 shares and 300,000 warrants granted vest over a 3 year period, at 50,000 shares and 100,000 warrants per year of which thirty-six months had vested as of September 30, 2017. The approximate value vested for the three months ended September 30, 2017 and 2016 $5,100 respectively and for the nine months ended September 30, 2017 and 2016 was $14,200 and $15,300, respectively. As of September 30, 2017, all of the 150,000 shares were issued and the 300,000 warrants granted have expired. In September 2014, the Company granted 200,000 shares of common stock along with 200,000 warrants to a consultant. The shares were valued at $30,600 or $0.16 per share (including a 15% discount of fair market value due to these shares being restricted and lacking market liquidity). The warrants were valued at $34,611, using the Black-Scholes options pricing model under the following assumptions: stock price at issuance of $0.18 per share; exercise price of $0.25; 3 year life; discount rate of 2.00%; and volatility rate of 245%. The 200,000 shares and 200,000 warrants granted had a vesting period of nine months and were fully vested as March 31, 2015. During the three months ended March 31, 2016 the company had issued the 200,000 shares and warrant for 200,000 shares of common stock. As of September 30, 2017, warrants relating to 200,000 shares have been exercised for total proceeds of $50,000. 12 -- In October 2014, the Company granted 150,000 shares of common stock to an advisory board member with a total value of $32,400 or $0.21 per share (including a 10% discount of fair market value due to these shares being restricted and lacking market liquidity). The 150,000 shares granted will vest over a 3 year period, at 50,000 shares per year and is fully vested as of September 30, 2017. The approximate value vested for the three months and nine months ended September 30, 2017 and 2016 was $2,700 and $8,100, respectively. As of September 30, 2017, all 150,000 of the shares have been issued. In November 2014, the Company issued a warrant for 100,000 shares of common stock as part of an issuance of note payable totaling $100,000. The warrant has an exercise price of $0.50 per share and life of three years. In October 2013, the Company granted 300,000 shares of common stock to an employee of the Company with a total value of $38,250 or $0.15 per share (including a 15% discount of fair market value due to these shares being restricted and lacking market liquidity). The 300,000 shares granted have a vesting period of three years and was fully vested as of October 2016. The approximate value vested for the three and nine months ended September 30, 2017 and 2016 was $0.00 and $3,200, respectively. As of March 31, 2017, all 300,000 shares granted have been issued. 6. LEGAL SETTLEMENT PAYABLE On August 11, 2015, PSKW, LLC (“PSKW”) served the Company, with a complaint titled PSKW, LLC v. 3Pea International, Inc., filed in the United States District Court for the Northern District of California, Case No. 5:15-cv-03576-RMW, San Jose Division (the “Action”). In the Action, PSKW asserted claims against the Company for $5,800,000 for marketing fees allegedly due by the Company. The Company contended, among other things, that PSKW breached its agreement with the Company, for which the Company was damaged in an amount in excess of the amount which PSKW claimed was owed by the Company to PSKW. The parties each denied liability, and entered into a Settlement Agreement and Release on October 2, 2015 whereby the Company agreed to pay $2,500,000 to PSKW in full settlement of the Action. The settlement amount was payable by an initial payment of $1,000,000 which was paid in October 2015, with the balance of $1,500,000 being payable in equal monthly installments over 18 months with interest at 3% per annum commencing on November 1, 2015. The Court dismissed the Action with prejudice, but retained jurisdiction to enforce the Settlement Agreement. 3Pea Technologies, Inc., a wholly-owned subsidiary of the Company, guaranteed the amount due under the Settlement Agreement. The Company expensed the entire $2,500,000 settlement during the year ended December 31, 2015 since the principal terms of the Settlement Agreement had been agreed to as of that date. As of March 31, 2017, the settlement was paid in full. 7. SUBSEQUENT EVENTS There were no reportable subsequent events after September 30, 2017 through the date of this filing. 13 -- Item 2. Management’s discussion and analysis of financial condition and results of operations. Disclosure Regarding Forward Looking Statements This Quarterly Report on Form 10-Q includes forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (“Forward Looking Statements”). All statements other than statements of historical fact included in this report are Forward Looking Statements. In the normal course of our business, we, in an effort to help keep our shareholders and the public informed about our operations, may from time-to-time issue certain statements, either in writing or orally, that contains or may contain Forward-Looking Statements. Although we believe that the expectations reflected in such Forward-Looking Statements are reasonable, we can give no assurance that such expectations will prove to have been correct. Generally, these statements relate to business plans or strategies, projected or anticipated benefits or other consequences of such plans or strategies, past and possible future, of acquisitions and projected or anticipated benefits from acquisitions made by or to be made by us, or projections involving anticipated revenues, earnings, levels of capital expenditures or other aspects of operating results. All phases of our operations are subject to a number of uncertainties, risks and other influences, many of which are outside of our control and any one of which, or a combination of which, could materially affect the results of our proposed operations and whether Forward Looking Statements made by us ultimately prove to be accurate. Such important factors (“Important Factors”) and other factors could cause actual results to differ materially from our expectations are disclosed in this report, including those factors discussed in “Item 1A. Risk Factors.” All prior and subsequent written and oral Forward Looking Statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the Important Factors described below that could cause actual results to differ materially from our expectations as set forth in any Forward Looking Statement made by or on behalf of us. Overview 3PEA International, Inc. is a vertically integrated provider of innovative prepaid card programs and processing services for corporate, consumer and government applications. Our payment solutions are utilized by our corporate customers as a means to increase customer loyalty, reduce administration costs and streamline operations. Public sector organizations can utilize the solutions to disburse public benefits or for internal payments. We market our prepaid debit card solutions under our PaySign brand. As we are a payment processor and debit card program manager, we derive our revenue from all stages of the debit card lifecycle. We provide a card processing platform consisting of proprietary systems and innovative software applications based on the unique needs of our programs. We have extended our processing business capabilities through our proprietary PaySign platform. Through the PaySign platform, we provide a variety of services including transaction processing, cardholder enrollment, value loading, cardholder account management, reporting, and customer service. The PaySign platform was built on modern cross-platform architecture and designed to be highly flexible, scalable and customizable. The platform has allowed 3PEA to significantly expand its operational capabilities by facilitating our entry into new markets within the payments space through its flexibility and ease of customization. The PaySign platform delivers cost benefits and revenue building opportunities to our partners. We have developed prepaid card programs for corporate and incentive rewards including, but not limited to healthcare reimbursement payments, pharmaceutical co-pay assistance, donor compensation and automobile dealership incentives. We are expanding our product offering to include additional corporate incentive products, payroll cards, general purpose re-loadable cards, travel cards, and expense reimbursement cards. Our cards are offered to end users through our relationships with bank issuers. We are a vertically integrated payment processor and debit card program manager offering innovative payment solutions to corporations, government agencies, universities and other organizations. Our payment solutions are utilized by our customers as a means to increase customer loyalty, reduce administration costs and streamline operations. We market our prepaid debit card solutions under our PaySign brand. As we are a payment processor and debit card program manager, we derive our revenue from all stages of the debit card lifecycle. These revenues can include fees from program set-up; customization and development; data processing and report generation; card production and fulfillment; transaction fees derived from card usage; inactivity fees; card replacement fees and program administration fees. We provide an in-house customer service center which includes live bi-lingual phone operators staffed 24/7, for incoming calls. We also provide in house Interactive Voice Response (IVR), SMS alerts and two way SMS messaging platforms. 14 -- We are a vertically integrated payment processor and debit card program manager offering innovative payment solutions to corporations, government agencies, universities and other organizations. Our payment solutions are utilized by our customers as a means to increase customer loyalty, reduce administration costs and streamline operations. We market our prepaid debit card solutions under our PaySign brand. As we are a payment processor and debit card program manager, we derive our revenue from all stages of the debit card lifecycle. These revenues can include fees from program set-up; customization and development; data processing and report generation; card production and fulfillment; transaction fees derived from card usage; inactivity fees; card replacement fees and program administration fees. We provide an in-house customer service center which includes live bi-lingual phone operators staffed 24/7, for incoming calls. We also provide in house Interactive Voice Response and two way SMS messaging platforms. The Company divides prepaid cards into two general categories: corporate and consumer reloadable, and non-reloadable cards. Reloadable Cards: These types of cards are generally incentive, payroll or considered general purpose reloadable (“GPR”) cards. Payroll cards are issued to an employee by an employer to receive the direct deposit of their payroll. GPR cards can also be issued to a consumer at a retail location or mailed to a consumer after completing an on-line application. GPR cards can be reloaded multiple times with a consumer’s payroll, government benefit, a federal or state tax refund or through cash reload networks located at retail locations. Reloadable cards are generally open loop cards as described below. Non-Reloadable Cards: These are generally one-time use cards that are only active until the funds initially loaded to the card are spent. These types of cards are gift or incentive cards. These cards may be open loop or closed loop. Normally these types of cards are used for purchase of goods or services at retail locations and cannot be used to receive cash. These prepaid cards may be open loop, closed loop or semi-closed loop. Open loop cards can be used to receive cash at ATM locations or purchase goods or services by PIN or signature at retail locations. These cards can be used virtually anywhere that the network brand (Visa, MasterCard, Discover, etc.) is accepted. Closed loop cards can only be used at a specific merchant. Semi-closed loop cards can be used at several merchants such as a shopping mall. The prepaid card market is one of the fastest growing segments of the payments industry in the U.S. This market has experienced significant growth in recent years due to consumers and merchants embracing improved technology, greater convenience, more product choices and greater flexibility. Prepaid cards have also proven to be an attractive alternative to traditional bank accounts for certain segments of the population, particularly those without, or who could not qualify for, a checking or savings account. We have developed prepaid card programs for healthcare reimbursement payments, corporate and incentive rewards and expense reimbursement cards. We plan to expand our product offering to include payroll cards, general purpose re-loadable cards and travel cards. Our cards are offered to end users through our relationships with bank issuers. Our products and services are aimed at capitalizing on the growing demand for stored value and reloadable ATM/prepaid card financial products in a variety of market niches. Our proprietary platform is scalable and customizable, delivering cost benefits and revenue building opportunities to partners. We manage all aspects of the debit card lifecycle, from managing the card design and approval processes with banking partners and card associations, to production, packaging, distribution, and personalization. We also oversee inventory and security controls, renewals, lost and stolen card management and replacement. As part of our platform expansion development process, we evaluate current and emerging technologies for applicability to our existing and future software platform. To this end, we engage with various hardware and software vendors in evaluation of various infrastructure components. Where appropriate, we use third-party technology components in the development of our software applications and service offerings. Third-party software may be used for highly specialized business functions, which we may not be able to develop internally within time and budget constraints. Our principal target markets for processing services include prepaid card issuers, retail and private-label issuers, small third-party processors, and small and mid-size financial institutions in the United States and in emerging international markets. The Company is devoting more extensive resources to sales and marketing activities as we have added essential personnel to our marketing and sales department. We sell our products directly to customers in the U.S. but may work with a small number of resellers and third parties in international markets to identify, sell and support targeted opportunities. 15 -- In order to expand into new markets, we will need to invest additional funds in technology improvements, sales and marketing expenses, and regulatory compliance costs. We are considering raising capital to enable us to diversify into new market verticals. If we do not raise new capital, we believe that we will still be able to expand into new markets using internally generated funds, but our expansion will not be as rapid. Results of Operations Three Months ended September 30, 2017 and 2016 Revenues for the three months ended September 30, 2017 were $4,001,991, an increase of $1,189,455 compared to the same period in the prior year, when revenues were $2,812,536. The increase in revenue is primarily due to an increase in the number of new corporate incentive prepaid card products and growth within our existing corporate incentive prepaid card products. However, our revenue during this period was slightly impacted by diminished card usage in areas affected by hurricanes in Texas and Florida. As of September 30, 2017, we managed 175 card programs with over 1,390,000 participating cardholders. The Company expects revenues to continue to trend upwards for the foreseeable future as we expect to onboard over 35 additional corporate incentive card programs in the fourth quarter of 2017. Cost of revenues for the three months ended September 30, 2017 were $2,145,621, an increase of $623,163 compared to the same period in the prior year, when cost of revenues was $1,522,458. Cost of revenues constituted approximately 54% and 54% of total revenues in the same quarter 2017 and 2016, respectively. Although cost of revenues remained relatively constant when compared to the same period in the previous year, cost of revenue in the period ended September 30, 2017 was impacted by costs associated with program set up and launch. Cost of revenues is comprised of transaction processing fees, data connectivity and data center expenses, network fees, card production costs, customer service and program management expenses, application integration setup and sales expense. Gross profit for the three months ended September 30, 2017 was $1,856,370, an increase of $566,292 compared to the same period in the prior year, when gross profit was $1,290,078. Our overall gross profit percentage approximated 46% and 46% during the second quarters of 2017 and 2016 which is consistent with our overall expectations. Depreciation and amortization for the three months ended September 30, 2017 were $276,533, an increase of $127,191 compared to the same period prior year of $149,342. Overall increase in depreciation and amortization was primarily a result of an increase in depreciation related to an increase in capital expenditures and amortization expense related to additional capitalized platform costs. Selling, general and administrative expenses for the three months ended September 30, 2017 were $1,104,280, an increase of $443,724 compared to the same period in the prior year, when selling, general and administrative expenses were $660,556. The increase in selling, general and administrative expenses was due to increases in staff as we experienced an accelerated rate of new card product launches in the second half of 2017. In the three months ended September 30, 2017, we recorded operating income of $475,557, as compared to $480,180 in the same period in the prior year, representing a decrease in operating income of $(4,623). Other income (expense) for the three months ended September 30, 2016 was $14,398 an increase in net other income (expense) of $29,895 compared to the same period in the prior year when other income (expense) was $(15,497) which is within our overall expectations. Net income before noncontrolling interest for the three months ended September 30, 2017 was $489,955, an increase of $25,272 compared to the same period in the prior year of $464,683. The increase in our net income before noncontrolling interest is attributable to the aforementioned factors. Net loss attributable to noncontrolling interest for the three months ended September 30, 2017 was $13,213, a decrease of $2,533 compared to the same period in the prior year of $15,746 The decrease in net loss attributable to noncontrolling interest is primarily due to a decrease in expenses related to our European operations. 16 -- Net income attributable to 3Pea International, Inc. for the three months ended September 30, 2017 was $500,168, an increase of $19,739 compared to the same period in the prior year, when we recorded net income of $480,429. The increase in our net income is attributable to the aforementioned factors. Nine Months ended September 30, 2017 and 2016 Revenues for the nine months ended September 30, 2017 were $10,621,055, an increase of $3,251,515 compared to the same period in the prior year, when revenues were $7,369,540. The increase in revenue is primarily due to an increase in the number of new corporate incentive prepaid card products and growth within our existing corporate incentive prepaid card products. Cost of revenues for the nine months ended September 30, 2017 were $5,834,709, an increase of $1,772,647 compared to the same period in the prior year, when cost of revenues was $4,062,062. Cost of revenues constituted approximately 55% and 55% of total revenues in 2017 and 2016, respectively. Cost of revenues is comprised of transaction processing fees, data connectivity and data center expenses, network fees, card production costs, customer service and program management expenses, application integration setup and sales expense. Gross profit for the nine months ended September 30, 2017 was $4,786,346, an increase of $1,478,868 compared to the same period in the prior year, when gross profit was $3,307,478. Our overall gross profit percentage approximated 45% and 45% during the first nine months of 2017 and 2016 which is consistent with our overall expectations. Depreciation and amortization for the nine months ended September 30, 2017 were $725,401, an increase of $319,073 compared to the same period prior year of $406,328. Overall increase in depreciation and amortization was primarily a result of an increase in amortization expense related to additional capitalized platform costs. Selling, general and administrative expenses for the nine months ended September 30, 2017 were $2,847,955, an increase of $793,604 compared to the same period in the prior year, when selling, general and administrative expenses were $2,054,351. The increase in selling, general and administrative expenses was due to increases in staff in anticipation of an accelerated rate of new card product launches in the second half of 2017. In the nine months ended September 30, 2017, we recorded operating income of $1,212,990, as compared to $846,799 in the same period in the prior year, an increase in operating income of $366,191. Other income (expense) for the nine months ended September 30, 2017 was $8,772, an increase in net other income (expense) of $56,620 compared to the same period in the prior year when other income (expense) was $(47,848) which is within our overall expectations. Net income before noncontrolling interest for the nine months ended September 30, 2017 was $1,212,762, an increase of $413,811 compared to the same period in the prior year of $798,951. The increase in our net income before noncontrolling interest is attributable to the aforementioned factors. Net loss attributable to noncontrolling interest for the nine months ended September 30, 2017 was $41,242, a decrease of $(57,855) compared to the same period in the prior year of $99,097. The decrease in net loss attributable to noncontrolling interest is primarily due to a decrease in expenses related to our European subsidiary. Net income attributable to 3Pea International, Inc. for the nine months ended September 30, 2017 was $1,254,004, an increase of $355,956 compared to the same period in the prior year, when we recorded net income of $898,048. The increase in our net income is attributable to the aforementioned factors. Liquidity and Sources of Capital The following table sets forth the major sources and uses of cash for the nine months ended September 30, 2017 and 2016: | Nine months ended September 30, | -----------------------------------------------------------+---------------------------------+----------- | 2017 | | | 2016 | -----------------------------------------------------------+---------------------------------+------------+---+------+-- Net cash provided by operating activities | $ | 4,133,672 | | | $ | 2,370,551 | -----------------------------------------------------------+---------------------------------+------------+---+------+---+-----------+-- Net cash (used) in investing activities | | (1,250,795 | ) | | | (603,559 | ) -----------------------------------------------------------+---------------------------------+------------+---+------+---+-----------+-- Net cash (used) in financing activities | | (102,060 | ) | | | (97,255 | ) -----------------------------------------------------------+---------------------------------+------------+---+------+---+-----------+-- Net increase in cash, restricted cash and cash equivalents | $ | 2,780,817 | | | $ | 1,669,737 | -----------------------------------------------------------+---------------------------------+------------+---+------+---+-----------+-- 17 -- Comparison of nine months ended September 30, 2017 and 2016 During the nine months ended September 30, 2017 and 2016, we financed our operations primarily through revenues generated from operations. Operating activities provided $4,133,672 of cash and restricted cash in the nine months ended September 30, 2017, as compared to $2,370,551 of cash and restricted cash in the same period in the prior year. Restricted cash increased by $2,496,024 as a result of an increase in customer card funding. Major non-cash items that affected our cash flow from operations in the nine months ended September 30, 2017 were non-cash charges of $725,401 for depreciation and amortization and stock based compensation of $238,040. Our operating assets and liabilities provided 1,957,469 of cash, most of which resulted from an increase in customer card funding of $2,496,024 a decrease in prepaid expenses of $(251,261) and a decrease in our legal settlement payable of $(254,900). Major non-cash items that affected our cash flow from operations in the nine months ended September 30, 2016 were non-cash charges of $406,328 for depreciation and amortization and stock based compensation of $40,091. Our operating assets and liabilities provided $1,125,181 of cash, most of which resulted from an increase in customer card funding of $1,726,127, offset by a decrease in our legal settlement payable of $(746,954). Investing activities used $(1,250,795) of cash in the nine months ended September 30, 2017, as compared to $(603,559) of cash used in the same period in 2016, in both periods, cash used in investing activities related to capital expenditures and the continuous enhancement of the processing platform used in our business. Financing activities used $(102,060) of cash in the nine months ended September 30, 2017 as compared to $(97,255) of cash used in the nine months ended September 30, 2016. In 2017, cash used in financing activities consisted of payments on notes payables totaling $152,060 offset by $50,000 received from the exercise of a warrant. In 2016, cash used in financing activities consisted of payments on notes payables totaling $126,308 offset by $29,053 received from a note payable. Sources of Financing We believe that our available unrestricted cash on hand at September 30, 2017 of $1,916,736 and revenues anticipated for the remainder of 2017and 2018 will be sufficient to sustain our operations for the next twelve months. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements that are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors. Critical Accounting Estimates Our significant accounting policies are described in Note 1 of Notes to Financial Statements. At this time, we are not required to make any material estimates and assumptions that affect the reported amounts and related disclosures of assets, liabilities, revenue, and expenses. Any estimates we make will be based on our experience and our interpretation of economic, political, regulatory, and other factors that affect our business prospects. Actual results may differ significantly from our estimates. Item 3. Quantitative and Qualitative Disclosures about Market Risk. Because the Company is a smaller reporting company, it is not required to provide the information called for by this Item. Item 4. Controls and Procedures. Evaluation of Disclosure Controls and Procedures Our chief executive officer and chief financial officer are responsible for establishing and maintaining our disclosure controls and procedures. Disclosure controls and procedures means controls and other procedures that are designed to ensure that information we are required to disclose in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and to ensure that information required to be disclosed by us in those reports is accumulated and communicated to the our management, including our principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. Our chief executive officer and chief financial officer evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of September 30, 2017. Based on that evaluation, our chief executive officer and chief financial officer have concluded that, as of the evaluation date, such controls and procedures were effective. Changes in internal controls There were no changes in our internal controls over financial reporting that occurred during the quarter ended September 30, 2016 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 18 -- PART II. OTHER INFORMATION Item 1. Legal Proceedings. From time to time, we may become involved in various lawsuits and legal proceedings which arise in the ordinary course of business. However, litigation is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm our business. We are not presently a party to any material litigation, nor to the knowledge of management is any litigation threatened against us, which may materially affect us. Item 1A. Risk Factors. Not applicable. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds. During the three months ended September 30, 2017, the Company issued 50,000 shares of common stock for current services rendered and 200,000 shares of restricted common stock to an employee. The shares were granted pursuant to an exemption from registration provided by Section 4(2) of the Securities Act of 1933. Item 3. Defaults upon Senior Securities. None. Item 4. MINE SAFETY DISCLOSURES None Item 5. Other Information. None. Item 6. Exhibits. 31.1 | Certification Pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934 --------+----------------------------------------------------------------------------------------------------------------------- 31.2 | Certification Pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934 --------+----------------------------------------------------------------------------------------------------------------------- 32.1 | Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 --------+----------------------------------------------------------------------------------------------------------------------- 32.2 | Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 --------+----------------------------------------------------------------------------------------------------------------------- 101.INS | XBRL Instance Document --------+----------------------------------------------------------------------------------------------------------------------- 101.SCH | XBRL Schema Document --------+----------------------------------------------------------------------------------------------------------------------- 101.CAL | XBRL Calculation Linkbase Document --------+----------------------------------------------------------------------------------------------------------------------- 101.LAB | XBRL Label Linkbase Document --------+----------------------------------------------------------------------------------------------------------------------- 101.PRE | XBRL Presentation Linkbase Document --------+----------------------------------------------------------------------------------------------------------------------- 101.DEF | XBRL Definition Linkbase Document --------+----------------------------------------------------------------------------------------------------------------------- 19 -- SIGNATURES In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. | 3PEA INTERNATIONAL, INC. ------------------------+-------------------------------------------------------------------------------------- Date: November 13, 2017 | /s/ Mark Newcomer ------------------------+-------------------------------------------------------------------------------------- | By: Mark Newcomer, Chief Executive Officer (principal executive officer) ------------------------+-------------------------------------------------------------------------------------- Date: November 13, 2017 | /s/ Brian Polan ------------------------+-------------------------------------------------------------------------------------- | By: Brian Polan, Chief Financial Officer (principal financial and accounting officer) ------------------------+-------------------------------------------------------------------------------------- 20 --

AB Private Credit Investors Corp

1634452

10-Q

0001193125-17-341166

AB Private Credit Investors Corporation UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) ☒ | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2017 --+------------------------------------------------------------------------------------------------------------------------------------------ ☐ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 --+----------------------------------------------------------------------------------------- COMMISSION FILE NUMBER: 814-01196 AB Private Credit Investors Corporation (Exact name of registrant as specified in its charter) Maryland | 47-5049745 -------------------------+------------------------------------- (State of incorporation) | (I.R.S. Employer Identification No.) -------------------------+------------------------------------- 1345 Avenues of the Americas New York, NY 10105 (Address of principal executive offices) (212) 969-1000 (Registrant’s telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☐ No ☐ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large accelerated filer | ☐ | Accelerated filer | ☐ ------------------------+--------------------------------------------------+---------------------------+-- Non-accelerated filer | ☒ (do not check if a smaller reporting company) | Smaller reporting company | ☐ ------------------------+--------------------------------------------------+---------------------------+-- Emerging Growth Company | ☒ | | ------------------------+--------------------------------------------------+---------------------------+-- If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act). ☐ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒ The issuer had 2,500 shares of common stock, $0.01 par value per share, outstanding as of November 13, 2017. AB PRIVATE CREDIT INVESTORS CORPORATION FORM 10-Q FOR THE QUARTER ENDED September 30, 2017 Table of Contents | INDEX | PAGENO. | -----------+------------------------------------------------------------------------------------------------+---------+--- PART I. | FINANCIAL INFORMATION | | -----------+------------------------------------------------------------------------------------------------+---------+--- Item 1. | Financial Statements | | 3 -----------+------------------------------------------------------------------------------------------------+---------+--- | Statement of Assets and Liabilities as of September 30, 2017 (unaudited) and December 31, 2016 | | 3 -----------+------------------------------------------------------------------------------------------------+---------+--- | Statement of Operations for the three and nine months ended September 30, 2017 (unaudited) | | 4 -----------+------------------------------------------------------------------------------------------------+---------+--- Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations | | 11 -----------+------------------------------------------------------------------------------------------------+---------+--- Item 3. | Quantitative and Qualitative Disclosures About Market Risk | | 20 -----------+------------------------------------------------------------------------------------------------+---------+--- Item 4. | Controls and Procedures | | 20 -----------+------------------------------------------------------------------------------------------------+---------+--- PART II. | OTHER INFORMATION | | 21 -----------+------------------------------------------------------------------------------------------------+---------+--- Item 1. | Legal Proceedings | | 21 -----------+------------------------------------------------------------------------------------------------+---------+--- Item 1A. | Risk Factors | | 21 -----------+------------------------------------------------------------------------------------------------+---------+--- Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | | 21 -----------+------------------------------------------------------------------------------------------------+---------+--- Item 3. | Defaults Upon Senior Securities | | 21 -----------+------------------------------------------------------------------------------------------------+---------+--- Item 4. | Mine Safety Disclosures | | 21 -----------+------------------------------------------------------------------------------------------------+---------+--- Item 5. | Other Information | | 21 -----------+------------------------------------------------------------------------------------------------+---------+--- Item 6. | Exhibits | | 21 -----------+------------------------------------------------------------------------------------------------+---------+--- SIGNATURES | | | -----------+------------------------------------------------------------------------------------------------+---------+--- 2 Item 1. | Financial Statements --------+--------------------- AB Private Credit Investors Corporation Unaudited Statement of Assets and Liabilities | September 30,2017 (unaudited) | | December 31, 2016 | -------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+---------+-------------------+-- ASSETS: | | | | | -------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+---------+-------------------+---+------ Cash | $ | 25,000 | | $ | 1,000 -------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+---------+-------------------+---+------ Expense Payment from Adviser | $ | 565,647 | | | -------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+---------+-------------------+---+------ Deferred Offering Cost | $ | 235,353 | | | -------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+---------+-------------------+---+------ Total Assets | $ | 826,000 | | $ | 1,000 -------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+---------+-------------------+---+------ LIABILITIES: | | | | | -------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+---------+-------------------+---+------ Organizational and Offering Expenses | $ | 703,000 | | | -------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+---------+-------------------+---+------ Professional Fees | $ | 98,000 | | | -------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+---------+-------------------+---+------ Total Liabilities | $ | 801,000 | | $ | 0 -------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+---------+-------------------+---+------ Net Assets | $ | 25,000 | | $ | 1,000 -------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+---------+-------------------+---+------ Composition of Net Assets: | | | | | -------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+---------+-------------------+---+------ Common Stock, $0.01 par value | $ | 25 | | $ | 1 -------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+---------+-------------------+---+------ Additional paid in capital | | 24,975 | | | 999 -------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+---------+-------------------+---+------ | $ | 25,000 | | $ | 1,000 -------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+---------+-------------------+---+------ Shares | | | | | -------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+---------+-------------------+---+------ Net asset value per share(2,500 and 100 shares of Common Stock issued and outstanding at September 30, 2017 and December 31, 2016, respectively) | $ | 10.00 | | $ | 10.00 -------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+---------+-------------------+---+------ See accompanying notes to financial statements. 3 AB Private Credit Investors Corporation Unaudited Statement of Operations | Three MonthsEndedSeptember 30, 2017 | | | Nine MonthsEndedSeptember 30, 2017 | -------------------------------------+-------------------------------------+------------+---+------------------------------------+-- Investment income | | | | | | | -------------------------------------+-------------------------------------+------------+---+------------------------------------+---+------------+-- Total Investment Income | $ | 0 | | | $ | 0 | -------------------------------------+-------------------------------------+------------+---+------------------------------------+---+------------+-- Operating expenses | | | | | | | -------------------------------------+-------------------------------------+------------+---+------------------------------------+---+------------+-- Organizational and Offering Expenses | | 467,647 | | | | 467,647 | -------------------------------------+-------------------------------------+------------+---+------------------------------------+---+------------+-- Directors’ Fees | | 149,000 | | | | 149,000 | -------------------------------------+-------------------------------------+------------+---+------------------------------------+---+------------+-- Professional Fees | | 385,500 | | | | 385,500 | -------------------------------------+-------------------------------------+------------+---+------------------------------------+---+------------+-- Total Operating Expenses | | 1,002,147 | | | | 1,002,147 | -------------------------------------+-------------------------------------+------------+---+------------------------------------+---+------------+-- Expense Payment | | (1,002,147 | ) | | | (1,002,147 | ) -------------------------------------+-------------------------------------+------------+---+------------------------------------+---+------------+-- Net Income | $ | 0 | | | $ | 0 | -------------------------------------+-------------------------------------+------------+---+------------------------------------+---+------------+-- 4 Notes to Financial Statements 1. Organization AB Private Credit Investors Corporation (the “Fund”), an externally managed, closed-end, non-diversified management investment company that is regulated as a business development company (“BDC”) under the Investment Company Act of 1940, as amended (the “1940 Act”), was incorporated under the laws of the state of Maryland on February 6, 2015. The Fund was formed to invest in primary-issue middle-market credit opportunities that are directly sourced and privately negotiated. The Fund is conducting private offerings (each a “Private Offering”) of its common stock to investors in reliance on an exemption from the registration requirements of the Securities Act of 1933, as amended (the “Securities Act”). At the closing of any Private Offering, each investor will make a capital commitment (a “Capital Commitment”) to purchase shares of the Fund’s common stock pursuant to a subscription agreement entered into with the Fund. Investors will be required to fund drawdowns to purchase shares of the Fund’s common stock up to the amount of their respective Capital Commitment on an as-needed basis each time the Fund delivers a notice to its investors. The Fund anticipates commencing its loan origination and investment activities contemporaneously with the initial drawdown from investors in the initial Private Offering. As of September 30, 2017, no significant operations other than the sale and issuance of (i) 100 shares of common stock, par value $0.01, on June 27, 2016, at an aggregate purchase price of $1,000 ($10.00 per share) and (ii) 2,400 shares of common stock, par value $0.01, on May 26, 2017 to AB Private Credit Investors LLC, the Fund’s external investment adviser (the “Adviser”) have occurred. The sale of common shares was approved by the unanimous consent of the Fund’s board of directors on both occasions. On September 29, 2017, the Fund completed the initial closing (“Initial Closing”) of its Private Offering after entering into subscription agreements (collectively, the “Subscription Agreements”) with several investors, providing for the private placement of the Fund’s common shares. Under the terms of the Subscription Agreements, investors are required to fund drawdowns to purchase the Fund’s common shares up to the amount of their respective Capital Commitments on an as-needed basis upon the issuance of a capital drawn-down notice. At September 30, 2017 the Fund had total Capital Commitments of $70,928,060, of which 100% is unfunded. Capital Commitments may be drawn down by the Fund on a pro rata basis, as needed (including follow-on investments), for paying the Fund’s expenses, including fees under the Advisory Agreement, and/or maintaining a reserve account for the payment of future expenses or liabilities. As of September 30, 2017, the Fund had not commenced significant operational or investment activities. The Fund’s fiscal year ends on December 31. 2. Significant Accounting Policies The Fund is an investment company under accounting principles generally accepted in the United States of America (“U.S. GAAP”) and follows the accounting and reporting guidance applicable to investment companies in the Financial Accounting Standards Board (“FASB”) ASC 946, Financial Services – Investment Companies. Actual results could differ from those estimates. The financial statements have been prepared in conformity with U.S. GAAP, which requires the use of estimates and assumptions that affect the reported amounts and disclosures in the financial statements. Actual amounts and results could differ from these estimates, and such differences could be material. The following is a summary of significant accounting policies followed by the Fund. 5 Cash consists of demand deposits. Cash is carried at cost, which approximates fair value. The Fund maintains deposits of its cash with financial institutions, and, at times, cash held in bank accounts may exceed the Federal Deposit Insurance Corporation insured limit. The Fund intends to elect to be treated as a regulated investment company (“RIC”) under Subchapter M of the Internal Revenue Code of 1986, as amended. So long as the Fund is able to maintain its status as a RIC, it intends not to be subject to U.S. federal income on the portion of its taxable income and gains distributed to stockholders, if any. To qualify for RIC tax treatment, the Fund is required to distribute at least 90% of its investment company taxable income annually, meet diversification requirements quarterly and file Form 1120-RIC, as defined by the Internal Revenue Code. In the normal course of business, the Fund enters into general business contracts that contain a variety of representations and warranties and which may provide for indemnification. The Fund’s maximum exposure under these arrangements is unknown. However, the Fund expects the risk of material loss to be remote and no amounts have been recorded in the financial statement for such arrangements. In November 2016, the FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash (a Consensus of the Emerging Issues Task Force) (“ASU 2016-18”), which requires that the statement of cash flows explain the change during the period in the total of cash, cash equivalents, and amounts generally describes as restricted cash or restricted cash equivalents. ASU 2016-18 is effective for annual reporting periods beginning after December 15, 2017, including interim periods within those fiscal years, with early adoption permitted. Management does not believe this accounting standard, which is not yet effective, if currently adopted, would have a material effect on the accompanying financial statements. The Adviser is assessing the impact this accounting standard will have once the Fund commences investment activities. 3. Agreements and Related Party Transactions Advisory Agreement On July 5, 2017, the Fund’s board of directors approved the investment advisory agreement with the Adviser (the “Advisory Agreement”), pursuant to which the Fund will pay the Adviser, quarterly in arrears, a base management fee calculated at an annual rate of 1.50%. The base management fee is calculated based on a percentage of the average outstanding assets of the Fund (which equals the gross value of equity and debt instruments, including investments made utilizing leverage), excluding cash and cash equivalents, during such fiscal quarter. The average outstanding assets will be calculated by taking the average of the amount of assets of the Fund at the beginning and end of each month that occurs during the calculation period. The base management fee will be calculated and paid quarterly in arrears but will be accrued monthly by the Fund over the fiscal quarter for which such base management fee is paid. The base management fee for any partial month or quarter will be appropriately prorated. The Fund will also pay the Adviser an incentive fee that provides the Adviser with a share of the income that the Adviser generates for the Fund. The incentive fee will consist of an income-based incentive fee component and a capital-gains component, which are largely independent of each other, with the result that one component may be payable even if the other is not. Income-Based Incentive Fee: The income-based incentive fee is calculated and payable quarterly in arrears based on the Fund’s net investment income prior to any deductions with respect to such income-based incentive fees and capital gains incentive fees (“Pre-incentive Fee Net Investment Income”) for the quarter, as further described below. Pre-incentive fee net investment income means interest income, dividend income and any other income (including any other fees, such as commitment, origination, structuring, diligence, managerial and consulting fees or 6 other fees the Fund receives from portfolio companies) that the Fund accrues during the fiscal quarter, minus the Fund’s operating expenses for the quarter (including the base management fee, expenses payable under the administration agreement (the “Administration Agreement”) we have entered into with State Street Bank and Trust Company (the “Administrator”), and any interest expense and dividends paid on any issued and outstanding indebtedness or preferred stock, respectively, but excluding, for avoidance of doubt, the income-based incentive fee accrued under U.S. GAAP). Pre-incentive fee net investment income also includes, in the case of investments with a deferred interest feature (such as original issue discount, debt instruments with pay in kind interest and zero coupon securities), accrued income that the Fund has not yet received in cash. The Adviser is not under any obligation to reimburse the Fund for any part of the income-based incentive fees it received that was based on accrued interest that the Fund never actually received. Pre-incentive Fee Net Investment Income does not include any realized capital gains, realized capital losses or unrealized capital appreciation or depreciation. Because of the structure of the income-based incentive fee, it is possible that the Fund may accrue such income-based incentive fee in a quarter where the Fund incurs a net loss. For example, if the Fund receives Pre-incentive Fee Net Investment Income in excess of a hurdle rate (as defined below) for a quarter, the Fund will accrue the applicable income-based incentive fee even if the Fund has incurred a realized and/or unrealized capital loss in that quarter. However, cash payment of the income-based incentive fee may be deferred in this situation, subject to the restrictions detailed at the end of this section. • | Pre-incentive Fee Net Investment Income, expressed as a rate of return on the value of net assets (defined as total assets, less indebtedness and before taking into account any incentive fees payable during the period) at the end of the immediately preceding fiscal quarter, will be compared to various “hurdle rates,” with the income-based incentive fee rate of return increasing at each hurdle rate. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ Description of Quarterly Incentive Fee Calculations We pay the Adviser an income-based incentive fee with respect to Pre-incentive Fee Net Investment Income in each calendar quarter as follows: • | No income-based incentive fee in any calendar quarter in which Pre-incentive Fee Net Investment Income does not exceed 1.5% per quarter (approximately 6% per annum), the “6% Hurdle Rate”; --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | 100% of Pre-incentive Fee Net Investment Income with respect to that portion of such Pre-incentive Fee Net Investment Income, if any, that exceeds the 6% Hurdle Rate but is less than 1.67% in any calendar quarter (the “6% Catch-up Cap”), approximately 6.67% per annum. This portion of Pre-incentive Fee Net Investment Income (which exceeds the 6% Hurdle Rate but is less than the 6% Catch-up Cap) is referred to as the “6% Catch-up.” The 6% Catch-up is meant to provide the Adviser with 10.0% of the Pre-incentive Fee Net Investment Income as if hurdle rate did not apply if this net investment income exceeded 1.67% but was less than 1.94% in any calendar quarter; and --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | 10.0% of the amount of Pre-incentive Fee Net Investment Income, if any, that exceeds the 6% Catch-up Cap, but is less than 1.94% (the “7% Hurdle Rate”), approximately 7.78% per annum. The 7% Hurdle Rate is meant to limit the Adviser to 10% of the Pre-incentive Fee Net Investment Income until the amount of Pre-incentive Fee Net Investment Income exceeds 1.94%, approximately 7.78% per annum; and --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 7 • | 100% of Pre-incentive Fee Net Investment Income with respect to that portion of such Pre-incentive Fee Net Investment Income, if any, that exceeds the 7% Hurdle Rate but is less than 2.06% in any calendar quarter (the “7% Catch-up Cap”), approximately 8.24% per annum. This portion of Pre-incentive Fee Net Investment Income (which exceeds the 7% Hurdle Rate but is less than the 7% Catch-up Cap) is referred to as the “7% Catch-up.” The 7% Catch-up is meant to provide the Adviser with 15.0% of the Pre-incentive Fee Net Investment Income as if a hurdle rate did not apply if this net investment income exceeded 2.06% but was less than 2.35% in any calendar quarter; and --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ • | 15.0% of the amount of Pre-incentive Fee Net Investment Income, if any, that exceeds the 7% Catch-up Cap, but is less than 2.35% (the “8% Hurdle Rate”, approximately 9.41% per annum). The 8% Hurdle Rate is meant to limit the Adviser to 15% of the Pre-incentive Fee Net Investment Income until the amount of Pre-incentive Fee Net Investment Income exceeds 2.06%, approximately 9.41% per annum; and --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | 100% of Pre-incentive Fee Net Investment Income with respect to that portion of such Pre-incentive Fee Net Investment Income, if any, that exceeds the 8% Hurdle Rate but is less than 2.50% in any calendar quarter (the “8% Catch-up Cap”), approximately 10% per annum. This portion of Pre-incentive Fee Net Investment Income (which exceeds the 8% Hurdle Rate but is less than the 8% Catch-up cap) is referred to as the “8% Catch-up”. The 8% Catch-up is meant to provide the Adviser with 20.0% of the Pre-incentive Fee Net Investment Income as if a hurdle rate did not apply if this net investment income exceeded 2.50% in any calendar quarter; and --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | 20.0% of the amount of Pre-incentive Fee Net Investment Income, if any, that exceeds 2.50% in any calendar quarter. --+-------------------------------------------------------------------------------------------------------------------- Capital Gains Incentive Fee: The capital gains incentive fee is determined and payable at the end of each fiscal year as 17.5% of aggregate cumulative realized capital gains from the date of the Fund’s election to be regulated as a BDC through the end of that year, computed net of all aggregate cumulative realized capital losses and aggregate cumulative unrealized depreciation through the end of such year, less the aggregate amount of any previously paid capital gain incentive fees. For the foregoing purpose, “aggregate cumulative realized capital gains” will not include any unrealized appreciation. It should be noted, however, that the Fund will accrue an incentive fee for accounting purposes taking into account any unrealized appreciation in accordance with U.S. GAAP. For accounting purposes only, in order to reflect the theoretical capital gains incentive fee that would be payable for a given period as if all unrealized gains were realized, the Fund will accrue a capital gains incentive fee based upon net realized gains and unrealized depreciation for that calendar year (in accordance with the terms of the Advisory Agreement), plus unrealized appreciation on investments held at the end of the period. The capital gains incentive fee is not subject to any minimum return to stockholders. If such amount is negative, then no capital gains incentive fee will be payable for such year. Additionally, if the Advisory Agreement is terminated as of a date that is not a calendar year end, the termination date will be treated as though it were a calendar year end for purposes of calculating and paying the capital gains incentive fee. The amount of capital gains incentive fee expense related to a hypothetical liquidation of the portfolio (and assuming no other changes in realized or unrealized gains and losses) would only become payable to the Adviser in the event of a complete liquidation of the Fund’s portfolio as of period end and the termination of the Advisory Agreement on such date. Also, it should be noted that the capital gains incentive fee expense fluctuates with the Fund’s overall investment results. The Fund will defer cash payment of any income-based incentive fee and/or any capital gains incentive fee otherwise earned by the Adviser if during the most recent four full fiscal quarter period ending on or prior to the date such payment is to be made, the sum of (a) the pre-incentive fee net investment income, and (b) the realized capital gain / loss and (c) unrealized capital appreciation/ depreciation expressed as a rate of return on the value of our net assets, is less than 6.0%. Any such deferred fees are carried over for payment in subsequent calculation periods to the extent such payment is payable under the Advisory Agreement. 8 Administration Agreement and Expense Reimbursement Agreement We have entered into the Administration Agreement with the Administrator and a separate expense reimbursement agreement with the Adviser (the “Expense Reimbursement Agreement”) under which any allocable portion of the cost of our Chief Compliance Officer and Chief Financial Officer and their respective staffs will be reimbursed by the Fund. Under the Administration Agreement, the Administrator will be responsible for providing us with clerical, bookkeeping, recordkeeping and other administrative services. We will reimburse the Adviser an amount equal to our allocable portion (subject to the review of our Board) of its overhead resulting from its obligations under the Expense Reimbursement Agreement, including the allocable portion of the cost of our Chief Compliance Officer and Chief Financial Officer and their respective staffs. Expense Support and Conditional Reimbursement Agreement On September 29, 2017, the Fund and the Adviser entered into an agreement (the “Expense Support and Conditional Reimbursement Agreement”) to limit certain of the Fund’s Operating Expenses, as defined in the Expense Support and Conditional Reimbursement Agreement, to no more than 1.5% of the Fund’s average quarterly gross assets. To achieve this percentage limitation, the Adviser has agreed to reimburse the Fund for certain Operating Expenses on a quarterly basis (any such payment by the Adviser, an “Expense Payment” and the Fund has agreed to later repay such amounts (any such payment by the Fund, a “Reimbursement Payment”), pursuant to the terms of the Expense Support and Conditional Reimbursement Agreement. The actual percentage of Operating Expenses paid by the Fund in any quarter after deducting any Expense Payment, as a percentage of the Fund’s average quarterly gross assets, is referred to as the “Percentage Limit.” Any Expense Payment by the Adviser pursuant to the Expense Support and Conditional Reimbursement Agreement will be subject to repayment by the Fund on a quarterly basis within the three years following the fiscal quarter of the Fund in which the Operating Expenses were paid or absorbed, if the total Operating Expenses for the current quarter, including Reimbursement Payments, expressed as a percentage of the Fund’s average gross assets during such quarter is less than the then-current Percentage Limit, if any, and the Percentage Limit that was in effect at the time when the Advisor reimbursed the Operating Expenses that are the subject of the repayment, subject to certain provisions of the Expense Support and Conditional Reimbursement Agreement, as described below. For purposes of the Expense Support and Conditional Reimbursement Agreement, “Operating Expenses” means the Fund’s Total Operating Expenses (as defined below), excluding base management fees, incentive fees, distribution and shareholder servicing fees, financing fees and costs, interest expense, brokerage commissions and extraordinary expenses and “Total Operating Expenses” means all of the Fund’s operating costs and expenses incurred, as determined in accordance with generally accepted accounting principles for investment companies. The calculation of average net assets will be consistent with such periodic calculations of average net assets in the Fund’s financial statements. However, no Reimbursement Payment for any quarter will be made if: (1) the Effective Rate of Distributions Per Share (as defined below) declared by the Fund at the time of such Reimbursement Payment is less than or equal to the Effective Rate of Distributions Per Share at the time the Expense Payment was made to which such Reimbursement Payment relates, or (2) the Fund’s Operating Expense Ratio at the time of such Reimbursement Payment is greater than or equal to the Operating Expense Ratio (as defined below) at the time the Expense Payment was made to which such Reimbursement Payment relates. For purposes of the Expense Support and Conditional Reimbursement Agreement, “Effective Rate of Distributions Per Share” means the annualized rate (based on a 365- day year) of regular cash distributions per share exclusive of returns of capital, distribution rate reductions due to distribution and shareholder fees, and declared special dividends or special distributions, if any. The “Operating Expense Ratio” is calculated by dividing Operating Expenses in any quarter by the Fund’s average net assets in such quarter. The specific amount of expenses paid by the Adviser, if any, will be determined at the end of each quarter. The Fund or the Adviser may terminate the Expense Support and Conditional Reimbursement Agreement at any time, 9 with or without notice. The Expense Support and Conditional Reimbursement Agreement will automatically terminate in the event of (a) the termination of the Advisory Agreement, or (b) the board of directors of the Fund makes a determination to dissolve or liquidate the Fund. Upon termination of the Expense Support and Conditional Reimbursement Agreement, the Fund will be required to fund any Expense Payments, subject to the aforementioned requirements per the Expense Support and Conditional Reimbursement Agreement that have not been reimbursed by the Fund to the Adviser. As of September 30, 2017, the amount of Expense Payments provided by the Adviser since inception is $1,002,147. Management believes that a Reimbursement Payment by the Fund to the Adviser were not probable under the terms of the Expense Support Agreement as of September 30, 2017. The following table reflects the Expense Payments that may be subject to reimbursement pursuant to the Expense Agreement: For the Quarter Ended | Amount ofExpenseSupport | | Effective Rateof Distributionper Share(1) | | ReimbursementEligibilityExpiration | Percentagelimit(2) ----------------------+-------------------------+-----------+-------------------------------------------+-----+------------------------------------+------------------- September 30, 2017 | $ | 1,002,147 | | n/a | | September 30, 2020 | 0.00 | % ----------------------+-------------------------+-----------+-------------------------------------------+-----+------------------------------------+--------------------+------+-- Total | $ | 1,002,147 | | | | | | ----------------------+-------------------------+-----------+-------------------------------------------+-----+------------------------------------+--------------------+------+-- (1) | The effective rate of distribution per share is expressed as a percentage equal to the projected annualized distribution amount as of the end of the applicable period (which is calculated by annualizing the regular weekly cash distributions per share as of such date without compounding), divided by the Fund’s gross offering price per share as of such date. ----+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (2) | Represents the actual percentage of Operating Expenses paid by the Fund in any quarter after deducting any Expense Payment, as a percentage of the Fund’s average quarterly gross assets. ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ Transfer Agency Agreement On September 26, 2017, the Fund and AllianceBernstein Investor Services, Inc. (“ABIS”), an affiliate of the Fund, entered into an agreement pursuant to which ABIS will provide transfer agent services to the Fund. The Fund bears the expenses related to the agreement with ABIS. 4. Organizational and Offering Expenses Organization costs include, among other things, the cost of organizing as a Maryland corporation, including the cost of legal services and other fees pertaining to the Fund’s organization, all of which are expensed as incurred. Offering costs include, among other things, legal fees and other costs pertaining to the preparation of the Fund’s private placement memorandum and other offering documents, including travel-related expenses. As of September 30, 2017, total organization expenses incurred amounted to $467,000. Offering expenses, which are being deferred, totaled $236,000, which is being amortized on a straight line basis over a one year period starting from September 29, 2017. For the quarter ended September 30, 2017, the Adviser had reimbursed the above expenses as part of its Expense Payment, amounting to $467,647. 5. Fund Expenses As of September 30, 2017, the Adviser and its affiliates have incurred expenses of approximately $534,500 on behalf of the Fund in relation to professional fees for insurance, legal, audit and tax services and board of directors’ compensation costs. For the quarter ended September 30, 2017, the Adviser had reimbursed the above expenses as part of its Expense Payment, amounting to $534,500. 10 6. Net Assets In connection with its formation, the Fund has the authority to issue 200,000,000 shares of the Fund’s common stock, par value $0.01 per share. On September 29, 2017, the Fund completed its Initial Closing after entering into Subscription Agreements with several investors, including the Adviser, providing for the private placement of the Fund’s common shares. Under the terms of the Subscription Agreements, investors are required to fund drawdowns to purchase the Fund’s common shares up to the amount of their respective Capital Commitments on an as-needed basis upon the issuance of a capital drawn-down notice. At September 30, 2017 the Fund had total Capital Commitments of $70,928,060, of which 100% is unfunded. The minimum Capital Commitment of an investor is $50,000. The Fund, however, may waive the minimum Capital Commitment at its discretion. Capital Commitments may be drawn down by the Fund on a pro rata basis, as needed (including follow-on investments), for paying the Fund’s expenses, including fees under the Advisory Agreement, and/or maintaining a reserve account for the payment of future expenses or liabilities. 11 Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations --------+-------------------------------------------------------------------------------------- Forward-Looking Statements This Quarterly Report on Form 10-Q contains forward-looking statements that involve substantial risks and uncertainties. Such statements involve known and unknown risks, uncertainties and other factors, and undue reliance should not be placed thereon. These forward-looking statements are not historical facts, but rather are based on current expectations, estimates and projections about us, our current and prospective portfolio investments, our industry, our beliefs and opinions, and our assumptions. Words such as “anticipates,” “expects,” “intends,” “plans,” “will,” “may,” “continue,” “believes,” “seeks,” “estimates,” “would,” “could,” “should,” “targets,” “projects,” “outlook,” “potential,” “predicts” and variations of these words and similar expressions are intended to identify forward-looking statements. These statements are not guarantees of future performance and are subject to risks, uncertainties and other factors, some of which are beyond our control and difficult to predict and could cause actual results to differ materially from those expressed or forecasted in the forward-looking statements, including without limitation: • | an economic downturn could impair our portfolio companies’ ability to continue to operate, which could lead to the loss of some or all of our investments in such portfolio companies; --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | such an economic downturn could disproportionately impact the companies that we intend to target for investment, potentially causing us to experience a decrease in investment opportunities and diminished demand for capital from these companies; --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | a contraction of available credit and/or an inability to access the equity markets could impair our lending and investment activities; --+--------------------------------------------------------------------------------------------------------------------------------------- • | interest rate volatility could adversely affect our results, particularly if we elect to use leverage as part of our investment strategy; --+------------------------------------------------------------------------------------------------------------------------------------------ • | our future operating results; --+------------------------------ • | our business prospects and the prospects of our portfolio companies; --+--------------------------------------------------------------------- • | our contractual arrangements and relationships with third parties; --+------------------------------------------------------------------- • | the ability of our portfolio companies to achieve their objectives; --+-------------------------------------------------------------------- • | competition with other entities and our affiliates for investment opportunities; --+--------------------------------------------------------------------------------- • | the speculative and illiquid nature of our investments; --+-------------------------------------------------------- • | the use of borrowed money to finance a portion of our investments; --+------------------------------------------------------------------- • | the adequacy of our financing sources and working capital; --+----------------------------------------------------------- • | the loss of key personnel; --+--------------------------- • | the timing of cash flows, if any, from the operations of our portfolio companies; --+---------------------------------------------------------------------------------- • | the ability of the Adviser to locate suitable investments for us and to monitor and administer our investments; --+---------------------------------------------------------------------------------------------------------------- • | the ability of the Adviser to attract and retain highly talented professionals; --+-------------------------------------------------------------------------------- • | our ability to qualify and maintain our qualification as a regulated investment company (“RIC”) under Subchapter M of the Internal Revenue Code of 1986, as amended (the “Code”), and as a business development company (“BDC”); --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | the effect of legal, tax and regulatory changes; and --+----------------------------------------------------- • | the other risks, uncertainties and other factors we identify under “Item 1A. Risk Factors” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2016. --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Although we believe that the assumptions on which these forward-looking statements are based are reasonable, any of those assumptions could prove to be inaccurate, and as a result, the forward-looking statements based on those assumptions also could be inaccurate. In light of these and other uncertainties, the inclusion of a projection or forward-looking statement in this report should not be regarded as a representation by us that our plans and objectives will be achieved. These risks and uncertainties include those described or identified in the section entitled “Item 1A. Risk Factors” of Annual Report on Form 10-K for the fiscal year ended December 31, 2016 and elsewhere in this report. These forward-looking statements apply only as of the date of this report. Moreover, we assume no duty and do not undertake to update the forward-looking statements. The following analysis of our financial condition and results of operations should be read in conjunction with our financial statements and the related notes thereto contained elsewhere in this Quarterly Report on Form 10-Q. Overview AB Private Credit Investors Corporation (the “Fund”) was formed on February 6, 2015 as a corporation under the laws of the State of Maryland. We are currently in the development stage and have not commenced investment operations. Since inception, there has been no investment or operational activity. In conjunction with our formation, we issued and sold (i) 100 shares of common stock, par value $0.01, on June 27, 2016, at an aggregate purchase price of $1,000 ($10.00 per share) and (ii) 2,400 shares of common stock, par value $0.01, on May 26, 2017 to AB Private Credit Investors LLC. On October 6, 2016 we filed with the Securities and Exchange Commission (the “SEC”) an election to be treated as a BDC under the Investment Company Act of 1940, as amended (the “1940 Act”). We also intend to elect to be treated, and intend to qualify annually thereafter, as a RIC under Subchapter M of the Code for U.S. federal income tax purposes. While we intend to elect to be treated as a RIC as soon as practicable, we may have difficulty satisfying the asset diversification requirements as we deploy initial capital and build our portfolio. To the extent that we have net taxable income prior to our qualification as RIC, we will be subject to U.S. federal income tax on such income. As a BDC and a RIC, respectively, we are and will be required to comply with various regulatory requirements, such as the requirement to invest at least 70% of our assets in “qualifying assets,” source of income limitations, asset diversification requirements, and the requirement to distribute annually at least 90% of our taxable income and tax-exempt interest. 12 Our investment activities are managed by our external investment adviser, AB Private Credit Investors LLC (the “Adviser”), an investment adviser that is registered under the Investment Advisers Act of 1940, as amended. We intend to enter into an administration agreement (the “Administration Agreement”) with a third party administrator (the “Administrator”), pursuant to which the Administrator will provide the administrative services necessary for us to operate. We are an “emerging growth company,” as defined in the Jumpstart Our Business Startups Act of 2012. We will remain an emerging growth company for up to five years following an initial public offering, if any, although if the market value of our common stock that is held by non-affiliates exceeds $700 million as of any June 30 before that time, we would cease to be an emerging growth company as of the following December 31. For so long as we remain an emerging growth company under the JOBS Act, we will be subject to reduced public company reporting requirements. The Fund is conducting private offerings (each a “Private Offering”) of its common stock to investors in reliance on an exemption from the registration requirements of the Securities Act of 1933, as amended (the “Securities Act”). At the closing of any Private Offering, each investor will make a capital commitment (a “Capital Commitment”) to purchase shares of the Fund’s common stock pursuant to a subscription agreement entered into with the Fund. Investors will be required to fund drawdowns to purchase shares of the Fund’s common stock up to the amount of their respective Capital Commitment on an as-needed basis each time the Fund delivers a notice to its investors. The Fund anticipates commencing its loan origination and investment activities contemporaneously with the initial drawdown from investors in the initial Private Offering. On September 29, 2017, the Fund completed the initial closing (“Initial Closing”) of its Private Offering after entering into subscription agreements (collectively, the “Subscription Agreements”) with several investors, including the Adviser, providing for the private placement of the Fund’s common shares. Under the terms of the Subscription Agreements, investors are required to fund drawdowns to purchase the Fund’s common shares up to the amount of their respective Capital Commitments on an as-needed basis upon the issuance of a capital drawn-down notice. At September 30, 2017 the Fund had total Capital Commitments of $70,928,060, of which 100% is unfunded. Capital Commitments may be drawn down by the Fund on a pro rata basis, as needed (including follow-on investments), for paying the Fund’s expenses, including fees under the Advisory Agreement, and/or maintaining a reserve account for the payment of future expenses or liabilities. Portfolio and Investment Activity As of September 30, 2017 and December 31, 2016, we have not commenced investment activities. Results of Operations As of September 30, 2017, we completed the Initial Closing of our Private Offering but had not commenced any significant operational or investment activities. As of December 31, 2016, we had not completed the Initial Closing of our private offering or commenced any operational or investment activities. Therefore, no results of operations are reported. Revenues Our investment objective is to generate current income and prioritize capital preservation through a portfolio that primarily invests in directly-sourced, privately-negotiated, secured, middle market loans. We intend to primarily invest in middle market businesses based in the United States. We expect that the primary use of proceeds by the companies in which we invest will be for leveraged buyouts, recapitalizations, mergers and acquisitions and growth capital. We will primarily hold secured loans, which encompass traditional first lien, uni-tranche and second lien loans, but may also invest in mezzanine, structured preferred stock and non-control equity co-investment opportunities. We will seek to deliver attractive risk adjusted returns with lower volatility and low correlation relative to the public credit markets. The Adviser believes our flexibility to invest across the capital structure and liquidity spectrum will allow us to optimize investor risk-adjusted returns. 13 Expenses Expenses for the three and nine months ended September 30, 2017 were as follows: Expenses for the three and nine months ended September 30, 2017, were $1,002,147, which consisted of $467,647 in organizational and offering expenses, $149,000 in directors’ fees, and $385,500 in professional fees. Pursuant to the Expense Support and Conditional Reimbursement Agreement, our Adviser provided expense support of $1,002,147, reducing our expenses to $0.00. See “Item 1. – Notes to Financial Statements – Note 3. Agreements and Related Party Transactions – Expense Support and Conditional Reimbursement Agreement.” Organization and Offering Costs As of September 30, 2017, the Adviser and its affiliates have incurred or expect to incur organizational costs of approximately $467,000 and offering costs of approximately $236,000 on behalf of the Fund. Organization costs include, among other things, the cost of organizing as a Maryland corporation, including the cost of legal services, directors’ fees and other fees, including travel-related expenses, pertaining to our organization, all of which are expensed as incurred. Offering costs include, among other things, legal fees and other costs pertaining to the preparation of our private placement memorandum and other offering documents. Offering costs are being deferred and will be amortized on a straight line basis over a one-year period starting from September 29, 2017. Pursuant to the Expense Support and Conditional Reimbursement Agreement, our Adviser provided expense support of $467,000 and $236,000 for our organizational costs and offering costs, respectively, reducing our organizational costs and offering costs to $0.00. See “Item 1. – Notes to Financial Statements – Note 3. Agreements and Related Party Transactions – Expense Support and Conditional Reimbursement Agreement.” Operating Expenses Under the Advisory Agreement, our primary operating expenses include the payment of fees to the Adviser our allocable portion of overhead expenses under the Expense Reimbursement Agreement (as defined below) and other operating costs described below. We bear all other out-of-pocket costs and expenses of our operations and transactions, including those relating to: • | reasonable and documented organization and offering expenses to the extent reimbursement of such expenses is included in any future agreement with the Adviser; --+---------------------------------------------------------------------------------------------------------------------------------------------------------------- • | calculating our net asset value (including the cost and expenses of any independent valuation firm); --+----------------------------------------------------------------------------------------------------- • | fees and expenses payable to third parties, including agents, consultants or other advisers, in connection with monitoring financial (including advising with respect to our financing strategy) and legal affairs for us and in providing administrative services, monitoring our investments and performing due diligence on our prospective portfolio companies or otherwise relating to, or associated with, evaluating and making investments; --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | interest payable on debt, if any, incurred to finance our investments; --+----------------------------------------------------------------------- • | sales and purchases of our common stock and other securities; --+-------------------------------------------------------------- • | base management fees and incentive fees payable to the Adviser; --+---------------------------------------------------------------- • | transfer agent and custodial fees; --+----------------------------------- • | federal and state registration fees; --+------------------------------------- 14 • | all costs of registration and listing our securities on any securities exchange; --+--------------------------------------------------------------------------------- • | U.S. federal, state and local taxes; --+------------------------------------- • | independent directors’ fees and expenses; --+------------------------------------------ • | costs of preparing and filing reports or other documents required by the SEC, the Financial Industry Regulatory Authority or other regulators; --+----------------------------------------------------------------------------------------------------------------------------------------------- • | costs of any reports, proxy statements or other notices to stockholders, including printing costs; --+--------------------------------------------------------------------------------------------------- • | our allocable portion of any fidelity bond, directors’ and officers’ errors and omissions liability insurance, and any other insurance premiums; --+------------------------------------------------------------------------------------------------------------------------------------------------- • | direct costs and expenses of administration, including printing, mailing, long distance telephone, copying, secretarial and other staff, independent auditors and outside legal costs; and --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | all other expenses incurred by us, the Administrator or the Adviser in connection with administering our business, including payments under the Administration Agreement and payments under the Expense Reimbursement Agreement based on our allocable portion of the Adviser’s overhead in performing its obligations under the Expense Reimbursement Agreement, including the allocable portion of the cost of our Chief Compliance Officer and Chief Financial Officer and their respective staffs. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Financial Condition, Liquidity and Capital Resources We expect to generate cash primarily from (i) the net proceeds of the Private Offering, (ii) cash flows from our operations, (iii) any financing arrangements we may enter into in the future and (iv) any future offerings of our equity or debt securities. We may fund a portion of our investments through borrowings from banks, or other large global institutions such as insurance companies, and issuances of senior securities. Our primary use of funds from a credit facility will be investments in portfolio companies, cash distributions to holders of our common stock and the payment of operating expenses. In the future, we may also securitize or finance a portion of our investments with a special purpose vehicle. If we undertake a securitization transaction, we will consolidate our allocable portion of the debt of any securitization subsidiary on our financial statements, and include such debt in our calculation of the asset coverage test, if and to the extent required pursuant to the guidance of the staff of the SEC. Cash and cash equivalents as of September 30, 2017, taken together with our uncalled Capital Commitments of $70,928,060, is expected to be sufficient for our investing activities and to conduct our operations in the near term. As of September 30, 2017, we had $25,000 in cash and cash equivalents. During the nine months ended September 30, 2017, we used no cash for operating activities, as the Fund had not yet begun investment activities. Equity Activity In connection with our formation, we have the authority to issue 200,000,000 shares of common stock at a $0.01 per share par value. On June 27, 2016, we issued 100 shares of our common stock to the Adviser, for an aggregate purchase price of $1,000. On May 26, 2017, we issued 2,400 shares of our common stock to the Adviser, for an aggregate purchase price of $24,000. We have not had any other equity transactions as of September 30, 2017 and December 31, 2016. Contractual Obligations As of September 30, 2017 and December 31, 2016, we have not commenced operations. We have entered into the Advisory Agreement with the Adviser in accordance with the 1940 Act. Under the Advisory Agreement, the Adviser is responsible for sourcing, reviewing and structuring investment opportunities for us, underwriting and conducting diligence on our investments and monitoring our investment portfolio on an ongoing basis. For these services, we will pay (i) a base management fee equal to a percentage of the average 15 outstanding assets of the Fund (which equals the gross value of equity and debt instruments, including investments made utilizing leverage), excluding cash and cash equivalents, during such fiscal quarter and (ii) an incentive fee based on our performance. The cost of both the base management fee and the incentive fee will ultimately be borne by our stockholders. We have entered into the Administration Agreement with the Administrator and a separate expense reimbursement agreement with the Adviser (the “Expense Reimbursement Agreement”) under which any allocable portion of the cost of our Chief Compliance Officer and Chief Financial Officer and their respective staffs will be reimbursed by the Fund. Under the Administration Agreement, the Administrator will be responsible for providing us with clerical, bookkeeping, recordkeeping and other administrative services. We will reimburse the Adviser an amount equal to our allocable portion (subject to the review of our Board) of its overhead resulting from its obligations under the Expense Reimbursement Agreement, including the allocable portion of the cost of our Chief Compliance Officer and Chief Financial Officer and their respective staffs. Stockholder approval is not required to amend the Administration Agreement or the Expense Reimbursement Agreement. If any of the contractual obligations discussed above are terminated, our costs under any new agreements that we enter into may increase. In addition, we would likely incur significant time and expense in locating alternative parties to provide the services we receive under the Advisory Agreement, the Administration Agreement and the Expense Reimbursement Agreement. Any new investment advisory agreement would also be subject to approval by our stockholders. Expense Support and Conditional Reimbursement Agreement On September 29, 2017, the Fund and the Adviser entered into an agreement (the “Expense Support and Conditional Reimbursement Agreement”) to limit certain of the Fund’s Operating Expenses, as defined in the Expense Support and Conditional Reimbursement Agreement, to no more than 1.5% of the Fund’s average quarterly gross assets. To achieve this percentage limitation, the Adviser has agreed to reimburse the Fund for certain Operating Expenses on a quarterly basis (any such payment by the Adviser, an (“Expense Payment”) and the Fund has agreed to later repay such amounts (any such payment by the Fund, a “Reimbursement Payment”), pursuant to the terms of the Expense Support and Conditional Reimbursement Agreement. The actual percentage of Operating Expenses paid by the Fund in any quarter after deducting any Expense Payment, as a percentage of the Fund’s average quarterly gross assets, is referred to as the “Percentage Limit”). Any Expense Payment by the Adviser pursuant to the Expense Support and Conditional Reimbursement Agreement will be subject to repayment by the Fund on a quarterly basis within the three years following the fiscal quarter of the Fund in which the Operating Expenses were paid or absorbed, if the total Operating Expenses for the current quarter, including Reimbursement Payments, expressed as a percentage of the Fund’s average gross assets during such quarter is less than the then-current Percentage Limit, if any, and the Percentage Limit that was in effect at the time when the Advisor reimbursed the Operating Expenses that are the subject of the repayment, subject to Sections 2(b) and 2(c) as applicable. For purposes of the Expense Support and Conditional Reimbursement Agreement, “Operating Expenses” means the Fund’s Total Operating Expenses (as defined below), excluding base management fees, incentive fees, distribution and shareholder servicing fees, financing fees and costs, interest expense, brokerage commissions and extraordinary expenses, and “Total Operating Expenses” means all of the Fund’s operating costs and expenses incurred, as determined in accordance with generally accepted accounting principles for investment companies. The calculation of average net assets will be consistent with such periodic calculations of average net assets in the Fund’s financial statements. However, no Reimbursement Payment for any quarter will be made if: (1) the Effective Rate of Distributions Per Share (as defined below) declared by the Fund at the time of such Reimbursement Payment is less than or equal to the Effective Rate of Distributions Per Share at the time the Expense Payment was made to which such Reimbursement Payment relates, or (2) the Fund’s Operating Expense Ratio at the time of such Reimbursement Payment is greater than or equal to the Operating Expense Ratio (as defined below) at the time the Expense Payment was made to which such Reimbursement Payment relates. For purposes of the Expense Support and Conditional Reimbursement Agreement, “Effective Rate of Distributions Per Share” means the annualized rate (based on a 365-day year) of regular cash distributions per share exclusive of returns of capital, distribution rate reductions due to distribution and shareholder fees, and declared special dividends or special distributions, if any. The “Operating Expense Ratio” is calculated by dividing Operating Expenses in any quarter by the Fund’s average net assets in such quarter. 16 The specific amount of expenses paid by the Adviser, if any, will be determined at the end of each quarter. The Fund or the Adviser may terminate the Expense Support and Conditional Reimbursement Agreement at any time, with or without notice. The Expense Support and Conditional Reimbursement Agreement will automatically terminate in the event of (a) the termination of the Investment Advisory Agreement, or (b) the Board of the Fund makes a determination to dissolve or liquidate the Fund. Upon termination of the Expense Support and Conditional Reimbursement Agreement, the Fund will be required to fund any Expense Payments, subject to the aforementioned requirements per the Expense Support and Conditional Reimbursement Agreement that have not been reimbursed by the Fund to the Adviser. For the quarter ended September 30, 2017, the Adviser’s Expense Payment amounted to $1,002,147. See “Item 1. – Notes to Financial Statements – Note 3. Agreements and Related Party Transactions – Expense Support and Conditional Reimbursement Agreement.” Off-Balance Sheet Arrangements We had no off-balance sheet arrangements as of December 31, 2016. As of September 30, 2017, we had $70,928,060 in total Capital Commitments from investors, all of which were unfunded. Co-investment Exemptive Order On October 11, 2016, the SEC granted us relief sought in an exemptive application that expands our ability to co-invest in portfolio companies with certain of our affiliates managed by the Adviser (“Affiliated Funds”) in a manner consistent with our investment objective, positions, policies, strategies and restrictions as well as regulatory requirements and other pertinent factors, subject to compliance with certain conditions (the “Order”). Pursuant to the Order, we are permitted to co-invest with Affiliated Funds if, among other things, a “required majority” (as defined in Section 57(o) of the 1940 Act) of our independent directors make certain conclusions in connection with a co-investment transaction, including that (1) the terms of the transactions, including the consideration to be paid, are reasonable and fair to us and our stockholders and do not involve overreaching in respect of us or our stockholders on the part of any person concerned, and (2) the transaction is consistent with the interests of our stockholders and is consistent with our investment objective and strategies. We intend to co-invest with Affiliated Funds, subject to the conditions included in the Order. Critical Accounting Policies Valuation of Investments We measure the value of our investments at fair value accordance with Accounting Standards Codification Topic 820, Fair Value Measurements and Disclosure, or “ASC Topic 820,” issued by the Financial Accounting Standards Board (“FASB”). Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The audit committee of our Board (the “Audit Committee’) is also responsible for assisting our Board in valuing investments that are not publicly traded or for which current market values are not readily available. Investments for which market quotations are readily available are valued using market quotations, which are generally obtained from independent pricing services, broker-dealers or market makers. With respect to portfolio investments for which market quotations are not readily available, our Board, with the assistance of the Adviser and its senior investment team and independent valuation firms, is responsible for determining in good faith the fair value in accordance with the valuation policy approved by our Board. If more than one valuation method is used to measure fair value, the results are evaluated and weighted, as appropriate, considering the reasonableness of the range indicated by those results. We consider a range of fair values based upon the valuation techniques utilized and select the value within that range that was most representative of fair value based on current market conditions as well as other factors the Adviser’s senior investment team considers relevant. Our Board will make this fair value determination on a quarterly basis and any other time when a decision regarding the fair value of the portfolio investments is required. A determination of fair value involves subjective 17 judgments and estimates and depends on the facts and circumstances. Due to the inherent uncertainty of determining the fair value of portfolio investments that do not have a readily available market value, the fair value of the investments may differ significantly from the values that would have been used had a readily available market value existed for such investments, and the differences could be material. ASC Topic 820 specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. ASC Topic 820 also provides guidance regarding a fair value hierarchy, which prioritizes information used to measure fair value and the effect of fair value measurements on earnings and provides for enhanced disclosures determined by the level within the hierarchy of information used in the valuation. In accordance with ASC Topic 820, these inputs are summarized in the three levels listed below: • | Level 1—Valuations are based on quoted prices in active markets for identical assets or liabilities that are accessible at the measurement date. --+------------------------------------------------------------------------------------------------------------------------------------------------- • | Level 2—Valuations are based on quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly and model-based valuation techniques for which all significant inputs are observable. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Level 3—Valuations based on inputs that are unobservable and significant to the overall fair value measurement. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models incorporating significant unobservable inputs, such as discounted cash flow models and other similar valuations techniques. The valuation of Level 3 assets and liabilities generally requires significant management judgment due to the inability to observe inputs to valuation. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, an investment’s level within the fair value hierarchy is based on the lowest level of observable input that is significant to the fair value measurement. The assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the investment. Under ASC Topic 820, the fair value measurement also assumes that the transaction to sell an asset occurs in the principal market for the asset or, in the absence of a principal market, the most advantageous market for the asset, which may be a hypothetical market, and excludes transaction costs. The principal market for any asset is the market with the greatest volume and level of activity for such asset in which the reporting entity would or could sell or transfer the asset. In determining the principal market for an asset or liability under ASC Topic 820, it is assumed that the reporting entity has access to such market as of the measurement date. Market participants are defined as buyers and sellers in the principal or most advantageous market that are independent, knowledgeable and willing and able to transact. With respect to investments for which market quotations are not readily available, our Board will undertake a multi-step valuation process each quarter, as described below: • | Our quarterly valuation process will begin with each portfolio company or investment being initially valued by the Adviser’s professionals that are responsible for the portfolio investment; --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Preliminary valuation conclusions will then be documented and discussed with the Adviser’s senior investment team; --+------------------------------------------------------------------------------------------------------------------- • | Our Audit Committee will then review these preliminary valuations; --+------------------------------------------------------------------- • | At least once annually, the valuation for each portfolio investment will be reviewed by an independent valuation firm; and --+--------------------------------------------------------------------------------------------------------------------------- • | Our Board will then discuss valuations and determine the fair value of each investment in our portfolio in good faith, based on the input of the Adviser, the respective independent valuation firms and the Audit Committee. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 18 Because of the inherent uncertainty of valuation for all fair value investments and interests, the Board’s determination of fair value may differ from the values that would have been used had a ready market existed, or that could have been (or will be) realized in an actual sale, and such differences could be material. The value of any investment on any valuation date is intended to represent the fair value of such investment on such date based upon the amount at which the investment could be exchanged between willing parties, other than in a forced liquidation sale, and reflects the Board’s determination of fair value using the methodology described herein. Any valuation of an investment may not reflect the actual amount received by the Fund upon the liquidation of such investment. Our investments will be primarily loans made to middle-market companies. These investments are mostly considered Level 3 assets under ASC Topic 820 because there is not usually a known or accessible market or market indices for these types of debt instruments and, thus, the Adviser’s senior investment team must estimate the fair value of these investment securities based on models utilizing unobservable inputs. Security Transactions, Realized/Unrealized Gains or Losses, and Income Recognition Security transactions are recorded on a trade-date basis. We measure realized gains or losses from the repayment or sale of investments using the specific identification method. The amortized cost basis of investments represents the original cost adjusted for the accretion/amortization of discounts and premiums and upfront loan origination fees. We report changes in fair value of investments that are measured at fair value as a component of net change in unrealized appreciation (depreciation) on investments in the statement of operations. Interest income, adjusted for amortization of market premium and accretion of market discount, is recorded on an accrual basis to the extent that we expect to collect such amounts. Original issue discount, principally representing the estimated fair value of detachable equity or warrants obtained in conjunction with our debt investments, and market discount or premium are capitalized and accreted or amortized into interest income over the life of the respective security using the effective interest method. Loan origination fees received in connection with the closing of investments are reported as unearned income which is included as amortized cost of the investment; the unearned income from such fees is accreted over the contractual life of the loan based on the effective interest method. Upon prepayment of a loan or debt security, any prepayment penalties, unamortized loan origination fees, and unamortized market discounts are recorded as interest income. Management and Incentive Fees We will accrue for the base management fee and incentive fee. The accrual for incentive fee includes the recognition of incentive fee on unrealized capital gains, even though such incentive fee is neither earned nor payable to the Adviser until the gains are both realized and in excess of unrealized depreciation on investments. The amount of capital gains incentive fee expense related to the hypothetical liquidation of the portfolio (and assuming no other changes in realized or unrealized gains and losses) would only become payable to the Adviser in the event of a complete liquidation of the Fund’s portfolio as of period end and the termination of the Advisory Agreement on such date. Also, it should be noted that the capital gains incentive fee expense fluctuates with the Fund’s overall investment results. Federal Income Taxes We intend to elect to be treated, and intend to qualify annually thereafter, as a RIC under Subchapter M of the Code as soon as practicable. Generally, a RIC is not subject to federal income taxes on distributed income and gains if it distributes at least 90% of its net ordinary income and net short-term capital gains in excess of its net long-term capital losses, if any, to its stockholders. We intend to distribute sufficient dividends to maintain our RIC status each year and we do not anticipate paying any material federal income taxes in the future. 19 Item 3. | Quantitative and Qualitative Disclosures about Market Risk --------+----------------------------------------------------------- As of September 30, 2017 and December 31, 2016, we had not commenced investment activities. When investing commences, we will be subject to financial market risks, including changes in interest rates. To the extent that we borrow money to make investments, our net investment income will be dependent upon the difference between the rate at which we borrow funds and the rate at which we invest these funds. In periods of rising interest rates, our cost of funds would increase, which may reduce our net investment income. Because we expect that most of our investments will bear interest at floating rates, we anticipate that an increase in interest rates would have a corresponding increase in our interest income that would likely offset any increase in our cost of funds and, thus, net investment income would not be reduced. However, there can be no assurance that a significant change in market interest rates will not have an adverse effect on our net investment income. In addition, although we do not currently intend to make investments that are denominated in a foreign currency, to the extent we do, we will be subject to risks associated with changes in currency exchange rates. These risks include the possibility of significant fluctuations in the foreign currency markets, the imposition or modification of foreign exchange controls and potential illiquidity in the secondary market. These risks will vary depending upon the currency or currencies involved. We may hedge against interest rate and currency exchange rate fluctuations by using standard hedging instruments such as futures, options and forward contracts subject to the requirements of the 1940 Act. While hedging activities may insulate us against adverse changes in interest rates, they may also limit our ability to participate in benefits of lower interest rates with respect to our portfolio of investments with fixed interest rates. Item 4. | Controls and Procedures --------+------------------------ As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our President and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15 under the Exchange Act). Based on that evaluation, our President and Chief Financial Officer have concluded that our current disclosure controls and procedures are effective in timely alerting them to material information relating to us that is required to be disclosed by us in the reports we file or submit under the Exchange Act. There have been no changes in our internal control over financial reporting that occurred during our most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 20 PART II. OTHER INFORMATION Item 1. | Legal Proceedings --------+------------------ We are not currently subject to any material legal proceedings, nor, to our knowledge, is any material legal proceeding threatened against us. From time to time, we may be a party to certain legal proceedings in the ordinary course of business, including proceedings relating to the enforcement of our rights under contracts with our portfolio companies. Our business is also subject to extensive regulation, which may result in regulatory proceedings against us. While the outcome of these legal proceedings cannot be predicted with certainty, we do not expect that these proceedings will have a material effect upon our financial condition or results of operations. Item 1A. | Risk Factors ---------+------------- As of September 30, 2017, there have been no material changes from the risk factors set forth in our Annual Report on Form 10-K for the year ended December 31, 2016. Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds --------+------------------------------------------------------------ None. Item 3. | Defaults Upon Senior Securities --------+-------------------------------- None. Item 4. | Mine Safety Disclosure --------+----------------------- Not applicable. Item 5. | Other Information --------+------------------ Not applicable. Item 6. | Exhibits --------+--------- The following exhibits are filed as part of this report or hereby incorporated by reference to exhibits previously filed with the SEC: 3.1 | Articles of Incorporation(1) -----+--------------------------------------------------------------------------------------------------------------------- 3.2 | Articles of Amendment(1) -----+--------------------------------------------------------------------------------------------------------------------- 3.3 | Articles of Amendment and Restatement(3) -----+--------------------------------------------------------------------------------------------------------------------- 3.4 | Bylaws(2) -----+--------------------------------------------------------------------------------------------------------------------- 10.1 | Investment Advisory Agreement between the Fund and the Adviser, dated July 27, 2017(3) -----+--------------------------------------------------------------------------------------------------------------------- 10.2 | License Agreement between the Fund and the Adviser, dated August 14, 2017(3) -----+--------------------------------------------------------------------------------------------------------------------- 10.3 | Form of Subscription Agreement* -----+--------------------------------------------------------------------------------------------------------------------- 10.4 | Expense Reimbursement Agreement, dated August 14, 2017(3) -----+--------------------------------------------------------------------------------------------------------------------- 10.5 | Administration Agreement, dated September 29, 2017(4) -----+--------------------------------------------------------------------------------------------------------------------- 10.6 | Custodian Agreement, dated September 29, 2017(4) -----+--------------------------------------------------------------------------------------------------------------------- 10.7 | Expense Support and Conditional Reimbursement Agreement, dated September 29, 2017(4) -----+--------------------------------------------------------------------------------------------------------------------- 10.8 | Dividend Reinvestment Plan, dated September 29, 2017(4) -----+--------------------------------------------------------------------------------------------------------------------- 31.1 | Certification of Chief Executive Officer pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as amended* -----+--------------------------------------------------------------------------------------------------------------------- 31.2 | Certification of Chief Financial Officer pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as amended* -----+--------------------------------------------------------------------------------------------------------------------- 32.1 | Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002* -----+--------------------------------------------------------------------------------------------------------------------- 32.2 | Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002* -----+--------------------------------------------------------------------------------------------------------------------- 21 (1) | Previously filed as an exhibit to the Registration Statement on Form 10 (File No. 000-55640) filed with the SEC on April 8, 2016. ----+---------------------------------------------------------------------------------------------------------------------------------- (2) | Previously filed as an exhibit to the Registration Statement on Form 10 (File No. 000-55640) filed with the SEC on July 1, 2016. ----+--------------------------------------------------------------------------------------------------------------------------------- (3) | Previously filed as an exhibit to the Fund’s quarterly report on Form 10-Q (File No. 814-01196) filed with the SEC on August 14, 2017. ----+--------------------------------------------------------------------------------------------------------------------------------------- (4) | Previously filed as an exhibit to the Fund’s current report on Form 8-K (File No. 814-01196 filed with the SEC on September 29, 2017. ----+-------------------------------------------------------------------------------------------------------------------------------------- * | Filed herewith --+--------------- 22 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. | | AB PRIVATE CREDIT INVESTORS CORPORATION ------------------------+-----+--------------------------------------------- Date: November 13, 2017 | By: | /s/ J. Brent Humphries ------------------------+-----+--------------------------------------------- | | J. Brent Humphries ------------------------+-----+--------------------------------------------- | | President and Chief Executive Officer ------------------------+-----+--------------------------------------------- | | (Principal Executive Officer) ------------------------+-----+--------------------------------------------- Date: November 13, 2017 | By: | /s/ Wesley Raper ------------------------+-----+--------------------------------------------- | | Wesley Raper ------------------------+-----+--------------------------------------------- | | Chief Financial Officer and Treasurer ------------------------+-----+--------------------------------------------- | | (Principal Financial and Accounting Officer) ------------------------+-----+---------------------------------------------

ACURA PHARMACEUTICALS, INC

786947

10-Q

0001144204-17-058390

UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20649 Form 10-Q (Mark One) þ | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. --+----------------------------------------------------------------------------------------- For the quarterly period ended September 30, 2017 ¨ | TRANSACTION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. --+------------------------------------------------------------------------------------------- For the transition period from ______________________ to_______________________ Commission File Number 1-10113 Acura Pharmaceuticals, Inc. (Exact name of registrant as specified in its charter) New York | 11-0853640 -----------------------------------------+------------------------------------- (State or other Jurisdiction of | (I.R.S. Employer Identification No.) -----------------------------------------+------------------------------------- incorporation or organization) | -----------------------------------------+------------------------------------- 616 N. North Court, Suite 120 | -----------------------------------------+------------------------------------- Palatine, Illinois | 60067 -----------------------------------------+------------------------------------- (Address of Principal Executive Offices) | (Zip Code) -----------------------------------------+------------------------------------- 847 705 7709 (Registrant's telephone number, including area code) (Former name, former address and former fiscal year, if changed since last report.) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 S-T (§232.405 of this charter) during the preceding 12 months (or to such shorter period that the registrant was required to submit and post such files). Yes þ No o Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large” filer, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer | ¨ | Accelerated filer | ¨ ----------------------------------------------+-------------------------+---------------------------+-- Non-accelerated filer | ¨ | Smaller reporting company | þ ----------------------------------------------+-------------------------+---------------------------+-- (Do not check if a smaller reporting company) | Emerging growth company | ¨ ----------------------------------------------+-------------------------+-------------------------- If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ As of November 10, 2017 the registrant had 20,795,994 shares of common stock, $.01 par value, outstanding. ACURA PHARMACEUTICALS, INC. AND SUBSIDIARY TABLE OF CONTENTS FORM 10-Q FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2017 | | Page No. -------------------------------+----------------------------------------------------------------------------------------------------------------------------------+--------- Part 1. FINANCIAL INFORMATION | -------------------------------+--------------------------------------------------------------------------------------------------------------------------------- Item 1. | Consolidated Financial Statements (Unaudited): | 2 -------------------------------+----------------------------------------------------------------------------------------------------------------------------------+--------- | Consolidated Balance Sheets as of September 30, 2017 and December 31, 2016 | 2 -------------------------------+----------------------------------------------------------------------------------------------------------------------------------+--------- | Consolidated Statements of Operations and Comprehensive Loss for the Three and Nine months Ended September 30, 2017 and 2016 | 3 -------------------------------+----------------------------------------------------------------------------------------------------------------------------------+--------- | Consolidated Statement of Stockholders’ Equity for the Nine months Ended September 30, 2017 | 4 -------------------------------+----------------------------------------------------------------------------------------------------------------------------------+--------- | Consolidated Statements of Cash Flows for the Nine months Ended September 30, 2017 and 2016 | 5 -------------------------------+----------------------------------------------------------------------------------------------------------------------------------+--------- | Notes to Consolidated Financial Statements | 7 -------------------------------+----------------------------------------------------------------------------------------------------------------------------------+--------- Item 2. | Management's Discussion and Analysis of Financial Condition and Results of Operations | 25 -------------------------------+----------------------------------------------------------------------------------------------------------------------------------+--------- Item 4. | Controls and Procedures | 47 -------------------------------+----------------------------------------------------------------------------------------------------------------------------------+--------- Part II. OTHER INFORMATION | -------------------------------+--------------------------------------------------------------------------------------------------------------------------------- Item 1. | Legal Proceedings | 47 -------------------------------+----------------------------------------------------------------------------------------------------------------------------------+--------- Item 1A. | Risk Factors | 47 -------------------------------+----------------------------------------------------------------------------------------------------------------------------------+--------- Item 6. | Exhibits | 48 -------------------------------+----------------------------------------------------------------------------------------------------------------------------------+--------- Signatures | | 49 -------------------------------+----------------------------------------------------------------------------------------------------------------------------------+--------- 1 - Item 1. Financial Statements ACURA PHARMACEUTICALS, INC. CONSOLIDATED BALANCE SHEETS (Unaudited; in thousands except par value) | September 30, 2017 | | | December 31, 2016 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+-- Assets: | | | | | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- Cash and cash equivalents | $ | 4,787 | | | $ | 2,681 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- Restricted cash equivalents (Note 10) | | - | | | | 2,500 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- Trade accounts receivable (net of allowances of $- and $7) | | - | | | | 23 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- Collaboration revenue receivable | | - | | | | 79 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- Royalty receivable | | 65 | | | | 50 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- Inventories (net of allowances of $- and $32) (Note 6) | | - | | | | 309 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- Prepaid expenses and other current assets | | 442 | | | | 268 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- Total current assets | | 5,294 | | | | 5,910 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- Property, plant and equipment, net (Note 7) | | 699 | | | | 867 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- Intangible asset, net of accumulated amortization of $724 and $569 (Note 3) | | 1,276 | | | | 1,431 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- Total assets | $ | 7,269 | | | $ | 8,208 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- Liabilities: | | | | | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- Accounts payable | $ | 127 | | | $ | 77 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- Accrued expenses (Note 8) | | 890 | | | | 703 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- Accrued interest | | 26 | | | | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- Other current liabilities | | 36 | | | | 27 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- Sales returns liability | | 303 | | | | 304 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- Debt - current (Note 10) | | 2,917 | | | | 2,376 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- Total current liabilities | | 4,299 | | | | 3,487 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- Debt – non-current portion, net of discounts (Note 10) | | 702 | | | | 2,979 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- Accrued interest – non-current portion (Note 10) | | 668 | | | | 559 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- Total liabilities | | 5,669 | | | | 7,025 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- Commitments and contingencies (Note 17) | | | | | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- Stockholders’ equity: | | | | | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- Common stock - $.01 par value per share; 100,000 shares authorized, 20,796 and 11,834 shares issued and outstanding at September 30, 2017 and December 31, 2016, respectively | | 208 | | | | 118 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- Additional paid-in capital | | 380,034 | | | | 375,763 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- Accumulated deficit | | (378,642 | ) | | | (374,698 | ) ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- Total stockholders’ equity | | 1,600 | | | | 1,183 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- Total liabilities and stockholders’ equity | $ | 7,269 | | | $ | 8,208 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------+----------+---+--------------------+---+----------+-- See accompanying Notes to Consolidated Financial Statements. 2 - ACURA PHARMACEUTICALS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS (Unaudited; in thousands except per share amounts) | Three months Ended September 30, | | | Nine months Ended September 30, | -----------------------------------------------+----------------------------------+--------+---+---------------------------------+-- | 2017 | | | 2016 | | | 2017 | | 2016 | -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+-- Revenues: | | | | | | | | | | | | | -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- License fee revenue | $ | - | | | $ | - | | $ | 2,500 | | $ | - | -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Collaboration revenue | | - | | | | 74 | | | 59 | | | 307 | -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Royalty revenue | | 83 | | | | 39 | | | 226 | | | 86 | -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Product sales, net | | - | | | | 105 | | | 107 | | | 306 | -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Total revenues, net | | 83 | | | | 218 | | | 2,892 | | | 699 | -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Cost and expenses: | | | | | | | | | | | | | -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Cost of sales (excluding inventory provisions) | | - | | | | 108 | | | 128 | | | 309 | -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Inventory provisions | | - | | | | - | | | - | | | 26 | -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Research and development | | 1,077 | | | | 841 | | | 2,808 | | | 3,258 | -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Selling, marketing, general and administrative | | 1,068 | | | | 1,338 | | | 3,427 | | | 5,392 | -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Total costs and expenses | | 2,145 | | | | 2,287 | | | 6,363 | | | 8,985 | -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Operating loss | | (2,062 | ) | | | (2,069 | ) | | (3,471 | ) | | (8,286 | ) -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Non-operating income (expense): | | | | | | | | | | | | | -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Interest and investment income | | 1 | | | | 11 | | | 3 | | | 59 | -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Interest expense (Note 10) | | (139 | ) | | | (215 | ) | | (476 | ) | | (697 | ) -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Other income (expense) | | - | | | | 23 | | | - | | | 2 | -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Total other expense, net | | (138 | ) | | | (181 | ) | | (473 | ) | | (636 | ) -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Loss before provision for income taxes | | (2,200 | ) | | | (2,250 | ) | | (3,944 | ) | | (8,922 | ) -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Provision for income taxes | | - | | | | - | | | - | | | - | -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Net loss | $ | (2,200 | ) | | $ | (2,250 | ) | $ | (3,944 | ) | $ | (8,922 | ) -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Other comprehensive income: | | | | | | | | | | | | | -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Unrealized (losses) gains on securities | | - | | | | (26 | ) | | - | | | 65 | -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Comprehensive loss | $ | (2,200 | ) | | $ | (2,276 | ) | $ | (3,944 | ) | $ | (8,857 | ) -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Loss per share: | | | | | | | | | | | | | -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Basic | $ | (0.12 | ) | | $ | (0.19 | ) | $ | (0.27 | ) | $ | (0.75 | ) -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Diluted | $ | (0.12 | ) | | $ | (0.19 | ) | $ | (0.27 | ) | $ | (0.75 | ) -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Weighted average shares outstanding: | | | | | | | | | | | | | -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Basic | | 16,686 | | | | 11,880 | | | 14,147 | | | 11,858 | -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Diluted | | 16,686 | | | | 11,880 | | | 14,147 | | | 11,858 | -----------------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- See accompanying Notes to Consolidated Financial Statements. 3 - ACURA PHARMACEUTICALS, INC. CONSOLIDATED STATEMENT OF CHANGES IN ACCUMULATED STOCKHOLDERS' EQUITY (Unaudited; in thousands) | Common Stock | | | | | | | ------------------------------------------------------------------------------+-------------------+--------+-----------+---+-----+-----------------------------+---+--------------------- | Number of Shares | | Par Value | | | Additional Paid-in Capital | | Accumulated Deficit | Total | ------------------------------------------------------------------------------+-------------------+--------+-----------+---+-----+-----------------------------+---+----------------------+-------+--------- Balance at January 1, 2017 | | 11,834 | | $ | 118 | | $ | 375,763 | $ | (374,698 | ) | $ | 1,183 | ------------------------------------------------------------------------------+-------------------+--------+-----------+---+-----+-----------------------------+---+----------------------+-------+----------+---+---+--------+-- Net loss | | - | | | - | | | - | | (3,944 | ) | | (3,944 | ) ------------------------------------------------------------------------------+-------------------+--------+-----------+---+-----+-----------------------------+---+----------------------+-------+----------+---+---+--------+-- Share-based compensation | | - | | | - | | | 353 | | - | | | 353 | ------------------------------------------------------------------------------+-------------------+--------+-----------+---+-----+-----------------------------+---+----------------------+-------+----------+---+---+--------+-- Issuance of shares and warrants under private placement | | 8,913 | | | 89 | | | 3,911 | | | | | 4,000 | ------------------------------------------------------------------------------+-------------------+--------+-----------+---+-----+-----------------------------+---+----------------------+-------+----------+---+---+--------+-- Net distribution of common stock pursuant to restricted stock unit award plan | | 49 | | | 1 | | | 7 | | - | | | 8 | ------------------------------------------------------------------------------+-------------------+--------+-----------+---+-----+-----------------------------+---+----------------------+-------+----------+---+---+--------+-- Balance at September 30, 2017 | | 20,796 | | $ | 208 | | $ | 379,539 | $ | (378,642 | ) | $ | 1,600 | ------------------------------------------------------------------------------+-------------------+--------+-----------+---+-----+-----------------------------+---+----------------------+-------+----------+---+---+--------+-- See accompanying Notes to Consolidated Financial Statements. 4 - ACURA PHARMACEUTICALS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited; in thousands) | Nine months Ended September 30, | ------------------------------------------------------------------------------------------+---------------------------------+------- | 2017 | | | 2016 | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+-- Cash Flows from Operating Activities: | | | | | | | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Net loss | $ | (3,944 | ) | | $ | (8,922 | ) ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Adjustments to reconcile net loss to net cash provided by (used in) operating activities: | | | | | | | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Depreciation | | 68 | | | | 104 | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Provision to reduce inventory to net realizable value | | - | | | | 26 | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Provision for sales returns | | 49 | | | | 83 | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Share-based compensation | | 353 | | | | 450 | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Amortization of debt discount and deferred debt issue costs | | 79 | | | | 113 | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Amortization of bond premium in marketable securities | | - | | | | 31 | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Amortization of intangible asset | | 155 | | | | 155 | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- (Gain) loss on disposal of machinery and equipment | | (3 | ) | | | 2 | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- (Gain) loss on sales of marketable securities | | - | | | | (2 | ) ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Change in assets and liabilities: | | | | | | | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Trade accounts receivable, net | | 23 | | | | (24 | ) ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Collaboration revenue receivable | | 79 | | | | (27 | ) ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Royalty receivable | | (15 | ) | | | (30 | ) ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Accrued investment income | | - | | | | 37 | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Inventories | | 103 | | | | (174 | ) ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Prepaid expenses and other current assets | | (174 | ) | | | 4 | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Other assets | | - | | | | 175 | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Accounts payable | | 50 | | | | 293 | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Accrued expenses | | 187 | | | | 170 | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Accrued interest | | 135 | | | | 176 | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Other current liabilities | | 17 | | | | 17 | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Sales returns liability | | (50 | ) | | | - | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Net cash used in operating activities | | (2,888 | ) | | | (7,343 | ) ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Cash Flows from Investing Activities: | | | | | | | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Proceeds from sales and maturities of marketable securities | | - | | | | 10,873 | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Proceeds from transfer of equipment to licensee | | 103 | | | | - | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Proceeds from transfer of inventory to licensee | | 206 | | | | - | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Capital expenditures | | - | | | | (72 | ) ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Net cash provided by investing activities | | 309 | | | | 10,801 | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Cash Flows from Financing Activities: | | | | | | | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Principal payments on debt | | (1,815 | ) | | | (1,671 | ) ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Issuance of common stock | | 4,000 | | | | - | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Net cash provided by (used in) financing activities | | 2,185 | | | | (1.671 | ) ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Net (decrease) increase in cash, cash equivalents, and restricted cash | | (394 | ) | | | 1,787 | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Cash, cash equivalents, and restricted cash at beginning of period | | 5,181 | | | | 2,485 | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Cash, cash equivalents, and restricted cash at end of period | $ | 4,787 | | | $ | 4,272 | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Supplemental disclosure of cash flow information: | | | | | | | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Cash paid during the year for: | | | | | | | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Interest on term loan with Oxford Finance LLC | $ | 262 | | | $ | 407 | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Income taxes | $ | - | | | $ | - | ------------------------------------------------------------------------------------------+---------------------------------+--------+---+------+---+--------+-- See accompanying Notes to Consolidated Financial Statements. 5 - ACURA PHARMACEUTICALS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED) (Unaudited; in thousands) The following table provides a reconciliation of cash, cash equivalents, and restricted cash reported within the consolidated balance sheet that sum to the total of the same such amounts shown in the consolidated statements of cash flows: | September 30, 2017 | | September 30, 2016 | ----------------------------------------------------------------------------------------------------+--------------------+-------+---------------------+-- | (in thousands) | ----------------------------------------------------------------------------------------------------+--------------------+------ Cash and cash equivalents | $ | 4,787 | | $ | 1,772 ----------------------------------------------------------------------------------------------------+--------------------+-------+---------------------+---+------ Restricted cash equivalents | | - | | | 2,500 ----------------------------------------------------------------------------------------------------+--------------------+-------+---------------------+---+------ Total cash, cash equivalents and restricted cash shown in the consolidated statements of cash flows | $ | 4,787 | | $ | 4,272 ----------------------------------------------------------------------------------------------------+--------------------+-------+---------------------+---+------ See accompanying Notes to Consolidated Financial Statements. 6 - ACURA PHARMACEUTICALS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 2017 AND SEPTEMBER 30, 2016 NOTE 1 – OPERATIONS AND BASIS OF PRESENTATION Principal Operations Acura Pharmaceuticals, Inc., a New York corporation, and its subsidiary (the “Company”, “We”, or “Our”) is a specialty pharmaceutical company engaged in the research and development of technologies and products intended to address medication abuse and misuse. We have discovered and developed three proprietary platform technologies which can be used to develop multiple products. Our Aversion® and Limitx™ Technologies are intended to address methods of product tampering associated with opioid abuse while our Impede® Technology is directed at minimizing the extraction and conversion of pseudoephedrine into methamphetamine. · | Our Limitx Technology, is designed to retard the release of active drug ingredients when too many tablets are accidently or purposefully ingested by neutralizing stomach acid with buffer ingredients but deliver efficacious amounts of drug when taken as a single tablet with a nominal buffer dose. We have completed two clinical studies of various product formulations utilizing immediate-release hydromorphone HCl and one clinical study using immediate-release hydrocodone bitartrate and acetaminophen. We plan to conduct another dose ranging study for immediate-release hydrocodone bitartrate and acetaminophen to commence in the fourth quarter of 2017, with topline results expected in the first quarter of 2018. The FDA has designated the development program for immediate-release hydromorphone HCl as Fast Track, which is designed to facilitate the development, and expedite the review of drugs to treat serious conditions and fill an unmet medical need. However, we intend to advance immediate-release hydrocodone bitartrate and acetaminophen as a lead Limitx product candidate due to its larger market size and its known prevalence of oral excessive tablet abuse. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ · | Our Aversion Technology incorporates gelling ingredients and irritants into tablets to discourage abuse by snorting and provide barriers to abuse by injection. Aversion is used in Oxaydo® Tablets (oxycodone HCl, CII), and is the first approved immediate-release oxycodone product in the United States with abuse deterrent labeling. On January 7, 2015, we entered into a Collaboration and License Agreement with Egalet US, Inc. and Egalet Ltd., each a subsidiary of Egalet Corporation (collectively, “Egalet”) pursuant to which we exclusively licensed to Egalet worldwide rights to manufacture and commercialize Oxaydo®. Oxaydo is currently approved by the FDA for marketing in the United States in 5mg and 7.5mg strengths. Egalet launched Oxaydo in the United States late in the third quarter of 2015. (see Note 3). --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ · | Our Impede Technology is a proprietary mixture of inactive ingredients that prevents the extraction of pseudoephedrine, or PSE, from tablets using known extraction methods and disrupts the direct conversion of PSE from tablets into methamphetamine. Impede is used in Nexafed® Tablets (30mg pseudoephedrine HCl) and Nexafed® Sinus Pressure + Pain Tablets (30/325mg pseudoephedrine HCl and acetaminophen), and those Nexafed products were launched by us into the United States market in December 2012 and February 2015, respectively. We have multiple PSE products in development utilizing our Impede Technology. On March 16, 2017, we and MainPointe Pharmaceuticals, LLC (“MainPointe”) entered into a License, Commercialization and Option Agreement (“MainPointe Agreement”) pursuant to which we granted MainPointe an exclusive license to our Impede technology in the United States and Canada to commercialize our Nexafed products. The MainPointe Agreement also grants MainPointe the option to expand the licensed territory to the European Union, Japan and South Korea and to add additional pseudoephedrine-containing products utilizing our Impede Technology. (see Note 3). MainPointe is controlled by John Schutte, who became our largest shareholder pursuant to a private placement transaction completed in July 2017. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 7 - Basis of Presentation and Going Concern The accompanying unaudited consolidated financial statements of the Company have been prepared assuming the Company will continue as a going concern and in accordance with generally accepted accounting principles in the United States of America for interim financial information, the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not contain all disclosures required by generally accepted accounting principles. Reference should be made to the Company’s Annual Report on Form 10-K for the year ended December 31, 2016. In the opinion of the Company, all normal recurring adjustments have been made that are necessary to present fairly the results of operations for the interim periods. Operating results for the three and nine month periods ended September 30, 2017 are not necessarily indicative of the results that may be expected for the year ending December 31, 2017. The going concern basis of presentation assumes that we will continue in operation for the next twelve months and will be able to realize our assets and discharge our liabilities and commitments in the normal course of business and does not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from our inability to continue as a going concern. At September 30, 2017, we had cash and cash equivalents of $4.8 million, working capital of $1.0 million and an accumulated deficit of $378.6 million. We had loss from operations of $3.5 million and a net loss of $3.9 million for the nine months ended September 30, 2017. Historically, we have suffered annual losses from operations and have not generated or have generated limited annual positive cash flows from operations. We expect our cash and cash equivalents will be sufficient to fund the development of our products and our related operating expenses only into April 2018. Our term loan agreement with Oxford contains customary affirmative and negative covenants. One such covenant is that the Company must submit on an annual basis to Oxford, within 120 days after the end of its fiscal year, audited consolidated financial statements, together with an unqualified audit opinion from an independent registered public accounting firm, or the Unqualified Audit Opinion Covenant. Per the term loan agreement an audit opinion with an explanatory paragraph noting substantial doubt about the Company’s ability to continue in business (the “going concern opinion”) is deemed to violate the Unqualified Audit Opinion Covenant. Failure to comply with the Unqualified Audit Opinion Covenant is a breach of the term loan agreement and unless such covenant or breach is waived, Oxford would have the option of accelerating the debt under the term loan agreement and initiating enforcement collection actions, foreclosing on collateral (which includes most assets of the Company) and, among other things, preventing the Company from using any funds in its bank or securities accounts. On March 16, 2017, we and Oxford entered into a third amendment to the Loan Agreement, or the Third Amendment. Pursuant to the Third Amendment (i) we granted Oxford a lien on our intellectual property, (ii) Oxford provided a waiver of compliance with the Unqualified Audit Opinion Covenant in connection with our receipt of our auditor’s going concern opinion for our 2016 financial statements and (iii) Oxford consented to the terms of the MainPointe Agreement. There can be no assurance, however, that Oxford will grant a similar waiver of compliance with the Unqualified Audit Opinion Covenant in connection with our receipt of our auditor’s opinion relating to our 2017 financial statements. These factors, among others, raise substantial doubt about the Company's ability to continue as a going concern. To fund further operations and product development activities beyond April 2018, we must raise additional financing or enter into license or collaboration agreements with third parties relating to our technologies. The Company intends to explore a variety of capital raising and other transactions to provide additional funding to continue operations. These include potential private offerings of common stock to accredited and/or institutional investors, and licensing transactions with pharmaceutical company partners for our proprietary technologies, including Limitx. We are actively seeking a licensing partner for our Limitx technology, with the objective of receiving an upfront license fee, development milestone payments and royalties on the net sales of products utilizing the Limitx technology, similar to the Egalet Agreement. We are also exploring licensing or selling select assets and intellectual property in an effort to raise capital and reduce operating expenses. Finally, the Company is evaluating the potential for a strategic transaction which may involve the Company being acquired in a merger or asset purchase transaction. No assurance can be given that we will be successful in completing any one or more of such transactions on acceptable terms, if at all, or if completed, that such transactions will provide payments to the Company sufficient to fund continued operations. In the absence of the Company’s completion of one or more of such transactions, there will be substantial doubt about the Company’s ability to continue as a going concern and the Company will be required to scale back or terminate operations and/or seek protection under applicable bankruptcy laws. An extended delay or cessation of the Company’s continuing product development efforts will have a material adverse effect on the Company’s financial condition and results of operations. 8 - In view of the matters described above, recoverability of a major portion of the recorded asset amounts shown in the Company’s accompanying balance sheets is dependent upon continued operations of the Company, which in turn is dependent upon the Company’s ability to meet its funding requirements on a continuous basis, to maintain existing financing and to succeed in its future operations. The Company’s financial statements do not include any adjustment relating to the recoverability and classification of recorded asset amounts and classification of liabilities that might be necessary should the Company be unable to continue in existence. NOTE 2 – RECENT ACCOUNTING PRONOUNCEMENTS Revenue from Contracts with Customers In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (ASU 2014-09), which supersedes nearly all existing revenue recognition guidance under U.S. GAAP. The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, more judgment and estimates may be required within the revenue recognition process than are required under existing U.S. GAAP. The standard is effective for us on January 1, 2018, using either of the following transition methods: (i) a full retrospective approach reflecting the application of the standard in each prior reporting period with the option to elect certain practical expedients, or (ii) a modified retrospective approach with the cumulative accounting effect of initially adopting ASU 2014-09 to be recognized on January 1, 2018. We have determined the transition method we will utilize to adopt the standard for use in 2018 to be the modified retrospective approach. Under the modified retrospective method, we will recognize the cumulative effect of initially applying the new revenue standard as an adjustment to the opening balance of retained earnings account along with having additional footnote disclosures. The comparative information will not be restated and will continue to be reported under the accounting standards in effect for those periods. In order to evaluate the impact that the adoption of ASU 2014-09 will have on our consolidated financial statements and related disclosures, we have initiated a comprehensive review of revenues. We have identified four significant contracts that will need to be evaluated under the standard. We are reviewing these four contracts and agreements to identify significant performance obligations and other factors to determine what impact the adoption of the standard will have on our consolidated financial statements and related disclosures. We are reviewing our current accounting policies, procedures and controls with respect to these contracts and arrangements to determine what changes, if any, may be required by the adoption of ASU 2014-09.We expect to complete our evaluation prior to the filing of, and make disclosures in, the 2017 Form 10-K. Additional disclosures will be required to enable users to understand the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. Inventories In July 2015, the FASB issued ASU No. 2015-11, which amended Accounting Standards Codification (“ASC”) Topic 330 Inventory. The amendment simplifies the measurement of inventory, applying to inventories for which cost is determined by methods other than last-in first-out (LIFO) and the retail inventory method (RIM), specifying that an entity should measure inventory at the lower of cost and net realizable value instead of at the lower of cost or market. The amendments in this ASU were effective for annual and interim periods, within those fiscal years, beginning after December 15, 2016. The Company adopted the guidance of the standard in the first quarter of 2017 which did not have a material impact on the Company’s consolidated financial statements. 9 - Leases In February 2016, the FASB issued ASU 2016-02, Leases, which establishes a comprehensive new lease accounting model. The new standard will require most leases (with the exception of leases with terms of one year or less) to be recognized on the balance sheet as a lease liability with a corresponding right-of-use asset. Leases will be classified as an operating lease or a financing lease. Operating leases are expensed using the straight-line method whereas financing leases will be treated similarly to a capital lease under the current standard. The new standard will be effective for annual and interim periods, within those fiscal years, beginning after December 15, 2018 but early adoption is permitted. The new standard must be presented using the modified retrospective transition method existing at or entered into after the beginning of the earliest comparative period presented in the financial statements, but it does not require transition accounting for leases that expire prior to the date of initial application. Upon adoption, operating leases will be reported on the balance sheet as a gross-up of assets and liabilities. The Company is currently evaluating the impact that the standard will have on the consolidated financial statements and related footnote disclosures. Employee Share-Based Payments In March 2016, the FASB issued ASU 2016-09, Improvements to Employee Share-Based Payment Accounting, which provides for simplification of certain aspects of employee share-based payment accounting including income taxes, classification of awards as either equity or liabilities, accounting for forfeitures and classification on the statement of cash flows. ASU 2016-09 is to be applied either prospectively, retrospectively or using a modified retrospective transition approach depending on the area covered in this update. The new standard was effective for annual and interim periods, within those fiscal years, beginning after December 15, 2016. The Company adopted the guidance in the first quarter of 2017 which did not have a material impact on the Company’s consolidated financial statements. Statement of Cash Flows In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments, which clarifies existing guidance on how companies present and classify certain cash receipts and cash payments in the statement of cash flows by addressing specific cash flow issues in an effort to reduce diversity in practice, including guidance on debt prepayment or extinguishment costs and contingent consideration payments made after a business combination. This update is effective for annual reporting periods beginning after December 15, 2017, with early adoption permitted. The Company expects that the standard will not have an impact on the Company’s consolidated financial statements and related footnote disclosures. Intra-Entity Transfers of Assets Other than Inventory In October 2016, the FASB issued ASU 2016-16, Intra-Entity Transfers of Assets Other Than Inventory. ASU 2016-16 eliminates from Topic 740, Income Taxes, the recognition exception for intra-entity asset transfers other than inventory so that an entity’s consolidated financial statements reflect the current and deferred tax consequences of those intra-entity asset transfers when they occur. The new standard will be effective for annual and interim periods, within those fiscal years, beginning after December 15, 2017 but early adoption is permitted. The Company expects that the standard will not have an impact on the Company’s consolidated financial statements and related footnote disclosures. Statement of Cash Flows - Restricted Cash In November 2016, the FASB issued ASU 2016-18, Statements of Cash Flows (Topic 230): Restricted Cash. ASU 2016-18 requires that at statement of cash flows explain the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. The new standard will be effective for annual and interim periods, within those fiscal years, beginning after December 15, 2017 but early adoption is permitted. The Company early adopted the guidance in the first quarter of 2017 which did not have a material impact on the Company’s consolidated financial statements or related footnote disclosures. Compensation – Stock Compensation In May 2017, the FASB issued ASU No. 2017-09, Compensation - Stock Compensation (ASC 718) - Scope of Modification Accounting. The amendments provide guidance as to how an entity should apply modified accounting in Topic 718 when changing the terms and conditions of its share-based payment awards. The guidance clarifies that modification accounting will be applied if the value, vesting conditions or classification of the award changes. The ASU is effective for annual reporting periods, including interim periods within those annual periods, beginning after December 15, 2017 but early adoption is permitted. The Company has not adopted the standard and does not anticipate that the standard will have a material effect, if any, on our consolidated financial statements and related disclosures. 10 -- NOTE 3 – LICENSE, DEVELOPMENT, AND COMMERCIALIZATION AGREEMENTS MainPointe Agreement covering Nexafed Product Line On March 16, 2017, we and MainPointe entered into the MainPointe Agreement, pursuant to which we granted MainPointe an exclusive license to our Impede technology to commercialize our Nexafed products in the U.S. and Canada. We also conveyed to MainPointe our existing inventory and equipment relating to our Nexafed products. MainPointe is responsible for all development, manufacturing and commercialization activities with respect to products covered by the Agreement. On signing the MainPointe Agreement, MainPointe paid us an upfront licensing fee of $2.5 million plus approximately $309 thousand for inventories and equipment being transferred to them. The MainPointe Agreement also provides for our receipt of a 7.5% royalty on net sales of the licensed products. The royalty payment for each product will expire on a country-by-country basis when the Impede® patent rights for such country have expired or are no longer valid; provided that if no Impede patent right exists in a country, then the royalty term for that country will be the same as the royalty term for the United States. After the expiration of a royalty term for a country, MainPointe retains a royalty free license to our Impede® technology for products covered by the Agreement in such country. MainPointe has the option to expand the licensed territory beyond the United States and Canada to the European Union (and the United Kingdom), Japan and South Korea for payments of $1.0 million, $500 thousand and $250 thousand, respectively. In addition, MainPointe has the option to add to the MainPointe Agreement certain additional products, or Option Products, containing PSE and utilizing the Impede technology for a fee of $500 thousand per product (for all product strengths). Such Option Products include the product candidate Loratadine with pseudoephedrine. If the territory has been expanded prior to the exercise of a product option, the option fee will be increased to $750 thousand per product. If the territory is expanded after the payment of the $500 thousand product option fee, a one-time $250 thousand fee will be due for each product. If a third party is interested in developing or licensing rights to an Option Product, MainPointe must exercise its option for that product or its option rights for such product will terminate. The MainPointe Agreement may be terminated by either party for a material breach of the other party, or by Acura if MainPointe challenges certain of its patents. Upon early termination of the MainPointe Agreement, MainPointe’s licenses to the Impede technology and all products will terminate. Upon termination, at Acura’s request the parties will use commercially reasonable efforts to transition the Nexafed® and Nexafed® Sinus Pressure + Pain products back to Acura. KemPharm Agreement Covering Certain Opioid Prodrugs On October 13, 2016, we and KemPharm Inc. (”KemPharm”) entered into a worldwide License Agreement (the “KemPharm Agreement”) pursuant to which we licensed our Aversion® technology to KemPharm for its use in the development and commercialization of three products using 2 of KemPharm’s prodrug candidates. KemPharm has also been granted an option to extend the KemPharm Agreement to cover two additional prodrug candidates. KemPharm is responsible for all development, manufacturing and commercialization activities. Upon execution of the KemPharm Agreement, KemPharm paid us an upfront payment of $3.5 million. If KemPharm exercises its option to use our Aversion technology with more than the two licensed prodrugs, then KemPharm will pay us up to $1.0 million for each additional prodrug license. In addition, we will receive from KemPharm a low single digit royalty on commercial sales by KemPharm of products developed using our Aversion technology under the KemPharm Agreement. KemPharm’s royalty payment obligations commence on the first commercial sale of a product using our Aversion technology and expire, on a country-by-country basis, upon the expiration of the last to expire patent claim of the Aversion technology covering a product in such country, at which time the license for the particular product and country becomes fully paid and royalty free. 11 -- The KemPharm Agreement expires upon the expiration of KemPharm’s royalty payment obligations in all countries. Either party may terminate the KemPharm Agreement in its entirety if the other party materially breaches the KemPharm Agreement, subject to applicable cure periods. Acura or KemPharm may terminate the KemPharm Agreement with respect to the U.S. and other countries if the other party challenges the patents covering the licensed products. KemPharm may terminate the KemPharm Agreement for convenience on ninety (90) days prior written notice. Termination does not affect a party’s rights accrued prior thereto, but there are no stated payments in connection with termination other than payments of obligations previously accrued. For all terminations (but not expiration), the KemPharm Agreement provides for termination of our license grant to KemPharm. Egalet Agreement covering Oxaydo In April 2014, we terminated an agreement with Pfizer and the return to us of Aversion Oxycodone (formerly known as Oxecta®) and all Aversion product rights in exchange for a one-time termination payment of $2.0 million. Our termination payment of $2.0 million has been recorded in our consolidated financial statements as an intangible asset and is being amortized over the remaining useful life of the patent covering Aversion Oxycodone, which was 9.7 years as of the date the agreement was terminated. During each of the three and nine months ended September 30, 2017 and 2016, we recorded amortization expense of approximately $52 thousand in each three month period and approximately $155 thousand in each nine month period, respectively. Annual amortization of the patent for years 2017 through 2021 is expected to approximate $208 thousand. On January 7, 2015, we and Egalet entered into a Collaboration and License Agreement (the “Egalet Agreement”) to commercialize Aversion Oxycodone (formerly known as Oxecta®) under our tradename Oxaydo. Oxaydo is approved by the FDA for marketing in the United States in 5 mg and 7.5 mg strengths. Under the terms of the Egalet Agreement, we transferred the approved New Drug Application, or NDA, for Oxaydo to Egalet and Egalet is granted an exclusive license under our intellectual property rights for development and commercialization of Oxaydo worldwide (the “Territory”) in all strengths, subject to our right to co-promote Oxaydo in the United States. Eaglet launched Oxaydo in the United States late in the third quarter of 2015. In accordance with the Egalet Agreement, we and Egalet have formed a joint steering committee to coordinate commercialization strategies and the development of product line extensions. Egalet is responsible for the fees and expenses relating to the Oxaydo NDA and product line extensions of Oxaydo, provided that Egalet will pay a substantial majority of the fees and expenses and we will pay for the remaining fees and expense relating to (i) annual NDA PDUFA product fees, (ii) expenses of the FDA required post-marketing study for Oxaydo and (iii) expenses of clinical studies for product line extensions (additional strengths) of Oxaydo for the United States. Egalet will bear all of the expenses of development and regulatory approval of Oxaydo for sale outside the United States. Egalet is responsible for all manufacturing and commercialization activities in the Territory for Oxaydo. Subject to certain exceptions, Egalet will have final decision making authority with respect to all development and commercialization activities for Oxaydo, including pricing, subject to our co-promotion right. Egalet may develop Oxaydo for other countries and in additional strengths, in its discretion. Egalet paid us a $5.0 million license fee upon signing of the Egalet Agreement and on October 9, 2015, paid us a $2.5 million milestone in connection with the first commercial sale of Oxaydo. We will be entitled to a one-time $12.5 million milestone payment when worldwide Oxaydo net sales reach $150 million in a calendar year. We are receiving from Egalet a stepped royalty at percentage rates ranging from mid-single digits to double-digits based on Oxaydo net sales during each calendar year (excluding net sales resulting from our co-promotion efforts). In any calendar year of the agreement in which net sales exceed a specified threshold, we will receive a double digit royalty on all Oxaydo net sales in that year (excluding net sales resulting from our co-promotion efforts). If we exercise our co-promotion rights, we will receive a share of the gross margin attributable to incremental Oxaydo net sales from our co-promotion activities. Egalet’s royalty payment obligations commence on the first commercial sale of Oxaydo and expire, on a country-by-country basis, upon the expiration of the last to expire valid patent claim covering Oxaydo in such country (or if there are no patent claims in such country, then upon the expiration of the last valid claim in the United States or the date when no valid and enforceable listable patent in the FDA’s Orange Book remains with respect to Oxaydo). Royalties will be reduced upon the entry of generic equivalents, as well as for payments required to be made by Egalet to acquire intellectual property rights to commercialize Oxaydo, with an aggregate minimum floor. 12 -- The Egalet Agreement expires upon the expiration of Egalet’s royalty payment obligations in all countries. Either party may terminate the Egalet Agreement in its entirety if the other party breaches a payment obligation, or otherwise materially breaches the Egalet Agreement, subject to applicable cure periods, or in the event the other party makes an assignment for the benefit of creditors, files a petition in bankruptcy or otherwise seeks relief under applicable bankruptcy laws. We also may terminate the Egalet Agreement with respect to the U.S. and other countries if Egalet materially breaches its commercialization obligations. Egalet may terminate the Egalet Agreement for convenience on 120 days prior written notice, which termination may not occur prior to the second anniversary of Egalet’s launch of Oxaydo. Termination does not affect a party’s rights accrued prior thereto, but there are no stated payments in connection with termination other than payments of obligations previously accrued. For all terminations (but not expiration), the Egalet Agreement provides for the transition of development and marketing of Oxaydo from Egalet to us, including the conveyance by Egalet to us of the trademarks and all regulatory filings and approvals relating to Oxaydo, and for Egalet’s supply of Oxaydo for a transition period. Terminated Bayer Agreement Covering Methamphetamine Resistant Pseudoephedrine-containing Product On June 15, 2015, we and Bayer entered into a License and Development Agreement (the “Bayer Agreement”) granting Bayer an exclusive worldwide license to our Impede Technology for use in an undisclosed methamphetamine resistant pseudoephedrine–containing product (the “Bayer Licensed Product”) and providing for the joint development of such product utilizing our Impede Technology for the U.S. market. On June 28, 2017, we received Bayer’s notice of termination of the Bayer Agreement pursuant to its convenience termination right exercised prior to the Company’s completion of its product development obligations under the Bayer Agreement. We have received reimbursement of certain of our development costs under the Bayer Agreement. Following Bayer’s termination of the Bayer Agreement the Bayer License Product is now subject to MainPointe’s option rights under the MainPointe Agreement. NOTE 4 - REVENUE RECOGNITION License Fee Revenue On signing the MainPointe Agreement in March 2017, MainPointe paid us an upfront licensing fee of $2.5 million. The payment was non-refundable and non-creditable when made and we had no further requirements to earn the payment. The amount was recognized as revenue when received (see Note 3). Milestone Revenue Milestone revenue is contingent upon the achievement of certain pre-defined events in the development agreements. Milestone payments are recognized as revenue upon achievement of the “at risk” milestone events, which represent the culmination of the earnings process related to that milestone. Milestone payments are triggered either by the results of our research and development efforts or by events external to us, such as regulatory approval to market a product. As such, the milestones are substantially at risk at the inception of an agreement, and the amounts of the payments assigned thereto are commensurate with the milestone achieved. In addition, upon the achievement of a milestone event, we have no future performance obligations related to that milestone payment. Each milestone payment is non-refundable and non-creditable when made and is recognized as revenue when received. Collaboration Revenue Collaboration revenue is derived from research and development services we provide from time to time and are recognized when those services are incurred pursuant to the agreements. The ongoing research and development services being provided under the collaboration are priced at fair value based upon the service’s hourly rates pursuant to the collaboration agreement. We did not have collaboration revenue for the three months ended September 30, 2017 and recognized $74 thousand of revenue for the three months ended September 30, 2016. We recognized $59 thousand and $307 thousand of collaboration revenue during the nine months ended September 30, 2017 and 2016, respectively. 13 -- Royalty Revenue In connection with our Collaboration and License Agreement with Egalet to commercialize Oxaydo tablets we are receiving a stepped royalty at percentage rates ranging from mid-single digits to double-digits based on Oxaydo net sales during each calendar year over the term of the agreement (excluding net sales resulting from any co-promotion efforts by us). We recognize royalty revenue each calendar quarter based on net sales reported to us by Egalet in accordance with the agreement. We recognized royalty revenue of $78 thousand and $39 thousand for the three months ended September 30, 2017 and 2016, respectively and $213 thousand and $86 thousand for the nine months ended September 30, 2017 and 2016, respectively. (see Note 3). In connection with our License, Commercialization and Option Agreement with MainPointe, which occurred on March 16, 2017, we are receiving a royalty of 7.5% on net sales of the licensed products over the term of the agreement. Such royalty shall be payable for sales made during each calendar quarter and payment will be remitted within forty-five (45) days after the end of the quarter to which it relates. We have recorded royalties of $5 thousand and $13 thousand for the three months and nine months ended September 30, 2017, respectively. (see Note 3). Product Sales Nexafed was launched in mid-December 2012 and Nexafed Sinus Pressure + Pain was launched in February 2015. Prior to entering into the MainPointe Agreement, we sold our Nexafed products in the United States to wholesale pharmaceutical distributors as well as directly to chain drug stores. Our Nexafed products were sold subject to the right of return usually for a period of up to twelve months after the product expiration. Both products had an initial shelf life of twenty-four months from the date of manufacture, which shelf life had been extended to thirty-six months for Nexafed product supplied to us during 2016 from one of the Company’s contract manufacturers. Prior to entering into the MainPointe Agreement, we recognized revenue from our Nexafed product line sales when the price was fixed and determinable at the date of sale, title and risk of ownership were transferred to the customer, and returns could be reasonably estimated, which generally occurred at the time of product shipment. Shipping and Handling Costs We record shipping and handling costs in selling expenses. As of mid-March 2017 we no longer manufacture, distribute or sell the Nexafed product line as the Company granted MainPointe an exclusive license to our Impede technology to commercialize our Nexafed products in the U.S. and Canada. The amounts recorded to selling expenses from the shipments of the Nexafed product line during each of the nine month periods ended September 30, 2017 and 2016 were not material. NOTE 5 - RESEARCH AND DEVELOPMENT ACTIVITIES Research and Development (“R&D”) expenses include internal R&D activities, external Contract Research Organization (“CRO”) services and their clinical research sites, and other activities. Internal R&D activity expenses include facility overhead, equipment and facility maintenance and repairs, laboratory supplies, pre-clinical laboratory experiments, formulation work, depreciation, salaries, benefits, and share-based compensation expenses. CRO activity expenses include preclinical laboratory experiments and clinical trial studies. Other activity expenses include regulatory consulting, and regulatory legal counsel. Internal R&D activities and other activity expenses are charged to operations as incurred. We make payments to the CRO's based on agreed upon terms and may include payments in advance of a study starting date. We review and accrue CRO expenses and clinical trial study expenses based on services performed and rely on estimates of those costs applicable to the stage of completion of a study as provided by the CRO. Accrued CRO costs are subject to revisions as such studies progress to completion. Revisions are charged to expense in the period in which the facts that give rise to the revision become known. During 2015, we entered into a cancelable arrangement for contract manufacturing services on a project to integrate Impede 2.0 technology into our Nexafed 30mg tablet while moving supply to an alternate contract manufacturer. Approximately $50 thousand of services was remaining under this agreement at December 31, 2016. During the second quarter of 2017, this project was completed and our Impede 2.0 technology was integrated into Nexafed 30mg tablets. Also during the second quarter of 2017, we entered into a cancelable arrangement with a CRO for Study 401 and it was completed during the third quarter of 2017. Also during the third quarter of 2017 we entered into a cancelable arrangement for Study 300 and it was substantially completed at September 30, 2017. We did not have any remaining obligations under cancelable CRO arrangements at September 30, 2017. We did not have prepaid CRO costs nor did we have prepaid clinical trial study expenses at either September 30, 2017 or December 31, 2016. 14 -- NOTE 6 – INVENTORIES We did not have inventories at September 30, 2017 as all our inventories were transferred to MainPointe under the MainPointe Agreement in March 2017. (See Note 3). Inventories at December 31, 2016 are stated at the lower of cost (first-in, first-out method) or net realizable value. We write down inventories to net realizable value based on forecasted demand and market conditions, which may differ from actual results. Our purchases of ingredients and other materials required in our development and clinical trial activities are expensed as incurred. Inventories at December 31, 2016 are summarized as follows: | December 31, | ---------------------------------+----------------+---- | 2016 | ---------------------------------+----------------+---- | (in thousands) | ---------------------------------+----------------+---- Raw and packaging materials | $ | 98 | ---------------------------------+----------------+-----+-- Finished goods | | 243 | ---------------------------------+----------------+-----+-- Total | | 341 | ---------------------------------+----------------+-----+-- Less: reserve for finished goods | | (32 | ) ---------------------------------+----------------+-----+-- Net inventories | $ | 309 | ---------------------------------+----------------+-----+-- NOTE 7 – PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment at September 30, 2017 and December 31, 2016 are summarized as follows: | September 30, | | | December 31, | ----------------------------------+----------------+--------+---+--------------+-- | 2017 | | | 2016 | ----------------------------------+----------------+--------+---+--------------+-- | (in thousands) | ----------------------------------+----------------+------- Building and improvements | $ | 1,273 | | | $ | 1,273 | ----------------------------------+----------------+--------+---+--------------+---+--------+-- Scientific equipment | | 598 | | | | 598 | ----------------------------------+----------------+--------+---+--------------+---+--------+-- Computer hardware and software | | 107 | | | | 109 | ----------------------------------+----------------+--------+---+--------------+---+--------+-- Machinery and equipment | | 275 | | | | 568 | ----------------------------------+----------------+--------+---+--------------+---+--------+-- Land and improvements | | 162 | | | | 162 | ----------------------------------+----------------+--------+---+--------------+---+--------+-- Other personal property | | 70 | | | | 70 | ----------------------------------+----------------+--------+---+--------------+---+--------+-- Office equipment | | 27 | | | | 27 | ----------------------------------+----------------+--------+---+--------------+---+--------+-- Total | | 2,512 | | | | 2,807 | ----------------------------------+----------------+--------+---+--------------+---+--------+-- Less: impairment reserve | | - | | | | (82 | ) ----------------------------------+----------------+--------+---+--------------+---+--------+-- Less: accumulated depreciation | | (1,813 | ) | | | (1,858 | ) ----------------------------------+----------------+--------+---+--------------+---+--------+-- Net property, plant and equipment | $ | 699 | | | $ | 867 | ----------------------------------+----------------+--------+---+--------------+---+--------+-- The impairment reserve of $82 thousand at December 31, 2016 was for specific machinery and other equipment which was used in the production of our Nexafed product line and which was not conveyed to MainPointe under the MainPointe Agreement. During 2017, we applied the reserve against the disposal of these specific assets. We do not have leasehold improvements nor do we have capitalized leases. Costs of betterments are capitalized while maintenance costs and repair costs are charged to operations as incurred. When a depreciable asset is retired from service, the cost and accumulated depreciation will be removed from the respective accounts. NOTE 8 - ACCRUED EXPENSES Accrued expenses at September 30, 2017 and December 31, 2016 are summarized as follows: 15 -- | September 30, | | December 31, | -----------------------------------------------+----------------+-----+--------------+-- | 2017 | | 2016 | -----------------------------------------------+----------------+-----+--------------+-- | (in thousands) | -----------------------------------------------+----------------+---- Cost sharing expenses under license agreement | $ | 274 | | $ | 150 -----------------------------------------------+----------------+-----+--------------+---+---- Other fees and services | | 80 | | | 47 -----------------------------------------------+----------------+-----+--------------+---+---- Payroll, payroll taxes and benefits | | 114 | | | 116 -----------------------------------------------+----------------+-----+--------------+---+---- Professional services | | 157 | | | 232 -----------------------------------------------+----------------+-----+--------------+---+---- Clinical, non-clinical and regulatory services | | 236 | | | 131 -----------------------------------------------+----------------+-----+--------------+---+---- Marketing, advertising, and promotion | | - | | | 10 -----------------------------------------------+----------------+-----+--------------+---+---- Property taxes | | 15 | | | 16 -----------------------------------------------+----------------+-----+--------------+---+---- Franchise taxes | | 14 | | | 1 -----------------------------------------------+----------------+-----+--------------+---+---- Total | $ | 890 | | $ | 703 -----------------------------------------------+----------------+-----+--------------+---+---- NOTE 9 – EQUITY FINANCING On July 24, 2017, we completed a $4.0 million private placement with John Schutte (the “Investor”), consisting of 8,912,655 units (“Units) of the Company, at a price of $0.4488 per Unit (the “Transaction). Each Unit consists of one share of Common Stock and a Warrant to purchase one fifth (0.2) of a share of Common Stock. The issue price of the Units was equal to 85% of the average last sale price of our Common Stock for the five trading days prior to completion of the Transaction. The Warrants are immediately exercisable at a price of $0.528 per share (which equals the average last sale price of the Company’s Common Stock for the five trading days prior to completion of the Transaction) and expire five years after issuance (subject to earlier expiration in event of certain acquisitions). We have assigned a relative fair value of $495 thousand to the warrants out of the total $4.0 million proceeds from the private placement transaction and have accounted these warrants as equity. The Transaction was completed through a private placement to an accredited investor and was exempt from registration pursuant to Section 4(2) of the Securities Act of 1933, as amended and/or Regulation D promulgated under the Securities Act of 1933. Investor is a principal of MainPointe, a Kentucky limited liability company. In March 2017, we granted MainPointe an exclusive license to our Impede technology to commercialize our Nexafed® and Nexafed® Sinus Pressure + Pain Products in the United States and Canada for an upfront licensing fee of $2.5 million plus approximately $425 thousand for transferred inventory and equipment. The Company will receive a 7.5% royalty on sales of licensed products. MainPointe also has options to expand the territory and products covered for additional sums. As part of the closing of the Transaction, the Company, Essex Woodlands Health Ventures V, L.P. (“Essex”) and Galen Partners III, L.P. (“Galen”) amended and restated the existing Voting Agreement between the parties to provide for the Investor to join as a party (as so amended, the “Second Amended and Restated Voting Agreement”). The Second Amended and Restated Voting Agreement provides that our Board of Directors shall remain comprised of no more than seven members (subject to certain exceptions), (i) one of whom is the Company’s Chief Executive Officer, (ii) three of whom are independent under Nasdaq standards, and (iii) one of whom shall be designated by each of Essex, Galen and Investor. The right of each of Essex, Galen and Investor to designate one director to our Board will continue as long as he or it and their affiliates collectively hold at least 600,000 shares of our Common Stock (including warrants exercisable for such shares). Immanuel Thangaraj is the designee of Essex. Neither Galen nor Investor has designated a director. NOTE 10 – DEBT On December 27, 2013, we entered into a Loan and Security Agreement (the “Loan Agreement”) with Oxford Finance LLC (“Oxford” or the “Lender”), for a term loan to the Company in the principal amount of $10.0 million (the “Term Loan”). The Term Loan accrues interest at a fixed rate of 8.35% per annum (with a default rate of 13.35% per annum). The Company was required to make monthly interest−only payments until April 1, 2015 (“Amortization Date”) and on the Amortization Date, the Company began to make payments of principal and accrued interest in equal monthly installments of $260 thousand sufficient to amortize the Term Loan through the maturity date of December 1, 2018. All unpaid principal and accrued and unpaid interest with respect to the Term Loan is due and payable in full on December 1, 2018. As security for its obligations under the initial Loan Agreement (prior to the Third Amendment), the Company granted Lender a security interest in substantially all of its existing and after−acquired assets, exclusive of its intellectual property assets, which the Company was prohibited from pledging to others. Upon the execution of the Loan Agreement, we issued to the Lender warrants to purchase an aggregate of up to 60 thousand shares of our common stock at an exercise price equal to $7.98 per share (after adjustment for our one-for-five reverse stock split) (the “Warrants”). We recorded $400 thousand as debt discount associated with the relative fair value of the Warrants and are amortizing it to interest expense over the term of the loan using the loan’s effective interest rate. The Warrants are immediately exercisable for cash or by net exercise and will expire December 27, 2020. 16 -- On January 7, 2015, we and Oxford entered into an amendment to the Loan Agreement. Pursuant to the amendment, (i) the exercise price of the warrants was lowered from $7.98 to $2.52 per share (the average closing price of our common stock on Nasdaq for the 10 trading days preceding the date of the amendment and after giving effect to our one-for-five reverse stock split) and we recorded additional debt discount of $33 thousand representing the fair value of the warrant modification, (ii) we agreed to maintain $2.5 million cash reserves until such time as we have repaid $5.0 million in principal of the Term Loan, and (iii) the Lender consented to the terms of our Collaboration and License Agreement with Egalet relating to our Oxaydo product. On October 13, 2016, we and Oxford entered into a second amendment to the Loan Agreement (the “Second Amendment”). Pursuant to the Second Amendment, (i) the requirement that we maintain a $2.5 million cash balance reserve until such time as $5.0 million in principal was repaid under the Term Loan was modified so that the $2.5 million cash balance reserve remains in place until we raise an additional $6.0 million (excluding payments received under the KemPharm Agreement) through the issuance of equity securities and from upfront payments under license, joint venture, collaboration or other partnering transactions, provided that at least $3.0 million of such amount must be raised through the issuance and sale of our equity securities, and (ii) the Lender consented to the terms of our Agreement with KemPharm. On July 24, 2017, the Company completed a private placement of its equity units to an investor, each unit consisting of one share of common stock and a warrant to purchase one-fifth of a share of common stock. The net proceeds to the Company from the private offering was approximately $3.9 million. Giving effect to the $2.5 million upfront payment received from MainPointe pursuant to the MainPointe Agreement and the $3.9 million in net proceeds from the July 2017 private offering, the Company has satisfied the condition in the Second Amendment to the Oxford Loan Agreement to waive the $2.5 million cash reserve requirement. On March 16, 2017, we and Oxford entered into a third amendment to the Loan Agreement (the “Third Amendment”). Pursuant to the Third Amendment (i) we granted Oxford a lien on our intellectual property, (ii) Oxford provided a waiver of compliance with the Unqualified Audit Opinion Covenant in connection with our receipt of our auditor’s going concern opinion for our 2016 financial statements and (iii) Oxford consented to the terms of the MainPointe Agreement. Under the Loan Agreement, an audit opinion with an explanatory paragraph noting substantial doubt about the Company’s ability to continue in business is deemed to violate the Unqualified Audit Opinion Covenant. The Company may voluntarily prepay the Term Loan in full, but not in part, and any prepayment is subject to a prepayment premium equal to 1% of the principal prepaid. In addition, at the maturity, termination or upon voluntary or mandatory prepayment of the Term Loan the Company must pay the Lender an additional one-time interest payment of $795 thousand. We are accruing additional monthly interest expense over the term of the loan for this additional one-time interest payment using the loan’s effective cash interest rate. As of September 30, 2017 and December 31, 2016, we have accumulated and accrued $668 thousand and $559 thousand, respectively, of this additional interest. The Company was obligated to pay customary lender fees and expenses, including a one-time facility fee of $50 thousand and the Lender’s expenses in connection with the Loan Agreement. Combined with the Company’s own expenses and a $100 thousand consulting placement fee, the Company incurred $231 thousand in deferred debt issue costs. We are amortizing these costs, including debt modification additional costs, into interest expense over the term of the loan using the loan’s effective interest rate of 10.16%. The Loan Agreement contains customary representations and warranties and customary affirmative and negative covenants, including, among others, limits or restrictions on the Company’s ability to incur liens, incur indebtedness, pay dividends, redeem stock, and merge or consolidate and dispose of assets. In addition, it contains customary events of default that entitles the Lender to cause any or all of the Company’s indebtedness under the Loan Agreement to become immediately due and payable. The events of default (some of which are subject to applicable grace or cure periods), include, among other things, non−payment defaults, covenant defaults (including breach of the Unqualified Audit Opinion Covenant), a material adverse change in the Company, bankruptcy and insolvency defaults and material judgment defaults. 17 -- Our debt at September 30, 2017 is summarized below (in thousands): Current Debt | Current | | | Long-term | | | Total --------------------------+---------+--------+---+-----------+---+--------+------ Balance at Jan. 1, 2017 | $ | 2,521 | | | $ | 2,979 | | $ | 5,500 | --------------------------+---------+--------+---+-----------+---+--------+-------+---+--------+-- Principal payments | | (1,815 | ) | | | - | | | (1,815 | ) --------------------------+---------+--------+---+-----------+---+--------+-------+---+--------+-- Classification | | 2,211 | | | | (2,211 | ) | | - | --------------------------+---------+--------+---+-----------+---+--------+-------+---+--------+-- Balance at Sept. 30, 2017 | $ | 2,917 | | | $ | 768 | | $ | 3,685 | --------------------------+---------+--------+---+-----------+---+--------+-------+---+--------+-- Debt Discount | Current | | | Long-term | | | Total --------------------------+---------+-----+---+-----------+---+-----+------ Balance at Jan. 1, 2017 | $ | (98 | ) | | $ | - | | $ | (98 | ) --------------------------+---------+-----+---+-----------+---+-----+-------+---+-----+-- Classification | | 98 | | | | (98 | ) | | - | --------------------------+---------+-----+---+-----------+---+-----+-------+---+-----+-- Amortization expense | | - | | | | 52 | | | 52 | --------------------------+---------+-----+---+-----------+---+-----+-------+---+-----+-- Balance at Sept. 30, 2017 | $ | - | | | $ | (46 | ) | $ | (46 | ) --------------------------+---------+-----+---+-----------+---+-----+-------+---+-----+-- Deferred Debt Issuance Costs | Current | | | Long-term | | | Total ------------------------------------+---------+-------+---+-----------+---+-----+------ Balance at Jan. 1, 2017 | $ | (47 | ) | | $ | - | | $ | (47 | ) ------------------------------------+---------+-------+---+-----------+---+-----+-------+---+-------+-- Classification | | 47 | | | | (47 | ) | | - | ------------------------------------+---------+-------+---+-----------+---+-----+-------+---+-------+-- Amortization expense | | - | | | | 27 | | | 27 | ------------------------------------+---------+-------+---+-----------+---+-----+-------+---+-------+-- Balance at Sept. 30, 2017 | $ | - | | | $ | (20 | ) | $ | (20 | ) ------------------------------------+---------+-------+---+-----------+---+-----+-------+---+-------+-- Current Debt, net at Sept. 30, 2017 | $ | 2,917 | | | $ | 702 | | $ | 3,619 | ------------------------------------+---------+-------+---+-----------+---+-----+-------+---+-------+-- Our interest expense for the three and nine months ended September 30, 2017 and 2016 consisted of the following (in thousands): | Three months Ended September 30, | | Nine months Ended September 30, | -----------------------+----------------------------------+-----+----------------------------------+-- Interest expense: | 2017 | | 2016 | | | 2017 | | 2016 -----------------------+----------------------------------+-----+----------------------------------+---+-----+------+---+----- Term loan | $ | 116 | | $ | 180 | | $ | 397 | $ | 584 -----------------------+----------------------------------+-----+----------------------------------+---+-----+------+---+------+---+---- Debt discount | | 15 | | | 23 | | | 52 | | 74 -----------------------+----------------------------------+-----+----------------------------------+---+-----+------+---+------+---+---- Debt issue costs | | 8 | | | 12 | | | 27 | | 39 -----------------------+----------------------------------+-----+----------------------------------+---+-----+------+---+------+---+---- Total interest expense | $ | 139 | | $ | 215 | | $ | 476 | $ | 697 -----------------------+----------------------------------+-----+----------------------------------+---+-----+------+---+------+---+---- The remaining annual principal payments of the debt outstanding at September 30, 2017 are as follows: | Remaining Annual Principal Payments | ------+--------------------------------------+------ Year | (in thousands) | ------+--------------------------------------+------ 2017 | $ | 707 ------+--------------------------------------+------ 2018 | | 2,978 ------+--------------------------------------+------ Total | $ | 3,685 ------+--------------------------------------+------ NOTE 11 – FAIR VALUE MEASUREMENTS The Company’s financial instruments consist primarily of cash and cash equivalents, receivables from trade, royalties and collaboration, trade accounts payable, and our long-term debt. The carrying amounts of these financial instruments, other than our long-term debt, are representative of their respective fair values due to their relatively short maturities. NOTE 12 - COMMON STOCK WARRANTS At September 30, 2017 and 2016, we have outstanding common stock purchase warrants as follows (in thousands except price data): 18 -- | Nine months Ended September 30, | ----------------------+---------------------------------+------ | 2017 | | 2016 | ----------------------+---------------------------------+-------+---------------------+-- | Number | | WAvg Exercise Price | | | Number | WAvg Exercise Price ----------------------+---------------------------------+-------+---------------------+---+------+--------+-------------------- Outstanding, Jan. 1 | | 60 | | $ | 2.52 | | 60 | $ | 2.52 ----------------------+---------------------------------+-------+---------------------+---+------+--------+---------------------+---+----- Issued | | 1,783 | | | 0.53 | | - | | - ----------------------+---------------------------------+-------+---------------------+---+------+--------+---------------------+---+----- Exercised | | - | | | - | | - | | - ----------------------+---------------------------------+-------+---------------------+---+------+--------+---------------------+---+----- Expired | | - | | | - | | - | | - ----------------------+---------------------------------+-------+---------------------+---+------+--------+---------------------+---+----- Modification | | - | | | - | | - | | - ----------------------+---------------------------------+-------+---------------------+---+------+--------+---------------------+---+----- Outstanding, Sept. 30 | | 1,843 | | $ | 0.59 | | 60 | $ | 2.52 ----------------------+---------------------------------+-------+---------------------+---+------+--------+---------------------+---+----- In connection with the issuance of the $10.0 million secured promissory notes in December 2013, we issued common stock purchase warrants (“warrants”) exercisable for 60 thousand shares of our common stock having an exercise price of $2.52 per share (after giving effect to our one-for-five reverse stock split) with an expiration date in December 2020. See Note 10 for a discussion of the reduction of the exercise price of these warrants to $2.52 per share. These warrants contain a cashless exercise feature. As part of our July 2017 private placement transaction, we issued warrants to purchase 1,782,531 shares of our common stock. The Warrants are immediately exercisable at a price of $0.528 per share and expire five years after issuance. We have assigned a relative fair value of $495 thousand to the warrants out of the total $4.0 million proceeds from the private placement transaction and have accounted these warrants as equity. NOTE 13 - SHARE-BASED COMPENSATION Share-based Compensation We have four share-based compensation plans covering stock options and RSUs for our employees and directors. We measure our compensation cost related to share-based payment transactions based on fair value of the equity or liability instrument issued. For purposes of estimating the fair value of each stock option unit on the date of grant, we utilize the Black-Scholes option-pricing model. Option valuation models require the input of highly subjective assumptions including the expected volatility factor of the market price of our common stock (as determined by reviewing our historical public market closing prices). Our accounting for share-based compensation for RSUs is based on the market price of our common stock on the date of grant, less its exercise cost. Our non-cash share-based compensation expense recognized in the Company’s results of operations from all types of issued instruments comprised the following (in thousands): | Three months Ended September 30, | | Nine months Ended September 30, | ------------------------------------+----------------------------------+-----+----------------------------------+-- | 2017 | | 2016 | | | 2017 | | 2016 ------------------------------------+----------------------------------+-----+----------------------------------+---+-----+------+---+----- Research and development expense: | | | | | | | | | | ------------------------------------+----------------------------------+-----+----------------------------------+---+-----+------+---+------+---+---- Stock options | $ | 38 | | $ | 43 | | $ | 106 | $ | 128 ------------------------------------+----------------------------------+-----+----------------------------------+---+-----+------+---+------+---+---- Restricted stock units | | - | | | - | | | - | | - ------------------------------------+----------------------------------+-----+----------------------------------+---+-----+------+---+------+---+---- Subtotal | $ | 38 | | $ | 43 | | $ | 106 | $ | 128 ------------------------------------+----------------------------------+-----+----------------------------------+---+-----+------+---+------+---+---- General and administrative expense: | | | | | | | | | | ------------------------------------+----------------------------------+-----+----------------------------------+---+-----+------+---+------+---+---- Stock options | $ | 52 | | $ | 77 | | $ | 158 | $ | 232 ------------------------------------+----------------------------------+-----+----------------------------------+---+-----+------+---+------+---+---- Restricted stock units | | 30 | | | 30 | | | 89 | | 90 ------------------------------------+----------------------------------+-----+----------------------------------+---+-----+------+---+------+---+---- Subtotal | $ | 82 | | $ | 107 | | $ | 247 | $ | 322 ------------------------------------+----------------------------------+-----+----------------------------------+---+-----+------+---+------+---+---- Total | $ | 120 | | $ | 150 | | $ | 353 | $ | 450 ------------------------------------+----------------------------------+-----+----------------------------------+---+-----+------+---+------+---+---- 19 -- Stock Option Award Plans We maintain various stock option plans. A summary of our stock option plan activity during the nine month periods ending September 30, 2017 and 2016 is shown below: | Nine Months Ended September 30, | ----------------------+----------------------------------+------ | 2017 | | | 2016 | ----------------------+----------------------------------+-------+---+---------------------------------+-- | Number of Options (000’s) | | | Weighted Average Exercise Price | | | Number of Options (000’s) | Weighted Average Exercise Price ----------------------+----------------------------------+-------+---+---------------------------------+---+-------+-----------------------------+-------------------------------- Outstanding, Jan. 1 | | 1,397 | | | $ | 13.57 | | 1,198 | $ | 15.67 ----------------------+----------------------------------+-------+---+---------------------------------+---+-------+-----------------------------+---------------------------------+---+------ Granted | | 185 | | | | 0.31 | | - | | - ----------------------+----------------------------------+-------+---+---------------------------------+---+-------+-----------------------------+---------------------------------+---+------ Exercised | | (1 | ) | | | (0.92 | ) | - | | - ----------------------+----------------------------------+-------+---+---------------------------------+---+-------+-----------------------------+---------------------------------+---+------ Forfeited or expired | | 87 | | | | 6.48 | | - | | - ----------------------+----------------------------------+-------+---+---------------------------------+---+-------+-----------------------------+---------------------------------+---+------ Outstanding, Sept. 30 | | 1,494 | | | $ | 12.33 | | 1,198 | $ | 15.67 ----------------------+----------------------------------+-------+---+---------------------------------+---+-------+-----------------------------+---------------------------------+---+------ Options exercisable | | 1,176 | | | $ | 15.46 | | 1,000 | $ | 18.37 ----------------------+----------------------------------+-------+---+---------------------------------+---+-------+-----------------------------+---------------------------------+---+------ The following table summarizes information about nonvested stock options outstanding at September 30, 2017 (in thousands except price data): | Number of Options Not Exercisable | | | Weighted Average Fair Value | ----------------------------+------------------------------------+------+---+--------------------------------+-- Outstanding, Jan. 1, 2017 | | 335 | | | $ | 1.18 ----------------------------+------------------------------------+------+---+--------------------------------+---+----- Granted | | 185 | | | | 0.31 ----------------------------+------------------------------------+------+---+--------------------------------+---+----- Vested | | (188 | ) | | | 1.36 ----------------------------+------------------------------------+------+---+--------------------------------+---+----- Forfeited | | (14 | ) | | | 1.05 ----------------------------+------------------------------------+------+---+--------------------------------+---+----- Outstanding, Sept. 30, 2017 | | 318 | | | $ | 0.58 ----------------------------+------------------------------------+------+---+--------------------------------+---+----- We estimate the option’s fair value on the date of grant using the Black-Scholes option-pricing model. Black-Scholes utilizes assumptions related to expected term, forfeitures, volatility, the risk-free interest rate, the dividend yield (which is assumed to be zero, as we have not paid any cash dividends) and employee exercise behavior. Expected volatilities utilized in the Black-Scholes model are based on the historical volatility of our common stock price. The risk-free interest rate is derived from the U.S. Treasury yield curve in effect at the time of grant. The expected life of the grants is derived from historical exercise activity. There was no intrinsic value of any option awards vested and outstanding at either September 30, 2017 or 2016. The total remaining unrecognized compensation cost on unvested option awards outstanding at September 30, 2017 was $174 thousand, and is expected to be recognized in operating expenses in varying amounts over the 14 months remaining in the requisite service periods. Restricted Stock Unit Award Plan We have a Restricted Stock Unit Award Plan (the “2014 RSU Plan”) for our employees and non-employee directors. Vesting of an RSU entitles the holder to receive a share of our common stock on a distribution date. The share-based compensation cost to be incurred on a granted RSU is the RSU’s fair value, which is the market price of our common stock on the date of grant, less its exercise cost. The compensation cost is amortized to expense over the vesting period of the RSU award. 20 -- A summary of the grants under the RSU Plans consisted of the following: | Nine months Ended September 30, | ----------------------+---------------------------------+---- | 2017 | | | 2016 ----------------------+---------------------------------+-----+---+------------------------ | (in thousands) | ----------------------+---------------------------------+---- | Number of RSUs | | | Number of Vested RSUs | | Number of RSUs | Number of Vested RSUs | ----------------------+---------------------------------+-----+---+-------------------------+-----+-----------------+-------------------------+-- Outstanding, Jan. 1 | | 91 | | | 91 | | 45 | | 45 | ----------------------+---------------------------------+-----+---+-------------------------+-----+-----------------+-------------------------+---+-----+-- Granted | | 238 | | | - | | 88 | | - | ----------------------+---------------------------------+-----+---+-------------------------+-----+-----------------+-------------------------+---+-----+-- Distributed | | (67 | ) | | (67 | ) | (42 | ) | (42 | ) ----------------------+---------------------------------+-----+---+-------------------------+-----+-----------------+-------------------------+---+-----+-- Vested | | - | | | 178 | | - | | 66 | ----------------------+---------------------------------+-----+---+-------------------------+-----+-----------------+-------------------------+---+-----+-- Forfeited or expired | | - | | | - | | - | | - | ----------------------+---------------------------------+-----+---+-------------------------+-----+-----------------+-------------------------+---+-----+-- Outstanding, Sept. 30 | | 262 | | | 202 | | 91 | | 69 | ----------------------+---------------------------------+-----+---+-------------------------+-----+-----------------+-------------------------+---+-----+-- Our 2014 RSU Plan was approved by shareholders on May 1, 2014 and permits the grant of up to 400 thousand shares of our common stock pursuant to awards under the 2014 RSU Plan. As of September 30, 2017, we had 3 thousand shares available for award under the 2014 RSU Plan. Information about the awards under the 2014 RSU Plan is as follows: · | On January 2, 2015, we awarded approximately 10 thousand RSUs to each of our four non-employee directors which also allow for them to receive payment in cash, instead of stock, for up to 40% of each RSU award. Such awards vest 25% at the end of each calendar quarter in 2015. The RSU awards subject to cash settlement are subject to marked-to market accounting. Distributions of stock under the January 2, 2015 award cannot be deferred until a later date and the stock under such awards were distributed on January 4, 2016. --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | On January 4, 2016, we awarded approximately 22 thousand RSUs to each of our 4 non-employee directors which also allow for them to receive payment in cash, instead of stock, for up to 40% of each RSU award. Such awards vest 25% at the end of each calendar quarter in 2016. The portion of the RSU awards which are subject to cash settlement are also subject to marked-to market accounting and the liability recorded in the Company’s balance sheet as an estimate for such cash settlement was $27 thousand at December 31, 2016. Distributions of stock under the January 4, 2016 award are generally distributed on the first business day of the year after vesting, but such distribution can be deferred until a later date at the election of the non-employee director. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ · | On January 3, 2017, we awarded approximately 60 thousand RSUs to each of our 4 non-employee directors which also allow for them to receive payment in cash, instead of stock, for up to 40% of each RSU award. Such awards vest 25% at the end of each calendar quarter in 2017. The portion of the RSU awards which are subject to cash settlement are also subject to marked-to market accounting and the liability recorded in the Company’s balance sheet as an estimate for such cash settlement was $36 thousand at September 30, 2017. Distributions of stock under the January 3, 2017 award are generally distributed on the first business day of the year after vesting, but such distribution can be deferred until a later date at the election of the non-employee director. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Information about the distribution of shares under the 2014 RSU Plan is as follows: · | On January 4, 2016, 1 thousand RSUs from the May 1, 2014 award and 41 thousand RSUs from the January 2, 2015 award were distributed. There are 2 thousand RSUs from the May 1, 2014 award which remain deferred until a future distribution date. Of the 42 thousand RSUs distributed, 33 thousand RSUs were distributed in common stock and 9 thousand RSUs were settled in cash. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | On January 3, 2017, 1 thousand RSUs from the May 1, 2014 award and 66 thousand RSUs from the January 4, 2016 award were distributed. There are 1 thousand RSUs from the May 1, 2014 award and 22 thousand RSUs from the January 4, 2016 award which remain deferred until a future distribution date. Of the 67 thousand RSUs distributed, 49 thousand RSUs were distributed in common stock and 18 thousand RSUs were settled in cash. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- NOTE 14 – INCOME TAXES We account for income taxes under the liability method. Under this method, deferred income tax assets and liabilities are determined based on differences between financial reporting and income tax basis of assets and liabilities and are accounted for using the enacted income tax rates and laws that will be in effect when the differences are expected to reverse. Additionally, net operating loss and tax credit carryforwards are reported as deferred income tax assets. The realization of deferred income tax assets is dependent upon future earnings. A valuation allowance is required against deferred income tax assets if, based on the weight of available evidence, it is more likely than not that some or all of the deferred income tax assets may not be realized. At both September 30, 2017 and December 31, 2016, all our remaining net deferred income tax assets were offset by a valuation allowance due to uncertainties with respect to future utilization of net operating loss (“NOL”) carryforwards. If in the future it is determined that additional amounts of our deferred income tax assets would likely be realized, the valuation allowance would be reduced in the period in which such determination is made and an additional benefit from income taxes in such period would be recognized. We have approximately $47.2 million federal income tax benefits at December 31, 2016 derived from $138.8 million Federal NOLs at the U.S. statutory tax rate of 34% and $2.1 million state NOLs, available to offset future taxable income, some of which already have limitations for future use as prescribed under IRC Section 382. Our Federal and State NOLs will expire in varying amounts between 2017 and 2036 if not used, and those expirations will cause fluctuations in our valuation allowances. We believe our equity financing transaction on July 24, 2017 under IRS Section 382 appears to have triggered further limitation on all the NOLs available to us for future use. As of December 31, 2016 we had federal research and development tax credits of approximately $1.2 million, which expire in the years 2024 through 2034 if gone unused. We also had approximately $0.2 million of Indiana state research and development tax credits, which will expire in 2017 if gone unused. 21 -- NOTE 15 – EARNINGS PER SHARE (“EPS”) Basic EPS is computed by dividing net income or loss by the weighted average common shares outstanding during a period, including shares weighted related to vested Restricted Stock Units (“RSUs”) (see Note 13). Diluted EPS is based on the treasury stock method and computed based on the same number of shares used in the basic share calculation and includes the effect from potential issuance of common stock, such as shares issuable pursuant to the exercise of stock options, common stock purchase warrants and nonvested RSUs, assuming the exercise of all in-the-money stock securities. The weighted-average common shares outstanding computation for Diluted EPS is not impacted during any period where the exercise price of the security is greater than the period’s average market price of our common stock. Common stock equivalents are excluded from the Diluted EPS where their inclusion would be anti-dilutive. No such adjustments were made for either 2017 or 2016 as the Company reported a net loss for the three and nine month periods, and including the effects of the common stock equivalents in the Diluted EPS calculations would have been antidilutive. A reconciliation of the numerators and denominators of Basic and Diluted EPS consisted of the following (in thousands except per share data): | Three months Ended September 30, | | | Nine months Ended September 30, | ------------------------------------------------------+-----------------------------------+--------+---+----------------------------------+-- | 2017 | | | 2016 | | | 2017 | | 2016 | ------------------------------------------------------+-----------------------------------+--------+---+----------------------------------+---+--------+------+---+--------+-- EPS – basic and diluted | | | | | | | | | | | | | ------------------------------------------------------+-----------------------------------+--------+---+----------------------------------+---+--------+------+---+--------+---+---+--------+-- Numerator: net loss | $ | (2,200 | ) | | $ | (2,250 | ) | $ | (3,944 | ) | $ | (8,922 | ) ------------------------------------------------------+-----------------------------------+--------+---+----------------------------------+---+--------+------+---+--------+---+---+--------+-- Denominator (weighted): | | | | | | | | | | | | | ------------------------------------------------------+-----------------------------------+--------+---+----------------------------------+---+--------+------+---+--------+---+---+--------+-- Common shares | | 18,544 | | | | 11,834 | | | 14,103 | | | 11,833 | ------------------------------------------------------+-----------------------------------+--------+---+----------------------------------+---+--------+------+---+--------+---+---+--------+-- Vested RSUs | | 142 | | | | 46 | | | 44 | | | 25 | ------------------------------------------------------+-----------------------------------+--------+---+----------------------------------+---+--------+------+---+--------+---+---+--------+-- Basic and diluted weighted average shares outstanding | | 16,686 | | | | 11,880 | | | 14,147 | | | 11,858 | ------------------------------------------------------+-----------------------------------+--------+---+----------------------------------+---+--------+------+---+--------+---+---+--------+-- EPS – basic and diluted | $ | (0.12 | ) | | $ | (0.19 | ) | $ | (0.27 | ) | $ | (0.75 | ) ------------------------------------------------------+-----------------------------------+--------+---+----------------------------------+---+--------+------+---+--------+---+---+--------+-- Excluded securities (non-weighted): | | | | | | | | | | | | | ------------------------------------------------------+-----------------------------------+--------+---+----------------------------------+---+--------+------+---+--------+---+---+--------+-- Common shares issuable: | | | | | | | | | | | | | ------------------------------------------------------+-----------------------------------+--------+---+----------------------------------+---+--------+------+---+--------+---+---+--------+-- Stock options | | 1,494 | | | | 1,198 | | | 1,494 | | | 1,198 | ------------------------------------------------------+-----------------------------------+--------+---+----------------------------------+---+--------+------+---+--------+---+---+--------+-- Nonvested RSUs | | 60 | | | | 22 | | | 60 | | | 22 | ------------------------------------------------------+-----------------------------------+--------+---+----------------------------------+---+--------+------+---+--------+---+---+--------+-- Common stock purchase warrants | | 1,843 | | | | 60 | | | 1,843 | | | 60 | ------------------------------------------------------+-----------------------------------+--------+---+----------------------------------+---+--------+------+---+--------+---+---+--------+-- Total excluded common shares | | 3,397 | | | | 1,280 | | | 3,397 | | | 1,280 | ------------------------------------------------------+-----------------------------------+--------+---+----------------------------------+---+--------+------+---+--------+---+---+--------+-- NOTE 16 – RELATED PARTY TRANSACTIONS On July 24, 2017, we completed a $4.0 million private placement with John Schutte (the “Investor”), consisting of 8,912,655 units (“Units”) of the Company, at a price of $0.4488 per Unit (the “Transaction”). Investor is a principal of MainPointe, a Kentucky limited liability company. In March 2017, we granted MainPointe an exclusive license to our Impede technology to commercialize Nexafed® and Nexafed® Sinus Pressure + Pain in the United States and Canada for an upfront licensing fee of $2.5 million plus approximately $425 thousand for transferred inventory and equipment. The Company will receive a 7.5% royalty on sales of licensed products. MainPointe also has options to expand the territory and products covered for additional sums. Included in the reported revenue for the three and nine months ended September 30, 2017 is $5 thousand and $13 thousand, respectively, of royalty revenue from MainPointe (See Note 3). 22 -- As part of the closing of the Transaction, the Company, Essex Woodlands Health Ventures V, L.P. (“Essex”) and Galen Partners III, L.P. (“Galen”) amended and restated the existing Voting Agreement between the parties to provide for the Investor to join as a party (as so amended, the “Second Amended and Restated Voting Agreement”). The Second Amended and Restated Voting Agreement provides that our Board of Directors shall remain comprised of no more than seven members (subject to certain exceptions), (i) one of whom is the Company’s Chief Executive Officer, (ii) three of whom are independent under Nasdaq standards, and (iii) one of whom shall be designated by each of Essex, Galen and Investor. The right of each of Essex, Galen and Investor to designate one director to our Board will continue as long as he or it and their affiliates collectively hold at least 600,000 shares of our Common Stock (including warrants exercisable for such shares). Immanuel Thangaraj is the designee of Essex. Galen has not designated a director. Investor has not designated a director as of the date of filing of this Report . NOTE 17 – COMMITMENTS AND CONTINGENCIES Reglan®/Metoclopramide Litigation Halsey Drug Company, as predecessor to Acura, has been named along with numerous other companies as a defendant in cases filed in three separate state coordinated litigations pending in Pennsylvania, New Jersey and California, respectively captioned In re: Reglan®/Metoclopramide Mass Tort Litigation, Philadelphia County Court of Common Pleas, January Term, 2010, No. 01997; In re: Reglan Litigation, Superior Court of New Jersey, Law Division, Atlantic County, Case No. 289, Master Docket No. ATL-L-3865-10; and Reglan/Metoclopramide Cases, Superior Court of California, San Francisco County, Judicial Council Coordination Proceeding No. 4631, Superior Court No.: CJC-10-004631. In addition, we were served with a similar complaint by two individual plaintiffs in Nebraska federal court, which plaintiffs voluntarily dismissed in December 2014. In this product liability litigation against numerous pharmaceutical product manufacturers and distributors, including Acura, plaintiffs claim injuries from their use of the Reglan brand of metoclopramide and generic metoclopramide. In the Pennsylvania action, over 200 lawsuits were filed against Acura and Halsey Drug Company alleging that plaintiffs developed neurological disorders as a result of their use of the Reglan brand and/or generic metoclopramide. In the New Jersey action, plaintiffs filed approximately 150 lawsuits against us, but served less than 50 individual lawsuits upon us. In the California action, there are 89 pending cases against us, with more than 445 individual plaintiffs. In the lawsuits filed to date, plaintiffs have not confirmed they ingested any of the generic metoclopramide manufactured by us. We discontinued manufacture and distribution of generic metoclopramide more than 19 years ago. In addition, we believe the June 23, 2011 decision by the U.S. Supreme Court in PLIVA v. Mensing (“Mensing decision”) holding that state tort law failure to warn claims against generic drug companies are pre-empted by the 1984 Hatch-Waxman Act Amendments and federal drug regulations will assist us in favorably resolving these cases. In New Jersey, Generic Defendants, including Acura, filed dispositive motions based on the Mensing decision, which the Court granted with a limited exception. In June 2012, the New Jersey trial court dismissed all of the New Jersey cases pending against us with prejudice. In Pennsylvania, and California, Generic Defendants, including us, also filed dispositive motions based on the Mensing decision. In Pennsylvania, on November 18, 2011, the trial court denied Generic Defendants’ dispositive preemption motions, without prejudice. In July 2013, the Pennsylvania Superior Court issued an adverse decision, and a subsequent appeal to the Pennsylvania Supreme Court was denied. On December 16, 2014, the Generic Defendants filed a Joint Petition for Certiorari with the United States Supreme Court captioned Teva Pharmaceuticals USA, Inc. et al. v. Dorothy Bentley, et al., No. 14-711 (U.S.) seeking reversal of the Pennsylvania state court decision. On April 27, 2015, the U.S. Supreme Court denied this Petition and this matter was returned to the trial court for further proceedings. From July, 2015 to date, the court has taken procedural steps to narrow this litigation, including requests for plaintiffs to voluntarily discontinue cases, such as those filed against us, where there is no case-specific product identification. The trial court proceedings were stayed on January 12, 2017. On June 15, 2017, a Stipulation of Dismissal without prejudice was entered as to nearly all of the Pennsylvania cases pending against us. We expect that the remaining few cases will be dismissed based on lack of product identification and the Court will finally dismiss the Pennsylvania-based litigation against us with prejudice within the next several months. Legal fees related to this matter are currently covered by our insurance carrier. 23 -- In California, the trial court entered a May 25, 2012 Order denying Generic Defendants’ dispositive preemption motions. The Generic Defendants’ appeals from this order were denied by the California appellate courts. In May 2014, the California Court denied a subsequent demurrer and motion to strike seeking dismissal of plaintiffs’ manufacturing defect and defective product claims to the extent that they are barred by federal preemption based upon the June 2013 Bartlett decision. Thus far, we and most Generic Defendants have not been required to file answers or other responsive pleadings in each individual case in which they are named defendants. On May 24, 2016, the Court entered an Order approving a stipulation which stays the individual cases against us and provides for an agreed upon dismissal protocol for all cases where there is a lack of product identification. On January 13, 2017, the Court also entered a general stay of this entire litigation. To date, none of these plaintiffs have confirmed they ingested any of the generic metoclopramide manufactured by us. Plaintiffs are proceeding to resolve all of their claims with co-defendants. Therefore, upon completion of this process, we expect that the lawsuits filed against us will be dismissed voluntarily with prejudice. Legal fees related to this matter are currently covered by our insurance carrier. As any potential loss is neither probable nor estimable, we have not accrued for any potential loss related to these matters as of September 30, 2017 and we are presently unable to determine if any potential loss would be covered by our insurance carrier. Purdue Pharma Settlement In April 2015, Purdue Pharma L.P., Purdue Pharmaceuticals L.P. and The P.F. Laboratories, Inc. (collectively, “Purdue”) commenced a patent infringement lawsuit against us and our Oxaydo product licensee Egalet US, Inc. and its parent Egalet Corporation in the United States District Court for the District of Delaware alleging our Oxaydo product infringes Purdue’s U.S. Patent No. 8,389,007 (the “ 007 patent”). In April 2016, Purdue commenced a second patent infringement lawsuit against us and Egalet in the United States District Court for the District of Delaware alleging our Oxaydo product infringes Purdue’s newly issued U.S. Patent No. 9,308,171 (the “171 Patent”). The actions regarding the 007 Patent and the 171 Patent are collectively referred to as the “Actions”. On April 6, 2016, we filed a petition for Inter Partes Review (the “IPR Review”) with the U.S. Patent and Trademark Office (“USPTO”) seeking to invalidate Purdue’s 007 Patent. On May 20, 2016, Purdue on behalf of themselves and certain affiliates, Egalet Corporation, on behalf of itself and its affiliates and we, on behalf of ourselves and our affiliates entered into a settlement agreement (the “Settlement Agreement”) to settle the Actions and the IPR Review. Under the Settlement Agreement the parties dismissed or withdrew the Actions, requested that the USPTO terminate the IPR Review and exchanged mutual releases. No payments were made under the Settlement Agreement. The Settlement Agreement also provides that Purdue will not, in the future, assert certain Purdue U.S. patents, including the 007 Patent, the 171 Patent and related technologies (the “Purdue Patents”) against any Acura Settlement Product or Egalet Settlement Product (except generally in an action or interference by Acura or Egalet challenging a Purdue Patent). Acura Settlement Products and Egalet Settlement Products are certain immediate-release and extended-release products, including Oxaydo. In addition, the Settlement Agreement provides that Purdue will not challenge, with certain exceptions, the Acura/Egalet Patents with respect to the Purdue Settlement Products (as defined below) and that Purdue provides Acura and/or Egalet certain waivers of non-patent marketing exclusivity with respect to Purdue Settlement Products. The Settlement Agreement also provides that Acura and Egalet will not, in the future, assert certain Acura and/or Egalet U.S. patents (the “Acura/Egalet Patents”), including Acura’s Aversion® Technology patents, against any Purdue Settlement Products (except generally in an action or interference by Purdue challenging an Acura/Egalet Patent). Purdue Settlement Products are certain immediate-release and extended-release products. In addition, the Settlement Agreement provides that Acura and Egalet will not challenge, with certain exceptions, the Purdue Patents with respect to the Acura Settlement Products and Egalet Settlement Products and that Acura and Egalet provide Purdue certain waivers of non-patent marketing exclusivity with respect to the Acura Settlement Products and Egalet Settlement Products. In addition, Purdue has certain rights to negotiate to exclusively distribute an authorized generic version of certain Egalet Settlement Products, including, in some circumstances, Oxaydo® and other products using Acura’s Aversion® Technology if licensed to Egalet. 24 -- The Settlement Agreement specifically excludes our patents related to our Impede® and Limitx™ technologies from the scope of the Acura/Egalet Patents under the Settlement Agreement . Egalet Agreement covering Oxaydo On January 7, 2015, we and Egalet entered into a Collaboration and License Agreement (the “Egalet Agreement”) to commercialize Aversion Oxycodone (formerly known as Oxecta®) under our tradename Oxaydo. Oxaydo is approved by the FDA for marketing in the United States in 5 mg and 7.5 mg strengths. Under the terms of the Egalet Agreement, we transferred the approved New Drug Application, or NDA, for Oxaydo to Egalet and Egalet is granted an exclusive license under our intellectual property rights for development and commercialization of Oxaydo worldwide (the “Territory”) in all strengths, subject to our right to co-promote Oxaydo in the United States. Eaglet launched Oxaydo in the United States late in the third quarter of 2015. In accordance with the Egalet Agreement, we and Egalet have formed a joint steering committee to coordinate commercialization strategies and the development of product line extensions. Egalet is responsible for the fees and expenses relating to the Oxaydo NDA and product line extensions of Oxaydo, provided that Egalet will pay a substantial majority of the expenses and we will pay for the remaining fees and expenses relating to (i) annual NDA PDUFA product fees, (ii) expenses of the FDA required post-marketing study for Oxaydo and (iii) expenses of clinical studies for product line extensions (additional strengths) of Oxaydo for the United States. Egalet will bear all of the expenses of development and regulatory approval of Oxaydo for sale outside the United States. Egalet is responsible for all manufacturing and commercialization activities in the Territory for Oxaydo. Subject to certain exceptions, Egalet will have final decision making authority with respect to all development and commercialization activities for Oxaydo, including pricing, subject to our co-promotion right. Egalet may develop Oxaydo for other countries and in additional strengths, in its discretion. At September 30, 2017 and December 31, 2016, we have accrued approximately $274 thousand and $150 thousand, respectively, of these potential cost sharing reimbursable expenses under the Egalet Agreement. Facility Lease The Company leases administrative office space in Palatine, Illinois on a month to month basis at the rate of approximately $2,000 per month. Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations This discussion and analysis should be read in conjunction with the Company's financial statements and accompanying notes included elsewhere in this Report. Historical operating results are not necessarily indicative of results in future periods. Forward-Looking Statements Certain statements in this Report constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be materially different from any future results, performance, or achievements expressed or implied by such forward-looking statements. Forward-looking statements may include, but are not limited to: · | our ability to fund or obtain funding for our continuing operations, including the development of our products utilizing our Limitx and Impede technologies; --+------------------------------------------------------------------------------------------------------------------------------------------------------------- · | our ability to remain in compliance with our obligations under our term loan with Oxford Finance LLC, or to obtain a waiver from Oxford Finance LLC for our failure to comply with our covenants contained in such term loan agreement; --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 25 -- · | the expected results of clinical studies relating to LTX-03 or any successor product candidate, the date by which such studies will be complete and the results will be available and whether LTX-03 will ultimately receive FDA approval; --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | whether Limitx will retard the release of opioid active ingredients as dose levels increase; --+--------------------------------------------------------------------------------------------- · | whether we will be able to reformulate LTX-03 or any successor product candidate, to provide an efficacious level of drug when one or two tablets are taken; --+------------------------------------------------------------------------------------------------------------------------------------------------------------- · | whether a reformulated Limitx formulation that achieves an efficacious level of drug will continue to demonstrate acceptable abuse deterrent performance; --+---------------------------------------------------------------------------------------------------------------------------------------------------------- · | whether we will be able to reformulate LTX-03 or any successor product candidate, to improve its abuse deterrent performance; --+------------------------------------------------------------------------------------------------------------------------------ · | whether the extent to which products formulated with the Limitx technology deter abuse will be determined sufficient by the FDA to support approval or labelling describing abuse deterrent features; --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ · | whether our Limitx technology can be expanded into extended-release formulations; --+---------------------------------------------------------------------------------- · | our and our licensee’s ability to successfully launch and commercialize our products and technologies, including Oxaydo® Tablets and our Nexafed® products; --+------------------------------------------------------------------------------------------------------------------------------------------------------------ · | the pricing and price discounting that may be offered by Egalet for Oxaydo; --+---------------------------------------------------------------------------- · | the results of our development of our Limitx Technology; --+--------------------------------------------------------- · | our or our licensees’ ability to obtain necessary regulatory approvals and commercialize products utilizing our technologies; --+------------------------------------------------------------------------------------------------------------------------------ · | the market acceptance of, timing of commercial launch and competitive environment for any of our products; --+----------------------------------------------------------------------------------------------------------- · | expectations regarding potential market share for our products; --+---------------------------------------------------------------- · | our ability to develop and enter into additional license agreements for our product candidates using our technologies; --+----------------------------------------------------------------------------------------------------------------------- · | our exposure to product liability and other lawsuits in connection with the commercialization of our products; --+--------------------------------------------------------------------------------------------------------------- · | the increasing cost of insurance and the availability of product liability insurance coverage; --+----------------------------------------------------------------------------------------------- · | the ability to avoid infringement of patents, trademarks and other proprietary rights of third parties; --+-------------------------------------------------------------------------------------------------------- · | the ability of our patents to protect our products from generic competition and our ability to protect and enforce our patent rights in any paragraph IV patent infringement litigation; --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | whether the FDA will agree with or accept the results of our studies for our product candidates; --+------------------------------------------------------------------------------------------------- · | the ability to fulfill the FDA requirements for approving our product candidates for commercial manufacturing and distribution in the United States, including, without limitation, the adequacy of the results of the laboratory and clinical studies completed to date, the results of laboratory and clinical studies we may complete in the future to support FDA approval of our product candidates and the sufficiency of our development process to meet over-the-counter (“OTC”) Monograph standards, as applicable; --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | the adequacy of the development program for our product candidates, including whether additional clinical studies will be required to support FDA approval of our product candidates; --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | changes in regulatory requirements; --+------------------------------------ · | adverse safety findings relating to our commercialized products or product candidates in development; --+------------------------------------------------------------------------------------------------------ · | whether the FDA will agree with our analysis of our clinical and laboratory studies; --+------------------------------------------------------------------------------------- · | whether further studies of our product candidates will be required to support FDA approval; --+-------------------------------------------------------------------------------------------- · | whether or when we are able to obtain FDA approval of labeling for our product candidates for the proposed indications and whether we will be able to promote the features of our abuse discouraging technologies; and --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | whether Oxaydo or our Aversion and Limitx product candidates will ultimately deter abuse in commercial settings and whether our Nexafed products and Impede technology product candidates will disrupt the processing of pseudoephedrine into methamphetamine. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- In some cases, you can identify forward-looking statements by terms such as “may,” “will,” “should,” “could,” “would,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “indicates,” “projects,” “predicts,” “potential” and similar expressions intended to identify forward-looking statements. These statements reflect our current views with respect to future events and are based on assumptions and subject to risks and uncertainties. Given these uncertainties, you should not place undue reliance on these forward-looking statements. We discuss many of these risks in greater detail in our 2016 Annual Report on Form 10-K as filed with the U.S. Securities and Exchange Commission. In light of these risks, uncertainties and assumptions, the forward-looking events and circumstances discussed in this Report may not occur and actual results could differ materially and adversely from those anticipated or implied in the forward-looking statements. 26 -- Unless required by law, we undertake no obligation to update or revise any forward-looking statements to reflect new information or future events or developments. Accordingly, you should not assume that our silence over time means that actual events are bearing out as expressed or implied in such forward-looking statements. Company Overview We are a specialty pharmaceutical company engaged in the research and development of technologies and products intended to address medication abuse and misuse. We have discovered and developed three proprietary platform technologies which can be used to develop multiple products. Our Aversion® and Limitx™ Technologies are intended to address methods of abuse associated with opioid analgesics while our Impede® Technology is directed at minimizing the extraction and conversion of pseudoephedrine, or PSE, into methamphetamine. Oxaydo Tablets (oxycodone HCl, CII), which utilizes the Aversion Technology, is the first approved immediate-release oxycodone product in the United States with abuse deterrent labeling. On January 7, 2015, we entered into a Collaboration and License Agreement with Egalet US, Inc. and Egalet Ltd., each a subsidiary of Egalet Corporation, or collectively Egalet, pursuant to which we exclusively licensed to Egalet worldwide rights to manufacture and commercialize Oxaydo. Oxaydo is currently approved by the U. S. Food and Drug Administration, or FDA, for marketing in the United States in 5mg and 7.5mg strengths. Egalet launched Oxaydo in the United States late in the third quarter of 2015. We launched our first Impede Technology product, Nexafed, into the United States market in December 2012 and launched our Nexafed Sinus Pressure + Pain product in the United States in February 2015. We have an additional pseudoephedrine product in development utilizing our Impede Technology. On March 16, 2017, we and MainPointe Pharmaceuticals, LLC (“MainPointe”), entered into a License, Commercialization and Option Agreement (“MainPointe Agreement”), pursuant to which we granted MainPointe an exclusive license to our Impede technology in the U.S. and Canada to commercialize our Nexafed products. The MainPointe Agreement also grants MainPointe the option to expand the licensed territory to the European Union, Japan and South Korea and to add additional pseudoephedrine-containing products utilizing our Impede technology. Our third abuse deterrent technology, Limitx, is designed to retard the release of active drug ingredients when too many tablets are accidently or purposefully ingested by neutralizing stomach acid with buffer ingredients but deliver efficacious amounts of drug when taken as a single tablet with a nominal buffer dose. We have completed three clinical studies of various product formulations utilizing the Limitx technology which have demonstrated that maximum drug blood levels (Cmax) are reduced when excess buffer is introduced but exhibits what we believe to be efficacious blood levels when no buffer are used. Studies AP-LTX-400, or Study 400, and AP-LTX-401, or Study 401, were open label, crossover design pharmacokinetic studies in healthy adult subjects of LTX-04 (immediate-release hydromorphone HCl) compared to a marketed comparator, or reference drug. Each of Study 400 and Study 401 demonstrated the Cmax was reduced by 50% to 65% when excessive buffer levels were ingested. Study AP-LTX-300, or Study 300, a parallel design pharmacokinetic buffer dose ranging study of LTX-03 (immediate-release hydrocodone bitartrate and acetaminophen) compared to a reference drug, demonstrated drug Cmax from LTX-03 in the presence of no buffer ingredient which are expected to provide therapeutic drug levels in the bloodstream for a single dosage, but that due to erratic release of the drug from the over-encapsulated tablets used in the Study, we were unable to reliably identify the precise buffer level for a single Limitx tablet. We plan to conduct another dose ranging study, AP-LTX-301, or Study 301, without using over-encapsulated tablets. We expect to commence Study 301 in the fourth quarter of 2017, with topline results expected in the first quarter of 2018. We believe the results of Study 301 will guide us on the final formulation of LTX-03 tablets, which will combine the hydrocodone micro-particles, acetaminophen and buffer ingredients into a single tablet. We also plan to identify a commercial manufacturer to assist in finalizing the LTX-03 formulation. The FDA has designated the development program for LTX-04 as Fast Track, which is designed to facilitate the development, and expedite the review of drugs to treat serious conditions and fill an unmet medical need. However, we intend to advance LTX-03 as a lead Limitx product candidate due to its larger market size and its known prevalence of oral excessive tablet abuse. Opioid analgesics are one of the largest prescription drug markets in the United States with 222 million prescriptions dispensed in 2016. Prescription opioids are also the most widely abused drugs with 11 million people abusing or misusing these products annually. Oxaydo will compete in the immediate-release opioid product segment. Because immediate-release opioid products are used for both acute and chronic pain, a prescription, on average, contains 66 tablets or capsules. According to IMS Health, in 2016, sales in the immediate-release opioid product segment were approximately 208 million prescriptions and $2.7 billion, of which approximately 98% was attributable to generic products. Immediate-release oxycodone tablets represent 20.1 million of these prescriptions or almost 1.7 billion tablets. The FDA approved label for our Oxaydo product describes the unique, and we believe promotable, abuse deterrent features of our product which we believe makes prescribing our product attractive to some healthcare providers. We are advised that Egalet has approximately 50 sales representatives promoting Oxaydo to a target group of approximately 6,000 opioid prescribing physicians. 27 -- In 2014, the United States retail market for over-the-counter market, or OTC, cold and allergy products containing the pseudoephedrine oral nasal decongestant was approximately $0.7 billion. In 2014, the DEA reported 9,339 laboratory incidents involving the illegal use of OTC pseudoephedrine products to manufacture the highly addictive drug methamphetamine, or meth. According to the Substance Abuse and Mental Health Services Administration, users of methamphetamine surged in 2013 to 595,000 people up from 440,000 in 2012. We have a development program to develop an extended-release version of our Impede Technology to capitalize on higher sales products in the category. We also have investigated new technologies that would improve on our meth-resistant capabilities. On March 23, 2015, we announced preliminary top line results from our pilot clinical study demonstrating bioequivalence of our Nexafed extended release tablets to Johnson & Johnson’s Sudafed® 12-hour Tablets. In October 2016, we received FDA recommendations on our meth-resistant testing protocols for our Nexafed extended release tablets which utilizes our Impede 2.0 enhanced meth-resistant technology. Our Impede 2.0 Technology has demonstrated, in the direct conversion, or “one-pot”, methamphetamine conversion process performed by an independent pharmaceutical services company, the ability to reduce meth-yields, on average, by 75% compared to Sudafed® Tablets. We can now scale-up our manufacture batch size at a contract manufacturer which will allow us to submit an IND to the FDA for our Nexafed extended release tablets, however, we have not yet committed to that level of development. We are also finalizing the formulation of a Loratadine/PSE extended-release combination product utilizing our Impede technology. Abuse of Prescription Opioid Products and Development of Abuse Deterrent Formulations Prescription opioids drugs, such as morphine and oxycodone, have a long history of use for the management of pain. Because they are highly effective, they are one of the largest prescribed drug categories in the U.S. However, a side effect of high doses of opioids is euphoria, or “a high”. For these reasons, opioids are the most misused or abused prescription drugs in the U.S. Opioids are offered in a variety of dosages including immediate-release tablets (or capsules), extended-release tablets (or capsules), patches and other formats. Abusers will often manipulate or tamper with the formulations to achieve their high, including: · | Oral Excessive Tablet Abuse (ETA). Generally recognized as the most prevalent route of administration by abusers, the abuser simply orally ingests more tablets (or capsules) than is recommended for pain relief. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | Oral Manipulated Tablet Abuse (MTA). Extended-release tablets or patches are sometimes crushed, chewed or otherwise physically or chemically manipulated to defeat the extended-release mechanism and provide an immediate-release of the opioid for oral ingestion. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | Nasal snorting. Crushed tablets are insufflated for absorption of the drug through the nasal tissues. --+------------------------------------------------------------------------------------------------------ · | Injection. The opioid is physically or chemically removed from the dosage and injected into the vein using a syringe. --+---------------------------------------------------------------------------------------------------------------------- · | Poly-pharmacy. Opioids are sometimes used in conjunction with alcohol or other drugs to accentuate the high. --+------------------------------------------------------------------------------------------------------------- Abuse deterrent formulations of opioid dosages incorporate physical and/or chemical barriers or functionality in the formulations to prevent or discourage an abuser from inappropriately administering the product. The extent and manner in which any of the features of abuse deterrent opioids may be described in the FDA approved label for our pipeline products will be dependent on the results of and the acceptance by the FDA of our and our licensees’ studies for each product. 28 -- Development of our Limitx and Aversion (if recommenced) product candidates will require one or more abuse deterrent studies consistent with FDA’s 2015 Guidance. These studies may include in vitro laboratory studies to determine, among other things, syringeability of the formulation, extractability of the opioid, and particle size of the crushed product. It is also expected that development will include human abuse liability studies comparing the abuse liability of our product candidates to currently marketed products. Because our products use known active ingredients in approved dosage strengths, the safety and efficacy of the opioid will need to be established by a series of pharmacokinetic studies demonstrating: (a) bioequivalence to an approved reference drug, (b) food effect of our formulations, and (c) dose proportionality of our formulation. A product candidate that does not achieve satisfactory pharmacokinetic results may require a phase III clinical pain study although an FDA Advisory Committee recently recommended an opioid analgesic product for approval that did not meet the FDA’s bioequivalence standard. Further development will likely also entail additional safety and/or efficacy assessment as may be identified by the FDA for each specific formulation during the Investigational New Drug application, or IND, or NDA phase of development. In accordance with the FDA’s 2015 Guidance, we will likely have a post-approval requirement for each of our products, if approved, to perform an epidemiology study to assess the in-market impact on abuse of our formulation. Limitx™ Technology Limitx Technology is intended to address oral ETA or accidental consumption of multiple tablets and provide a margin of safety during accidental over-ingestion of tablets. Limitx is also expected to exhibit barriers to abuse by snorting and injection. The FDA’s 2015 Guidance singles out immediate-release combination products with acetaminophen as being predominately abused by the oral route and that reducing nasal snorting of these products may not be meaningful. The initial Limitx formulation (LTX-04) utilizes hydromorphone as its sole active ingredient. We are redirecting our development focus from LTX-04 to a hydrocodone/APAP product candidate utilizing our Limitx Technology (LTX-03). Development of our LTX-04 was supported by a $300 thousand grant by the National Institute on Drug Abuse of the National Institutes of Health for Phase I development, which entailed the development of an optimized formulation suitable for commercial manufacture and human testing. NIDA Disclaimer: Research on LTX-04 was supported by the National Institute on Drug Abuse of the National Institutes of Health under Award Number R44DA037921. The results and content of any such research is solely the responsibility of Acura and does not necessarily represent the official views of the National Institutes of Health. The LTX-04 development program is also designated as Fast Track by the FDA for its potential to address an unmet medical need. Limitx Technology Products in Development We have the following products in development utilizing our Limitx Technology: Limitx Technology Product | Status ---------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- Immediate-release hydromorphone HCI (LTX-04) | Two Phase I exploratory pharmacokinetic studies completed ---------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- Immediate-release hydrocodone bitartrate with acetaminophen (LTX-03) | Initial buffer dose ranging study completed October 2017 Follow on dose ranging study expected to commence Q4 2017 ---------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- Immediate-release oxycodone HCl (LTX-01) & (LTX-02) | Formulation development in process ---------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- Immediate-release non-opioid drug (LTX-09) | Formulation development in process ---------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------- 29 -- Study 400 The initial LTX-04 clinical study, or Study 400, was a two cohort, open label, crossover design pharmacokinetic study in healthy adult subjects. Study 400 measured the rate and extent of absorption of the active drug ingredient into the bloodstream with the maximum concentration, or Cmax, typically associated with an increase in drug abuse. Cohort 1 enrolled 30 subjects who were randomized into three subgroups of 10 taking either 1, 2 or 3 tablets. Each subgroup subject orally swallowed the planned number of tablets in a randomized manner taking single doses of two different test formulations of LTX-04 (designated as LTX-04P and LTX-04S and distinguished by their respective acid neutralizing capacity) and Purdue Pharma’s marketed drug Dilaudid® as a comparator. The 1, 2 and 3 tablets subgroups in Cohort 1 completed 8, 10 and 8 subjects, respectively. Cohort 2 enrolled 30 subjects who were randomized into three subgroups of 10 taking either 4, 6 or 8 tablets. Each subgroup subject orally swallowed the planned number of tablets in a randomized manner taking single doses of LTX-04P and the marketed drug Dilaudid as a comparator. The 4, 6 and 8 tablets subgroups in Cohort 2 completed 8, 9 and 8 subjects, respectively. All tablets contained 2mg of hydromorphone hydrochloride. All subjects received doses of naltrexone and there was a one week washout between doses. Blood samples were taken at pre-designated time-points after dosing and were subsequently analyzed for the concentration of hydromorphone contained in the sample. All subjects in Cohort 1 had continuous pH (a measure of acid concentration) monitoring of their gastric fluid. The objective of Cohort 1 was to determine if adequate active drug entered the blood stream when one or two Limitx tablets were swallowed and to begin assessing the ability of the Limitx Technology to start retarding the release of active ingredients when three tablets are ingested. The objective of Cohort 2 was to further explore the extent the release of the hydromorphone active ingredient from LTX-04P tablets is retarded as the dose level increases to abusive levels. A safety assessment of Limitx Hydromorphone will be made from both study cohorts. The topline results from Study 400 demonstrated that a single tablet dose delivered a Cmax of 45% and 50% lower than the reference drug for LTX-04S and LTX-04P, respectively. For an 8 tablet dose, the Cmax for LTX-04P was 59% lower than the reference drug. Doses between 1 and 8 tablets had similar reduction in Cmax compared to the reference. The extent of drug absorption, measure by area under the curve (AUC) was consistent between the Limitx products and the reference. On December 14, 2016, we announced that we had received advice from the FDA on the continued development of LTX-04 following the FDA’s review of summary data from Study 400. The FDA confirmed our intention to reformulate LTX-04 to provide increased drug levels following an intended 1 or 2 tablet dose, noting that a scientific bridge of bioequivalence to the reference product will support a finding of safety and efficacy. The FDA also recommended that we identify studies to measure the clinical impact on abuser behavior and overdose outcome (such as drug liking and respiratory depression) associated with the reduction in Cmax when three or more LTX-04 tablets were ingested. The FDA’s advice also identified longer term studies necessary for submitting a NDA for LTX-04, including in vitro extraction studies, drug interaction studies, additional pharmacokinetic studies assessing the impact of food and beverages, and a category 3 abuse liability study. Study 401 Our second LTX-04 clinical study, or Study 401, also was a two cohort, open label, crossover design pharmacokinetic study in fasted, health adult subjects. Study 401 utilized a modified LTX-04 formulation containing micro-particles intended to improve drug delivery with one and two tablet dosing (LTX-04P3). Study 401 measured the rate and extent of absorption of the active drug ingredient into the blood stream with the Cmax typically associated with an increase in drug abuse. 27 subjects completed Cohort 1 swallowing a single dose tablet of LTX-04 compared to a generic hydromorphone tablet. 13 subjects completed Cohort 2 swallowing 7 LTX-04 and generic tablets doses. 15 subjects followed an undisclosed, exploratory protocol. All tablets contained 2 mg of hydromorphone hydrochloride. All subjects received dosages of naltrexone and/or naloxone and there was a one week washout between dosages. Blood samples were taken at pre-designated time-points after dosing and were subsequently analyzed for the concentration of hydromorphone contained in the sample. The objective of Cohort 1 was to determine if adequate active drug entered the bloodstream when one Limitx tablet was swallowed. The objective of Cohort 2 was to explore the extent to which the release of the hydromorphone active ingredient from LTX-04 tablets is retarded at a seven tablet dose (oral excess abuse levels). A safety assessment of Limitx hydromorphone would be made from both study cohorts. 30 -- The topline results from Study 401 demonstrated that Cmax for a one tablet LTX-04P3 dose was approximately 50% less than the active comparator. The Cmax for the 7 tablet LTX-04P3 dose was 65% below the comparator. Study 401 also included a 7 tablet dose of LTX-04P3 taken simultaneously with an agent known to increase gastric emptying time (i.e. increase retention time of the ingredients in the stomach) which demonstrated an increase in Tmax (time of Cmax) of over 1 hour compared to LTX-04P3 taken without this agent. Since the micro-particles used in Study 401 release drug much faster than the micro-particles used in Study 400, we have concluded that the buffer levels used in both studies were excessive and is retarding the release of drug even with a single dose. Also, given that manipulating the duration of stomach acidity with a gastric emptying agent produced a significant increase in Tmax which is indicative of a delayed release of drug from LTX-04P3, we concluded the Limitx micro-particles are working as designed in that when we neutralize the stomach acid we are slowing the release of drug and subsequent absorption of drug into the blood stream. We believe the results from Study 400 and 401 indicate the micro-particle are working as designed but that we used too much buffer for even a single tablet and did not achieve full release of the drug at a 1 tablet dose. Study 300 Study 300 was a parallel design, open label, pharmacokinetic buffer dose ranging study in 56 in fasted healthy subjects. Study 300 was a single dose of LTX-03 (10mg of hydrocodone bitartrate in Limitx micro-particles and 325mg of acetaminophen) without any buffering capacity compared to the reference drug, Norco®. A buffering component, that contained a fraction of the buffering capacity that we have previously used in testing LTX-04, was included with the LTX-03 active component with an incremental number of buffering units from 0 (no buffer) to 5 buffer doses. All study drug, including the reference, was over-encapsulated to allow dosing multiple Limitx test articles simultaneously to replicate the action of a single tablet dose. The goal of Study 300 was to identify the highest buffer level that allows for a full release of hydrocodone at a single tablet dose relative to the positive control before the LIMITx buffering effect is observed. Acetaminophen blood levels were also analyzed and compared to the positive control. Study 300 demonstrated rapid release of drug from the micro-particle formulation, providing expected therapeutic drug levels in the bloodstream for a single dose, but that due to erratic release of the drug from the over-encapsulated tablets used in the Study, we were unable to reliably identify the precise buffer level for a single Limitx tablet. A single LTX-03 dose formulated without any buffer achieved a Cmax of hydrocodone of 82% of the reference drug. Comparatively, the Cmax of acetaminophen in LTX-03 from the same non-buffered dose was 63% of the reference drug. The acetaminophen Cmax was 100% of the reference drug across all doses in Study 300 indicating the non-buffered Limitx cohort was apparently unduly affected by the over-encapsulation. We observed the time to maximum blood concentration (Tmax) for the over-encapsulated reference drug as compared to published standards was 60 (183%) minutes and 50 (188%) minutes longer for hydrocodone and acetaminophen, respectively. We plan to conduct another dose ranging study, AP-LTX-301, or Study 301, without using over-encapsulated tablets. We expect to commence Study 301 in the fourth quarter of 2017, with topline results expected in the first quarter of 2018. We believe the results of Study 301 will guide us on the final formulation of LTX-03 tablets, which will combine the hydrocodone micro-particles, acetaminophen and buffer ingredients into a single tablet. We also plan to identify a commercial manufacturer to assist in finalizing the LTX-03 formulation. Aversion Technology Aversion Technology incorporates gelling ingredients and irritants into tablets to discourage abuse by snorting and provide barriers to abuse by injection. Our Aversion Technology and related opioid products, like Oxaydo, are covered by claims in five issued U.S. patents, which expire between 2023 and 2025. Our Aversion Technology products are intended to provide the same therapeutic benefits of the active drug ingredient as currently marketed products containing the same active pharmaceutical ingredient. 31 -- Oxaydo Tablets Oxaydo (oxycodone HCI tablets) is a Schedule II narcotic indicated for the management of acute and chronic moderate to severe pain where the use of an opioid analgesic is appropriate. On January 7, 2015, we entered into a Collaboration and License Agreement with Egalet pursuant to which we exclusively licensed to Egalet worldwide rights to manufacture and commercialize Oxaydo. Oxaydo is approved in 5mg and 7.5mg strengths. Egalet launched Oxaydo in the United States late in the third quarter of 2015. The 2016 market for immediate-release oxycodone products was 20.1 million dispensed prescription or 1.7 billion tablets. The current market is predominately serviced by generic formulations that contain no abuse deterrent features and sell for approximately $0.10 to $0.40 per tablet, depending on strength. Immediate-release opioids are prescribed by a broad cross-section of healthcare providers including primary care physicians, surgeons and pain specialists. We believe Oxaydo, given its differentiated label compared to generic products, can offer an alternative for opioid prescribing physicians concerned with the abuse or diversion for abuse of their prescriptions even at premium pricing to generics. The safety and efficacy of Oxaydo 5mg and 7.5mg tablets was established by demonstrating bioequivalence to commercially available oxycodone immediate-release tablets in the fasted state. Oxaydo differs from oxycodone tablets when taken with a high fat meal though these differences are not considered clinically relevant, and Oxaydo can be taken without regard to food. The FDA-approved label for Oxaydo describes elements unique to our Aversion Technology, which differs from current commercially available oxycodone immediate-release tablets. The label for Oxaydo includes the results from a clinical study that evaluated the effects of nasally snorting crushed Oxaydo and commercially available oxycodone tablets, and limitations on exposing Oxaydo tablets to water and other solvents and administration through feeding tubes. The clinical study evaluated 40 non-dependent recreational opioid users, who self-administered the equivalent of 15mg of oxycodone. After accounting for a first sequence effect, the study demonstrated: · | 30% of subjects exposed to Oxaydo responded that they would not take the drug again compared to 5% of subjects exposed to immediate-release oxycodone; --+------------------------------------------------------------------------------------------------------------------------------------------------------- · | subjects taking Oxaydo reported a higher incidence of nasopharyngeal and facial adverse events compared to immediate-release oxycodone; --+---------------------------------------------------------------------------------------------------------------------------------------- · | a decreased ability to completely insufflate two crushed Oxaydo tablets within a fixed time period (21 of 40 subjects), while all subjects were able to completely insufflate the entire dose of immediate-release oxycodone; and --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | small numeric differences in the median and mean drug liking scores, which were lower in response to Oxaydo than immediate-release oxycodone. --+---------------------------------------------------------------------------------------------------------------------------------------------- Although we believe these abuse deterrent characteristics differentiate Oxaydo from older immediate-release oxycodone products currently on the market, consistent with FDA guidance which requires epidemiology studies to support a claim of abuse deterrence, the clinical significance of the difference in drug liking and difference in response to taking the drug again in this study has not been established. There is no evidence that Oxaydo has a reduced abuse liability compared to immediate release oxycodone. We and Egalet have a post-approval commitment with the FDA to perform an epidemiology study to assess the actual impact on abuse of Oxaydo tablets. Further, the Oxaydo product label guides patients not to crush and dissolve the tablets or pre-soak, lick or otherwise wet the tablets prior to administration. Similarly, caregivers are advised not to crush and dissolve the tablets or otherwise use Oxaydo for administration via nasogastric, gastric or other feeding tubes as it may cause an obstruction. Our laboratory studies demonstrated that the Oxaydo tablet may gel when Oxaydo is exposed to certain solvents, including water. Egalet has advised us that it has commenced formulation work on a 15mg dosage strength for Oxaydo, has achieved bioequivalence of this new strength to a reference formulation, and has set a target date for submission of this new dosage strength to the FDA in the second half of 2017. Egalet has also advised that late in the fourth quarter of 2016 it filed a supplemental NDA for Oxaydo with the FDA to support an abuse-deterrent label claim for the intravenous route of abuse. 32 -- We are advised that Egalet commenced promoting Oxaydo in September 2015 and is targeting approximately 6,000 immediate-release opioid prescribing physicians using approximately 50 sales representatives. Commercial shipments of Oxaydo commenced in early October 2015. Egalet has further advised us that they have implemented a co-pay support program in which any non-government insurance covered patient receiving an Oxaydo prescription will be eligible to receive a credit such that their out-of-pocket cost, or co-pay, is limited to $15 per prescription. On June 20, 2017, Egalet announced that it had received a complete response letter from the FDA in response to its prior approval supplement to the Oxaydo NDA seeking approval for 10mg and 15mg strengths of Oxaydo. Eaglet has advised that the FDA is requesting more information regarding the effect of food on Oxaydo 15mg and the intranasal abuse-deterrent properties of Oxaydo 10mg and 15mg. Egalet Agreement Covering Oxaydo On January 7, 2015, we and Egalet US, Inc. and Egalet Ltd., each a subsidiary of Egalet Corporation, or Egalet, entered into a Collaboration and License Agreement, or the Egalet Agreement, to commercialize Oxaydo tablets containing our Aversion® Technology. Oxaydo is approved by the FDA for marketing in the United States in 5 mg and 7.5 mg strengths. Under the terms of the Egalet Agreement, we transferred the approved NDA for Oxaydo to Egalet and Egalet is granted an exclusive license under our intellectual property rights for development and commercialization of Oxaydo worldwide, or the Territory, in all strengths, subject to our right to co-promote Oxaydo in the United States. In accordance with the Egalet Agreement, we and Egalet have formed a joint steering committee to oversee commercialization strategies and the development of product line extensions. Egalet will pay a significant portion of the expenses relating to (i) annual NDA PDUFA product fees, (ii) expenses of the FDA required post-marketing study for Oxaydo and (iii) expenses of clinical studies for product line extensions (additional strengths) of Oxaydo for the United States and will bear all of the expenses of development and regulatory approval of Oxaydo for sale outside the United States. Egalet is responsible for all manufacturing and commercialization activities in the Territory for Oxaydo. Subject to certain exceptions, Egalet will have final decision making authority with respect to all development and commercialization activities for Oxaydo, including pricing, subject to our co-promotion right. Egalet may develop Oxaydo for other countries and in additional strengths, in its discretion. Egalet paid us an upfront payment of $5.0 million upon signing of the Egalet Agreement and a $2.5 million milestone in October 2015 in connection with the launch of Oxaydo. In addition, we will be entitled to a one-time $12.5 million milestone payment when worldwide Oxaydo net sales reach $150.0 million in a calendar year. In addition, we will receive from Egalet a stepped royalty at percentage rates ranging from mid-single digits to double-digits on net sales during a calendar year based on Oxaydo net sales during such year (excluding net sales resulting from our co-promotion efforts). In any calendar year in which net sales exceed a specified threshold, we will receive a double digit royalty on all Oxaydo net sales in that year (excluding net sales resulting from our co-promotion efforts). If we exercise our co-promotion rights, we will receive a share of the gross margin attributable to incremental Oxaydo net sales from our co-promotion activities. Egalet’s royalty payment obligations commenced on the first commercial sale of Oxaydo and expire, on a country-by-country basis, upon the expiration of the last to expire valid patent claim covering Oxaydo in such country (or if there are no patent claims in such country, then upon the expiration of the last valid claim in the United States or the date when no valid and enforceable listable patent in the FDA’s Orange Book remains with respect to the Product). Royalties will be reduced upon the entry of generic equivalents, as well as for payments required to be made by Egalet to acquire intellectual property rights to commercialize Oxaydo, with an aggregate minimum floor. The Egalet Agreement expires upon the expiration of Egalet’s royalty payment obligations in all countries. Either party may terminate the Egalet Agreement in its entirety if the other party breaches a payment obligation, or otherwise materially breaches the Egalet Agreement, subject to applicable cure periods, or in the event the other party makes an assignment for the benefit of creditors, files a petition in bankruptcy or otherwise seeks relief under applicable bankruptcy laws. We also may terminate the Egalet Agreement with respect to the U.S. and other countries if Egalet materially breaches its commercialization obligations. Egalet may terminate the Egalet Agreement for convenience on 120 days prior written notice, which termination may not occur prior to the second anniversary of Egalet’s launch of Oxaydo. Termination does not affect a party’s rights accrued prior thereto, but there are no stated payments in connection with termination other than payments of obligations previously accrued. For all terminations (but not expiration), the Egalet Agreement provides for the transition of development and marketing of Oxaydo from Egalet to us, including the conveyance by Egalet to us of the trademarks and all regulatory filings and approvals relating to Oxaydo, and for Egalet’s supply of Oxaydo for a transition period. 33 -- KemPharm Agreement Covering Opioid Prodrugs On October 13, 2016, we and KemPharm Inc., or KemPharm, entered into a worldwide License Agreement, or the KemPharm Agreement, pursuant to which we licensed our Aversion® technology to KemPharm for its use in the development and commercialization of three products using 2 of KemPharm’s prodrug candidates. KemPharm has also been granted an option to extend the KemPharm Agreement to cover two additional prodrug candidates. KemPharm is responsible for all development, manufacturing and commercialization activities, although we may provide initial technical assistance. Upon execution of the KemPharm Agreement, KemPharm paid us an upfront payment of $3.5 million. If KemPharm exercises its option to use our Aversion technology with more than the 2 prodrugs licensed, then KemPharm will pay us up to $1.0 million for each additional prodrug license. In addition, we will receive from KemPharm a low single digit royalty on commercial sales by KemPharm of products developed using our Aversion technology under the KemPharm Agreement. KemPharm’s royalty payment obligations commence on the first commercial sale of a product using our Aversion technology and expire, on a country-by-country basis, upon the expiration of the last to expire patent claim of the Aversion technology covering a product in such country, at which time the license for the particular product and country becomes fully paid and royalty free. The KemPharm Agreement expires upon the expiration of KemPharm’s royalty payment obligations in all countries. Either party may terminate the KemPharm Agreement in its entirety if the other party materially breaches the KemPharm Agreement, subject to applicable cure periods. Acura or KemPharm may terminate the KemPharm Agreement with respect to the U.S. and other countries if the other party challenges the patents covering the licensed products. KemPharm may terminate the KemPharm Agreement for convenience on ninety (90) days prior written notice. Termination does not affect a party’s rights accrued prior thereto, but there are no stated payments in connection with termination other than payments of obligations previously accrued. For all terminations (but not expiration), the KemPharm Agreement provides for termination of our license grant to KemPharm. Aversion Technology Development Opioid Products On April 9, 2015, we announced the indefinite suspension of further development of our Aversion hydrocodone/APAP product candidate, in order to focus our time and available resources on the development of our Limitx technology product candidates. We currently have 6 additional opioids at various stages of formulation development using the Aversion Technology which are not being actively developed. Abuse of Pseudoephedrine Products The chemical structure of pseudoephedrine, or PSE, is very similar to methamphetamine, facilitating a straight-forward chemical conversion to methamphetamine. OTC PSE products are sometimes purchased and used for this conversion. There are multiple known processes to convert PSE to methamphetamine, all of which are not complex and do not require specialized equipment; however, many do require readily available but uncommon ingredients. Two of the three most popular processes follow two general processing steps: (1) dissolving the PSE tablets in a solvent to isolate, by filtration, purified PSE and (2) a chemical reduction of the PSE into methamphetamine for drying into crystals. The third method, or the “one-pot” method, involves the direct chemical reduction of the PSE to methamphetamine in the presence of the tablet’s inactive ingredients. All the solvents used are ultimately dried off or otherwise removed, so a wide range of solvents are amenable to the process. Impede 1.0 Technology Our Impede 1.0 Technology, a proprietary mixture of inactive ingredients, prevents the extraction of PSE from tablets using known extraction methods and disrupts the direct conversion of PSE from tablets into methamphetamine. 34 -- Studies sponsored by us at an international, independent laboratory demonstrated our Impede 1.0 Technology prevents the extraction of PSE from tablets for conversion into methamphetamine using what we believe are the two most common extraction methods, each requiring extraction of PSE as an initial step. Laboratory tests conducted on our behalf by an independent Clinical Research Organization, or CRO, using the “one-pot” method demonstrated that our Impede Technology disrupted the direct conversion of PSE from the tablets into methamphetamine. The study compared the amount of pure methamphetamine hydrochloride produced from Nexafed and Johnson & Johnson’s Sudafed® tablets. Using one hundred 30 mg tablets of both products, multiple one-pot tests and a variety of commonly used solvents, the study demonstrated an average of 38% of the maximum 2.7 grams of pure methamphetamine hydrochloride was recovered from Nexafed. Comparatively, approximately twice as much pure methamphetamine hydrochloride was recovered from Sudafed tablets. Both products yielded a substantial amount of additional solids such that the purity of the total powder provided contained approximately 65% methamphetamine hydrochloride. Impede 2.0 Technology We have developed a next generation, or Impede 2.0 Technology to improve the meth-resistance of our technology. We have completed one-pot, direct conversion meth testing performed by our CRO on the following commercially available products and on our Nexafed Impede 2.0 extended-release product, with the following results: Product/Formulation | Meth Resistant Technology | Meth Recovery1 | | | Purity2 ---------------------------------------+----------------------------+----------------+----+---+-------- Sudafed® 30mg Tablets | none | | 67 | % | | 62 | % ---------------------------------------+----------------------------+----------------+----+---+---------+----+-- Nexafed 30mg Technology | Impede® 1.0 | | 38 | % | | 65 | % ---------------------------------------+----------------------------+----------------+----+---+---------+----+-- Zephrex-D® 30mg Pills | Tarex® | | 28 | % | | 51 | % ---------------------------------------+----------------------------+----------------+----+---+---------+----+-- Nexafed 120mg Extended-release tablets | Impede® 2.0 | | 17 | % | | 34 | % ---------------------------------------+----------------------------+----------------+----+---+---------+----+-- 1 | Total methamphetamine HCl recovered from the equivalent of 100 PSE 30mg tablets divided by the maximum theoretical yield of 2.7 grams. --+--------------------------------------------------------------------------------------------------------------------------------------- 2 | Total methamphetamine HCl recovered from the equivalent of 100 PSE 30mg tablets divided by the total weight of powder recovered. --+--------------------------------------------------------------------------------------------------------------------------------- We have demonstrated in a pilot clinical study the bioequivalence of a formulation of our Nexafed extended release tablets utilizing our Impede 2.0 Technology to Sudafed® 12-hour Tablets. We have completed a project to integrate Impede 2.0 Technology into our commercially available Nexafed 30mg tablet while moving supply to an alternate contract manufacturer. We have completed process validation on this new formulation and we believe MainPointe launched the new formulation into the market in the 3rd quarter of 2017. Nexafed Products The Nexafed products currently marketed consist of immediate release tablets which currently utilize our patented Impede 1.0 Technology. Nexafed is a 30mg pseudoephedrine tablet and Nexafed Sinus Pressure + Pain is a 30/325mg pseudoephedrine and acetaminophen tablet. PSE is a widely-used nasal decongestant available in many non-prescription and prescription cold, sinus and allergy products. While the 30mg PSE tablet is not the largest selling PSE product on the market, we believe it is the most often used product to make meth due to: (a) its relatively low selling price and (b) its simpler formulation provides better meth yields. However, as meth-resistant products become pervasive, we believe meth cooks will migrate to other, larger selling, PSE containing products. We have demonstrated that our Nexafed 30mg tablets are bioequivalent to Johnson & Johnson’s Sudafed 30mg Tablets when a single 2 tablet dose is administered. Commencing in 2006, the CMEA, required all non-prescription PSE products to be held securely behind the pharmacy counter, has set monthly consumer purchase volume limits, and has necessitated consumer interaction with pharmacy personnel to purchase PSE-containing products. Prior the MainPointe Agreement completed in March 2017, we capitalized on this consumer-pharmacist interaction at the point of sale by soliciting distribution to pharmacies and educating and encouraging pharmacists to recommend Nexafed to their customers. We launched Nexafed commercially in mid-December 2012 into the United States OTC market for cold and allergy products. At March 15, 2017, Nexafed was stocked in approximately 13,900 pharmacies or about approximately 21% of the estimated 65,000 U.S. pharmacy outlets. Initial adoption was primarily in independent pharmacies in predominately rural communities with high meth awareness. Chain pharmacies, with more centralized control of the pharmacy operations, began adopting in mid-2013, including Kroger, Publix, Fruth and Bartells. Some pharmacists actively recommend Nexafed to their customers while some have replaced all 30mg PSE products, brand and generic, with Nexafed. Rite Aid, the nation’s fourth largest pharmacy operator, began purchasing Nexafed in late 2013. In late 2014, Kmart and Kroger initiated chain-wide stocking of Nexafed. 35 -- In February 2015, we began initial shipments of Nexafed Sinus Pressure + Pain. Prior to the MainPointe Agreement, we were marketing this product consistent with our Nexafed marketing efforts to pharmacists concerned with meth abuse of their products. We are not aware of any branded non-prescription product that contains PSE and acetaminophen believing that brands containing these ingredients have either been discontinued or reformulated with phenylephrine. We expect Nexafed Sinus Pressure + Pain to compete primarily against Advil® Cold and Sinus (PSE/ibuprofen) and to a lesser extent Aleve®-D and Sudafed® Pressure + Pain which are extended-release products. Nexafed and Nexafed Sinus Pressure + Pain products are marketed under FDA’s regulations applicable to OTC Monograph products. Nexafed and Nexafed Sinus Pressure + Pain tablets are offered in 24-count blister packaged cartons. MainPointe Agreement covering Nexafed Products On March 16, 2017, we and MainPointe entered into a License, Commercialization and Option Agreement, or the MainPointe Agreement, pursuant to which we granted MainPointe an exclusive license to our Impede technology to commercialize our Nexafed products in the U.S. and Canada. We also conveyed to MainPointe our existing inventory and equipment relating to our Nexafed products. MainPointe is responsible for all development, manufacturing and commercialization activities with respect to products covered by the Agreement. On signing the MainPointe Agreement, MainPointe paid us an upfront licensing fee of $2.5 million plus approximately $309 thousand for the net book value of inventory and equipment being transferred. The MainPointe Agreement also provides for our receipt of a 7.5% royalty on net sales of licensed products. The royalty payment for each product will expire on a country-by-country basis when the Impede® patent rights for such country have expired or are no longer valid; provided that if no Impede patent right exists in a country, then the royalty term for that country will be the same as the royalty term for the United States. After the expiration of a royalty term for a country, MainPointe retains a royalty free license to our Impede® technology for products covered by the Agreement in such country. MainPointe has the option to expand the licensed territory beyond the United States and Canada to the European Union (and the United Kingdom), Japan and South Korea for payments of $1.0 million, $500 thousand and $250 thousand, respectively. In addition, MainPointe has the option to add to the MainPointe Agreement certain additional products, or Option Products, containing PSE and utilizing the Impede technology for a fee of $500 thousand per product (for all product strengths), including the product candidate Loratadine with pseudoephedrine. If the territory has been expanded prior to the exercise of a product option, the option fee will be increased to $750 thousand per product. If the territory is expanded after the payment of the $500 thousand product option fee, a one-time $250 thousand fee will be due for each product. If a third party is interested in developing or licensing rights to an Option Product, MainPointe must exercise its option for that product or its option rights for such product will terminate. The MainPointe Agreement may be terminated by either party for a material breach of the other party, or by Acura if MainPointe challenges certain of its patents. Upon early termination of the MainPointe Agreement, MainPointe’s licenses to the Impede technology and all products will terminate. Upon termination, at Acura’s request the parties will use commercially reasonable efforts to transition the Nexafed® and Nexafed® Sinus Pressure + Pain products back to Acura. Impede Technology Products in Development Given the fragmented nature of the PSE market with products containing multiple active ingredients, we are developing additional products for our Nexafed franchise: Impede Technology Product | Status ----------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------- Nexafed 30mg with Impede 2.0 Technology | Manufacturing validation complete. We believe MainPointe launched commercial shipments in third quarter of 2017. ----------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------- Immediate-release pseudoephedrine HCl in combination with other cold and allergy active ingredients | Nexafed Sinus Pressure + Pain launched and licensed to MainPointe. Other formulations being considered. ----------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------- Extended-release formulation utilizing Impede 2.0 Technology | Pilot pharmacokinetic testing demonstrated bioequivalence to Sudafed® 12-hour Tablets. Pre-IND meeting held with the FDA. ----------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------- Extended-release combination products | Formulations being considered. ----------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------- Loratadine with pseudoephedrine | Final formulation development in process. ----------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------- 36 -- In July 2015, we had a pre-IND meeting with the FDA to discuss the results from our pharmacokinetic and meth-resistance testing studies to determine the development path for our extended-release development product. The FDA acknowledged the potential value of the development of risk-mitigating strategies for new formulations of pseudoephedrine products while also recognizing an approved “meth-deterrent” extended release pseudoephedrine product would be novel in the over-the-counter (OTC) setting. The FDA did not make a formal determination whether “meth-resistant” claims would be appropriate but is open to consider such an appropriately worded, evidence-based claim directed to the consumer and/or retailer. As recommended by the FDA, we have submitted additional “meth-resistant” testing information to the FDA for review prior to submitting an IND. In October 2016, we received FDA recommendations on our meth-resistant testing protocols for our Nexafed extended release tablets. We can now scale-up our manufacture batch size at a contract manufacturer which allows us to submit an IND to the FDA for our Nexafed extended release tablets, however, we have not yet committed to that level of development. In March 2017, we completed a pilot pharmacokinetic study for the PSE-containing combination product using our Impede 1.0 technology we were formerly developing for Bayer. The study in 24 healthy adult subjects demonstrated sufficient, but not bioequivalent blood levels of PSE to the comparator while the second active ingredient achieved bioequivalence. Based on the product profile, the Company believes this formulation can be moved into final development for a 5050(b)(2) NDA submission. The Company intends to upgrade this formulation with its Impede 2.0 technology before determining any advancement in development. Our objective is to establish, either directly or through third-party licensees, the Nexafed franchise in the United States with multiple product offerings, including both immediate and extended release products utilizing both single and combinations of active ingredients. We aim to make meth-resistant PSE product the standard of care in all U.S. pharmacies. In addition to the MainPointe Agreement, we may license our Impede technology to commercial partners to extend our internal development resources to develop difficult to formulate products, such as extended-release. Bayer Agreement On June 15, 2015, we and Bayer entered into a License and Development Agreement, or the Bayer Agreement, pursuant to which we granted Bayer an exclusive worldwide license to our Impede® Technology for use in an undisclosed methamphetamine resistant pseudoephedrine-containing product and providing for the joint development of such product using our Impede Technology for the U.S. market. We received reimbursement of certain our development expenses, and were entitled to success-based development and regulatory milestone payments, and low mid-single digit royalties on the net sales of the developed product. On June 28, 2017, we received Bayer’s written notice terminating the Bayer Agreement. Bayer exercised its convenience termination right prior to the completion of our development obligations under the Bayer Agreement, which we believe is as a result of Bayer’s de-prioritization of development of the methamphetamine resistant PSE-containing product contemplated in the Agreement. As a result of the termination, MainPointe has the option to license such product in the U.S. and Canada upon payment to us of $500 thousand, together with royalty of 7.5% of net sales of such product, under the MainPointe Agreement. U.S. Market Opportunity for Impede PSE Products PSE is a widely-used nasal decongestant available in many non-prescription and prescription cold, sinus and allergy products. PSE is sold in products as the only active ingredient in both immediate and extended-release products. In addition, PSE is combined with other cold, sinus and allergy ingredients such as pain relievers, cough suppressants and antihistamines. PSE also competes against phenylephrine, an alternate nasal decongestant available in non-prescription products. In 2014, a data service reported approximately $0.7 billion in retail sales of non-prescription products containing PSE. The top retail selling PSE OTC cold/allergy products in 2014 were: 37 -- Reference Brand1 | Brand Company | Active Ingredient(s) | 2014 Retail Sales ($ Millions) | -----------------+---------------+----------------------+--------------------------------+------ Claritin-D | Bayer | PSE & Loraditine2 | $ | 208.0 -----------------+---------------+----------------------+--------------------------------+------ Allegra-D | Chattem | PSE & Fexofenadine2 | $ | 101.3 -----------------+---------------+----------------------+--------------------------------+------ Zyrtec-D | Pfizer | PSE & Ceterizine2 | $ | 101.7 -----------------+---------------+----------------------+--------------------------------+------ Advil Sinus | Pfizer | PSE & Ibuprofen | $ | 58.4 -----------------+---------------+----------------------+--------------------------------+------ Sudafed 12 Hour | J&J | PSE2 | $ | 82.3 -----------------+---------------+----------------------+--------------------------------+------ Sudafed 30mg | J&J | PSE | $ | 70.4 -----------------+---------------+----------------------+--------------------------------+------ 1 | Branded product only. Does not include store brand sales. --+---------------------------------------------------------- 2 | Extended release PSE formulations --+---------------------------------- The 2014 market for 30mg PSE tablets, including store brands was approximately 470 million tablets or 19 million boxes of 24 tablets. MainPointe will control the price of Nexafed and Nexafed Sinus under the terms of the MainPointe Agreement. The market for cold, sinus and allergy products is highly competitive and many products have strong consumer brand recognition and, in some cases, prescription drug heritage. Category leading brands are often supported by national mass marketing and promotional efforts. Consumers often have a choice to purchase a less expensive store brand. Store brands contain the same active ingredients as the more popular national brands but are not supported by large marketing campaigns and are offered at a lower price. Non-prescription products are typically distributed through retail outlets including drug store chains, food store chains, independent pharmacies and mass merchandisers. The distribution outlets for PSE products are highly consolidated. According to Chain Drug Review, the top 50 drug, food and mass merchandising chains operate approximately 40,000 pharmacies in the U.S., of which 58% are operated by the four largest chains. Stocking decisions and pharmacists recommendations for these chain pharmacies are often centralized at the corporate headquarters. Product Labeling for Impede Technology Products Nexafed and Nexafed Sinus Pressure + Pain products are marketed pursuant to the FDA’s OTC Monograph regulations, which require that our product have labeling as specified in the regulations. Marketing for the Nexafed products includes advertising the extraction characteristics and methamphetamine-resistant benefits of these products which is supported by our published research studies. We expect that any of our other Impede Technology products that are marketed pursuant to an NDA or ANDA will be subject to a label approved by the FDA. We expect that such a label will require submission of our scientifically derived abuse liability data and we intend to seek descriptions of our abuse liability studies in the FDA approved product label, although there can be no assurance that this will be the case. U.S. Market Opportunity for Opioid Analgesic Products The misuse and abuse of controlled prescription drugs, or CPDs, in general, and opioid analgesics in particular, continues to constitute a dynamic and challenging threat to the United States and is the nation’s fastest growing drug problem. Results from the 2013 National Drug Threat Assessment conducted by the U.S. Drug Enforcement Administration, or DEA, report that CPD rates of abuse remain high, with individuals abusing CPDs at a higher prevalence rate than any illicit drug except marijuana. Opioid analgesics are the most common type of CPDs taken illicitly and are the CPDs most commonly involved in overdose incidents. According to the Drug Abuse Warning Network (DAWN), the estimated number of emergency department visits involving nonmedical use of prescription opiates/ opioids increased 112 percent—84,671 to 179,787— between 2006 and 2010. Immediate release, or IR, opioid products comprise the vast majority of this abuse compared with extended release, or ER, opioid products. It is estimated that more than 75 million people in the United States suffer from pain and the FDA estimates more than 45 million people receive a prescription for the opioid hydrocodone annually. For many pain sufferers, opioid analgesics provide their only pain relief. As a result, opioid analgesics are among the largest prescription drug classes in the United States with over 222 million tablet and capsule prescriptions dispensed in 2016 of which approximately 208 million were for IR opioid products and 14 million were for ER opioid products. However, physicians and other health care providers at times are reluctant to prescribe opioid analgesics for fear of misuse, abuse, and diversion of legitimate prescriptions for illicit use. 38 -- We expect our Aversion and Limitx Technology opioid products, to compete primarily in the IR opioid product segment of the United States opioid analgesic market. Because IR opioid products are used for both acute and chronic pain, a prescription, on average, contains 66 tablets or capsules. According to IMS Health, in 2016, sales in the IR opioid product segment were approximately $2.7 billion, of which ~98% was attributable to generic products. Due to fewer identified competitors and the significantly larger market for dispensed prescriptions for IR opioid products compared to ER opioid products, we have initially focused on developing IR opioid products utilizing our Aversion and Limitx Technologies. A summary of the IR opioid product prescription data for 2016 is provided below: IR Opioid Products(1) | 2016 US Prescriptions (Millions)(2) | | % of Total ----------------------+--------------------------------------------+-----+------------ Hydrocodone | | 90 | | 43 | % ----------------------+--------------------------------------------+-----+-------------+-----+-- Oxycodone | | 55 | | 26 | % ----------------------+--------------------------------------------+-----+-------------+-----+-- Tramadol | | 43 | | 21 | % ----------------------+--------------------------------------------+-----+-------------+-----+-- Codeine | | 15 | | 7 | % ----------------------+--------------------------------------------+-----+-------------+-----+-- 4 Others | | 5 | | 3 | % ----------------------+--------------------------------------------+-----+-------------+-----+-- Total | | 208 | | 100 | % ----------------------+--------------------------------------------+-----+-------------+-----+-- 1 | Includes all salts and esters of the opioid and opioids in combination with other active ingredients such as acetaminophen. --+---------------------------------------------------------------------------------------------------------------------------- 2 | IMS Health, 2016 --+----------------- Despite considerable publicity regarding the abuse of OxyContin® extended-release tablets and other ER opioid products, U.S. government statistics suggest that far more people have used IR opioid products non-medically than ER opioid products. These statistics estimate that nearly four times as many people have misused the IR opioid products Vicodin®, Lortab® and Lorcet® (hydrocodone bitartrate/acetaminophen brands and generics) than OxyContin®. Product Labeling for Abuse-Deterrent Opioid Products In April 2015, the FDA published guidance for industry on the evaluation and labeling of abuse-deterrent opioids. While the 2015 FDA Guidance is non-binding on the FDA, it outlines FDA’s current thinking on the development and labeling of abuse-deterrent products. The 2015 FDA Guidance provides for three distinct levels of pre-marketing studies that are potentially eligible for inclusion in the labeling: (1) laboratory-based in vitro manipulation and extraction studies, (2) pharmacokinetic studies, and (3) clinical abuse potential studies. The Guidance further prescribes additional post-approval or epidemiology studies to determine whether the marketing of a product with abuse-deterrent properties results in meaningful reductions in abuse, misuse, and related adverse clinical outcomes, including addiction, overdose, and death in the post-approval setting, which can also be included in the labeling. FDA notes “the science of abuse deterrence is relatively new. Both the technologies involved and the analytical, clinical, and statistical methods for evaluating those technologies are rapidly evolving. For these reasons, FDA will take a flexible, adaptive approach to the evaluation and labeling of potentially abuse-deterrent opioid products”. We or our licensee may seek to include descriptions of studies that characterize the abuse-deterrent properties in the label for our Aversion and Limitx Technology products in development. Although the FDA approved label for Oxaydo contains limitations on exposing Oxaydo tablets to water and other solvents and administration through feeding tubes, the FDA approved Oxaydo label does not contain a description of the I.V. injection studies we performed to characterize the abuse deterrent properties of Oxaydo. Egalet has committed to the FDA to undertake epidemiological studies to assess the actual consequences of abuse of Oxaydo in the market. Under the terms of the Egalet Agreement, we share a minority portion of the fees and expenses relating to such FDA required epidemiological studies. The extent to which a description of the abuse-deterrent properties or results of epidemiological or other studies will be added to or included in the FDA approved product label for our products in development will be the subject of our discussions with the FDA as part of the NDA review process, even after having obtained approval of Oxaydo. Further, because the FDA closely regulates promotional materials, even if FDA initially approves labeling that includes a description of the abuse deterrent properties of the product, the FDA’s Office of Prescription Drug Promotion, or OPDP, will continue to review the acceptability of promotional labeling claims and product advertising campaigns for our marketed products. 39 -- Patents and Patent Applications We have the following issued patent covering, among other things, our Limitx Technology: Patent No. (Jurisdiction) | Subject matter | Issued | Expires ---------------------------+-----------------------------------------------------------------------------------------------------------------+-----------+---------- 9,101,636 (US) | Abuse deterrent products wherein the release of active ingredient is retarded when 3 or more doses are consumed | Aug. 2015 | Nov. 2033 ---------------------------+-----------------------------------------------------------------------------------------------------------------+-----------+---------- 9,320,796 (US) | Abuse deterrent products wherein the release of active ingredient is retarded when 3 or more doses are consumed | Apr. 2016 | Nov. 2033 ---------------------------+-----------------------------------------------------------------------------------------------------------------+-----------+---------- 9,662,393 (US) | Abuse deterrent products wherein the release of active ingredient is retarded when 3 or more doses are consumed | May 2017 | Nov. 2033 ---------------------------+-----------------------------------------------------------------------------------------------------------------+-----------+---------- 2,892,908 (CAN) | Abuse deterrent products wherein the release of active ingredient is retarded when excessive doses are consumed | Apr. 2016 | Nov. 2033 ---------------------------+-----------------------------------------------------------------------------------------------------------------+-----------+---------- 5,922,851 (JAPAN) | Abuse deterrent products wherein the release of active ingredient is retarded when excessive doses are consumed | Apr. 2016 | Nov. 2033 ---------------------------+-----------------------------------------------------------------------------------------------------------------+-----------+---------- We have the following issued patents covering, among other things, Oxaydo and our Aversion Technology: Patent No. (Jurisdiction) | Subject Matter | Issued | Expires ---------------------------+-------------------------------------------------------------------------------------------------------------------+-----------+---------- 7,201,920 (US) | Pharmaceutical compositions including a mixture of functional inactive ingredients and specific opioid analgesics | Apr. 2007 | Mar. 2025 ---------------------------+-------------------------------------------------------------------------------------------------------------------+-----------+---------- 7,510,726 (US) | A wider range of compositions than those described in the 7,201,920 Patent | Mar. 2009 | Nov. 2023 ---------------------------+-------------------------------------------------------------------------------------------------------------------+-----------+---------- 7,981,439 (US) | Pharmaceutical compositions including any water soluble drug susceptible to abuse | Jul. 2011 | Aug. 2024 ---------------------------+-------------------------------------------------------------------------------------------------------------------+-----------+---------- 8,409,616 (US) | Pharmaceutical compositions of immediate-release abuse deterrent dosage forms | Apr. 2013 | Nov. 2023 ---------------------------+-------------------------------------------------------------------------------------------------------------------+-----------+---------- 8,637,540 (US) | Pharmaceutical compositions of immediate-release abuse deterrent opioid products | Jan. 2014 | Nov. 2023 ---------------------------+-------------------------------------------------------------------------------------------------------------------+-----------+---------- 9,492,443 (US) | Pharmaceutical compositions of immediate-release abuse deterrent opioid products | Nov. 2016 | Nov. 2023 ---------------------------+-------------------------------------------------------------------------------------------------------------------+-----------+---------- We have the following additional issued patents relating to our Aversion Technology: Patent No. (Jurisdiction) | Subject Matter | Issued | Expires ---------------------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-----------+---------- 7,476,402 (US) | Pharmaceutical compositions of certain combinations of kappa and mu opioid receptor agonists and other ingredients intended to deter opioid analgesic product misuse and abuse | Jan. 2009 | Nov. 2023 ---------------------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-----------+---------- 8,822,489 (US) | Pharmaceutical compositions of certain abuse deterrent products that contain polymers, surfactant and polysorb 80 | Jul. 2014 | Nov. 2023 ---------------------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-----------+---------- 2,004,294,953 (AUS) | Abuse deterrent pharmaceuticals | Apr. 2010 | Nov. 2024 ---------------------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-----------+---------- 2,010,200,979 (AUS) | Abuse deterrent pharmaceuticals | Aug. 2010 | Nov. 2024 ---------------------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-----------+---------- 2,547,334 (CAN) | Abuse deterrent pharmaceuticals | Aug. 2010 | Nov. 2024 ---------------------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-----------+---------- 2,647,360 (CAN) | Abuse deterrent pharmaceuticals | May 2012 | Apr. 2027 ---------------------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-----------+---------- 175,863 (ISR) | Abuse deterrent pharmaceuticals | Nov. 2004 | Nov. 2024 ---------------------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-----------+---------- 221,018 (ISR) | Abuse deterrent pharmaceuticals | Nov. 2004 | Nov. 2024 ---------------------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-----------+---------- 1694260 (EUR) | Abuse deterrent pharmaceuticals | Nov. 2004 | Nov. 2024 ---------------------------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-----------+---------- 40 -- We have the following issued patent covering, among other things, our Nexafed product line and Impede 1.0 and 2.0 Technologies: Patent No. (Jurisdiction) | Subject Matter | Issued | Expires --------------------------+--------------------------------------------------------------------------------------------------+-----------+---------- 8,901,113 (US) | Pharmaceutical compositions suitable for reducing the chemical conversion of precursor compounds | Dec. 2014 | Feb. 2032 --------------------------+--------------------------------------------------------------------------------------------------+-----------+---------- 9,757,466 (US) | Pharmaceutical compositions suitable for reducing the chemical conversion of precursor compounds | Sep. 2017 | Feb. 2032 --------------------------+--------------------------------------------------------------------------------------------------+-----------+---------- 2010300641 (AUS) | Pharmaceutical compositions suitable for reducing the chemical conversion of precursor compounds | Jun. 2016 | Sep. 2030 --------------------------+--------------------------------------------------------------------------------------------------+-----------+---------- 2,775,890 (CAN) | Pharmaceutical compositions suitable for reducing the chemical conversion of precursor compounds | Jun. 2016 | Sep. 2030 --------------------------+--------------------------------------------------------------------------------------------------+-----------+---------- 2,488,029 (EUR) | Pharmaceutical compositions suitable for reducing the chemical conversion of precursor compounds | Mar. 2016 | Sep. 2030 --------------------------+--------------------------------------------------------------------------------------------------+-----------+---------- 218533 (ISR) | Pharmaceutical compositions suitable for reducing the chemical conversion of precursor compounds | Jan. 2016 | Sep. 2030 --------------------------+--------------------------------------------------------------------------------------------------+-----------+---------- In addition to our issued patents listed above and additional unlisted issued patents, we have filed multiple U.S. patent applications and international patent applications relating to compositions containing abusable active pharmaceutical ingredients as well as applications covering our Impede 1.0 and 2.0 Technologies and filed U.S. patent applications for our Limitx Technology. Except for the rights granted in the Egalet Agreement, the KemPharm Agreement, and the MainPointe Agreement and in the patent infringement settlement agreements described below, we have retained all intellectual property rights to our Aversion Technology, Impede Technology, Limitx Technology and related product candidates. In 2012 and 2013, we received Paragraph IV Certification Notices from five generic sponsors of ANDAs for a generic drug listing our Oxaydo product as the reference listed drug. The Paragraph IV Notices referred to our 920, 726 and 439 Patents, which cover our Aversion® Technology and our Oxaydo product. We filed suit against each of such generic sponsors, Watson Laboratories, Inc., Par Pharmaceutical, Inc., Impax Laboratories, Inc., Sandoz Inc. and Ranbaxy Inc., in the United States District Court for the District of Delaware alleging infringement of our 726 Patent listed in the FDA’s Orange Book. Our litigation against Watson Laboratories was dismissed by us following Watson Laboratories’ change of its Paragraph IV Certification to a Paragraph III Certification, indicating it would not launch its generic product until the expiry of our applicable Patents. Our litigation against each of the remaining generic sponsors was settled during the period October 2013 through May 2014 on an individual basis, upon mutual agreement between us and such generic sponsors. None of such settlements impacted the validity or enforceability of our Patents. See our Annual Report on Form 10K under the caption “Item 1A. Risk Factors – Generic manufacturers are using litigation and regulatory means to seek approval for generic versions of Oxaydo, which could cause Egalet’s sales to suffer and adversely impact our royalty revenue” for a discussion of the settlements and license grants relating to such patent litigation. Notwithstanding the settlement of these prior infringement actions, it is possible that other generic manufacturers may also seek to launch a generic version of Oxaydo and challenge our patents. Any determination in such infringement actions that our patents covering our Aversion Technology and Oxaydo are invalid or unenforceable, in whole or in part, or that the products covered by generic sponsors’ ANDAs do not infringe our patents could have a material adverse effect on our operations and financial condition. In April, 2015, Purdue Pharma L.P., Purdue Pharmaceuticals L.P. and The P.F. Laboratories, Inc., or collectively Purdue, commenced a patent infringement lawsuit against us and our Oxaydo product licensee Egalet in the United States District Court for the District of Delaware alleging our Oxaydo product infringes Purdue’s U.S. Patent No. 8,389,007, or the 007 Patent. In April 2016, Purdue commenced a second patent infringement lawsuit against us and Egalet in the United States District Court for the District of Delaware alleging our Oxaydo product infringes Purdue’s newly issued U.S. Patent No. 9,308,171, or the 171 Patent. The actions regarding the 007 Patent and the 171 Patent are collectively referred to as the “Actions”. On April 6, 2016, we filed a petition for Inter Parties Review, or IPR Review, with the USPTO seeking to invalidate Purdue’s 007 Patent. 41 -- On May 20, 2016, we, Purdue and Egalet entered into a settlement agreement to settle the Actions and the IPR Review. Under the Settlement Agreement the parties dismissed or withdrew the Actions, requested that the USPTO terminate the IPR Review and exchanged mutual releases. No payments were made by the parties under the Settlement Agreement. The Settlement Agreement specifically excludes our patents related to our Impede and Limitx technologies from the scope of our patents subject to the Settlement Agreement. Reference is made to the Risk Factors contained in our Annual Report on Form 10-K for the year ended December 31, 2016 for a discussion, among other things, of patent applications and patents owned by third parties, including claims that may encompass our Aversion Technology and Oxaydo tablets, and the risk of infringement, interference or opposition proceedings that we may be subject to arising from such patents and patent applications. Company’s Present Financial Condition At September 30, 2017, we had cash and cash equivalents of $4.8 million, compared to $2.7 million of unrestricted cash and cash equivalents at December 31, 2016. We had an accumulated deficit of approximately $378.6 million at September 30, 2017. We had loss from operations of $3.5 million and net loss of $3.9 million for the nine months ended September 30, 2017 and we had a net loss from operations of $6.6 million and net loss of $7.4 million for the year ended December 31, 2016. We had cash and cash equivalents of $3.5 million at November 10, 2017. Our current cash and cash equivalents are expected to be sufficient to fund the development of our products and our related operating expenses only into April 2018. We expect to continue to incur substantial losses for the foreseeable future as we continue to develop our clinical and preclinical product candidates. To fund further operations and product development activities, we must raise additional financing or enter into license or collaboration agreements with third parties relating to our technologies. No assurance can be given that we will be successful in obtaining any such financing or in securing license or collaboration agreements with third parties on acceptable terms, if at all, or if secured, that such financing or license or collaboration agreements will provide payments to the Company sufficient to fund continued operations. In the absence of such financing or third-party license or collaboration agreements, the Company will be required to scale back or terminate operations and/or seek protection under applicable bankruptcy laws. An extended delay or cessation of the Company’s continuing product development efforts will have a material adverse effect on the Company’s financial condition and results of operations. Our losses have resulted principally from costs incurred in connection with research and development activities, salaries and other personnel-related costs and sales, marketing and general corporate expenses. Research and development activities include costs of pre-clinical studies, clinical trials, and clinical trial product supplies associated with our product candidates as well as cost sharing expenses of line extension studies and post-marketing studies under the Egalet Agreement. Sales and marketing expenses include costs associated with the Nexafed product line advertising, salaries and other personnel-related costs include the stock-based compensation associated with stock options and restricted stock units granted to employees and non-employee directors. 42 -- Three months Ended September 30, 2017 Compared to Three months Ended September 30, 2016 | September 30 | | | | -----------------------------------------------+--------------+--------+---+---------+-- | 2017 | | | 2016 | | | Increase (decrease) -----------------------------------------------+--------------+--------+---+---------+---+--------+-------------------- | $000’s | | | Percent | -----------------------------------------------+--------------+--------+---+---------+-- Revenues: | | | | | | | | | | | -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+------+---+------+--- Collaboration revenue | $ | - | | | $ | 74 | | (74 | ) | (100 | )% -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+------+---+------+--- Royalty revenue | | 83 | | | | 39 | | 44 | | 113 | -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+------+---+------+--- Product sales, net | | - | | | | 105 | | (105 | ) | (100 | ) -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+------+---+------+--- Total revenues, net | | 83 | | | | 218 | | (135 | ) | (62 | ) -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+------+---+------+--- Cost and expenses: | | | | | | | | | | | -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+------+---+------+--- Cost of sales (excluding inventory provisions) | | - | | | | 108 | | (108 | ) | (100 | ) -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+------+---+------+--- Inventory provisions | | - | | | | - | | - | | - | -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+------+---+------+--- Research and development | | 1,077 | | | | 841 | | 236 | | 28 | -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+------+---+------+--- Sales, marketing, general and administrative | | 1,068 | | | | 1,338 | | (270 | ) | (20 | ) -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+------+---+------+--- Total operating expenses | | 2,145 | | | | 2,287 | | (142 | ) | (6 | ) -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+------+---+------+--- Operating loss | | (2,062 | ) | | | (2,069 | ) | (7 | ) | - | -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+------+---+------+--- Non-operating income (expense): | | | | | | | | | | | -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+------+---+------+--- Investment income | | 1 | | | | 11 | | (10 | ) | (91 | ) -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+------+---+------+--- Interest expense | | (139 | ) | | | (215 | ) | (76 | ) | (35 | ) -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+------+---+------+--- Other expense | | - | | | | 23 | | (23 | ) | (100 | ) -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+------+---+------+--- Total other expense, net | | (138 | ) | | | (181 | ) | (43 | ) | (24 | ) -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+------+---+------+--- Loss before provision for income taxes | | (2,200 | ) | | | (2,250 | ) | (50 | ) | (2 | ) -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+------+---+------+--- Provision for income taxes | | - | | | | - | | - | | - | -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+------+---+------+--- Net loss | | (2,200 | ) | | | (2,250 | ) | (50 | ) | (2 | ) -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+------+---+------+--- Revenue Collaboration Collaboration revenue is derived from reimbursement of development expenses under various development agreements we may enter into, such as from our former collaboration agreement with Bayer, and are recognized when costs are incurred pursuant to the collaboration agreement. We did not have collaboration revenue for the three months ended September 30, 2017. We recognized $74 thousand of collaboration revenue during the three months ended September 30, 2016. Royalties In connection with our agreement with Egalet for Oxaydo tablets, we earn a royalty based on Oxaydo net sales. Egalet’s first commercial sale of Oxaydo occurred in October 2015. We recognized $78 thousand and $39 thousand of royalty revenue during the three months ended September 30, 2017 and 2016, respectively. In connection with our March 2017 agreement with MainPointe for the Nexafed product line, we earn a royalty of 7.5% on net sales of the licensed products. We recognized $5 thousand of royalty revenue during the three months ended September 30, 2017. Net Product Sales In March 2017 we stopped selling the Nexafed product line as we licensed the product line to MainPointe, who is actively manufacturing, distributing, and selling the Nexafed product line. Cost and Expenses Research and Development Research and development expense (R&D) is primarily for our Limitx Technology and Impede Technology development activity and may include costs of preclinical and non-clinical internal and external activities, clinical study trials, clinical supplies and its related formulation and design costs, salaries and other personnel related expenses of our employees, our facility costs, and a percentage share of cost sharing expenses for Oxaydo under the Egalet Agreement. For each of the three months ended September 30, 2017 and 2016, we did not incur cost sharing expenses from clinical studies for product line extensions (additional strengths) on Oxaydo. For the three months ended September 30, 2017 there is approximately $47 thousand of cost sharing expenses for a FDA required post-marketing study. We did not incur cost sharing expenses from a post-marketing study during the three months ended September 30, 2016. Also included in each of 2017 and 2016 quarterly results are non-cash share-based compensation expenses of approximately $38 thousand and $43 thousand, respectively. Excluding the share-based compensation expense, our R&D expenses increased approximately $241 thousand between reporting periods. During the third quarter of 2017, we completed Study AP-LTX-401 and we initiated and substantially completed Study AP-LTX-300. We believe MainPointe launched commercial shipments of Nexafed 30mg with Impede 2.0 into the market during the third quarter of 2017. 43 -- General, Administrative, Selling and Marketing Our selling and marketing expenses are primarily for the advertising and marketing activities on the Nexafed product line. In March 2017 we licensed the Nexafed product line to MainPointe and did not have any associated advertising and marketing expense during the three months ended September 30, 2017. Our general and administrative expenses primarily consisted of legal, audit and other professional services, corporate insurance, and payroll. Included in each of the three months ended September 30, 2017 and 2016 results are non-cash share-based compensation expenses of approximately $82 thousand and $107 thousand, respectively. Excluding the share-based compensation expense our selling, marketing, general and administrative expenses decreased by approximately $245 thousand between reporting periods, resulting primarily from the elimination of advertising and marketing activities on the Nexafed product line as well as decreases in patent and general legal activities. Non-Operating Income (Expense) During the three months ended September 30, 2017 and 2016, non-operating expense consisted principally of interest expense on our term loan from Oxford, which originated in December 2013, less any interest income or investment income derived from any of our cash equivalents and investments. Income Taxes Our results for the three months ended September 30, 2017 and 2016 show no federal or state income tax benefit provisions due to 100% allowances placed against their deferred tax asset for uncertainty of their future utilization. Nine months Ended September 30, 2017 Compared to Nine months Ended September 30, 2016 | September 30 | | | | -----------------------------------------------+--------------+--------+---+---------+-- | 2017 | | | 2016 | | | Increase (decrease) -----------------------------------------------+--------------+--------+---+---------+---+--------+-------------------- | $000’s | | | Percent | -----------------------------------------------+--------------+--------+---+---------+-- Revenues: | | | | | | | | | | | | -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+---+--------+---+------+-- License fee revenue | $ | 2,500 | | | $ | - | | $ | 2,500 | | - | % -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+---+--------+---+------+-- Collaboration revenue | | 59 | | | | 307 | | | (248 | ) | (81 | ) -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+---+--------+---+------+-- Royalty revenue | | 226 | | | | 86 | | | 140 | | 163 | -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+---+--------+---+------+-- Product sales, net | | 107 | | | | 306 | | | (199 | ) | (65 | ) -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+---+--------+---+------+-- Total revenues, net | | 2,892 | | | | 699 | | | 2,193 | | 314 | -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+---+--------+---+------+-- Cost and expenses: | | | | | | | | | | | | -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+---+--------+---+------+-- Cost of sales (excluding inventory provisions) | | 128 | | | | 309 | | | (181 | ) | (59 | ) -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+---+--------+---+------+-- Inventory provisions | | - | | | | 26 | | | (26 | ) | (100 | ) -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+---+--------+---+------+-- Research and development | | 2,808 | | | | 3,258 | | | (450 | ) | (14 | ) -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+---+--------+---+------+-- Sales, marketing, general and administrative | | 3,427 | | | | 5,392 | | | (1,965 | ) | (36 | ) -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+---+--------+---+------+-- Total costs and expenses | | 6,363 | | | | 8,985 | | | (2,622 | ) | (29 | ) -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+---+--------+---+------+-- Operating loss | | (3,471 | ) | | | (8,286 | ) | | (4,815 | ) | (58 | ) -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+---+--------+---+------+-- Non-operating income (expense): | | | | | | | | | | | | -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+---+--------+---+------+-- Investment income | | 3 | | | | 59 | | | (56 | ) | (95 | ) -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+---+--------+---+------+-- Interest expense | | (476 | ) | | | (697 | ) | | 221 | | (32 | ) -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+---+--------+---+------+-- Other expense | | - | | | | 2 | | | (2 | ) | (100 | ) -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+---+--------+---+------+-- Total other expense, net | | (473 | ) | | | (636 | ) | | (163 | ) | (26 | ) -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+---+--------+---+------+-- Loss before provision for income taxes | | (3,944 | ) | | | (8,922 | ) | | (4,978 | ) | (56 | ) -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+---+--------+---+------+-- Provision for income taxes | | - | | | | - | | | - | | - | -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+---+--------+---+------+-- Net loss | | (3,944 | ) | | $ | (8,922 | ) | | (4,978 | ) | (56 | ) -----------------------------------------------+--------------+--------+---+---------+---+--------+---------------------+---+--------+---+------+-- 44 -- Revenue License Fees In March 2017, under our Collaboration and License Agreement with MainPointe Agreement, we granted MainPointe an exclusive license to our Impede technology to commercialize our Nexafed products in the U.S. and Canada. On signing the MainPointe Agreement, MainPointe paid us an upfront licensing fee of $2.5 million. Collaboration Collaboration revenue is derived from reimbursement of development expenses under various development agreements we may enter into, such as from our former collaboration agreement with Bayer, and are recognized when costs are incurred pursuant to the collaboration agreement. We recognized $59 thousand and $307 thousand of collaboration revenue during the nine months ended September 30, 2017 and 2016, respectively. Royalties In connection with our agreement with Egalet for Oxaydo tablets, we earn a royalty based on Oxaydo net sales. Egalet’s first commercial sale of Oxaydo occurred in October 2015. We recognized $213 thousand and $86 thousand of royalty revenue during the nine months ended September 30, 2017 and 2016, respectively. In connection with our March 2017 agreement with MainPointe for the Nexafed product line, we earn a royalty of 7.5% on net sales of the licensed products. We recognized $13 thousand of royalty revenue during the nine months ended September 30, 2017. Net Product Sales In March 2017 we stopped selling the Nexafed product line as we licensed the product line to MainPointe, who is actively manufacturing, distributing, and selling the Nexafed product line. Cost and Expenses Cost of Sales Our cost of sales on the Nexafed product line includes third-party manufacturing costs, third-party warehousing and product distribution charges and inventory reserve expenses. Our cost of sales for the nine months ended September 30, 2017 and 2016 were $128 thousand and $309 thousand, respectively. In March 2017 we stopped selling the Nexafed product line as we licensed the product line to MainPointe, who is actively manufacturing, distributing, and selling the Nexafed product line. 45 -- Research and Development Research and development expense (R&D) is primarily for our Limitx Technology and Impede Technology development activity and may include costs of preclinical and non-clinical internal and external activities, clinical study trials, clinical supplies and its related formulation and design costs, salaries and other personnel related expenses of our employees, our facility costs, and a percentage share of cost sharing expenses for Oxaydo under the Egalet Agreement. For the nine months ended September 30, 2017 and 2016, there is approximately $86 thousand and $200 thousand, respectively of cost sharing expenses from clinical studies for product line extensions (additional strengths) on Oxaydo and approximately $95 thousand and $100 thousand, respectively of potential cost sharing expenses for a FDA required post-marketing study on Oxaydo. Also included in each of 2017 and 2016 nine month results are non-cash share-based compensation expenses of approximately $106 thousand and $128 thousand, respectively. Excluding the share-based compensation expense, our R&D expenses decreased approximately $428 thousand between reporting periods. During 2016 our initial LTX-04 clinical study, Study AP-LTX-400, was completed. Also during 2016, we substantially completed our project to integrate Impede 2.0 technology into our Nexafed 30mg tablet while moving supply to an alternate contract manufacturer. During the first quarter of 2017, our activities were addressing certain excipient issues in our LTX-04 tablet formulation and developing a new, faster releasing micro-particle formulation for LTX-04. We substantially completed our second pharmacokinetic study, AP-LTX-401 during the second quarter of 2017. During the third quarter of 2017, we initiated and substantially completed Study AP-LTX-300. We believe MainPointe launched commercial shipments of Nexafed 30mg with Impede 2.0 into the market during the third quarter of 2017. General, Administrative, Selling and Marketing Selling and marketing expenses are primarily of advertising and marketing activities on the Nexafed product line. In March 2017 we licensed the Nexafed product line to MainPointe. Our general and administrative expenses primarily consisted of legal, audit and other professional services, corporate insurance, and payroll. Included in each of the nine months ended September 30, 2017 and 2016 results are non-cash share-based compensation expenses of approximately $247 thousand and $322 thousand, respectively. Excluding the share-based compensation expense our selling, marketing, general and administrative expenses decreased by approximately $1.9 million between reporting periods, resulting primarily from the elimination of advertising and marketing activities on the Nexafed product line as well as decreases in patent and general legal activities. Non-Operating Income (Expense) During the nine months ended September 30, 2017 and 2016, non-operating expense consisted principally of interest expense on our term loan from Oxford, which originated in December 2013, less any interest income or investment income derived from any of our cash equivalents and investments. Income Taxes Our results for the nine months ended September 30, 2017 and 2016 include no federal or state income tax benefit provisions due to 100% allowances placed against their deferred tax asset for uncertainty of their future utilization. Liquidity and Capital Resources At September 30, 2017, we had cash and cash equivalents of $4.8 million compared to unrestricted cash and cash equivalents of $2.7 million at December 31, 2016. We had cash and cash equivalents of approximately $3.5 million at November 10, 2017. We estimate that our cash and cash equivalents, together with milestone and royalty payments, if any that may be made under the Egalet Agreement, the KemPharm Agreement and the MainPointe Agreement, is expected to be sufficient to fund our continuing operations only into April 2018. To fund further operations and product development activities beyond April 2018, we must raise additional financing or enter into license or collaboration agreements with third parties relating to our technologies. The Company intends to explore a variety of capital raising and other transactions to provide additional funding to continue operations. These include additional potential private offerings of common stock to institutional and/or accredited investors. The Company is also actively seeking a licensing partner for its Limitx Technology, with the objective of receiving an upfront license fee, development milestone payments and royalties on the net sales of products utilizing the Limitx Technology, similar to the Egalet Agreement. The Company is also exploring licensing or selling select assets and intellectual property in an effort to raise capital and reduce operating expenses. Finally, the Company is evaluating the potential for a strategic transaction which may involve the Company being acquired in a merger or asset purchase transaction. No assurance can be given that we will be successful in obtaining any such financing or in securing license or collaboration agreements with third parties on acceptable terms, if at all, or if secured, that such financing or license or collaboration agreements will provide payments to the Company sufficient to fund continued operations. Our auditors have included in their report relating to our 2016 financial statements a “going concern” explanatory paragraph as to substantial doubt of our ability to continue as a going concern. In the absence of such financing or third-party license or collaboration agreements, there will be substantial doubt about the Company’s ability to continue as a going concern and the Company will be required to scale back or terminate operations and/or seek protection under applicable bankruptcy laws. An extended delay or cessation of the Company’s continuing product development efforts will have a material adverse effect on the Company’s financial condition and results of operations. 46 -- In view of the matters described above, recoverability of a major portion of the recorded asset amounts shown in the Company’s accompanying balance sheets is dependent upon continued operations of the Company, which in turn is dependent upon the Company’s ability to meet its financing requirements on a continuous basis, to maintain existing financing and to succeed in its future operations. The Company’s financial statements do not include any adjustment relating to the recoverability and classification of recorded asset amounts and classification of liabilities that might be necessary should the Company be unable to continue in existence. Our future sources of revenue, if any, will be derived from milestone payments and royalties under the Egalet Agreement, the KemPharm Agreement, the MainPointe Agreement and similar agreements for our Limitx products in development with other pharmaceutical company partners, for which there can be no assurance. The amount and timing of our future cash requirements will depend on regulatory and market acceptance of our product candidates and the resources we devote to the development and commercialization of our product candidates. Critical Accounting Policies Note A of the Notes to Consolidated Financial Statements, in the Company’s 2016 Annual Report on Form 10-K, includes a summary of the Company's significant accounting policies and methods used in the preparation of the financial statements. The application of these accounting policies involves the exercise of judgment and use of assumptions as to future uncertainties and, as a result, actual results could differ from these estimates. The Company's critical accounting policies described in the 2016 Annual Report are also applicable to 2017. Item 4. Controls and Procedures (a) Disclosure Controls and Procedures. The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined on Rules 13a – 13(e) and 15(d) – 15(e) under the Exchange Act) as of the end of the period covered by this Report. The Company’s disclosure controls and procedures are designed to provide reasonable assurance that information is recorded, processed, summarized and reported accurately and on a timely basis in the Company’s periodic reports filed with the SEC. Based upon such evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company's disclosure controls and procedures are effective to provide reasonable assurance. Notwithstanding the foregoing, a control system, no matter how well designed and operated, can provide only reasonable, not absolute assurance that it will detect or uncover failures within the Company to disclose material information otherwise require to be set forth in the Company’s periodic reports. (b) Changes in Internal Controls over Financial Reporting. There were no changes in our internal controls over financial reporting during the third fiscal quarter of 2017 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting. Part II. OTHER INFORMATION Item 1. Legal Proceedings The information required by this Item is incorporated by reference to Note 17, “Commitments and Contingencies,” in Part I, Item 1, “Financial Statements.” Item 1A. Risk Factors Investors in our common stock should consider the following risk factors, in addition to those risk factors set forth in our 2016 Annual Report on Form 10-K: 47 -- We require additional funding; if we fail to raise additional funding we will cease operations and/or seek protection under applicable bankruptcy laws. We require additional financing or entry into license or collaborative agreements with third parties providing for net proceeds to us in order to continue to fund operations. No assurance can be given that we will be successful in obtaining any such financing or in securing license or collaborative agreements with third parties on acceptable terms, if at all, or if secured, that such financing or license or collaborative agreements will provide for funding or payments to us sufficient to continue to fund operations. Our auditors have included in their report relating to our 2016 financial statements a “going concern” explanatory paragraph as to substantial doubt of our ability to continue as a going concern. After giving effect to the net proceeds from our July 2017 private placement, we believe we have cash sufficient to fund operations only into April 2018. In the absence of the receipt of additional financing or payments under third-party license or collaborative agreements prior to such time, we will be required to scale back or terminate operations and/or seek protection under applicable bankruptcy laws. This could result in a complete loss of shareholder value in the Company. Even assuming we are successful in securing additional sources of financing to fund continued operations, there can be no assurance that the proceeds of such financing will be sufficient to fund operations until such time, if at all, that we generate sufficient revenue from our products and product candidates to sustain and grow our operations. Item 6. Exhibits The exhibits required by this Item are listed below. 31.1 | Certification of Periodic Report by Chief Executive Officer pursuant to Rule 13a-14 and 15d-14 of the Securities Exchange Act of 1934. -----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 31.2 | Certification of Periodic Report by Chief Financial Officer pursuant to Rule 13a-14 and 15d-14 of the Securities Exchange Act of 1934. -----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 32.1 | Certification of Periodic Report by the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. -----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 101.INS | XBRL Instance Document --------+---------------------------------------------- 101.SCH | XBRL Taxonomy Extension Schema Document --------+---------------------------------------------- 101.CAL | XBRL Taxonomy Extension Calculation Linkbase --------+---------------------------------------------- 101.LAB | XBRL Taxonomy Extension Label Linkbase --------+---------------------------------------------- 101.PRE | XBRL Taxonomy Extension Presentation Linkbase --------+---------------------------------------------- 101.DEF | XBRL Taxonomy Extension Definition Linkbase --------+---------------------------------------------- 48 -- Signatures Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. November 10, 2017 | ACURA PHARMACEUTICALS, INC. ------------------+------------------------------------ | /s/ Robert B. Jones ------------------+------------------------------------ | Robert B. Jones ------------------+------------------------------------ | Chief Executive Officer ------------------+------------------------------------ | /s/ Peter A. Clemens ------------------+------------------------------------ | Peter A. Clemens ------------------+------------------------------------ | Senior VP & Chief Financial Officer ------------------+------------------------------------ 49 --

ADESTO TECHNOLOGIES Corp

1395848

10-Q

0001564590-17-023472

iots-10q_20170930.htm UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington D.C. 20549 FORM 10-Q (Mark One) ☒ | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 --+---------------------------------------------------------------------------------------- For the quarterly period ended September 30, 2017 OR ☐ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 --+----------------------------------------------------------------------------------------- For the Transition Period from to Commission File Number: 001-37582 ADESTO TECHNOLOGIES CORPORATION (Exact name of registrant as specified in its charter) Delaware | 16-1755067 ---------------------------------------------------------------+------------------------------------- (State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) ---------------------------------------------------------------+------------------------------------- Adesto Technologies Corporation 3600 Peterson Way Santa Clara, CA 95054 (408) 400-0578 (Address and telephone number of Registrant’s executive offices) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuance to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No ☐ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See definition of “large accelerated filer,” “accelerated filer”, “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act: Large accelerated filer | ☐ | | Accelerated filer | ☐ ------------------------+---+-----------------------------------------------+---------------------------+-- Non-accelerated filer | ☐ | (Do not check if a smaller reporting company) | Smaller reporting company | ☒ ------------------------+---+-----------------------------------------------+---------------------------+-- Emerging growth company | ☒ ------------------------+-- If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☒ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒ Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date. | Class | | Outstanding at October 26, 2017 ------------------------------------------+-------+-------------------+-------------------------------- Common Stock, $0.0001 par value per share | | 21,138,980 shares ------------------------------------------+-------+------------------ ADESTO TECHNOLOGIES CORPORATION QUARTERLY REPORT ON FORM 10-Q FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2017 INDEX | PART I: FINANCIAL INFORMATION | -----------+-----------------------------------------------------------------------------------------------------------------------------------+--- Item 1. | Condensed Consolidated Financial Statements (unaudited) | 3 -----------+-----------------------------------------------------------------------------------------------------------------------------------+--- | Unaudited Condensed Consolidated Balance Sheets as of September 30, 2017 and December 31, 2016 | 3 -----------+-----------------------------------------------------------------------------------------------------------------------------------+--- | Unaudited Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2017 and 2016 | 4 -----------+-----------------------------------------------------------------------------------------------------------------------------------+--- | Unaudited Condensed Consolidated Statements of Comprehensive Loss for the three and nine months ended September 30, 2017 and 2016 | 5 -----------+-----------------------------------------------------------------------------------------------------------------------------------+--- | Unaudited Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2017 and 2016 | 6 -----------+-----------------------------------------------------------------------------------------------------------------------------------+--- | Notes to Condensed Consolidated Financial Statements (unaudited) | 7 -----------+-----------------------------------------------------------------------------------------------------------------------------------+--- Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations | 23 -----------+-----------------------------------------------------------------------------------------------------------------------------------+--- Item 3. | Quantitative and Qualitative Disclosures About Market Risk | 32 -----------+-----------------------------------------------------------------------------------------------------------------------------------+--- Item 4. | Controls and Procedures | 32 -----------+-----------------------------------------------------------------------------------------------------------------------------------+--- | PART II: OTHER INFORMATION | -----------+-----------------------------------------------------------------------------------------------------------------------------------+--- Item 1. | Legal Proceedings | 33 -----------+-----------------------------------------------------------------------------------------------------------------------------------+--- Item 1A. | Risk Factors | 33 -----------+-----------------------------------------------------------------------------------------------------------------------------------+--- Item 1B. | Unresolved Staff Comments | 48 -----------+-----------------------------------------------------------------------------------------------------------------------------------+--- Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | 48 -----------+-----------------------------------------------------------------------------------------------------------------------------------+--- Item 3. | Defaults Upon Senior Securities | 48 -----------+-----------------------------------------------------------------------------------------------------------------------------------+--- Item 4. | Mine Safety Disclosures | 48 -----------+-----------------------------------------------------------------------------------------------------------------------------------+--- Item 5. | Other Information | 48 -----------+-----------------------------------------------------------------------------------------------------------------------------------+--- Item 6. | Exhibits | 49 -----------+-----------------------------------------------------------------------------------------------------------------------------------+--- Signatures | 50 -----------+---------------------------------------------------------------------------------------------------------------------------------- PART I: FINANCI AL INFORMATION Item 1. | Financial Statements --------+--------------------- ADESTO TECHNOLOGIES CORPORATION CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands, except share and per share data) | September 30, | | | December 31, | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+-- | 2017 | | | 2016 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+-- | (unaudited) | | | (1) | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+-- Assets | | | | | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Current assets: | | | | | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Cash and cash equivalents | $ | 30,508 | | | $ | 19,719 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Accounts receivable, net | | 8,810 | | | | 6,111 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Inventories | | 4,263 | | | | 5,182 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Prepaid expenses | | 348 | | | | 462 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Other current assets | | 103 | | | | 105 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Total current assets | | 44,032 | | | | 31,579 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Property and equipment, net | | 6,325 | | | | 5,962 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Intangible assets, net | | 7,397 | | | | 8,324 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Other non-current assets | | 607 | | | | 296 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Goodwill | | 22 | | | | 22 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Total assets | $ | 58,383 | | | $ | 46,183 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Liabilities and Stockholders' Equity | | | | | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Current liabilities: | | | | | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Accounts payable | $ | 5,907 | | | $ | 5,167 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Accrued compensation and benefits | | 2,132 | | | | 1,599 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Accrued expenses and other current liabilities | | 1,946 | | | | 2,176 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Term loan, current | | — | | | | 6,466 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Total current liabilities | | 9,985 | | | | 15,408 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Line of credit | | 2,000 | | | | 1,807 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Term loan, non-current | | 11,396 | | | | 9,775 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Deferred rent, non-current | | 2,511 | | | | 2,826 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Deferred tax liability, non-current | | 2 | | | | 2 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Total liabilities | | 25,894 | | | | 29,818 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Commitments and contingencies (See Note 7) | | | | | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Stockholders' equity: | | | | | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Preferred stock, $0.0001 par value, 5,000,000 shares authorized as of September 30, 2017 and December 31, 2016; no shares issued and outstanding as of September 30, 2017 and December 31, 2016 | | — | | | | — | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Common stock, $0.0001 par value, 100,000,000 shares authorized; 21,121,497 and 15,494,308 shares issued and outstanding as of September 30, 2017 and December 31, 2016, respectively | | 2 | | | | 2 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Additional paid-in capital | | 132,467 | | | | 110,749 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Accumulated other comprehensive loss | | (301 | ) | | | (230 | ) ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Accumulated deficit | | (99,679 | ) | | | (94,156 | ) ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Total stockholders' equity | | 32,489 | | | | 16,365 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- Total liabilities and stockholders' equity | $ | 58,383 | | | $ | 46,183 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+---+--------------+---+---------+-- (1) The condensed consolidated balance sheet as of December 31, 2016 was derived from the audited consolidated financial statements as of that date. ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- See accompanying Notes to Condensed Consolidated Financial Statements. 3 ADESTO TECHNOLOGIES CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except share and per share data) (unaudited) | Three Months Ended September 30, | | | Nine Months Ended September 30, | -----------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+-- | 2017 | | | 2016 | | | 2017 | | 2016 | -----------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+-- Revenue, net | $ | 15,239 | | | $ | 11,180 | | $ | 39,958 | | $ | 31,638 | -----------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- Cost of revenue | | 7,773 | | | | 5,803 | | | 20,215 | | | 16,531 | -----------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- Gross profit | | 7,466 | | | | 5,377 | | | 19,743 | | | 15,107 | -----------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- Operating expenses: | | | | | | | | | | | | | -----------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- Research and development | | 3,606 | | | | 4,390 | | | 10,653 | | | 12,527 | -----------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- Sales and marketing | | 2,897 | | | | 2,870 | | | 8,408 | | | 8,315 | -----------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- General and administrative | | 1,761 | | | | 1,586 | | | 5,569 | | | 4,984 | -----------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- Gain from settlement with former foundry supplier | | - | | | | - | | | - | | | (1,962 | ) -----------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- Total operating expenses | | 8,264 | | | | 8,846 | | | 24,630 | | | 23,864 | -----------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- Loss from operations | | (798 | ) | | | (3,469 | ) | | (4,887 | ) | | (8,757 | ) -----------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- Other income (expense): | | | | | | | | | | | | | -----------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- Interest expense, net | | (170 | ) | | | (576 | ) | | (581 | ) | | (1,058 | ) -----------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- Other income (expense), net | | (12 | ) | | | (18 | ) | | 2 | | | (29 | ) -----------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- Total other income (expense), net | | (182 | ) | | | (594 | ) | | (579 | ) | | (1,087 | ) -----------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- Loss before provision for income taxes | | (980 | ) | | | (4,063 | ) | | (5,466 | ) | | (9,844 | ) -----------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- Provision for income taxes | | 17 | | | | 15 | | | 57 | | | 46 | -----------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- Net loss | $ | (997 | ) | | $ | (4,078 | ) | $ | (5,523 | ) | $ | (9,890 | ) -----------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- Net loss per share | | | | | | | | | | | | | -----------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- Basic and diluted | $ | (0.05 | ) | | $ | (0.27 | ) | $ | (0.31 | ) | $ | (0.66 | ) -----------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- Weighted average number of shares used in computing net loss per share | | | | | | | | | | | | | -----------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- Basic and diluted | | 21,058,635 | | | | 15,034,475 | | | 17,701,230 | | | 14,997,417 | -----------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- See accompanying Notes to Condensed Consolidated Financial Statements. 4 ADESTO TECHNOLOGIES CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS (in thousands) (unaudited) | Three Months Ended September 30, | | | Nine Months Ended September 30, | ----------------------------------------+----------------------------------+--------+---+---------------------------------+-- | 2017 | | | 2016 | | | 2017 | | 2016 | ----------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+-- Net loss | $ | (997 | ) | | $ | (4,078 | ) | $ | (5,523 | ) | $ | (9,890 | ) ----------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Other comprehensive loss, net of tax: | | | | | | | | | | | | | ----------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Foreign currency translation adjustment | | (20 | ) | | | (19 | ) | | (71 | ) | | (36 | ) ----------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- Comprehensive loss | $ | (1,017 | ) | | $ | (4,097 | ) | $ | (5,594 | ) | $ | (9,926 | ) ----------------------------------------+----------------------------------+--------+---+---------------------------------+---+--------+------+---+--------+---+---+--------+-- See accompanying Notes to Condensed Consolidated Financial Statements. 5 ADESTO TECHNOLOGIES CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) (unaudited) | Nine Months Ended September 30, | -----------------------------------------------------------------------------+---------------------------------+-------- | 2017 | | | 2016 | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+-- Cash flows from operating activities: | | | | | | | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Net loss | $ | (5,523 | ) | | $ | (9,890 | ) -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Adjustments to reconcile net loss to net cash used in operating activities: | | | | | | | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Stock-based compensation expense | | 2,873 | | | | 2,508 | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Depreciation and amortization | | 1,004 | | | | 684 | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Amortization of intangible assets | | 927 | | | | 927 | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Amortization of debt discount | | 64 | | | | 606 | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Deferred income taxes | | — | | | | 1 | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Gain from settlement with former foundry supplier | | — | | | | (1,962 | ) -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Changes in assets and liabilities: | | | | | | | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Accounts receivable | | (2,699 | ) | | | 1,528 | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Inventories | | 919 | | | | (539 | ) -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Prepaid expenses and other current assets | | 116 | | | | 619 | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Other non-current assets | | (311 | ) | | | — | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Accounts payable | | 1,426 | | | | (1,037 | ) -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Accrued compensation and benefits | | 533 | | | | 448 | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Accrued expenses and other current liabilities | | (230 | ) | | | 746 | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Deferred rent | | (315 | ) | | | — | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Net cash used in operating activities | | (1,216 | ) | | | (5,361 | ) -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Cash flows from investing activities: | | | | | | | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Acquisition of property and equipment | | (2,054 | ) | | | (2,358 | ) -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Net cash used in investing activities | | (2,054 | ) | | | (2,358 | ) -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Cash flows from financing activities: | | | | | | | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Proceeds from public offering, net of underwriting discounts and commissions | | 18,363 | | | | — | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Proceeds from exercise of stock options | | 639 | | | | 238 | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Tax withholdings related to net share settlement of restricted stock units | | (157 | ) | | | — | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Proceeds from revolving line of credit | | 27,427 | | | | 2,000 | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Payments on revolving line of credit | | (27,234 | ) | | | — | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Proceeds from term loan, net of fees | | — | | | | 17,825 | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Payments on term loan | | (4,909 | ) | | | (14,000 | ) -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Net cash provided by financing activities | | 14,129 | | | | 6,063 | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Effect of exchange rates on cash and equivalents | | (70 | ) | | | (56 | ) -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Net increase (decrease) in cash and cash equivalents | | 10,789 | | | | (1,712 | ) -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Cash and cash equivalents - beginning of period | | 19,719 | | | | 23,089 | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Cash and cash equivalents - end of period | $ | 30,508 | | | $ | 21,377 | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Supplemental disclosures of other cash flow information: | | | | | | | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Cash paid for interest expense | $ | 560 | | | $ | 494 | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Supplemental disclosures of non-cash investing information: | | | | | | | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- Purchase of property and equipment included in accounts payable | $ | 347 | | | $ | 1,123 | -----------------------------------------------------------------------------+---------------------------------+---------+---+------+---+---------+-- See accompanying Notes to Condensed Consolidated Financial Statements. 6 ADESTO TECHNOLOGIES CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) Note 1. Organization and Summary of Significant Accounting Policies. Organization and Nature of Operations. Adesto Technologies Corporation (together with its subsidiaries; “Adesto”, “we”, “our”, “us” or the “Company”) was incorporated in the state of California in January 2006 and reincorporated in Delaware in October 2015. We are a leading provider of application-specific and ultra-low power non-volatile memory (“NVM”) products. Our corporate headquarters are located in Santa Clara, California. On September 28, 2012, we purchased certain flash memory product assets from Atmel Corporation and our financial results include the operating results of those assets from the date of acquisition. Basis of Presentation. The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP to complete annual financial statements. In the opinion of our management, all adjustments (consisting of normal recurring adjustments) considered necessary to present fairly the financial position of the Company and its results of operations and cash flows for the interim periods presented have been included. Operating results for the three and nine months ended September 30, 2017 are not necessarily indicative of the results that may be expected for the year ending December 31, 2017, for any other interim period or for any other future year. The condensed consolidated balance sheet as of December 31, 2016 was derived from the audited consolidated financial statements as of that date, but does not include all of the disclosures required by U.S. GAAP. The accompanying condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016, filed with the Securities and Exchange Commission on March 24, 2017. The condensed consolidated financial statements include the results of our operations, and the operations of our wholly owned subsidiaries. All intercompany balances and transactions have been eliminated. There have been no material changes to our significant accounting policies described in Note 1, Organization and Summary of Significant Accounting Policies, in Notes to Consolidated Financial Statements in Item 8 of Part II of our Annual Report on Form 10-K for the year ended December 31, 2016 that have had a material impact on our condensed consolidated financial statements and related notes, except as described below. Use of Estimates. The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates, judgments and assumptions that affect the reported amount of assets, liabilities, revenue and expenses and related disclosures of contingent assets and liabilities. On an on-going basis, we evaluate those estimates, including those related to allowances for doubtful accounts, reserves for sales, warranty accrual, inventory write-downs, valuation of long-lived assets, including property and equipment and identifiable intangible assets and goodwill, loss on purchase commitments, valuation of deferred taxes and contingencies. In addition, we use assumptions when employing the Black-Scholes option-pricing model to calculate the fair value of stock options granted and Monte Carlo simulation techniques to value certain restricted stock units with performance-based vesting conditions. We base our estimates of the carrying value of certain assets and liabilities on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, when these carrying values are not readily available from other sources. Actual results could differ from these estimates. Revenue Recognition and Accounts Receivable Allowances. We recognize revenue from product sales when persuasive evidence of an arrangement exists, the selling price is fixed or determinable, transfer of title occurs, and the collectibility of the resulting receivable is reasonably assured. Due to the historical 7 ADESTO TECHNOLOGIES CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) immaterial level of product returns under warranty, we do not record a reserve for estimated returns under warranty at the time of revenue recognition. Generally, we meet product sale revenue recognition conditions upon shipment because, in most cases, title and risk of loss passes to the customer at that time. In addition, we estimate and record provisions for future returns and other charges against revenue at the time of shipment, consistent with the terms of sale. We sell products to distributors at the price listed in our distributor price book. At the time of sale, we record a sales reserve for ship from stock and debits (“SSDs”), stock rotation rights and any special programs approved by management. We offset the sales reserve against recorded revenues, producing the revenue amount reported in our condensed consolidated statements of operations. The market price for our products can differ significantly from the book price at which we sold the product to the distributor. When the market price of a particular distributor’s sales opportunity to their customers would result in low or negative margins for the distributor, as compared to our original book price, we negotiate SSDs with the distributor. Management analyzes our SSD history to develop current SSD rates that form the basis of the SSD revenue reserve recorded each period. We obtain the historical SSD rates from the distributor’s records and our internal records. We typically grant payment terms of between 30 and 60 days to our customers. Our customers generally pay within those terms. Distributors are invoiced for shipments at listed book price. When the distributors pay the invoice, they may claim debits for SSDs previously authorized by us when appropriate. Once claimed, we process the requests against prior authorizations and adjust reserves previously established for that customer. The revenue we record for sales to our distributors is net of estimated provisions for these programs. Determining net revenue requires significant judgments and estimates on our part. We base our estimates on historical experience rates, the levels of inventory held by our distributors, current trends and other related factors. Because of the inherent nature of estimates, there is a risk actual amounts may differ materially from our estimates. Our consolidated financial condition and operating results depend on our ability to make reliable estimates. We believe that such estimates are reasonable. We also monitor collectibility of accounts receivable primarily through review of our accounts receivable aging. When facts and circumstances indicate the collection of specific amounts or from specific customers is at risk, we assess the impact on amounts recorded for bad debts and, if necessary, record a charge in the period such determination is made. As of September 30, 2017 and December 31, 2016, there was no allowance for doubtful accounts. Product Warranty. Our products are sold with a limited warranty for a period of one year, warranting that the product conforms to specifications and is free from material defects in design, materials and workmanship. To date, we have had insignificant returns of any defective production parts. During the year ended December 31, 2015, we recorded $250,000 for a specific potential warranty claim. As of September 30, 2017 and December 31, 2016, approximately $226,000 and $41,000, respectively, has been incurred relating to this potential warranty claim. As of September 30, 2017 and December 31, 2016, the warranty accrual was $24,000 and $209,000, respectively, and is included in accrued expenses and other current liabilities on the condensed consolidated balance sheets. Foreign Currency Translation. The functional currency of our foreign subsidiaries is the local currency. In consolidation, we translate assets and liabilities at exchange rates in effect at the consolidated balance sheet date. We translate revenue and expense accounts at the average exchange rates during the period in which the transaction takes place. Net losses from foreign currency translation of assets and liabilities were $20,000 and $19,000 for the three months ended September 30, 2017 and 2016, respectively, and $71,000, and $36,000 for the nine months ended September 30, 2017 and 2016, respectively, and are included in the cumulative translation adjustment component of accumulated other comprehensive loss, net of tax, a component of stockholders’ equity. Net losses arising from transactions denominated in currencies other than the functional currency were $7,000 and $18,000 for the three months ended September 30, 2017 and 2016, respectively, and a $1,000 gain and a $30,000 loss for the nine months ended September 30, 2017 and 2016, respectively, and are included in other income (expense), net in the condensed consolidated statements of operations. 8 ADESTO TECHNOLOGIES CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) Concentration of Risk. Our products are primarily manufactured, assembled and tested by third-party foundries and other contractors in Asia and we are heavily dependent on a single foundry in Taiwan for the manufacture of wafers and a single contractor in the Philippines for assembly and testing of our products. We do not have long-term agreements with either of these suppliers. A significant disruption in the operations of these parties would adversely impact the production of our products for a substantial period of time, which could have a material adverse effect on our business, financial condition, operating results and cash flows. Financial instruments that potentially subject us to significant concentrations of credit risk consist principally of cash and cash equivalents and accounts receivables. We place substantially all of our cash and cash equivalents on deposit with a reputable, high credit quality financial institution in the United States of America. We believe that the bank that holds substantially all of our cash and cash equivalents is financially sound and, accordingly, subject to minimal credit risk. Deposits held with the bank may exceed the amount of insurance provided on such deposits. We generally do not require collateral or other security in support of accounts receivable. We periodically review the need for an allowance for doubtful accounts by considering factors such as historical experience, credit quality, the age of the accounts receivable balances and current economic conditions that may affect a customer’s ability to pay. As a result of our favorable collection experience and customer concentration, there was no allowance for doubtful accounts as of September 30, 2017 and December 31, 2016. Customer concentrations as a percentage of revenue, net were as follows: | Three Months Ended September 30, | | | Nine Months Ended September 30, | -----------+----------------------------------+----+---+---------------------------------+-- | 2017 | | | 2016 | | | 2017 | | 2016 | -----------+----------------------------------+----+---+---------------------------------+---+----+------+----+------+-- Customer A | | 13 | % | | | 12 | % | | 16 | % | | 14 | % -----------+----------------------------------+----+---+---------------------------------+---+----+------+----+------+---+----+----+-- Customer B | | 12 | % | | * | | | 10 | % | | 11 | % -----------+----------------------------------+----+---+---------------------------------+---+----+------+----+------+---+----+--- Customer C | | 13 | % | | | 10 | % | | 12 | % | | 10 | % -----------+----------------------------------+----+---+---------------------------------+---+----+------+----+------+---+----+----+-- * | less than 10% --+-------------- Customer concentrations as a percentage of gross accounts receivable were as follows: | September 30, | | | September 30, | -----------+---------------+----+---+---------------+--- | 2017 | | | 2016 | -----------+---------------+----+---+---------------+--- Customer A | | 23 | % | | | 16 | % -----------+---------------+----+---+---------------+----+----+-- Customer B | | 17 | % | | | 13 | % -----------+---------------+----+---+---------------+----+----+-- Customer C | * | | | | 12 | % -----------+---------------+----+---+---------------+----+--- * | less than 10% --+-------------- Recent Accounting Pronouncements. In May 2014, as part of its ongoing efforts to assist in the convergence of U.S. GAAP and International Financial Reporting Standards (“IFRS”), the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-09, “Revenue from Contracts with Customers (Topic 606). ” The new guidance sets forth a new five-step revenue recognition model which replaces the prior revenue recognition guidance in its entirety and is intended to eliminate numerous industry-specific pieces of revenue recognition guidance that have historically existed in U.S. GAAP. The underlying principle of the new standard is that a business or other organization will recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects what it expects in exchange for the goods or services. The standard also requires more detailed disclosures and provides additional guidance for transactions that were not addressed completely in the prior accounting guidance. The ASU provides alternative methods of initial adoption and is effective for annual and interim periods beginning after December 15, 2017. The FASB has issued several updates to the standard which i) defer the original effective date from January 1, 2017 to January 1, 2018, while allowing for early adoption as of January 1, 2017 (ASU 2015-14); ii) clarify the application of the principal versus agent guidance (ASU 2016-08); iii) clarify the guidance on inconsequential and perfunctory promises and licensing (ASU 2016-10); and (iv) clarify the guidance on 9 ADESTO TECHNOLOGIES CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) certain sections of the guidance providing technical corrections and improvements (ASU 2016-10). In May 2016, the FASB issued ASU 2016 -12, “ Revenue from Contracts with Customers (Topic 606) Narrow-Scope Improvements and Practical Expedients ”, to address certain narrow aspects of the guidance including collectibility criterion, collection of sales taxes from customers, noncash considerati on, contract modifications and completed contracts. This issuance does not change the core principle of the guidance in the initial topic issued in May 2014. We currently anticipate adopting the standard using the modified retrospective method. We are curr ently evaluating the impact of this new standard on our consolidated financial statements . In February 2016, the FASB issued ASU 2016-02, Leases, Topic 842. This ASU requires lease assets and lease liabilities arising from leases, including operating leases, to be recognized on the balance sheet, ASU 2016-02 will become effective for us on January 1, 2019. We are currently evaluating the impact of this guidance on our consolidated financial statements. In September 2017, the FASB issued ASU 2017-13, Revenue Recognition (Topic 605), Revenue from Contracts with Customers (Topic 606), Leases (Topic 840), and Leases (Topic 842): Amendment to SEC Paragraphs Pursuant to the Staff Announcement at the July 20, 2017 EITF Meeting and Rescission of Prior SEC Staff Announcements and Observer Comments (SEC Update). The amendments in ASU No. 2017-13 amends the early adoption date option for certain companies related to the adoption of ASU No. 2014-09 and ASU No. 2016-02. Note 2. Balance Sheet Components. Accounts Receivable, Net. Accounts receivable, net consisted of the following (in thousands): | September 30, | | | December 31, | ----------------------------------------------------------------------------+---------------+--------+---+--------------+-- | 2017 | | | 2016 | ----------------------------------------------------------------------------+---------------+--------+---+--------------+-- Accounts receivable | $ | 12,391 | | | $ | 8,800 | ----------------------------------------------------------------------------+---------------+--------+---+--------------+---+--------+-- Allowance for SSDs, price protection, rights of return and other activities | | (3,581 | ) | | | (2,689 | ) ----------------------------------------------------------------------------+---------------+--------+---+--------------+---+--------+-- Total accounts receivable, net | $ | 8,810 | | | $ | 6,111 | ----------------------------------------------------------------------------+---------------+--------+---+--------------+---+--------+-- Inventories. Inventories consisted of the following (in thousands): | September 30, | | December 31, | ------------------+---------------+-------+--------------+-- | 2017 | | 2016 | ------------------+---------------+-------+--------------+-- Raw materials | $ | 1,018 | | $ | 212 ------------------+---------------+-------+--------------+---+------ Work-in-process | | 2,299 | | | 3,793 ------------------+---------------+-------+--------------+---+------ Finished goods | | 946 | | | 1,177 ------------------+---------------+-------+--------------+---+------ Total inventories | $ | 4,263 | | $ | 5,182 ------------------+---------------+-------+--------------+---+------ For the three months ended September 30, 2017 and 2016, we realized a benefit of $0.4 million and $0.1 million, respectively, from the sales of previously reserved products. For the nine months ended September 30, 2017 and 2016, we realized a benefit of $1.0 million and $0.8 million, respectively, from the sales of previously reserved products. Inventory write-downs were primarily associated with products built in excess of customer demand which resulted in excess inventory levels, legacy products for which no demand exists and lower of cost or net realizable value write-downs associated with CBRAM products for which costs exceeded net realizable value. 10 ADESTO TECHNOLOGIES CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) Property and Equipment, Net. Property and equipment, net consisted of the following (in thousands): | September 30, | | | December 31, | ------------------------------------------+---------------+--------+---+--------------+-- | 2017 | | | 2016 | ------------------------------------------+---------------+--------+---+--------------+-- Machinery and equipment | $ | 8,561 | | | $ | 7,351 | ------------------------------------------+---------------+--------+---+--------------+---+--------+-- Furniture and fixtures | | 83 | | | | 77 | ------------------------------------------+---------------+--------+---+--------------+---+--------+-- Leasehold improvements | | 4,252 | | | | 4,252 | ------------------------------------------+---------------+--------+---+--------------+---+--------+-- Computer software | | 675 | | | | 668 | ------------------------------------------+---------------+--------+---+--------------+---+--------+-- Construction in progress | | 1,301 | | | | 1,098 | ------------------------------------------+---------------+--------+---+--------------+---+--------+-- Property and equipment, at cost | | 14,872 | | | | 13,446 | ------------------------------------------+---------------+--------+---+--------------+---+--------+-- Accumulated depreciation and amortization | | (8,547 | ) | | | (7,484 | ) ------------------------------------------+---------------+--------+---+--------------+---+--------+-- Property and equipment, net | $ | 6,325 | | | $ | 5,962 | ------------------------------------------+---------------+--------+---+--------------+---+--------+-- The Company incurs costs for the fabrication of masks used by its foundry partners to manufacture its products. Beginning the first fiscal quarter of 2017, the Company capitalizes mask costs that are expected to be utilized in production manufacturing as the Company’s product development process has become more predictable and thus supports capitalization of the mask. The capitalized mask costs begin depreciating to cost of revenue once the products go into production. Depreciation is computed using the straight-line method over a three year period which is the expected useful life of the mask. Previously mask sets were expensed to research and development. Depreciation and amortization expense of property and equipment for the three and nine months ended September 30, 2017 was $0.4 million and $1.0 million, respectively. Depreciation and amortization expense of property and equipment for the three and nine months ended September, 30, 2016 was $0.3 million and $0.7 million, respectively. Accrued Expenses and Other Current Liabilities. Accrued expenses and other current liabilities consisted of the following (in thousands): | September 30, | | December 31, | -----------------------------------------------------+---------------+-------+--------------+-- | 2017 | | 2016 | -----------------------------------------------------+---------------+-------+--------------+-- Accrued sales commission payable | $ | 329 | | $ | 366 -----------------------------------------------------+---------------+-------+--------------+---+------ Accrued manufacturing expenses | | 228 | | | 149 -----------------------------------------------------+---------------+-------+--------------+---+------ Deferred rent, current portion | | 413 | | | 388 -----------------------------------------------------+---------------+-------+--------------+---+------ Liabilities to certain customers | | 474 | | | 663 -----------------------------------------------------+---------------+-------+--------------+---+------ Product warranty | | 24 | | | 209 -----------------------------------------------------+---------------+-------+--------------+---+------ Other accrued liabilities | | 478 | | | 401 -----------------------------------------------------+---------------+-------+--------------+---+------ Total accrued expenses and other current liabilities | $ | 1,946 | | $ | 2,176 -----------------------------------------------------+---------------+-------+--------------+---+------ Note 3. Fair Value Measurements. Fair value is defined as the exchange price that would be received from selling an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. We measure financial assets and liabilities at fair value at each reporting period using a fair value hierarchy which requires us to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. A financial instrument’s classification within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement. Three levels of inputs may be used to measure fair value: Level 1. Quoted prices in active markets for identical assets or liabilities. 11 ADESTO TECHNOLOGIES CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) Level 2. Quoted prices for similar assets and liabilities in active markets or inputs other than quoted prices which are observable for the assets or liabilities, either directly or indirectly through market corroboration, for substantially the full term of the financial instruments. Level 3. Unobservable inputs which are supported by little or no market activity and which are significant to the fair value of the assets or liabilities. Financial assets measured at fair value on a recurring basis were as follows: | Fair Value Measurement at Reporting Date Using | -------------------------+------------------------------------------------+--------------------------------------------------------------- | | Quoted Prices in Active Markets for Identical Assets (Level 1) | | Significant Other Observable Inputs (Level 2) | | | Significant Unobservable Inputs (Level 3) | | Total -------------------------+------------------------------------------------+----------------------------------------------------------------+--------+-----------------------------------------------+---+---+-------------------------------------------+---+------ | | (in thousands) | -------------------------+------------------------------------------------+----------------------------------------------------------------+------- As of September 30, 2017 | | | | | | | | | | | -------------------------+------------------------------------------------+----------------------------------------------------------------+--------+-----------------------------------------------+---+---+-------------------------------------------+---+-------+---+------- Assets: | | | | | | | | | | | -------------------------+------------------------------------------------+----------------------------------------------------------------+--------+-----------------------------------------------+---+---+-------------------------------------------+---+-------+---+------- Money market funds | | $ | 11,497 | | $ | — | | $ | — | $ | 11,497 -------------------------+------------------------------------------------+----------------------------------------------------------------+--------+-----------------------------------------------+---+---+-------------------------------------------+---+-------+---+------- As of December 31, 2016 | | | | | | | | | | | -------------------------+------------------------------------------------+----------------------------------------------------------------+--------+-----------------------------------------------+---+---+-------------------------------------------+---+-------+---+------- Assets: | | | | | | | | | | | -------------------------+------------------------------------------------+----------------------------------------------------------------+--------+-----------------------------------------------+---+---+-------------------------------------------+---+-------+---+------- Money market funds | | $ | 16,540 | | $ | — | | $ | — | $ | 16,540 -------------------------+------------------------------------------------+----------------------------------------------------------------+--------+-----------------------------------------------+---+---+-------------------------------------------+---+-------+---+------- As of September 30, 2017 and December 31, 2016, we had no financial liabilities measured at fair value on a recurring basis. Note 4. Intangible Assets, net. In 2012, in connection with our purchase of the serial flash memory product line assets from Atmel Corporation, we recorded $16.4 million of intangible assets. Intangible assets, net were as follows (in thousands): | September 30, 2017 | ------------------------------------------------+-----------------------+------- | Gross Carrying Amount | | Accumulated Amortization | | | Net Carrying Amount ------------------------------------------------+-----------------------+--------+--------------------------+---+-------+-------------------- Developed technology | $ | 4,282 | | $ | 2,142 | | $ | 2,140 ------------------------------------------------+-----------------------+--------+--------------------------+---+-------+---------------------+---+------ Customer relationships | | 9,011 | | | 3,754 | | | 5,257 ------------------------------------------------+-----------------------+--------+--------------------------+---+-------+---------------------+---+------ Customer backlog | | 2,779 | | | 2,779 | | | — ------------------------------------------------+-----------------------+--------+--------------------------+---+-------+---------------------+---+------ Non-compete agreement | | 282 | | | 282 | | | — ------------------------------------------------+-----------------------+--------+--------------------------+---+-------+---------------------+---+------ Total intangible assets subject to amortization | $ | 16,354 | | $ | 8,957 | | $ | 7,397 ------------------------------------------------+-----------------------+--------+--------------------------+---+-------+---------------------+---+------ | December 31, 2016 | ------------------------------------------------+-----------------------+------- | Gross Carrying Amount | | Accumulated Amortization | | | Net Carrying Amount ------------------------------------------------+-----------------------+--------+--------------------------+---+-------+-------------------- Developed technology | $ | 4,282 | | $ | 1,820 | | $ | 2,462 ------------------------------------------------+-----------------------+--------+--------------------------+---+-------+---------------------+---+------ Customer relationships | | 9,011 | | | 3,191 | | | 5,820 ------------------------------------------------+-----------------------+--------+--------------------------+---+-------+---------------------+---+------ Customer backlog | | 2,779 | | | 2,779 | | | — ------------------------------------------------+-----------------------+--------+--------------------------+---+-------+---------------------+---+------ Non-compete agreement | | 282 | | | 240 | | | 42 ------------------------------------------------+-----------------------+--------+--------------------------+---+-------+---------------------+---+------ Total intangible assets subject to amortization | $ | 16,354 | | $ | 8,030 | | $ | 8,324 ------------------------------------------------+-----------------------+--------+--------------------------+---+-------+---------------------+---+------ 12 ADESTO TECHNOLOGIES CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) We recorded amortization expense related to the acquisition-related intangible assets as follows (in thousands): | Three Months Ended September 30, | | Nine Months Ended September 30, | ----------------------------+----------------------------------+-----+---------------------------------+-- | 2017 | | 2016 | | | 2017 | | 2016 ----------------------------+----------------------------------+-----+---------------------------------+---+-----+------+---+----- Operating expense category: | | | | | | | | | | ----------------------------+----------------------------------+-----+---------------------------------+---+-----+------+---+------+---+---- Research and development | $ | 121 | | $ | 121 | | $ | 364 | $ | 363 ----------------------------+----------------------------------+-----+---------------------------------+---+-----+------+---+------+---+---- Sales and marketing | | 188 | | | 188 | | | 563 | | 564 ----------------------------+----------------------------------+-----+---------------------------------+---+-----+------+---+------+---+---- Total | $ | 309 | | $ | 309 | | $ | 927 | $ | 927 ----------------------------+----------------------------------+-----+---------------------------------+---+-----+------+---+------+---+---- The estimated future amortization expense of acquisition-related intangible assets subject to amortization after September 30, 2017 is as follows (in thousands): Year Ended December 31, | | --------------------------+---+------ 2017 (remaining 3 months) | $ | 295 --------------------------+---+------ 2018 | | 1,179 --------------------------+---+------ 2019 | | 1,179 --------------------------+---+------ 2020 | | 1,179 --------------------------+---+------ 2021 | | 1,179 --------------------------+---+------ Thereafter | | 2,386 --------------------------+---+------ Total | $ | 7,397 --------------------------+---+------ Note 5. Borrowings. Opus Bank Term Loan. In April 2015, we entered into a three-year $15.0 million credit agreement, or the term loan facility. The agreement provided for a senior secured term loan facility, in an aggregate principal amount of up to $15.0 million to be used for general corporate purposes including working capital, to repay certain indebtedness and for capital expenditures and other expenses. Interest accrued on outstanding borrowings at a rate equal to (a) the higher of (i) the prime rate (as publicly announced from time to time by the Wall Street Journal) and (ii) 3.25% plus (b) (i) 1.00% if our cash equivalents are greater than 125% of the outstanding principal of our borrowings under the term loan facility, or (ii) 2.00% if our cash and cash equivalents are less than or equal to 125% of such borrowings. Indebtedness we incurred under this agreement was collateralized by substantially all of our assets and the agreement contained financial covenants requiring us to maintain a monthly asset coverage ratio after September 30, 2015 of not less than 1.10 to 1.00, and quarterly adjusted EBITDA (measured on a trailing three-month basis) of $1 through September 30, 2016 and increasing to higher levels thereafter. Under the agreement, the quarterly EBITDA covenant was not applicable if the asset coverage ratio is met at all times during any particular quarter. The agreement contained customary affirmative and negative covenants, including covenants that limited or restricted our ability to, among other things, incur additional indebtedness, grant liens, make investments, repurchase stock, pay dividends, transfer assets, merge or consolidate and make acquisitions. Upon an occurrence of an event of default, we could have been required to pay interest on all outstanding obligations under the agreement at a rate of 5% above the otherwise applicable interest rate, and the lender may accelerate our obligations under the agreement. Borrowings of $14.0 million under this facility were repaid in full in July 2016. In connection with the term loan facility, Opus Bank received a warrant to purchase 31,897 shares of Series E convertible preferred stock. Upon the completion of our initial public offering (“IPO”) on October 30, 2015 the preferred stock warrants were converted into 315,282 of our common stock warrants. In addition, we paid financing costs of $0.1 million. The financing costs and the value of the warrant, $1.0 million, were recorded as a debt discount and were being amortized over the life of the agreement. Amortization of debt discount was $0.2 million for the six months ended June 30, 2016. In connection with the repayment of this facility in July 2016, the remaining unamortized debt discount of $0.4 million was recorded as interest expense in the condensed consolidated statements of operations. 13 ADESTO TECHNOLOGIES CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) Western Alliance Bank Term Loan . The Company is a party to that certain Business Financing Agreement dated July 7, 2016, by and between Western Alliance Bank and the Company, as amended (“Credit Facility”). The Credit Facility originally provided for (i) a term loan of up to $18.0 million (the “Term Loan”) and (ii) a revolving credit line advance (the “Line of Credit”) in the aggregate amount of the lower of (x) $2.0 million and (y) 80% of certain of the Company’s receivables. Prior to the Amendment (as defined below), the Term Loan bore interest at a rate per annum equal to the greater of the prime rate or 3.5%, plus 0.75% (5.00% on September 30, 2017), and was scheduled to mature in June 2019. Prior to the Amendment, the Line of Credit bore interest at a rate per annum equal to the greater of the prime rate or 3.5% plus 0.50% (4.75% on September 30, 2017), and was scheduled to mature in July 2018.Prior to the Amendment, we made interest-only payments on the Term Loan from July 2016 through September 2016 and began making interest payments and principal payments in 33 equal monthly installments starting October 2016. Prior to the Amendment, the Credit Facility provided that any indebtedness we incurred thereunder was collateralized by substantially all assets of the Company and any domestic subsidiaries, subject to certain customary exceptions. We paid a facility fee of $150,000 as well as a $25,000 diligence fee upon entry into the Credit Facility and an additional $10,000 on July 7, 2017. These fees have been recorded as a debt discount and are being amortized over the life of the agreement. During the nine months ended September 30, 2017, amortization of debt discount was $64,000 and the unamortized debt discount was $59,000 as of September 30, 2017. The Credit Facility contains customary representations and warranties and affirmative and negative covenants. Among other negative covenants, prior to the Amendment, the Credit Facility provided that we may not (i) permit the ratio of the balance of unrestricted cash deposited at the financial institution, plus eligible receivables, net of reserve to the total amounts owed with respect to advances under the revolving credit line to be less than 1.50 to 1.00 and (ii) permit cash held at the financial institution in a deposit account to be less than 100% of the term loan outstanding. Upon an occurrence of an event of default, under the Credit Facility we could be required to pay interest on all outstanding obligations under the agreement at a rate of 5% above the otherwise applicable interest rate, and the lender may accelerate our obligations under the agreement. As of September 30, 2017, we were in compliance with all financial covenants and restrictions. On September 29, 2017, we amended the Credit Facility by entering into that certain Second Business Financing Modification Agreement, dated September 29, 2017 (the “Amendment”) with Western Alliance Bank. The Amendment extended the maturity dates of the Line of Credit and the Term Loan to July 2019 and September 2021, respectively, from July 2018 and June 2019, respectively. In addition, the Amendment increased the amount available under the Line of Credit in the aggregate amount to $5.0 million. The Amendment also decreased the interest rates under the Line of Credit and the Term Loan and changed the payment schedule under the Term Loan. Under the Agreement, we will make interest-only payments on the Term Loan from October 10, 2017 and on the 10th calendar day of each month thereafter, and will make principal and interest payments in 36 equal installments beginning on October 10, 2018, and on the 10th calendar day of each month thereafter, until the maturity date of the Term Loan. Pursuant to the Amendment, our Intellectual Property (as defined in the Amendment) is excluded from the collateral used to secure the indebtedness we incurred under the Credit Facility. Under the Amendment, we have agreed to modified and additional negative covenants, requiring us to maintain a ratio of at least 1.25 to 1.00 with respect to either of the following: (x) the sum of our cash and certain receivables to our indebtedness under the Credit Facility; or (y) our Adjusted EBITDA (as defined in the Amendment), less certain capital expenditures, to the sum of (a) all principal payments and interest expense that we would have owed to the Lender if the Term Loan’s amortization were to start on September 29, 2017, all measured on a trailing 4-quarter basis, plus (b) all principal payments and interest expense on any of our other debt. The Amendment also subjects us to the requirement that our quarterly revenues shall not negatively deviate more than 25% from the projections provided to Western Alliance Bank in accordance with the Credit Facility. Outstanding borrowings consisted of the following (in thousands): | September 30, | | December 31, | -----------------------+---------------+--------+--------------+-- | 2017 | | 2016 | -----------------------+---------------+--------+--------------+-- Term loan, current | $ | — | | $ | 6,466 -----------------------+---------------+--------+--------------+---+------- Term loan, non-current | | 11,396 | | | 9,775 -----------------------+---------------+--------+--------------+---+------- Line of credit | | 2,000 | | | 1,807 -----------------------+---------------+--------+--------------+---+------- Total | $ | 13,396 | | $ | 18,048 -----------------------+---------------+--------+--------------+---+------- 14 ADESTO TECHNOLOGIES CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) Future repayments on outstanding borrowings (excluding unamortized discount of $ 59 ,000 as of September 30, 2017 ) are as follows (in thousands): Year ending December 31, | | --------------------------+---+------- 2017 (remaining 3 months) | $ | — --------------------------+---+------- 2018 | | 1,000 --------------------------+---+------- 2019 | | 6,000 --------------------------+---+------- 2020 | | 4,000 --------------------------+---+------- 2021 | | 2,455 --------------------------+---+------- | $ | 13,455 --------------------------+---+------- Interest expense incurred under our borrowings was $0.2 million and $0.6 million for the three and nine months ended September 30, 2017, respectively. Interest expense incurred under our borrowings was $0.6 million and $1.1 million for the three and nine months ended September 30, 2016, respectively. Note 6. Segment Information. We operate in one business segment, application-specific and feature-rich, ultra-low power NVM products. Our chief decision-maker, the President and Chief Executive Officer, evaluates our performance based on company-wide consolidated results. Revenue is evaluated based on product category and by geographic region. Product revenue from customers is designated based on the geographic region to which the product is delivered. Revenue by geographic region was as follows (in thousands): | Three Months Ended September 30, | | Nine Months Ended September 30, | -----------------+----------------------------------+--------+---------------------------------+-- | 2017 | | 2016 | | | 2017 | | 2016 -----------------+----------------------------------+--------+---------------------------------+---+--------+------+---+------- United States | $ | 3,331 | | $ | 1,873 | | $ | 8,853 | $ | 4,780 -----------------+----------------------------------+--------+---------------------------------+---+--------+------+---+--------+---+------- Rest of Americas | | 58 | | | 64 | | | 189 | | 335 -----------------+----------------------------------+--------+---------------------------------+---+--------+------+---+--------+---+------- Europe | | 2,044 | | | 1,466 | | | 6,054 | | 4,313 -----------------+----------------------------------+--------+---------------------------------+---+--------+------+---+--------+---+------- Asia Pacific | | 9,729 | | | 7,730 | | | 24,540 | | 21,979 -----------------+----------------------------------+--------+---------------------------------+---+--------+------+---+--------+---+------- Rest of world | | 77 | | | 47 | | | 322 | | 231 -----------------+----------------------------------+--------+---------------------------------+---+--------+------+---+--------+---+------- Total | $ | 15,239 | | $ | 11,180 | | $ | 39,958 | $ | 31,638 -----------------+----------------------------------+--------+---------------------------------+---+--------+------+---+--------+---+------- Long-lived assets are attributed to the geographic region were they are located. Long-lived assets by geographic region were as follows (in thousands): | September 30, | | December 31, | ----------------------------------+---------------+-------+--------------+-- | 2017 | | 2016 | ----------------------------------+---------------+-------+--------------+-- United States | $ | 5,646 | | $ | 5,489 ----------------------------------+---------------+-------+--------------+---+------ Asia Pacific | | 679 | | | 472 ----------------------------------+---------------+-------+--------------+---+------ Europe | | — | | | 1 ----------------------------------+---------------+-------+--------------+---+------ Total property and equipment, net | $ | 6,325 | | $ | 5,962 ----------------------------------+---------------+-------+--------------+---+------ Note 7. Commitments and Contingencies. Operating Leases. The Company leases office facilities under various non-cancelable operating lease agreements. Certain lease agreements contain free or escalating rent payment provisions. The Company recognizes rent expense under such leases on a straight-line basis over the term of the lease with the difference between the expense and the payments recorded as deferred rent on the condensed consolidated balance sheets. Any reimbursements by the landlord for tenant improvements are considered lease incentives, the balance of which is 15 ADESTO TECHNOLOGIES CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) recorded as a lease incentive obligation within deferred rent on the condensed consolidated balance sheets, and amortized as a reduction of rent expense over the life of the lease. Lease renewal periods are considered on a lease-by-lease basis in determining the lease term. On November 2, 2015, the Company extended the lease for its headquarters by six months to July 2016 by entering into that certain Amendment to Commercial Sublease (“Amendment”), dated November 2, 2015, between the Company and eGain Corporation. The Amendment provides for a base rent during the extension period of $47,000 per month. Subsequently, we extended the lease to August 31, 2016. Additionally, on November 2, 2015, the Company entered into a lease with Peterson Ridge LLC pursuant to which the Company leased a new headquarters facility, consisting of an aggregate of approximately 34,000 square feet of space in Santa Clara, California. The initial term of the lease commenced on November 2, 2015 and is scheduled to end on July 31, 2023 and may be extended, at the Company’s option, for an additional five-year period following the initial lease term. Pursuant to the lease, monthly base rental payments due under the lease are approximately $93,000 per month between August 1, 2016 and February 27, 2017, with annual increases of approximately 3% thereafter. The Company must also pay for certain other operating costs under the lease, including operating expenses, taxes, assessments, insurance, utilities, securities and property management fees. Peterson Ridge LLC is obligated to reimburse the Company for up to approximately $2.5 million of the Company’s out-of-pocket costs associated with any tenant improvements, as defined in the lease. The Company was reimbursed for this amount during the year ended December 31, 2016. As of September 30, 2017, the Company recorded a lease incentive obligation of $2.1 million in deferred rent on the condensed consolidated balance sheet. Rent expense under operating leases was $0.3 million and $0.8 million for the three and nine months ended September 30, 2017, respectively. Rent expense under operating leases was $0.4 million and $1.5 million for the three and nine months ended September 30, 2016, respectively. | Total | | Remaining 2017 | | | 2018 | | 2019 | 2020 | | 2021 | | | Thereafter -----------------+----------------+-------+----------------+---+-----+------+---+-------+------+-------+------+---+-------+----------- | (in thousands) | -----------------+----------------+------ Operating leases | $ | 7,390 | | $ | 302 | | $ | 1,210 | $ | 1,223 | | $ | 1,249 | | $ | 1,287 | $ | 2,119 -----------------+----------------+-------+----------------+---+-----+------+---+-------+------+-------+------+---+-------+------------+---+-------+---+------ Purchase Commitments. As of September 30, 2017, we had purchase commitments with our third-party foundries of $4.0 million due within one year, $0.6 million for a licensing and development agreement, and $7.9 million in conjunction with an agreement with TowerJazz Panasonic Semiconductor Company. Litigation. We may be subject to legal proceedings, claims and litigation, including intellectual property litigation, arising in the ordinary course of business. Such matters are subject to many uncertainties and outcomes and are not predictable with assurance. We accrue amounts that we believe are adequate to address any liabilities related to legal proceedings and other loss contingencies that we believe will result in a probable loss that is reasonably estimable. Indemnification. During the normal course of business, we may make certain indemnities, commitments and guarantees which may include intellectual property indemnities to certain of our customers in connection with the sales of our products and indemnities for liabilities associated with the infringement of other parties’ technology based upon our products. Our exposure under these indemnification provisions is generally limited to the total amount paid by a customer under the agreement. However, certain agreements include indemnification provisions that could potentially expose us to losses in excess of the amount received under the agreement. In addition, we indemnify our officers, directors and certain key employees while they are serving in good faith in such capacities. 16 ADESTO TECHNOLOGIES CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) We have not recorded any liability for these indemnities, commitments and guarantees in the accompanying condensed consolidated balance sheets. Where necessary, we accrue for losses for any known contingent liabilities, including those that may arise from indemnification provisions, when future payme nt is probable. Note 8. Common Stock, Common Stock Warrants and Stock Option Plan. Common Stock. We are authorized to issue 100,000,000 shares of common stock with $0.0001 par value per share as of September 30, 2017 and December 31, 2016. Each holder of common stock is entitled to one vote per share. As of September 30, 2017, no dividends have been declared by the Board of Directors, however, the holders of common stock are also entitled to receive dividends, when and if declared by our Board of Directors. We completed a follow-on offering of our common stock in June 2017. We sold 5,000,000 shares, including 625,000 shares upon exercise of the underwriters’ option to purchase additional shares. The shares were sold at a public offering price of $4.00 per share for net proceeds of $18.4 million to us, after deducting underwriting discounts and commissions and offering expenses. Common Stock Reserved for Future Issuance. As of September 30, 2017 and December 31, 2016, we had reserved shares of common stock for future issuances as follows: | September 30, | | December 31, ----------------------------------------------+---------------+-----------+------------- | 2017 | | 2016 ----------------------------------------------+---------------+-----------+------------- Warrants to purchase common stock | | 404,136 | | 411,514 ----------------------------------------------+---------------+-----------+--------------+---------- Stock option plan: | | | | ----------------------------------------------+---------------+-----------+--------------+---------- Options outstanding | | 1,592,551 | | 991,895 ----------------------------------------------+---------------+-----------+--------------+---------- Restricted stock units outstanding | | 635,161 | | 490,954 ----------------------------------------------+---------------+-----------+--------------+---------- Shares available for future grants/RSU grants | | 602,463 | | 1,275,685 ----------------------------------------------+---------------+-----------+--------------+---------- Shares available for ESPP | | 275,587 | | 231,355 ----------------------------------------------+---------------+-----------+--------------+---------- Total | | 3,509,898 | | 3,401,403 ----------------------------------------------+---------------+-----------+--------------+---------- Common Stock Warrants. The following common stock warrants were outstanding as of September 30, 2017 and December 31, 2016 and were the result of a conversion of preferred stock warrants upon the completion of our IPO on October 30, 2015. Total amount of securities issuable under the outstanding warrants | | Exercise Price | | | Issuance Date | Expiration Date -------------------------------------------------------------------+---------+----------------+---+-------+---------------+---------------- | 74,141 | | $ | 30.35 | | 2012-2013 | 2019 -------------------------------------------------------------------+---------+----------------+---+-------+---------------+-----------------+---------- | 329,995 | | $ | 2.38 | | 2014-2015 | 2022-2024 -------------------------------------------------------------------+---------+----------------+---+-------+---------------+-----------------+---------- | 404,136 | | | | | | -------------------------------------------------------------------+---------+----------------+---+-------+---------------+-----------------+---------- Common stock warrants are exercisable at the option of the holder any time after the date of issuance into shares of our common stock. The aggregate amount of shares of common stock that would be issued is determined by dividing the exercisable price by the conversion price applicable on the date of conversion multiplied by the number of warrants exercised. Employee Benefit Plans. 2007 Equity Incentive Plan. In 2007, our Board of Directors and shareholders approved the 2007 Equity Incentive Plan (the “2007 Plan”) under which 272,727 shares of common stock were reserved and available for the issuance of stock options and restricted stock to eligible participants. The 2007 Plan was subsequently amended to increase the number of shares of common stock reserved for issuance under the 2007 Plan to 787,878 and during the year ended December 31, 2015, the number of shares reserved for issuance under the 2007 Plan was increased 17 ADESTO TECHNOLOGIES CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) to 2,651,515. Options and restricted stock awards were granted at a price per share not l ess than the 85% of the fair value at the date of grant or award, respectively. Restricted stock awarded to persons controlling more than 10% of our stock were granted at a price per share not less than the 100% of the fair value at the date of the award. Options that were granted to new employees generally vest over a four-year period with 25% vesting at the end of one year and the remaining to vest monthly thereafter, while options that were granted to existing employees generally vest over a four-year pe riod. Options granted generally are exercisable up to 10 years from the date of grant. As of October 26, 2015, no shares were available for grant under the 2007 Plan and all outstanding options would continue to be governed and remain outstanding in accord ance with their existing terms under the 2007 Plan. In addition, any shares subject to outstanding awards under the 2007 Plan that are issuable upon the exercise of options that expire or become unexercisable for any reason without having been exercised in full will be available for future grant and issuance under the 2015 Plan (as defined below). 2015 Equity Incentive Plan. In September 2015, our Board of Directors adopted, and in October 2015 our stockholders approved, our 2015 Equity Incentive Plan. The 2015 Equity Incentive Plan became effective on the date immediately prior to the date of our IPO. As a result, 1,813,272 shares of common stock previously reserved but unissued under the 2007 Plan on the effective date of the 2015 Equity Incentive Plan became reserved for issuance under our 2015 Equity Incentive Plan, and we ceased granting awards under our 2007 Plan. The number of shares reserved for issuance under our 2015 Equity Incentive Plan will increase automatically on the first day of January of each of 2016 through 2025 by the number of shares equal to 4% of the total outstanding shares of our common stock as of the immediately preceding December 31. However, our Board of Directors may reduce the amount of the increase in any particular year. Our 2015 Equity Incentive Plan authorizes the award of stock options, restricted stock awards, stock appreciation rights, restricted stock units (“RSUs”), performance awards and stock bonuses. No person will be eligible to receive more than 2,000,000 shares in any calendar year under our 2015 Equity Incentive Plan other than a new employee of ours, who will be eligible to receive no more than 4,000,000 shares under the plan in the calendar year in which the employee commences employment. The aggregate number of shares of our common stock that may be subject to awards granted to any one non-employee director pursuant to the 2015 Equity Incentive Plan in any calendar year shall not exceed 300,000. Our 2015 Equity Incentive Plan provides that no more than 25,000,000 shares will be issued as incentive stock options. 2015 Employee Stock Purchase Plan In September 2015, our Board of Directors adopted, and in October 2015 our stockholders approved, our 2015 Employee Stock Purchase Plan (“ESPP”). The 2015 Employee Stock Purchase Plan became effective on the date of our IPO. We reserved 150,000 shares of our common stock for issuance under our 2015 Employee Stock Purchase Plan. The number of shares reserved for issuance under our 2015 Employee Stock Purchase Plan will increase automatically on the first day of January following the first offering date by the number of shares equal to 1% of the total outstanding shares of our common stock as of the immediately preceding December 31 (rounded to the nearest whole share). However, our Board of Directors may reduce the amount of the increase in any particular year. The aggregate number of shares issued over the term of our 2015 Employee Stock Purchase Plan will not exceed 2,250,000 shares of our common stock. Under our 2015 Employee Stock Purchase Plan, eligible employees will be able to acquire shares of our common stock by accumulating funds through payroll deductions. Eligible employees will be able to select a rate of payroll deduction up to 15% of their base cash compensation. The purchase price for shares of our common stock purchased under our 2015 Employee Stock Purchase Plan will be 85% of the lesser of the fair market value of our common stock on (i) the first trading day of the applicable offering period and (ii) the last trading day of each purchase period in the applicable offering period. Except for the first offering period, each offering period will run for no more than six months, with purchases occurring every six months. The first offering period began upon the effective date of our IPO and was originally set to end on June 30, 2016. On May 25, 2016, the Board of Directors extended the initial offering period to July 31, 2016. Subsequent purchase periods will be 6 months in duration beginning on August 1, 2016. On July 29, 2016, we issued 68,392 shares of common stock in conjunction with the end date of the initial purchase period. On January 31, 2017, we issued 50,917 shares of common stock in conjunction with the end date of that purchase period. On July 31, 2017, we issued 59,794 shares of common stock in conjunction with the end of the most recent purchase period. No participant will have the right to purchase shares of our common stock in an amount that has a fair market value greater than $25,000, determined as of the first day of the applicable purchase period, for each calendar year in which that right is outstanding. In addition, no participant will be permitted to purchase more than 2,500 shares during any one purchase period or a lesser amount as determined by our compensation committee. 18 ADESTO TECHNOLOGIES CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) Our 2015 Employee Stock Purchase Plan will continue until the earlier to occur of its termination by our Board of Directors, the issuance of all shares reserved for issuance under it or the tenth anniversary of its effective date. A summary of stock option and restricted stock units (including performance-based RSU) activity under the 2007 Plan and the 2015 Equity Incentive Plan is as follows: | Stock Options | -------------------------------------------------------------+------------------------------------------+---------- | Shares | | | Weighted- Average Exercise Price | | | Weighted- Average Remaining Contractual Term (Years) | Aggregate Intrinsic Value -------------------------------------------------------------+------------------------------------------+-----------+---+----------------------------------+---+------+------------------------------------------------------+-------------------------- | (aggregate intrinsic value in thousands) | -------------------------------------------------------------+------------------------------------------+---------- Outstanding as of December 31, 2015 | | 796,356 | | | $ | 2.49 | | 6.5 | $ | 4,157 -------------------------------------------------------------+------------------------------------------+-----------+---+----------------------------------+---+------+------------------------------------------------------+---------------------------+---+------ Granted | | 230,200 | | | | 3.38 | | | | -------------------------------------------------------------+------------------------------------------+-----------+---+----------------------------------+---+------+------------------------------------------------------+---------------------------+---+------ Exercised | | (13,112 | ) | | | 1.80 | | | | -------------------------------------------------------------+------------------------------------------+-----------+---+----------------------------------+---+------+------------------------------------------------------+---------------------------+---+------ Canceled | | (21,549 | ) | | | 3.73 | | | | -------------------------------------------------------------+------------------------------------------+-----------+---+----------------------------------+---+------+------------------------------------------------------+---------------------------+---+------ Outstanding as of December 31, 2016 | | 991,895 | | | | 2.68 | | 6.3 | | 161 -------------------------------------------------------------+------------------------------------------+-----------+---+----------------------------------+---+------+------------------------------------------------------+---------------------------+---+------ Granted | | 809,980 | | | | 4.19 | | | | -------------------------------------------------------------+------------------------------------------+-----------+---+----------------------------------+---+------+------------------------------------------------------+---------------------------+---+------ Exercised | | (176,265 | ) | | | 1.70 | | | | -------------------------------------------------------------+------------------------------------------+-----------+---+----------------------------------+---+------+------------------------------------------------------+---------------------------+---+------ Canceled | | (33,059 | ) | | | 4.06 | | | | -------------------------------------------------------------+------------------------------------------+-----------+---+----------------------------------+---+------+------------------------------------------------------+---------------------------+---+------ Outstanding as of September 30, 2017 | | 1,592,551 | | | $ | 3.53 | | 7.8 | $ | 6,996 -------------------------------------------------------------+------------------------------------------+-----------+---+----------------------------------+---+------+------------------------------------------------------+---------------------------+---+------ Options vested and expected to vest as of September 30, 2017 | | 1,526,547 | | | $ | 3.50 | | 7.8 | $ | 6,755 -------------------------------------------------------------+------------------------------------------+-----------+---+----------------------------------+---+------+------------------------------------------------------+---------------------------+---+------ Options vested and exercisable as of September 30, 2017 | | 766,120 | | | $ | 2.83 | | 6.3 | $ | 3,917 -------------------------------------------------------------+------------------------------------------+-----------+---+----------------------------------+---+------+------------------------------------------------------+---------------------------+---+------ | Restricted Stock Units | -------------------------------------+------------------------------------------+--------- | Shares | | | Weighted- Average Grant Date Fair Value | | | Weighted- Average Remaining Contractual Term (Years) | | Aggregate Intrinsic Value -------------------------------------+------------------------------------------+----------+---+----------------------------------------------+---+------+------------------------------------------------------+---+-------------------------- | (aggregate intrinsic value in thousands) | -------------------------------------+------------------------------------------+--------- Outstanding as of December 31, 2015 | | 874,508 | | | $ | 5.95 | | | 1.8 | | $ | 6,742 -------------------------------------+------------------------------------------+----------+---+----------------------------------------------+---+------+------------------------------------------------------+---+---------------------------+---+---+------ Granted | | 69,414 | | | | 4.82 | | — | | — | -------------------------------------+------------------------------------------+----------+---+----------------------------------------------+---+------+------------------------------------------------------+---+---------------------------+---+-- Released | | (438,086 | ) | | | 5.95 | | — | | — | -------------------------------------+------------------------------------------+----------+---+----------------------------------------------+---+------+------------------------------------------------------+---+---------------------------+---+-- Forfeited/expired | | (14,882 | ) | | | 5.70 | | — | | — | -------------------------------------+------------------------------------------+----------+---+----------------------------------------------+---+------+------------------------------------------------------+---+---------------------------+---+-- Outstanding as of December 31, 2016 | | 490,954 | | | | 5.80 | | | 0.5 | | | 908 -------------------------------------+------------------------------------------+----------+---+----------------------------------------------+---+------+------------------------------------------------------+---+---------------------------+---+---+------ Granted | | 541,513 | | | | 2.88 | | | | | | -------------------------------------+------------------------------------------+----------+---+----------------------------------------------+---+------+------------------------------------------------------+---+---------------------------+---+---+------ Released | | (371,866 | ) | | | 5.65 | | | | | | -------------------------------------+------------------------------------------+----------+---+----------------------------------------------+---+------+------------------------------------------------------+---+---------------------------+---+---+------ Forfeited/expired | | (25,440 | ) | | | 5.98 | | | | | | -------------------------------------+------------------------------------------+----------+---+----------------------------------------------+---+------+------------------------------------------------------+---+---------------------------+---+---+------ Outstanding as of September 30, 2017 | | 635,161 | | | $ | 3.39 | | | 1.3 | | $ | 4,986 -------------------------------------+------------------------------------------+----------+---+----------------------------------------------+---+------+------------------------------------------------------+---+---------------------------+---+---+------ Note 9. Stock-based Compensation. We record stock-based compensation based on fair value as of the grant date using the Black-Scholes option-pricing model for stock options granted and Monte Carlo simulation techniques for certain restricted stock units with performance-based vesting conditions. We recognize such costs as compensation expense on a straight-line basis over the employee’s requisite service period, which is generally four years. Our valuation assumptions for stock options are as follows: Fair value of common stock. Prior to our IPO in October 2015, we estimated the fair value of our common stock using various valuation methodologies, including valuation analyses performed by third-party valuation firms. After the IPO, we used the publicly quoted price as the fair value of our common stock. 19 ADESTO TECHNOLOGIES CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) Risk-free interest rate. We base the risk-free interest rate used in the Black-Scholes option-pricing model on the implied yield available on U.S. Tr easury zero-coupon issues with an equivalent expected term of the options for each option group. Expected term. The expected term represents the period that our stock-based awards are expected to be outstanding. The expected term assumption is based on the simplified method in which the expected term is equal to the average of the stock-based award’s weighted-average vesting period and its contractual term. We expect to continue using the simplified method until sufficient information about historical behavior is available. Volatility. We determine volatility based on the historical stock volatilities of a group of publicly listed guideline companies over a period equal to the expected terms of the options, as we do not have sufficient trading history to determine the volatility of our common stock. Dividend yield. We have never declared or paid any cash dividend and do not currently plan to pay a cash dividend in the foreseeable future. Consequently, we used an expected dividend yield of zero. The following table summarizes the weighted-average assumptions used in the Black-Scholes option-pricing model to determine fair value of stock options: | Three Months Ended September 30, | | Nine Months Ended September 30, -------------------------+----------------------------------+---+-------------------------------- | 2017 | | 2016 | | 2017 | 2016 | -------------------------+----------------------------------+---+---------------------------------+---+------+------+-- Volatility | | — | | — | | 86 | % | 51 | % -------------------------+----------------------------------+---+---------------------------------+---+------+------+---+------+-- Expected dividend yield | | — | | — | | — | | — | -------------------------+----------------------------------+---+---------------------------------+---+------+------+---+------+-- Risk-free rate | | — | | — | | 2.15 | % | 1.34 | % -------------------------+----------------------------------+---+---------------------------------+---+------+------+---+------+-- Expected term (in years) | | — | | — | | 6 | | 6 | -------------------------+----------------------------------+---+---------------------------------+---+------+------+---+------+-- The weighted-average grant date fair value of the options granted under the 2015 Equity Incentive Plan as calculated using the Black-Scholes option-pricing model was $3.03 per share for the nine months ended September 30, 2017. No grants were made during the three months ended September 30, 2017 and 2016. On April 1, 2017, our compensation committee granted 204,220 RSUs that do not begin vesting unless certain performance goals are met. All performance goals must be met in order for the shares to begin vesting. Vesting would begin on the one-year anniversary of the grant date. These performance goals relate to a) the price performance of our common stock one year from the grant date as compared to a threshold established by our compensation committee and b) revenue, gross profit and EBITDA performance relative to plan targets for fiscal 2017 established by our compensation committee. As a result of these performance-based vesting conditions we valued these RSUs using Monte Carlo simulation techniques to establish a fair value per share of $0.81 at the time of grant. The following table presents the effects of stock-based compensation for stock options, RSUs (including performance-based RSUs), and ESPP purchase rights (in thousands): | Three Months Ended September 30, | | Nine Months Ended September 30, | ---------------------------+----------------------------------+-------+---------------------------------+-- | 2017 | | 2016 | | | 2017 | | 2016 ---------------------------+----------------------------------+-------+---------------------------------+---+-----+------+---+------ Cost of revenue | $ | 35 | | $ | 22 | | $ | 86 | $ | 60 ---------------------------+----------------------------------+-------+---------------------------------+---+-----+------+---+-------+---+------ Research and development | | 373 | | | 273 | | | 937 | | 787 ---------------------------+----------------------------------+-------+---------------------------------+---+-----+------+---+-------+---+------ Sales and marketing | | 239 | | | 186 | | | 621 | | 530 ---------------------------+----------------------------------+-------+---------------------------------+---+-----+------+---+-------+---+------ General and administrative | | 420 | | | 398 | | | 1,229 | | 1,131 ---------------------------+----------------------------------+-------+---------------------------------+---+-----+------+---+-------+---+------ Total | $ | 1,067 | | $ | 879 | | $ | 2,873 | $ | 2,508 ---------------------------+----------------------------------+-------+---------------------------------+---+-----+------+---+-------+---+------ Stock-based compensation expense capitalized to inventories was not material during the three and nine months ended September 30, 2017 and 2016. We did not realize any income tax benefit from stock option exercises in any of the periods presented due to recurring losses and valuation allowances. 20 ADESTO TECHNOLOGIES CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) As of September 30, 2017 , the total unrecognized compensation cost related to stock options, net of estimated forfeitures , was approximately $ 2 . 1 million, and this amount is expected to be recognized over a weighted-average period of approximately 3 . 1 years. As of September 30, 2017, the total unrecognized compensation cost related to RSUs (including performance-based RSUs) and ESPP purchase rights was $1.4 million and $54,000, respectively, and these amounts are expected to be recognized over 2.0 years and 0.3 years, respectively. Note 10. Income Taxes. We recorded an income tax provision of $17,000 and $15,000 for the three months ended September 30, 2017 and 2016, respectively, and $57,000 and $46,000 for the nine months ended September 30, 2017 and 2016, respectively. The income tax provision is comprised of estimates of current taxes due in domestic and foreign jurisdictions. The income tax provision reflects tax expense associated with state income tax, foreign taxes, uncertain tax positions and tax expense related to the recording of a deferred tax liability that results from the amortization for income tax purposes of acquisition-related goodwill. The decrease in the tax provision between 2017 and 2016 is primarily due to a decrease in foreign taxes. As of September 30, 2017, our deferred tax assets are fully offset by a valuation allowance except in those jurisdictions where it is determined that a valuation allowance is not required. Accounting for income taxes provides for the recognition of deferred tax assets if realization of such assets is more likely than not. Based on the weight of available evidence, which includes historical operating performance, reported cumulative net losses since inception and difficulty in accurately forecasting our future results, we provided a full valuation allowance against our net U.S. deferred tax assets. We reassess the need for our valuation allowance on a quarterly basis. If it is later determined that a portion or all of the valuation allowance is not required, it generally will be a benefit to the income tax provision in the period that such determination is made. We evaluate tax positions for recognition using a more-likely-than-not recognition threshold, and those tax positions eligible for recognition are measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon the effective settlement with a taxing authority that has full knowledge of all relevant information. We believe that we have provided adequate reserves for our income tax uncertainties in all open tax years. We do not anticipate a material change in the total amount or composition of its unrecognized tax benefits within 12 months of September 30, 2017. We file federal, state and foreign income tax returns in jurisdictions with varying statutes of limitations. Due to our net operating loss and credit carryforwards, our income tax returns generally remain subject to examination by federal, state and international authorities. Note 11. Net Loss Per Share. The following outstanding common stock equivalents were excluded from the computation of diluted net loss per share for the periods presented because including them would have been antidilutive: | Three and Nine Months Ended September 30, | -----------------------------------------------------------------------------+-------------------------------------------+---------- | 2017 | | 2016 -----------------------------------------------------------------------------+-------------------------------------------+-----------+----- Shares not used in computing net loss per share as considered anti-dilutive: | | | | -----------------------------------------------------------------------------+-------------------------------------------+-----------+------+---------- Stock options | | 1,592,551 | | 984,386 -----------------------------------------------------------------------------+-------------------------------------------+-----------+------+---------- Common stock warrants | | 404,136 | | 411,514 -----------------------------------------------------------------------------+-------------------------------------------+-----------+------+---------- Restricted stock units | | 635,161 | | 931,874 -----------------------------------------------------------------------------+-------------------------------------------+-----------+------+---------- | | 2,631,848 | | 2,327,774 -----------------------------------------------------------------------------+-------------------------------------------+-----------+------+---------- 21 ADESTO TECHNOLOGIES CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) Note 12 . Related Party Transactions . The Company purchases certain wafers from one of its stockholders, Altis Semiconductor S.N.C. This stockholder was acquired in 2016 by X-FAB Silicon Foundries (“X-FAB”), resulting in X-FAB becoming one of our stockholders. We made payments of $45,000 and $82,000 to X-FAB during the three and nine months ended September 30, 2017. We made payments of $0 and $172,000 to X-FAB during the three and nine months ended September 30, 2016, respectively. As of September 30, 2017 and December 31, 2016, invoices totaling $113,000 and $195,000, respectively, were payable to X-FAB and included within accounts payable on the condensed consolidated balance sheets. Note 13. Subsequent Events. None 22 Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Forward-looking statements and factors that may affect future results The discussion below contains forward-looking statements, which are subject to safe harbors under the Securities Act of 1933, as amended (the “Securities Act”) and the Exchange Act of 1934, as amended (the “Exchange Act”). Forward-looking statements generally relate to future events or to our future financial or operating performance. You can generally identify forward-looking statements because they contain words such as “may,” “might,” “will,” “should,” “expects,” “plans,” “anticipates,” “could,” “intend,” “target,” “projects,” “contemplates,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of these terms or other similar expressions that concern our expectations, strategy, plans or intentions. We have based these forward-looking statements primarily on our current expectations and projections about future events and trends that we believe may affect our business, financial condition, results of operations and prospects. Except as required by law, we do not undertake any obligation to update these forward-looking statements to reflect events occurring or circumstances arising after the date of this report. You should not rely upon forward-looking statements as predictions of future events. We cannot assure you that the results, events and circumstances reflected in the forward-looking statements will be achieved or occur, and actual results, events or circumstances could differ materially from those projected in the forward-looking statements. These forward-looking statements involve risks and uncertainties, and our actual results, performance, or achievements could differ materially from those expressed or implied by the forward-looking statements on the basis of several factors, including those that we discuss in Risk Factors, set forth in Part II, Item 1A, of this Quarterly Report on Form 10-Q. We encourage you to read that section carefully. The following is a discussion and analysis of our financial condition and results of operations and should be read together with our condensed consolidated financial statements and related notes to condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q and our audited consolidated financial statements and related notes to audited consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2016. In this Quarterly Report, unless otherwise specified or the context otherwise requires, “Adesto,” “we,” “us,” and “our” refer to Adesto Technologies Corporation and its consolidated subsidiaries. Overview We are a leading provider of application-specific and ultra-low power non-volatile memory, or NVM, products. We optimize our NVM products for Internet of Things, or IoT, applications including current and next-generation Internet-connected devices in the consumer, industrial, medical and wearables markets. We combine our NVM design capabilities with proprietary intellectual property and differentiated technology platforms to deliver high-performance products that dramatically reduce the overall energy consumption of our customers’ systems and extend battery life. Our products feature embedded intelligence in a small form factor and high reliability. Our revenue is derived from the sale of our NVM products, primarily our serial flash memory products, which represented substantially all of our revenue for the three months ended September 30, 2017. On September 28, 2012, we purchased certain flash memory product assets from Atmel Corporation, or Atmel. The products we acquired were approaching the end of their life cycle and experiencing annual revenue declines. While we provide support for these products, we have not invested further in their research and development and generate no material revenue from their sale. Since the acquisition, we have invested in developing new products that are better suited for low-power, high-growth applications, accelerated development of select products and introduced new products based on the acquired technology. In 2013, we introduced the first of our next-generation DataFlash and Fusion Flash products, which have similar functionality to our legacy products, but also offer enhanced features such as ultra-deep power down and wide supply voltage range operation. Revenue from our next-generation NVM products were $15.2 million and $11.1 million for the three months ended September 30, 2017 and 2016, respectively. We had been exclusively developing products based on Conductive Bridging RAM, or CBRAM, technology prior to the acquisition of assets from Atmel. Since then, we have continued to invest our resources into developing and enhancing our families of CBRAM-based products, although revenue associated with these products has not been material to date. We have made and continue to make these upfront investments because we believe that the introduction of any fundamentally new semiconductor technology must necessarily go through a lengthy customer evaluation process and several cycles of improvement in the field before it can be widely adopted or generate material revenue. For the nine months ended September 30, 2017, our products were sold to more than 1,000 end customers. In general, we work directly with our customers to have our NVM devices designed into and qualified for their products. Although we maintain direct sales, support and development relationships with our customers, once our products are designed into a customer’s product, we sell a majority of our products to those customers through distributors. We generated 74% and 69% of our revenue from distributors during the nine months ended September 30, 2017 and 2016, respectively. Sales to three distributors generated approximately 38% and 35% of our revenue during the nine months ended September 30, 2017 and 2016, respectively. Additionally, we derived approximately 78% and 85% of our revenue internationally during the nine months ended September 30, 2017 and 2016, respectively, the majority of 23 which was recognized in the Asia Pacific, or APAC, region. Revenue by geography is recognized based on the region to which our products are sold, and not to where the end products are shipped . We employ a fabless manufacturing strategy and use market-leading suppliers for all phases of the manufacturing process, including wafer fabrication, assembly, testing and packaging. This strategy significantly reduces the capital investment that would otherwise by required to operate manufacturing facilities of our own. Factors Affecting Our Performance Product adoption in new markets and applications. We optimize our products to meet the technical requirements of the emerging IoT market. The growth in the IoT market is dependent on many factors, most of which are outside of our control. Should the IoT market not develop or develop more slowly, our financial results could be adversely affected. Ability to attract and retain customers that make large orders. In 2016, our products were sold to more than 500 end customers, of which approximately 20 generated more than half our revenue. One end customer accounted for 10% or more of our revenue in 2016 and 2015 and the first nine months of 2017. No end customer accounted for 10% or more of our revenue in 2014. While we expect the composition of our customers to change over time, our business and operating results will depend on our ability to continually target new and retain existing customers that make large orders, particularly those in growth markets which are less dependent on macroeconomic conditions. Design wins with new and existing customers. We believe our solutions significantly improve the performance and potentially lower the system cost of our customers’ designs, particularly if we are part of the early design phase. Accordingly, we work closely with our customers and targeted prospects to understand their product roadmaps and strategies. We consider design wins to be critical to our future success. We define a design win as the successful completion of the evaluation stage, where a customer has tested our product, verified that our product meets its requirements and qualified our NVM device for their products. The number of our design wins has grown from 65 in 2014 to 135 in 2015 and to 296 in 2016, including 63, 125 and 294 design wins for new products, respectively. The revenue that we generate, if any, from each design win can vary significantly. Our long-term sales expectations are based on forecasts from customers, internal estimates of customer demand factoring in expected time to market for end customer products incorporating our solutions and associated revenue potential and internal estimates of overall demand based on historical trends. We had 301 new design wins during the first nine months of 2017. Pricing, product cost and gross margins of our products. Our gross margin has been and will continue to be affected by a variety of factors, including the timing of changes in pricing, shipment volumes, new product introductions, changes in product mixes, changes in our purchase price of fabricated wafers and assembly and test service costs, manufacturing yields and inventory write downs, if any. In general, newly introduced products and products with higher performance and more features tend to be priced higher than older, more mature products. Average selling prices in the semiconductor industry typically decline as products mature. Consistent with this historical trend, we expect that the average selling prices of our products will decline as they mature. In the normal course of business, we will seek to offset the effect of declining average selling prices on existing products by reducing manufacturing costs and introducing new and higher value-added products. More recently, certain of our suppliers have increased costs although such increase did not have a material impact on our results of operations for the three or nine months ended September 30, 2017. If we are unable to maintain overall average selling prices or offset any declines in average selling prices with realized savings on product costs, our gross margin will decline. Investment in growth. We have invested, and intend to continue to invest, in expanding our operations, increasing our headcount, developing our products and differentiated technologies to support our growth and expanding our infrastructure. We expect our total operating expenses to increase in the foreseeable future to meet our growth objectives. We plan to continue to invest in our sales and support operations throughout the world, with a particular focus in adding additional sales and field applications personnel in APAC to further broaden our support and coverage of our existing customer base, in addition to developing new customer relationships and generating design wins. We also intend to continue to invest additional resources in research and development to support the development of our products and differentiated technologies. Any investments we make in our sales and marketing organization or research and development will occur in advance of experiencing any benefits from such investments, and the return on these investments may be lower than we expect. In addition, as we invest in expanding our operations internationally, our business and results will become further subject to the risks and challenges of international operations, including higher operating expenses and the impact of legal and regulatory developments outside the United States. 24 Components of Our Results of Operations Revenue We derive substantially all of our revenue through the sale of our NVM products to OEMs and ODMs, primarily through distributors. We generated 74% and 69% of our revenue from distributors during the nine months ended September 30, 2017 and 2016, respectively. We recognize revenue from product sales when persuasive evidence of an arrangement exists and all other revenue recognition criteria are met. We sell the majority of our products to distributors and generally recognize revenue when we ship the product directly to the distributors since title and risk of loss transfers at that time. Because our distributors market and sell their products worldwide, our revenue by geographic location is not necessarily indicative of where our customers’ product sales and design win activity occur, but rather of where their manufacturing operations occur. Cost of Revenue and Gross Margin Cost of revenue primarily consists of costs paid to our third-party manufacturers for wafer fabrication, assembly and testing of our NVM products, write-downs of inventory for excess and obsolete inventories including write-downs of inventory for products based on CBRAM technology and accruals for future losses on CBRAM wafer purchase commitments to the extent our costs exceed the market price for such products. To a lesser extent, cost of revenue also includes depreciation of test equipment and expenses relating to manufacturing support activities, including personnel-related costs, logistics and quality assurance and shipping. Our gross margin has been and will continue to be affected by a variety of factors, including the timing of changes in pricing, shipment volumes, new product introductions, changes in product mix, changes in our purchase price of fabricated wafers and assembly and test service costs, manufacturing yields and inventory write downs, if any. We expect our gross margin to fluctuate over time depending on the factors described above. Operating Expenses Our operating expenses consist of research and development, sales and marketing and general and administrative expense. Personnel-related costs, including salaries, benefits, bonuses and stock-based compensation, are the most significant component of each of our operating expense categories. In addition, in the near term we expect to hire additional personnel, primarily in our selling and marketing functions, and increase research and development expenditures, such as prototype wafers, associated with the implementation of our CBRAM technology in a manufacturing facility in Asia. Accordingly, we expect our operating expenses to increase in absolute dollars as we invest in these initiatives. Research and Development. Our research and development expenses consist primarily of personnel-related costs for the design and development of our products and technologies. Additional research and development expenses include product prototype costs, mask costs and other materials costs, external test and characterization expenses, depreciation, amortization of design tool software licenses, amortization of acquisition-related intangible assets and allocated overhead expenses. We also incur costs related to outsourced research and development activities and joint venture activities. We expect research and development expenses to increase in absolute dollars for the foreseeable future as we continue to improve our product features, increase our portfolio of solutions and implement our CBRAM manufacturing technology in a new manufacturing facility. Sales and Marketing. Sales and marketing expenses consist primarily of personnel-related costs for our sales, business development, marketing, and applications engineering activities, third-party sales representative commissions, promotional and other marketing expenses, amortization of acquisition-related intangible assets and travel expenses. We expect sales and marketing expenses to increase in absolute dollars for the foreseeable future as we continue to expand our direct sales teams and increase our marketing activities. General and Administrative. General and administrative expenses consist primarily of personnel-related costs, consulting expenses and professional fees. Professional fees principally consist of legal, audit, tax and accounting services. We expect general and administrative expenses to increase in absolute dollars for the foreseeable future as we hire additional personnel, make improvements to our infrastructure and incur significant additional costs for the compliance requirements of operating as a public company, including higher legal, insurance and accounting expenses. Other Income (Expense), Net Other income (expense), net is comprised of interest income (expense) and other income (expense). Interest expense consists of interest on our outstanding debt. Other expense, net consists primarily of the change in fair value of our preferred stock warrant 25 liability and foreign exchange gains or losses. Our foreign currency exchange gains and losses relate to transactio ns and asset and liability balances denominated in currencies other than the U.S. dollar. We expect our foreign currency gains and losses to continue to fluctuate in the future due to changes in foreign currency exchange rates . Prior to our IPO, we classified our preferred stock warrants as a liability on our consolidated balance sheets and recorded changes in fair value at each balance sheet date with the corresponding change recorded as other income (expense). We recorded a final adjustment to the fair value of the warrants as of the closing of our initial public offering on October 30, 2015 and the warrants will no longer be subject to fair value accounting thereafter due to their conversion into warrants to purchase common stock. Provision for Income Taxes Provision for income taxes consists primarily of U.S. federal and state income taxes in the United States and income taxes in certain foreign jurisdictions in which we conduct business. We have a full valuation allowance for deferred tax assets, including net operating loss carryforwards, and tax credits related primarily to research and development. We expect to maintain this full valuation allowance for the foreseeable future. Comparison of the Three and Nine Months Ended September 30, 2017 and 2016 (in thousands, except percentage data): Revenue | Three Months Ended September 30, | | Change | | Nine Months Ended September 30, | Change --------+----------------------------------+--------+--------+--------+---------------------------------+------- | 2017 | | 2016 | | $ | % | 2017 | | | 2016 | | $ | % --------+----------------------------------+--------+--------+--------+---------------------------------+--------+------+----+---+------+--------+---+------- Revenue | | 15,239 | | 11,180 | | 4,059 | | 36 | % | | 39,958 | | 31,638 | 8,320 | 26 | % --------+----------------------------------+--------+--------+--------+---------------------------------+--------+------+----+---+------+--------+---+--------+-------+----+-- | Three Months Ended September 30, | | | Nine Months Ended September 30, ----------------------+----------------------------------+----+---+-------------------------------- | 2017 | | | 2016 | | 2017 | 2016 | ----------------------+----------------------------------+----+---+---------------------------------+----+------+------+-- Revenue by geography: | | | | | | | | | | ----------------------+----------------------------------+----+---+---------------------------------+----+------+------+---+----+-- United States | | 22 | % | | 17 | % | 22 | % | 15 | % ----------------------+----------------------------------+----+---+---------------------------------+----+------+------+---+----+-- Europe | | 13 | % | | 13 | % | 15 | % | 14 | % ----------------------+----------------------------------+----+---+---------------------------------+----+------+------+---+----+-- Asia Pacific | | 64 | % | | 69 | % | 61 | % | 69 | % ----------------------+----------------------------------+----+---+---------------------------------+----+------+------+---+----+-- Rest of world | | 1 | % | | 1 | % | 2 | % | 2 | % ----------------------+----------------------------------+----+---+---------------------------------+----+------+------+---+----+-- Revenue increased by $4.1 million, or 36%, during the three months ended September 30, 2017 as compared to the three months ended September 30, 2016. This increase was due primarily to a 41% increase in unit shipments across our Bios Flash and Data Flash products, partially offset by a 2% decrease in average selling prices. Revenue increased by $8.3 million, or 26%, during the nine months ended September 30, 2017 as compared to the nine months ended September 30, 2016. This increase was due primarily to a 29% increase in unit shipments across our Fusion Flash, Bios Flash and Data Flash products. Cost of Revenue and Gross Margin | Three Months Ended September 30, | | | Change | | | Nine Months Ended September 30, | | Change ----------------+----------------------------------+-------+---+--------+---+-------+---------------------------------+---+------- | 2017 | | | 2016 | | | $ | | % | 2017 | | | 2016 | | | $ | | % | ----------------+----------------------------------+-------+---+--------+---+-------+---------------------------------+---+--------+------+----+---+------+---+--------+---+---+--------+-- Cost of revenue | $ | 7,773 | | | $ | 5,803 | | $ | 1,970 | | 34 | % | | $ | 20,215 | | $ | 16,531 | | $ | 3,684 | 22 | % ----------------+----------------------------------+-------+---+--------+---+-------+---------------------------------+---+--------+------+----+---+------+---+--------+---+---+--------+---+---+-------+----+-- Gross Profit | | 7,466 | | | | 5,377 | | | 2,089 | | 39 | % | | | 19,743 | | | 15,107 | | | 4,636 | 31 | % ----------------+----------------------------------+-------+---+--------+---+-------+---------------------------------+---+--------+------+----+---+------+---+--------+---+---+--------+---+---+-------+----+-- Gross Margin | | 49 | % | | | 48 | % | | | | | | | | 49 | % | | 48 | % | | | | ----------------+----------------------------------+-------+---+--------+---+-------+---------------------------------+---+--------+------+----+---+------+---+--------+---+---+--------+---+---+-------+----+-- Cost of revenue increased by $2.0 million, or 34%, during the three months ended September 30, 2017 as compared to the three months ended September 30, 2016. This increase was due primarily to a 41% increase in unit shipments. Cost of revenue increased by $3.7 million, or 22%, during the nine months ended September 30, 2017 as compared to the nine months ended September 30, 2016. This increase was due primarily to increased unit shipments and an increase in the benefit from sales of previously written-down products. 26 Gross profit increased by $2 . 1 million during the three months ended September 30, 2017 as compared to the three months ended September 30, 201 6 due primarily to i ncrease in unit shipments and a decrease in direct manufacturing costs as a percent age of revenue . Gross profit increased by $4.6 million during the nine months ended September 30, 2017 as compared to the nine months ended September 30, 2016 due primarily to an increase in unit shipments, and a decrease in direct manufacturing costs as a percentage of revenue. Operating Expenses | Three Months Ended September 30, | | Change | | | Nine Months Ended September 30, | | Change | --------------------------------------------------+----------------------------------+-------+--------+---+-------+---------------------------------+---+--------+-- | 2017 | | 2016 | | | $ | | % | | 2017 | | | 2016 | | | $ | | % | --------------------------------------------------+----------------------------------+-------+--------+---+-------+---------------------------------+---+--------+---+------+-----+----+------+---+--------+---+---+--------+-- Operating expenses: | | | | | | | | | | | | | | | | | | | | | | | | --------------------------------------------------+----------------------------------+-------+--------+---+-------+---------------------------------+---+--------+---+------+-----+----+------+---+--------+---+---+--------+---+---+--------+---+-----+--- Research and development | $ | 3,606 | | $ | 4,390 | | $ | (784 | ) | | (18 | )% | | $ | 10,653 | | $ | 12,527 | | $ | (1,874 | ) | (15 | )% --------------------------------------------------+----------------------------------+-------+--------+---+-------+---------------------------------+---+--------+---+------+-----+----+------+---+--------+---+---+--------+---+---+--------+---+-----+--- Sales and marketing | | 2,897 | | | 2,870 | | | 27 | | | 1 | | | | 8,408 | | | 8,315 | | | 93 | | 1 | --------------------------------------------------+----------------------------------+-------+--------+---+-------+---------------------------------+---+--------+---+------+-----+----+------+---+--------+---+---+--------+---+---+--------+---+-----+--- General and administrative | | 1,761 | | | 1,586 | | | 175 | | | 11 | | | | 5,569 | | | 4,984 | | | 585 | | 12 | --------------------------------------------------+----------------------------------+-------+--------+---+-------+---------------------------------+---+--------+---+------+-----+----+------+---+--------+---+---+--------+---+---+--------+---+-----+--- Gain from settlement with former foundry supplier | | — | | | — | | | — | | | — | | | | — | | | (1,962 | ) | | 1,962 | | 100 | --------------------------------------------------+----------------------------------+-------+--------+---+-------+---------------------------------+---+--------+---+------+-----+----+------+---+--------+---+---+--------+---+---+--------+---+-----+--- Total operating expenses | $ | 8,264 | | $ | 8,846 | | $ | (582 | ) | | (7 | )% | | $ | 24,630 | | $ | 23,864 | | $ | 766 | | 3 | % --------------------------------------------------+----------------------------------+-------+--------+---+-------+---------------------------------+---+--------+---+------+-----+----+------+---+--------+---+---+--------+---+---+--------+---+-----+--- Research and Development. Research and development expense decreased by $0.8 million, or 18%, during the three months ended September 30, 2017 as compared to the three months ended September 30, 2016. This decrease was due primarily to a $0.9 million decrease in materials cost, a $0.1 million decrease in outsourced research and development activities, partially offset by a $0.2 million increase in personnel costs. Research and development expense decreased by $1.9 million, or 15%, during the nine months ended September 30, 2017 as compared to the nine months ended September 30, 2016. This decrease was due primarily to a $1.7 million decrease in materials cost, a $0.3 million decrease in facilities expense, and a $0.3 million decrease in outsourced research and development activities, partially offset by a $0.4 million increase in personnel costs Sales and Marketing. There was virtually no change in sales and marketing expense for the three months ended September 30, 2017 as compared to the three months ended September 30, 2016. Sales and marketing expense increased by $0.1 million, or 1%, during the nine months ended September 30, 2017 as compared to the nine months ended September 30, 2016. This increase was due primarily to a $0.2 million increase in personnel costs partially offset by a $0.1 million decrease in third-party sales representative commissions. General and Administrative. General and administrative expenses increased by $0.2 million, or 11%, during the three months ended September 30, 2017 as compared to the three months ended September 30, 2016. This increase was due primarily to a $0.2 million increase in personnel costs. General and administrative expenses increased by $0.6 million, or 12%, during the nine months ended September 30, 2017 as compared to the nine months ended September 30, 2016. This increase was due primarily to a $0.6 million increase in personnel costs, and a $0.1 million increase in costs related to being a public company, partially offset by a $0.1 million decrease in software amortization expense. Gain from settlement with a former foundry supplier. During the nine months ended September 30, 2016, we recognized a non-cash gain of $2.0 million resulting from settlement of a disputed liability with a former foundry supplier. We did not recognize a similar gain or loss during the nine months ended September 30, 2017. 27 Other Income (Expense), Net | Three Months Ended September 30, | | | Change | | | Nine Months Ended September 30, | | Change | ----------------------------------+----------------------------------+------+---+--------+---+------+---------------------------------+---+--------+-- | 2017 | | | 2016 | | | $ | | % | | 2017 | | | 2016 | | | $ | | % | ----------------------------------+----------------------------------+------+---+--------+---+------+---------------------------------+---+--------+---+------+-----+----+------+---+------+---+---+--------+-- Interest expense, net | $ | (170 | ) | | | (576 | ) | $ | (406 | ) | | (70 | )% | | $ | (581 | ) | | (1,058 | ) | $ | (477 | ) | (45 | )% ----------------------------------+----------------------------------+------+---+--------+---+------+---------------------------------+---+--------+---+------+-----+----+------+---+------+---+---+--------+---+---+------+---+------+--- Other income (expense), net | | (12 | ) | | | (18 | ) | | (6 | ) | | (33 | ) | | | 2 | | | (29 | ) | | (31 | ) | (107 | ) ----------------------------------+----------------------------------+------+---+--------+---+------+---------------------------------+---+--------+---+------+-----+----+------+---+------+---+---+--------+---+---+------+---+------+--- Total other income (expense), net | $ | (182 | ) | | $ | (594 | ) | $ | (412 | ) | | (69 | )% | | $ | (579 | ) | $ | (1,087 | ) | $ | (508 | ) | (47 | )% ----------------------------------+----------------------------------+------+---+--------+---+------+---------------------------------+---+--------+---+------+-----+----+------+---+------+---+---+--------+---+---+------+---+------+--- Interest expense, net decreased by approximately $406,000 and $477,000 during the three and nine months ended September 30, 2017 as compared to the three and nine months ended September 30, 2016, primarily due to the elimination of warrant discount amortization. Other income (expense), net decreased by approximately $6,000 and by approximately $31,000 during the three and nine months ended September 30, 2017 as compared to the three and nine months ended September 30, 2016 due primarily to a decrease in foreign currency transaction charges. Provision for Income Taxes | Three Months Ended September 30, | | Change | | | Nine Months Ended September 30, | | Change ---------------------------+----------------------------------+----+--------+---+----+---------------------------------+---+------- | 2017 | | 2016 | | | $ | | % | 2017 | | | 2016 | | | $ | | % ---------------------------+----------------------------------+----+--------+---+----+---------------------------------+---+--------+------+----+---+------+---+----+---+---+--- Provision for income taxes | $ | 17 | | $ | 15 | | $ | 2 | | 13 | % | | $ | 57 | | $ | 46 | $ | 11 | 24 | % ---------------------------+----------------------------------+----+--------+---+----+---------------------------------+---+--------+------+----+---+------+---+----+---+---+----+---+----+----+-- Provision for income taxes increased by $2,000 during the three months ended September 30, 2017 as compared to the three months ended September 30, 2016 and increased by $11,000 during the nine months ended September 30, 2017. The increase was due primarily to a reduction in benefits related to our foreign subsidiaries as well as a reduction in benefits related to deferred taxes in the United States. Liquidity and Capital Resources Since inception, we have funded our operations primarily with gross proceeds from the sale of an aggregate of $78.5 million of convertible preferred stock, $22.5 million of term debt associated with the acquisition of the certain flash memory product assets from Atmel Corporation, net proceeds from our initial public offering on October 30, 2015 of $22.1 million, aggregate borrowings under our current term loan and line of credit facility of $16.6 million and net proceeds of $18.4 million from a follow-on equity offering on June 20, 2017. Our principal source of liquidity as of September 30, 2017 consisted of cash and cash equivalents of $30.5 million. Our outstanding borrowings under this credit facility as of September 30, 2017 were $13.5 million. Substantially all of our cash and cash equivalents are held in the United States. We believe our existing cash and cash equivalents will be sufficient to meet our anticipated cash needs over the next 12 months. Our future capital requirements will depend on many factors, including our growth rate, the timing and extent of our spending to support research and development activities, the timing and cost of establishing additional sales and marketing capabilities, the introduction of new and enhanced products and our costs to implement new manufacturing technologies. In the event that additional financing is required from outside sources, we may not be able to raise it on terms acceptable to us or at all. Any additional debt financing obtained by us in the future could also involve restrictive covenants relating to our capital-raising activities and other financial and operational matters, which may make it more difficult for us to obtain additional capital and to pursue business opportunities, including potential acquisitions. Additionally, if we raise additional funds through further issuances of equity, convertible debt securities or other securities convertible into equity, our existing stockholders could suffer significant dilution in their percentage ownership of our company, and any new equity securities we issue could have rights, preferences and privileges senior to those of holders of our common stock. If we are unable to obtain adequate financing or financing on terms satisfactory to us, when we require it, our ability to continue to grow or support our business and to respond to business challenges could be significantly limited. 28 The following table summarizes our cash flows for the periods indicated: | Nine Months Ended September 30, | --------------------------------------------+---------------------------------+------- | 2017 | | | 2016 | --------------------------------------------+---------------------------------+--------+---+------+-- Cash flows used in operating activities | $ | (1,216 | ) | | $ | (5,361 | ) --------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Cash flows used in investing activities | | (2,054 | ) | | | (2,358 | ) --------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Cash flows provided by financing activities | | 14,129 | | | | 6,063 | --------------------------------------------+---------------------------------+--------+---+------+---+--------+-- Cash Flows from Operating Activities Our primary source of cash from operating activities has been from cash collections from our customers. We expect cash inflows from operating activities to be affected by increases in sales and timing of collections. Our primary uses of cash from operating activities have been for personnel costs and investments in research and development and sales and marketing. Net cash used in operating activities for the periods presented consisted of net losses adjusted for certain noncash items and changes in working capital. Within changes in working capital, changes in accounts receivable, inventory and accounts payable generally account for the largest adjustments, as we typically use more cash to fund accounts receivable and build inventory as our business grows. Increases in accounts payable typically provides more cash as we do more business with our contract foundries and other third parties, depending on the timing of payments. During the nine months ended September 30, 2017, cash used in operating activities was approximately $1.2 million and was due primarily to a net loss of $5.5 million, partially offset by non-cash charges of $2.9 million related to stock-based compensation expense, $1.0 million related to depreciation and amortization, $0.9 million related to amortization of intangible assets, and an increase in our net assets and liabilities of $0.6 million. The increase in assets and liabilities is due primarily to an increase in accounts receivable of $2.7 million, an increase in prepaid expenses and other assets of $0.2 million, a decrease in deferred rent of $0.3 million, partially offset by an increase in accounts payable and accrued compensation of $2.0 million, and a decrease in inventories of $0.9 million. During the nine months ended September, 2016, cash used in operating activities was $5.4 million, primarily from a net loss of $9.9 million and the impact of a $2.0 million non-cash gain resulting from a settlement with a former foundry supplier partially offset by non-cash charges of $2.5 million related to stock-based compensation expense, $1.6 million related to depreciation and amortization, $0.6 million related to the amortization of debt discount along with a decrease in accounts receivable of $1.5 million and an increase in accounts payable and accruals of $0.2 million. Cash Flows from Investing Activities Our investing activities consist primarily of purchases of property and equipment. We expect to continue to make significant capital expenditures to support continued growth of our business. During the nine months ended September 30, 2017 and 2016, cash used in investing activities was $2.1 million and $2.4 million, respectively, due to purchases of equipment and investments in leasehold improvements related to our new headquarters facility in Santa Clara, CA which was occupied in August 2016. Cash Flows from Financing Activities During the nine months ended September 30, 2017, cash provided by financing activities was $14.1 million and was due primarily to proceeds from a follow-on offering of our common stock of $18.4 million, net of fees, net proceeds from our line of credit of $0.2 million, and net proceeds from the exercise of stock options of $0.6 million, partially offset by repayments on our term loan of $4.9 million and tax witholdings related to settlement of RSUs of $0.2 million. During the nine months ended September 30, 2016, cash provided by financing activities was $6.1 million due to $17.8 million in net proceeds from a new term loan, $2.0 million in proceeds from a new line of credit, and $0.2 million from the issuance of common stock, partially offset by the repayment of $14.0 million outstanding on the prior term loan. Off Balance Sheet Arrangements During the periods presented, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off balance sheet arrangements or other contractually narrow or limited purpose. 29 Credit Facility The Company is a party to that certain Business Financing Agreement dated July 7, 2016, by and between Western Alliance Bank and the Company, as amended (“Credit Facility”). The Credit Facility originally provided for (i) a term loan of up to $18.0 million (the “Term Loan”) and (ii) a revolving credit line advance (the “Line of Credit”) in the aggregate amount of the lower of (x) $2.0 million and (y) 80% of certain of the Company’s receivables. Prior to the Amendment (as defined below), the Term Loan bore interest at a rate per annum equal to the greater of the prime rate or 3.5%, plus 0.75% (5.00% on September 30, 2017), and was scheduled to mature in June 2019. Prior to the Amendment, the Line of Credit bore interest at a rate per annum equal to the greater of the prime rate or 3.5% plus 0.50% (4.75% on September 30, 2017), and was scheduled to mature in July 2018. Prior to the Amendment, we made interest-only payments on the Term Loan from July 2016 through September 2016 and began making interest payments and principal payments in 33 equal monthly installments starting October 2016. Prior to the Amendment, the Credit Facility provided that any indebtedness we incurred thereunder was collateralized by substantially all assets of the Company and any domestic subsidiaries, subject to certain customary exceptions. We paid a facility fee of $150,000 as well as a $25,000 diligence fee upon entry into the Credit Facility and an additional $10,000 on July 7, 2017. These fees have been recorded as a debt discount and are being amortized over the life of the agreement. During the nine months ended September 30, 2017, amortization of debt discount was $64,000 and the unamortized debt discount was $59,000 as of September 30, 2017. The Credit Facility contains customary representations and warranties and affirmative and negative covenants. Among other negative covenants, prior to the Amendment, the Credit Facility provided that we may not (i) permit the ratio of the balance of unrestricted cash deposited at the financial institution, plus eligible receivables, net of reserve to the total amounts owed with respect to advances under the revolving credit line to be less than 1.50 to 1.00 and (ii) permit cash held at the financial institution in a deposit account to be less than 100% of the term loan outstanding. Upon an occurrence of an event of default, under the Credit Facility we could be required to pay interest on all outstanding obligations under the agreement at a rate of 5% above the otherwise applicable interest rate, and the lender may accelerate our obligations under the agreement. As of September 30, 2017, we were in compliance with all financial covenants and restrictions. On September 29, 2017, we amended the Credit Facility by entering into that certain Second Business Financing Modification Agreement, dated September 29, 2017 (the “Amendment”) with Western Alliance Bank. The Amendment extended the maturity dates of the Line of Credit and the Term Loan to July 2019 and September 2021, respectively, from July 2018 and June 2019, respectively. In addition, the Amendment increased the amount available under the Line of Credit in the aggregate amount to $5.0 million. The Amendment also decreased the interest rates under the Line of Credit and the Term Loan and changed the payment schedule under the Term Loan. Under the Agreement, we will make interest-only payments on the Term Loan from October 10, 2017 and on the 10th calendar day of each month thereafter, and will make principal and interest payments in 36 equal installments beginning on October 10, 2018, and on the 10th calendar day of each month thereafter, until the maturity date of the Term Loan. Pursuant to the Amendment, our Intellectual Property (as defined in the Amendment) is excluded from the collateral used to secure the indebtedness we incurred under the Credit Facility. Under the Amendment, we have agreed to modified and additional negative covenants, requiring us to maintain a ratio of at least 1.25 to 1.00 with respect to either of the following: (x) the sum of our cash and certain receivables to our indebtedness under the Credit Facility; or (y) our Adjusted EBITDA (as defined in the Amendment), less certain capital expenditures, to the sum of (a) all principal payments and interest expense that we would have owed to the Lender if the Term Loan’s amortization were to start on September 29, 2017, all measured on a trailing 4-quarter basis, plus (b) all principal payments and interest expense on any of our other debt. The Amendment also subjects us to the requirement that our quarterly revenues shall not negatively deviate more than 25% from the projections provided to Western Alliance Bank in accordance with the Credit Facility. 30 Contractual Obligations and Commitments The following is a summary of our contractual obligations and commitments as of September 30, 2017, after giving effect to the Amendment: | | | | Payments due by period | --------------------------------------------------+----------------+--------+------------------+------------------------+------ Contractual Obligations | Total | | Less than 1 year | | | 1 – 3 Years | | 4 – 5 Years | | More than 5 Years | --------------------------------------------------+----------------+--------+------------------+------------------------+-------+-------------+---+-------------+---+-------------------+------ | (in thousands) | --------------------------------------------------+----------------+------- Operating leases (1) | $ | 7,390 | | $ | 302 | | $ | 2,433 | | $ | 2,536 | | | $ | 2,119 --------------------------------------------------+----------------+--------+------------------+------------------------+-------+-------------+---+-------------+---+-------------------+-------+---+---+---+------ Inventory-related commitments (2) | | 4,040 | | | 4,040 | | — | | — | | | — | --------------------------------------------------+----------------+--------+------------------+------------------------+-------+-------------+---+-------------+---+-------------------+-------+---+-- Financing arrangements (3) | | 13,455 | | | — | | | 11,000 | | | 2,455 | | | — | --------------------------------------------------+----------------+--------+------------------+------------------------+-------+-------------+---+-------------+---+-------------------+-------+---+---+---+------ Joint Development and Manufacturing Agreement (4) | | 7,850 | | | 1,850 | | | 6,000 | | — | | | — | --------------------------------------------------+----------------+--------+------------------+------------------------+-------+-------------+---+-------------+---+-------------------+-------+---+---+-- Licensing and Development Agreement (5) | | 575 | | | 575 | | | — | | — | | | — | --------------------------------------------------+----------------+--------+------------------+------------------------+-------+-------------+---+-------------+---+-------------------+-------+---+---+-- Total contractual cash obligations | $ | 33,310 | | $ | 6,767 | | $ | 19,433 | | $ | 4,991 | | | $ | 2,119 --------------------------------------------------+----------------+--------+------------------+------------------------+-------+-------------+---+-------------+---+-------------------+-------+---+---+---+------ (1) | Operating leases primarily relate to our leases of office space with terms expiring through July 31, 2023. ----+----------------------------------------------------------------------------------------------------------- (2) | Represents outstanding purchase orders for wafer commitments that we have placed with our suppliers as of September 30, 2017. ----+------------------------------------------------------------------------------------------------------------------------------ (3) | Financing arrangements represent debt maturities under our term loan and line of credit. ----+----------------------------------------------------------------------------------------- (4) | Represents our commitments under the CBRAM Joint Development and Manufacturing Agreement executed on February 18, 2016 with TowerJazz Panasonic Semiconductor Company. ----+----------------------------------------------------------------------------------------------------------------------------------------------------------------------- (5) | Represents our commitments under the Licensing and Development Agreement executed on April 21, 2016 with Semitech Semiconductor Pty, Ltd. ----+------------------------------------------------------------------------------------------------------------------------------------------ As of September 30, 2017, we had a liability of $33,000 for uncertain tax positions. 31 Item 3. | Quantitative and Qualitative Disclosures About Market Risk --------+----------------------------------------------------------- We are exposed to market risks in the ordinary course of our business. These risks primarily include foreign exchange rate and interest rate sensitivities as follows: Foreign Currency Risk Our results of operations and cash flows are subject to fluctuations due to changes in foreign currency exchange rates. The majority of our revenue is denominated in U.S. dollars. Our expenses are generally denominated in the currencies in which our operations are located, which is primarily in the United States and to a lesser extent in Europe, Middle East and Africa, or EMEA, and APAC. Our results of operations and cash flows are, therefore, subject to fluctuations due to changes in foreign currency exchange rates and may be adversely affected in the future due to changes in foreign exchange rates. The effect of a hypothetical 10% change in foreign currency exchanges rates applicable to our business would not have a material impact on our historical consolidated financial statements. We have not hedged exposures denominated in foreign currencies or used any other derivative financial instruments. Although we transact the substantial majority of our business in U.S. dollars, future fluctuations in the value of the U.S. dollar may affect the competitiveness of our products and thus may impact our results of operations and cash flows. Interest Rate Sensitivity We had cash and cash equivalents of $30.5 million as of September 30, 2017, consisting of bank deposits and money market funds. Such interest-earning instruments carry a degree of interest rate risk. To date, fluctuations in interest income have not been significant. We also had total outstanding gross debt of $13.5 million offset by an unamortized debt discount of approximately $59,000 as of September 30, 2017. The outstanding debt relates to a new term loan and line of credit described in section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Credit Facility”. We do not enter into investments for trading or speculative purposes and have not used any derivative financial instruments to manage our interest rate risk exposure. We have not been exposed to, nor do we anticipate being exposed to, material risks due to changes in interest rates. Our exposure to interest rates relates to the change in the amounts of interest we must pay on our variable rate borrowings. A hypothetical 10% increase in our borrowing rates would not have a material impact on interest expense on our principal balances as of September 30, 2017. Item 4. | Controls and Procedures. --------+------------------------- (a) | Disclosure Controls and Procedures ----+----------------------------------- We maintain “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”), that are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), as appropriate, to allow timely decisions regarding required disclosure. Our management is responsible for establishing and maintaining our disclosure controls and procedures. Under the supervision and with the participation of our management, including our CEO and CFO, we conducted an evaluation of the effectiveness of our disclosure controls and procedures as of September 30, 2017. Based on this evaluation, our CEO and CFO concluded that our disclosure controls and procedures were effective as of September 30, 2017. (b) | Changes in Internal Control over Financial Reporting ----+----------------------------------------------------- There were no changes in our internal control over financial reporting that occurred during the three months ended September 30, 2017 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act). Internal control over financial reporting means a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. 32 PART II: OTHE R INFORMATION ITEM 1. | Legal Proceedings --------+------------------ We are not currently a party to any legal proceedings which, if determined adversely to us, would individually or in the aggregate have a material adverse effect on our business, operating results, financial condition or cash flows. We may, from time to time, become involved in legal proceedings arising in the ordinary course of our business and as our business grows, we may become a party to an increasing number of legal proceedings. ITEM 1A. | Risk Factors ---------+------------- An investment in our common stock involves a high degree of risk. You should carefully consider the risks and uncertainties described below, together with all of the other information in this Quarterly Report on Form 10-Q, including the section titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our condensed consolidated financial statements and related notes, before making a decision to invest in our common stock. Our business, operating results, financial condition, or prospects could be materially and adversely affected by any of these risks and uncertainties. If any of these risks actually occurs, the trading price of our common stock could decline and you might lose all or part of your investment. Our business, operating results, financial performance, or prospects could also be harmed by risks and uncertainties not currently known to us or that we currently do not believe are material. Risks Related to Our Business and Our Industry We have a history of losses which may continue in the future, and we cannot be certain that we will achieve or sustain profitability. We have incurred net losses since our inception. We incurred net losses of $11.6 million, $8.4 million, and $8.9 million for the years ended December 31, 2016, 2015 and 2014, respectively and $5.5 million during the first nine months of 2017. As of September 30, 2017, we had an accumulated deficit of $99.7 million. We expect to incur significant expenses related to the continued development and expansion of our business, including in connection with our efforts to pursue opportunities in emerging IoT markets, develop and improve upon our products and technology, maintain and enhance our research and development and sales and marketing activities and hire additional personnel. Further, revenue may not grow or revenue may decline for a number of possible reasons, many of which are outside our control, including a decline in demand for our products, increased competition, business conditions that adversely affect the semiconductor memory industry, including reduced demand for products in the end markets that we serve, or our failure to capitalize on growth opportunities. If we fail to generate sufficient revenue to support our operations, we may not be able to achieve or sustain profitability. We rely on third parties to manufacture, package, assemble and test the semiconductor components comprising our products, which exposes us to a number of risks, including reduced control over manufacturing and delivery timing and potential exposure to price fluctuations, which could result in a loss of revenue or reduced profitability. As a fabless semiconductor company, we outsource the manufacturing, packaging, assembly and testing of our semiconductor components to third-party foundries and assembly and testing service providers. We use two foundries, United Microelectronics Corporation in Taiwan and XMC in Wuhan, China, for the production of our flash memory products and a single foundry, Altis Semiconductor S.N.C. in France (acquired by X-FAB Silicon Foundries in 2016), for our Mavriq and Moneta products. Our primary assembly and testing contractor in 2016 was Amkor Technology, Inc. in Taiwan, Korea and the Philippines. Our wafer probing is performed by King Yuan Electronics Co., Ltd. in Taiwan. Relying on third-party manufacturing, assembly and testing presents a number of risks, including but not limited to: • | capacity and materials shortages during periods of high demand; --+---------------------------------------------------------------- • | reduced control over delivery schedules, inventories and quality; --+------------------------------------------------------------------ • | the unavailability of, or potential delays in obtaining access to, key process technologies; --+--------------------------------------------------------------------------------------------- • | the inability to achieve required production or test capacity and acceptable yields on a timely basis; --+------------------------------------------------------------------------------------------------------- • | misappropriation of our intellectual property; --+----------------------------------------------- • | the third parties’ ability to perform its obligations due to bankruptcy or other financial constraints; --+-------------------------------------------------------------------------------------------------------- • | limited warranties on wafers or products supplied to us; and --+------------------------------------------------------------- • | potential increases in prices. --+------------------------------- 33 Any of the foregoing risks may affect our ability to meet customer demand. For example, a former silicon wafer supplier suddenly declared bankruptcy in December 2013 and abruptly shut down its foundry. As a result, we were unable to fu lfill a portion of our customers’ orders in 2014 while we transitioned wafer production to a new foundry. Based on the average selling prices then in effect for those wafers, we estimate that the potential loss of revenue exceeded $10.0 million . We currently do not have long-term supply contracts with our third-party contract manufacturers for our DataFlash and Fusion Flash products, including United Microelectronics Corporation and Amkor Technology, Inc. Therefore, they are not obligated to perform services or supply components to us for any specific period, in any specific quantities, or at any specific price, except as may be provided in a particular purchase order. During periods of high demand and tight inventories, our third-party foundries and assembly and testing contractors may allocate capacity to the production of other companies’ components while reducing deliveries to us, or significantly raise their prices. In particular, they may allocate capacity to other customers that are larger and better financed than us or that have long-term agreements, decreasing the capacity available to us. Shortages of capacity available to us may be caused by the actions of their other, large customers that may be difficult to predict, such as major product launches. If we need other foundries or assembly and test contractors because of increased demand, or if we are unable to obtain timely and adequate deliveries from our providers, we might not be able to cost-effectively and quickly retain other vendors to satisfy our requirements. Because the lead-time needed to establish a relationship with a new third-party supplier could be several quarters, there is no readily available alternative source of supply for any specific component. In addition, the time and expense to qualify a new foundry could result in additional expense, diversion of resources or lost sales, any of which would negatively impact our financial results. In the event that we expand production of a component to include a new contract manufacturer, it may take approximately 18 to 24 months to allow a transition from our current foundry or assembly services provider to the new provider. We may experience difficulty migrating production to a new contract manufacturer and, consequently, may experience reduced yields, delays in component deliveries and increased research and development expense. The inability by us or our third-party manufacturers to effectively and efficiently transition our technology to their infrastructure may adversely affect our operating results and our gross margin. There can be no assurance that we will be able to find suitable replacements for our third-party contract manufacturers. If any of our current or future foundry partners or assembly and test subcontractors significantly increases the costs of wafers or other materials, interrupts or reduces our supply, including for reasons outside of their control, or if any of our relationships with our suppliers is terminated, our operating results could be adversely affected. During 2017, one of our foundry partners increased the costs of wafers to us. Although such increase did not have a material impact on our results of operations for the three and nine months ended September 30, 2017 and is not expected to have a material impact in the near future, there can be no assurances that such an increase will not have a material adverse impact on our operating results. Such occurrences could also damage our customer relationships, result in lost revenue, cause a loss in market share or damage our reputation. We may be unable to match production with customer demand for a variety of reasons including our inability to accurately forecast customer demand or the capacity constraints of contract manufacturers, which could adversely affect our operating results. We make planning and spending decisions, including determining production levels, production schedules, component procurement commitments, personnel needs and other resource requirements, based on our estimates of product demand and customer requirements. Our products are typically purchased pursuant to individual purchase orders. While our customers may provide us with their demand forecasts, they are not contractually committed to buy any quantity of products beyond purchase orders. Furthermore, many of our customers may increase, decrease, cancel or delay purchase orders already in place without significant penalty. The short-term nature of commitments by our customers and the possibility of unexpected changes in demand for their products reduce our ability to accurately estimate future customer requirements. On occasion, customers may require rapid increases in production, which can strain our resources, necessitate more onerous procurement commitments and reduce our gross margin. If we overestimate customer demand, we may purchase products that we may not be able to sell, which could result in decreases in our prices or write-downs of unsold inventory. Conversely, if we underestimate customer demand or if sufficient manufacturing capacity was unavailable, we would lose sales opportunities and could lose market share or damage our customer relationships. The rapid pace of innovation in our industry could also render significant portions of our inventory obsolete. Excess or obsolete inventory levels could result in unexpected expenses or write-downs of inventory values that could adversely affect our business, operating results and financial condition. 34 Our quarterly operating results or other operating metrics may fluctuate significantly, which could cause the trading price of our common stock to decline. Our quarterly operating results and other operating metrics have fluctuated in the past and may continue to fluctuate from quarter to quarter. We expect that this trend will continue as a result of a number of factors, many of which are outside of our control and may be difficult to predict, including: • | the receipt, reduction, delay or cancellation of orders by large customers; --+---------------------------------------------------------------------------- • | the gain or loss of significant customers and distributors; --+------------------------------------------------------------ • | the timing and success of our launch of new or enhanced products and those of our competitors; --+----------------------------------------------------------------------------------------------- • | market acceptance of our products and our customers’ products; --+--------------------------------------------------------------- • | the level of growth or decline in the IoT market; --+-------------------------------------------------- • | the timing and extent of research and development and sales and marketing expenditures; --+---------------------------------------------------------------------------------------- • | the amount and timing of operating expenses related to the maintenance and expansion of our business, operations and infrastructure; --+------------------------------------------------------------------------------------------------------------------------------------- • | changes in our product mix; --+---------------------------- • | our ability to reduce the manufacturing costs of our products; --+--------------------------------------------------------------- • | competitive pressures resulting in lower than expected average selling prices; --+------------------------------------------------------------------------------- • | fluctuations in sales by and inventory levels of OEMs and ODMs who incorporate our memory products in their products; --+---------------------------------------------------------------------------------------------------------------------- • | cyclical and seasonal fluctuations in our markets; --+--------------------------------------------------- • | fluctuations in the manufacturing yields of our third-party contract manufacturers; --+------------------------------------------------------------------------------------ • | events that impact the availability of production capacity at our third-party subcontractors and other interruptions in the supply chain including due to geopolitical events, natural disasters, materials shortages, bankruptcy or other causes; --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | supply constraints for and changes in the cost of the other components incorporated into our customers’ products; --+------------------------------------------------------------------------------------------------------------------ • | the timing of expenses related to the acquisition of technologies or businesses; --+--------------------------------------------------------------------------------- • | product rates of return or price concessions in excess of those expected or forecasted; --+---------------------------------------------------------------------------------------- • | costs associated with the repair and replacement of defective products; --+------------------------------------------------------------------------ • | unexpected inventory write-downs or write-offs; --+------------------------------------------------ • | costs associated with litigation over intellectual property rights and other litigation; --+----------------------------------------------------------------------------------------- • | the length and unpredictability of the purchasing and budgeting cycles of our customers; --+----------------------------------------------------------------------------------------- • | loss of key personnel or the inability to attract qualified engineers; and --+--------------------------------------------------------------------------- • | geopolitical events, such as war, threat of war or terrorist actions, or the occurrence of natural disasters. --+-------------------------------------------------------------------------------------------------------------- Any one of the factors above or the cumulative effect of some of the factors above may result in significant fluctuations in our operating results. The semiconductor memory industry is highly cyclical and our markets may experience significant cyclical fluctuations in demand as a result of changing economic conditions, budgeting and buying patterns of customers and others factors. As a result of these and other factors affecting demand for our products and our results of operations in any given period, the results of any prior quarterly or annual periods should not be relied upon as indicative of our future revenue or operating performance. Fluctuations in our revenue and operating results could also cause our stock price to decline. The market for semiconductor memory products is characterized by declines in average selling prices, which we expect to continue, and which could negatively affect our revenue and margins. Our customers expect the average selling price of our products to decrease year-over-year and we expect this trend to continue. When such pricing declines occur, we may not be able to mitigate the effects by selling more or higher margin units, or by reducing 35 our manufacturing cos ts. In such circumstances, our operating results could be materially and adversely affected. Our legacy and new flash memory products have experienced declining average selling prices over their life cycle. The rate of decline may be affected by a number o f factors, including relative supply and demand, the level of competition, production costs and technological changes. As a result of the decreasing average selling prices of our products following their launch, our ability to increase or maintain our marg ins depends on our ability to introduce new or enhanced products with higher average selling prices and to reduce our per-unit cost of sales and our operating costs. We may not be able to reduce our costs as rapidly as companies that operate their own manu facturing, assembly and testing facilities, and our costs may even increase because we do not operate our own manufacturing, assembly or testing facilities, which could also reduce our gross margins. In addition, our new or enhanced products may not be as successful or enjoy as high margins as we expect. If we are unable to offset any reductions in average selling prices by introducing new products with higher average selling prices or reducing our costs, our revenue and margins will be negatively affected and may decrease. The semiconductor memory market is highly cyclical and has experienced severe downturns in the past, generally as a result of wide fluctuations in supply and demand, constant and rapid technological change, continuous new product introductions and price erosion. During downturns, periods of intense competition, or the presence of oversupply in the industry, the selling prices for our products may decline at a high rate over relatively short time periods as compared to historical rates of decline. We are unable to predict selling prices for any future periods and may experience unanticipated, sharp declines in selling prices for our products. Our prospects for growth depends on the growth and development of the emerging IoT industry, and if the market does not develop as we expect, our business prospects may be harmed. Our products are increasingly being utilized in IoT edge devices. The IoT industry is nascent and is characterized by rapidly changing technologies, devices and connectivity requirements, evolving industry standards and changing customer demands. The continued development of IoT depends in part on significant growth in the number of connected devices. Such growth is affected by various factors, including the continued growth in the use of mobile operator networks and the Internet to connect an increasing number and variety of devices, price reductions for key hardware and software components, innovation of other components of the IoT nodes toward low-power formats, and the continued development of IoT standards and protocols. Without these continued developments, IoT might not gain widespread market acceptance and our business could suffer. Security and privacy concerns, evolving business practices and consumer preferences may also slow the growth and development of IoT. Because our revenue growth ultimately depends upon the success of IoT, our business may suffer as a result of slowing or declining growth in IoT adoption. Even if the IoT industry does develop, we may not be well positioned or able to penetrate and capitalize on this new market. As a result of these factors, the future revenue and income potential of our business is uncertain. The markets for our products are evolving, and changing market conditions, such as the introduction of new technologies or changes in customer preferences, may negatively affect demand for our products. If we fail to properly anticipate or respond to changing market conditions, our business prospects and results of operations will suffer. The NVM industry is subject to constant and rapid changes in technology, frequent new product introductions, short product life cycles, rapid product obsolescence and evolving technical standards. New technologies may be introduced that make the current technologies on which our products are based less competitive or obsolete or require us to make changes to our technology that could be expensive and time consuming to implement. Due to the evolving nature of our markets, our future success depends on our ability to accurately anticipate and respond to changes in industry standards, technological requirements, customer and consumer preferences and other market conditions. Our technologies could become obsolete sooner than we expect because of faster than anticipated, or unanticipated, changes in one or more of the industry standards and technological requirements. We may be unable to develop and introduce new or enhanced technologies that satisfy customer requirements and achieve market acceptance in a timely manner or at all, succeed in commercializing the technologies on which we have focused our research and development expenditures to develop, and anticipate new industry standards and technological changes. If we fail to adapt successfully to technological changes or fail to obtain access to important new technologies, we may be unable to retain customers or attract new customers. Any decrease in demand for our products, or the need for low-power products in general, due to the emergence of competing technologies, changes in customer preferences and requirements or other factors, could adversely affect our business, results of operations and prospects. We must continuously develop new and enhanced products, and if we are unable to successfully market our new and enhanced products for which we incur significant expenses to develop, our results of operations and financial condition will be materially adversely affected. In order to compete effectively in our markets, we must continually design, develop and introduce new and improved products with improved features in a cost-effective manner in response to changing technologies and market demand. This requires us to devote substantial financial and other resources to research and development. We have developed and are continuing to develop next-generation products, such as our Moneta and EcoXip products, which we expect to be one of the drivers of our revenue growth in the future. However, we may not succeed in developing and marketing these new and enhanced products. We also face the risk that 36 customers may not value or be willing to bear the cost of incorporating our new and enhanced products into their products, particularly if they believe their customers are satisfied with current solutions. Regardless of the impro ved features or superior performance of our new and enhanced products, customers may be unwilling to adopt our solutions due to design or pricing constraints, or because they do not want to rely on a single or limited supply source. Because of the extensiv e time and resources that we invest in developing new and enhanced products, if we are unable to sell customers new generations of our products, our revenue could decline and our business, financial condition, results of operations and cash flows would be negatively affected. For example, we generated limited revenue from sales of our Mavriq products to date. While we expect revenue from our Mavriq products to grow, we may not be able to materially increase our revenue from this product family. Similarly, a ny of our more recently-introduced products or product families based on CBRAM or floating gate architecture , such as Moneta and EcoXip, may not achieve market acceptance and contribute significantly to our revenue. If we are unable to successfully develop and market our new and enhanced products that we have incurred significant expenses developing, our results of operations and financial condition will be materially and adversely affected . Our success and future revenue depend on our ability to secure design wins and on our customers’ ability to successfully sell the products that incorporate our solutions. Securing design wins is a lengthy, expensive and competitive process, and may not result in actual orders and sales, which could cause our revenue to decline. We sell to customers that incorporate our NVM into their products. A design win occurs after a customer has tested our product, verified that it meets the customer’s requirements, qualified our solutions for their products and placed an order for the purchase of our products. Our customers may need several months to years to test, evaluate and adopt our product and additional time to begin volume production of the product that incorporates our solution. Due to this generally lengthy design cycle, we may experience significant delays from the time we increase our operating expenses and make investments in our products to the time that we generate revenue from sales of these products. Moreover, even if a customer selects our solution, we cannot guarantee that this will result in any sales of our products, as the customer may ultimately change or cancel its product plans, or efforts by our customer to market and sell its product may not be successful. We may not generate any revenue from design wins after incurring the associated costs, which would cause our business and operating results to suffer. If a current or prospective customer designs a competitor’s solution into its product, it becomes significantly more difficult for us to sell our solutions to that customer because changing suppliers involves significant time, cost, effort and risk for the customer even if our solutions remain compatible with their product design. If current or prospective customers do not include our solutions in their products and we fail to achieve a sufficient number of design wins, our results of operations and business may be harmed. We rely on our relationships with OEMs and ODMs to enhance our solutions and market position, and our failure to continue to develop or maintain such relationships in the future would harm our ability to remain competitive. We develop our products for leading OEMs and ODMs that serve a variety of end markets and are developing devices for wearables, sensors, Bluetooth 4.0 and other IoT applications. For each application, manufacturers create products that incorporate specialized semiconductor technology, which makers of memory products use as the basis for their products. These manufacturers set the specifications for many of the key components to be used on each generation of their products and, in the case of memory components, generally qualify only a few vendors to provide memory components for their products. As each new generation of their products is released, vendors are validated in a similar fashion. We must work closely with semiconductor manufacturers to ensure our products become qualified for use in their products. As a result, maintaining close relationships with leading product manufacturers that are developing devices for wearables, Bluetooth 4.0 and other IoT applications is crucial to the long-term success of our business. We could lose these relationships for a variety of reasons, including our failure to qualify as a vendor, our failure to demonstrate the value of our new solutions, declines in product quality, or if OEMs or ODMs seek to work with vendors with broader product suites, greater production capacity or greater financial resources. If our relationships with key industry participants were to deteriorate or if our solutions were not qualified by our customers, our market position and revenue could be materially and adversely affected. Changes to industry standards and technical requirements relevant to our products and markets could adversely affect our business, results of operations and prospects. Our products are only a part of larger electronic systems. All products incorporated into these systems must comply with various industry standards and technical requirements created by regulatory bodies or industry participants in order to operate efficiently together. Industry standards and technical requirements in our markets are evolving and may change significantly over time. For our products, the industry standards are developed by the Joint Electron Device Engineering Council, an industry trade organization. In addition, large industry-leading semiconductor and electronics companies play a significant role in developing standards and technical requirements for the product ecosystems within which our products can be used. Our customers also may design certain specifications and other technical requirements specific to their products and solutions. These technical requirements may change as the customer introduces new or enhanced products and solutions. 37 Our ability to compe te in the future will depend on our ability to identify and comply with evolving industry standards and technical requirements. The emergence of new industry standards and technical requirements could render our products incompatible with products develope d by other suppliers or make it difficult for our products to meet the requirements of certain of our customers in consumer, industrial, IoT and other markets. As a result, we could be required to invest significant time and effort and to incur significant expense to redesign our products to ensure compliance with relevant standards and requirements. If our products are not in compliance with prevailing industry standards and technical requirements for a significant period of time, we could miss opportuniti es to achieve crucial design wins, our revenue may decline and we may incur significant expenses to redesign our products to meet the relevant standards, which could adversely affect our business, results of operations and prospects . If sales of our customers’ products decline or if their products do not achieve market acceptance, our business and operating results could be adversely affected. Our revenue depends on our customers’ ability to commercialize their products successfully. The markets for our customers’ products are extremely competitive and are characterized by rapid technological change. Competition in our customers’ markets is based on a variety of factors including price, performance, product quality, marketing and distribution capability, customer support, name recognition and financial strength. As a result of rapid technological change, the markets for our customers’ products are characterized by frequent product introductions, short product life cycles, fluctuating demand and increasing product capabilities. As a result, our customers’ products may not achieve market success or may become obsolete. We cannot assure you that our customers will dedicate the resources necessary to promote and commercialize their products, successfully execute their business strategies for such products, or be able to manufacture such products in quantities sufficient to meet demand or cost-effectively manufacture products at a high volume. Our customers do not have contracts with us that require them to manufacture, distribute or sell any products. Moreover, our customers may develop internally, or in collaboration with our competitors, technology that they may utilize instead of the technology available to them through us. Our customers’ failure to achieve market success for their products, including as a result of general declines in our customers’ markets or industries, could negatively affect their willingness to utilize our products, which may result in a decrease in our revenue and negatively affect our business and operating results. Our revenue also depends on the timely introduction, quality and market acceptance of our customers’ products that incorporate our solutions. Our customers’ products are often very complex and subject to design complexities that may result in design flaws, as well as potential defects, errors and bugs. We have in the past been subject to delays and project cancellations as a result of design flaws in the products developed by our customers. For example, in 2014, flaws in one of our customer’s products that were unrelated to our memory solutions generated negative publicity for our customer and delayed the product’s release until it could be redesigned. In the past, we have also been subject to delays and project cancellations as a result of changing market requirements, such as the customer adding a new feature, or because a customer’s product fails their end customer’s evaluation or field trial. Customer products may also be delayed due to issues with other vendors of theirs. We incur significant design and development costs in connection with designing our solutions for customers’ products. If our customers discover design flaws, defects, errors or bugs in their products, or if they experience changing market requirements, failed evaluations or field trials, or issues with other vendors, they may delay, change or cancel a project. If we have already incurred significant development costs, we may not be able to recoup those costs, which in turn would adversely affect our business and financial results. We face competition and expect competition to increase in the future. If we fail to compete effectively, our revenue growth and results of operations will be materially and adversely affected. The global semiconductor market in general, and the semiconductor memory market in particular, are highly competitive. We expect competition to increase and intensify as other semiconductor companies enter our markets, many of which have greater financial and other resources with which to pursue technology development, product design, manufacturing, marketing and sales and distribution of their products. Increased competition could result in price pressure, reduced profitability and loss of market share, any of which could materially and adversely affect our business, revenue and operating results. Currently, our competitors range from large, international companies offering a wide range of semiconductor products to companies specializing in other alternative, specialized emerging memory technologies. Our primary competitors include Macronix International Co. Ltd., Microchip Technology Inc., Micron Technology, Inc., Cypress Semiconductor Corporation and Winbond Electronics Corp. In addition, as the IoT market opportunity grows, we expect new entrants will enter these markets and existing competitors, including leading semiconductor companies, may make significant investments to compete more effectively against our products. These competitors could develop technologies or architectures that make our products or technologies obsolete. Our ability to compete successfully depends on factors both within and outside of our control, including: • | the functionality and performance of our products and those of our competitors; --+-------------------------------------------------------------------------------- • | our relationships with our customers and other industry participants; --+---------------------------------------------------------------------- 38 • | prices of our products and prices of our competitors’ products; --+---------------------------------------------------------------- • | our ability to develop innovative products; --+-------------------------------------------- • | our ability to retain high-level talent, including our management team and engineers; and --+------------------------------------------------------------------------------------------ • | the actions of our competitors, including merger and acquisition activity, launches of new products and other actions that could change the competitive landscape. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------- Competition could result in pricing pressure, reduced revenue and profitability and loss of market share, any of which could materially and adversely affect our business, results of operations and prospects. In the event of a market downturn, competition in the markets in which we operate may intensify as our customers reduce their purchase orders. Our competitors that are significantly larger and have greater financial, technical, marketing, distribution, customer support and other resources or more established market recognition than us may be better positioned to accept lower prices and withstand adverse economic or market conditions. Our customers require our products and our third-party contractors to undergo a lengthy and expensive qualification process. If we are unsuccessful or delayed in qualifying any of our products with a customer, our business and operating results would suffer. Prior to selecting and purchasing our products, our customers typically require that our products undergo extensive qualification processes, which involve testing of our products in the customers’ systems, as well as testing for reliability. This qualification process may continue for several months or years. However, obtaining the requisite qualifications for a memory product does not assure any sales of the product. Even after successful qualification and sales of a product to a customer, a subsequent revision in our third-party contractors’ manufacturing process or our selection of a new contract manufacturer may require a new qualification process, which may result in delays and excess or obsolete inventory. After our products are qualified and selected, it can and often does take several months or more before the customer commences volume production of systems that incorporate our products. Despite these uncertainties, we devote substantial resources, including design, engineering, sales, marketing and management efforts, to qualify our products with customers in anticipation of sales. If we are unsuccessful or delayed in qualifying any of our products with a customer, sales of those products may be precluded or delayed, which may impede our growth and harm our business. Our costs may increase substantially if our third-party manufacturing contractors do not achieve satisfactory product yields or quality. The fabrication process is extremely complicated and small changes in design, specifications or materials can result in material decreases in product yields or even the suspension of production. From time to time, the third-party foundries that we contract to manufacture our products may experience manufacturing defects and reduced manufacturing yields related to errors or problems in their manufacturing processes or the interrelationship of their processes with our designs. In some cases, our third-party foundries may not be able to detect these defects early in the fabrication process or determine the cause of such defects in a timely manner. Generally, in pricing our products, we assume that manufacturing yields will continue to improve, even as the complexity of our products increases. Once our products are initially qualified with our third-party foundries, minimum acceptable yields are established. We are responsible for the costs of the units if the actual yield is above the minimum. If actual yields are below the minimum we are not required to purchase the units. Typically, minimum acceptable yields for our new products are generally lower at first and gradually improve as we achieve full production. Unacceptably low product yields or other product manufacturing problems could substantially increase overall production time and costs and adversely impact our operating results. Product yield losses will increase our costs and reduce our gross margin. In addition to significantly harming our results of operations and cash flow, poor yields may delay shipment of our products and harm our relationships with existing and potential customers. 39 The complexity of our products may lead to errors, defects and bugs, which could negatively impact our reputation with customers and result in liability. Products as complex as ours may contain errors, defects and bugs when first introduced to customers or as new versions are released. Our products have in the past experienced such errors, defects and bugs. Delivery of products with production defects or reliability, quality or compatibility problems could significantly delay or hinder market acceptance of the products or result in a costly recall and could damage our reputation and adversely affect our ability to retain existing customers and attract new customers. Errors, defects or bugs could cause problems with the functionality of our products, resulting in interruptions, delays or cessation of sales of these products to our customers. We may also be required to make significant expenditures of capital and resources to resolve such problems. We cannot assure you that problems will not be found in new products, both before and after commencement of commercial production, despite testing by us, our suppliers or our customers. Any such problems could result in: • | delays in development, manufacture and roll-out of new products; --+----------------------------------------------------------------- • | additional development costs; --+------------------------------ • | loss of, or delays in, market acceptance; --+------------------------------------------ • | diversion of technical and other resources from our other development efforts; --+------------------------------------------------------------------------------- • | claims for damages by our customers or others against us; and --+-------------------------------------------------------------- • | loss of credibility with our current and prospective customers. --+---------------------------------------------------------------- Any such event could have a material adverse effect on our business, financial condition and results of operations. We may experience difficulties in transitioning to new wafer fabrication process technologies or in achieving higher levels of design integration, which may result in reduced manufacturing yields, delays in product deliveries and increased expenses. We aim to use the most advanced manufacturing process technology appropriate for our solutions that is available from our third-party foundries. As a result, we periodically evaluate the benefits of migrating our solutions to other technologies in order to improve performance and reduce costs. These ongoing efforts require us from time to time to modify the manufacturing processes for our products and to redesign some products, which in turn may result in delays in product deliveries. We may face difficulties, delays and increased expense as we transition our products to new processes, and potentially to new foundries. We will depend on our third-party foundries as we transition to new processes. We cannot assure you that our third-party foundries will be able to effectively manage such transitions or that we will be able to maintain our relationship with our third-party foundries or develop relationships with new third-party foundries. If we or any of our third-party foundries experience significant delays in transitioning to new processes or fail to efficiently implement transitions, we could experience reduced manufacturing yields, delays in product deliveries and increased expenses, any of which could harm our relationships with our customers and our operating results. As smaller line width geometry manufacturing processes become more prevalent, we intend to move our future products to increasingly smaller geometries in order to reduce costs while integrating greater levels of functionality into our products. This transition will require us and our third-party foundries to migrate to new designs and manufacturing processes for smaller geometry products. We may not be able to achieve smaller geometries with higher levels of design integration or to deliver new integrated products on a timely basis. We periodically evaluate the benefits, on a product-by-product basis, of migrating to smaller geometry process technologies to reduce our costs and increase performance. We are dependent on our relationships with our third-party foundries to transition to smaller geometry processes successfully. We cannot assure you that our third-party foundries will be able to effectively manage any such transition. If we or our third-party foundries experience significant delays in any such transition or fail to implement a transition, our business, financial condition and results of operations could be materially harmed. If we fail to retain qualified finance personnel and strengthen our financial reporting systems and infrastructure, we may not be able to timely and accurately report our financial results or comply with the requirements of being a public company, including compliance with the Sarbanes-Oxley Act and SEC reporting requirements. Our ability to timely and accurately report our financial results or comply with the requirements of being a public company depends on our maintaining adequate numbers of accounting and finance staff with technical accounting, SEC reporting and Sarbanes-Oxley Act compliance expertise. Any inability to recruit or retain qualified accounting and finance staff would have an adverse impact on our ability to accurately and timely prepare our financial statements. We may be unable to hire qualified professionals with requisite technical and public company experience when and as needed. In addition, new employees will require time and training to learn our business and operating processes and procedures. If our finance and accounting organization is unable for any reason to respond adequately to the increased demands from being a public company, the quality and timeliness of our financial reporting may suffer, which could result in the identification of material weaknesses in our internal controls. Any consequences resulting from 40 inaccuracies or delays in our reported financial statements could cause the trading price of our common stock to decli ne and could harm our business, operating results and financial condition. If we fail to strengthen our financial reporting systems, infrastructure and internal control over financial reporting to meet the demands placed upon us as a public company, including the requirements of the Sarbanes-Oxley Act, we may be unable to report our financial results timely and accurately and prevent fraud. We expect to incur significant expense and devote substantial management effort toward ensuring compliance with Section 404. A breach of our security systems may damage our reputation and adversely affect our business. Our security systems are designed to protect our customers’, suppliers’ and employees’ confidential information, as well as maintain the physical security of our facilities. We also rely on a number of third-party “cloud-based” service providers of corporate infrastructure services relating to, among other things, human resources, electronic communication services and some finance functions, and we are, of necessity, dependent on the security systems of these providers. Any security breaches or other unauthorized access by third parties to the systems of our cloud-based service providers or the existence of computer viruses in their data or software could expose us to a risk of information loss and misappropriation of confidential information. Accidental or willful security breaches or other unauthorized access by third parties to our information systems or facilities, or the existence of computer viruses in our data or software, could expose us to a risk of information loss and misappropriation of proprietary and confidential information belonging to us, our customers or our suppliers. Any theft or misuse of this information could result in, among other things, unfavorable publicity, damage to our reputation, difficulty in marketing our products, allegations by our customers that we have not performed our contractual obligations, litigation by affected parties and possible financial obligations for liabilities and damages related to the theft or misuse of this information, any of which could have a material adverse effect on our business, financial condition, our reputation, and our relationships with our customers and partners. Since the techniques used to obtain unauthorized access or to sabotage systems change frequently and are often not recognized until launched against a target, we may be unable to anticipate these techniques or to implement adequate preventative measures. Failure to protect our intellectual property could substantially harm our business. Our success and ability to compete depend in part upon our ability to protect our intellectual property. We rely on a combination of intellectual property rights, including patents, mask work protection, copyrights, trademarks, trade secrets and know-how, in the United States and other jurisdictions. The steps we take to protect our intellectual property rights may not be adequate, particularly in foreign jurisdictions such as China. Any patents we hold may not adequately protect our intellectual property rights or our products against competitors, and third parties may challenge the scope, validity or enforceability of our issued patents. In addition, other parties may independently develop similar or competing technologies designed around any patents or patent applications that we hold. Some of our products and technologies are not covered by any patent or patent application, as we do not believe patent protection of these products and technologies is critical to our business strategy at this time. A failure to timely seek patent protection on products or technologies generally precludes us from seeking future patent protection on these products or technologies. In addition to patents, we also rely on contractual protections with our customers, suppliers, distributors, employees and consultants, and we implement security measures designed to protect our trade secrets and know-how. However, we cannot assure you that these contractual protections and security measures will not be breached, that we will have adequate remedies for any such breach or that our customers, suppliers, distributors, employees or consultants will not assert rights to intellectual property or damages arising out of such contracts. We may initiate claims against third parties to protect our intellectual property rights if we are unable to resolve matters satisfactorily through negotiation. Litigation brought to protect and enforce our intellectual property rights could be costly, time-consuming and distracting to management. It could also result in the impairment or loss of portions of our intellectual property, as an adverse decision could limit our ability to assert our intellectual property rights, limit the value of our technology or otherwise negatively impact our business, financial condition and results of operations. Additionally, any enforcement of our patents or other intellectual property may provoke third parties to assert counterclaims against us. Our failure to secure, protect and enforce our intellectual property rights could materially harm our business. We may face claims of intellectual property infringement, which could be time-consuming, costly to defend or settle, result in the loss of significant rights, harm our relationships with our customers and distributors, or otherwise materially adversely affect our business, financial condition and results of operations. The semiconductor memory industry is characterized by companies that hold patents and other intellectual property rights and that vigorously pursue, protect and enforce intellectual property rights. These companies include patent holding companies or other adverse patent owners who have no relevant product revenue and against whom our own patents may provide little or no deterrence. 41 From time to time, third parties may assert against us and our customers’ patent and other intellectual property rights to technologies that are important to our business. Claims that our products, processes or technology infringe third-party intellectual property rights, regardless of their merit or resolution, could be costly to defend or settle and could divert the efforts and attention of our management and technical personnel. We may also be obligated to indemnify our customers or business partners in connection with any such litigation, which could result in increased costs. Infringement claims also could harm our relationships with our customers or distributors and might deter future customers from doing business with us. If any such proceedings result in an adverse outcome, we could be required to: • | cease the manufacture, use or sale of the infringing products, processes or technology; --+---------------------------------------------------------------------------------------- • | pay substantial damages for infringement; --+------------------------------------------ • | expend significant resources to develop non-infringing products, processes or technology, which may not be successful; --+----------------------------------------------------------------------------------------------------------------------- • | license technology from the third-party claiming infringement, which license may not be available on commercially reasonable terms, or at all; --+----------------------------------------------------------------------------------------------------------------------------------------------- • | cross-license our technology to a competitor to resolve an infringement claim, which could weaken our ability to compete with that competitor; or --+-------------------------------------------------------------------------------------------------------------------------------------------------- • | pay substantial damages to our customers to discontinue their use of or to replace infringing technology sold to them with non-infringing technology, if available. --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------- Any of the foregoing results could have a material adverse effect on our business, financial condition and results of operations. Furthermore, our exposure to the foregoing risks may also be increased as a result of acquisitions of other companies or technologies. For example, we may have a lower level of visibility into the development process with respect to intellectual property or the care taken to safeguard against infringement risks with respect to the acquired company or technology. In addition, third parties may make infringement and similar or related claims after we have acquired technology that had not been asserted prior to the acquisition. We rely upon third-party licensed technology to develop our products. If licenses of third-party technology are inadequate, our ability to develop and commercialize our products or product enhancements could be negatively impacted. Our products incorporate technology licensed from third parties. In connection with our acquisition of certain flash memory assets from Atmel Corporation in 2012, we obtained a perpetual license to Atmel’s flash memory technology. In addition, a component of our CBRAM technology is licensed from Axon Technology Corp. While we believe these licenses enable us to develop our products and pursue our current product strategies, these licenses may not provide us with the benefits we expect from them. From time to time, we may be required to license additional technology from third parties to develop our products or product enhancements. However, these third-party licenses may not be available to us on commercially reasonable terms or at all. Our inability to obtain third-party licenses necessary to develop products and product enhancements could require us to obtain substitute technology at a greater cost or of lower quality or performance standards or delay product development. Any of these results may limit our ability to develop new products, which could harm our business, financial condition and results of operations. Our success depends on our ability to attract and retain key employees, and our failure to do so could harm our ability to grow our business and execute our business strategies. Our success depends on our ability to attract and retain our key employees, including our management team and experienced engineers. Competition for personnel in the semiconductor technology field is intense, and the availability of suitable and qualified candidates is limited. We compete to attract and retain qualified research and development personnel with other semiconductor companies, universities and research institutions, particularly those in the San Francisco Bay Area where our headquarters is located. The members of our management and key employees are at-will employees. If we lose the services of any key senior management member or employee, we may not be able to locate suitable or qualified replacements, and may incur additional expenses to recruit and train new personnel, which could severely impact our business and prospects. The loss of the services of one or more of our key employees, especially our key engineers, or our inability to attract and retain qualified engineers, could harm our business, financial condition and results of operations. We may not be able to effectively manage our growth, and we may need to incur significant expenditures to address the additional operational and control requirements of our growth, either of which could harm our business and operating results. We expect to increase headcount and the overall size of our operations to support our growth. To effectively manage our growth, we must continue to expand our operational, engineering and financial systems, procedures and controls and to improve our 42 accounting and other internal management s ystems. This may require substantial managerial and financial resources, and our efforts in this regard may not be successful. Our current systems, procedures and controls may not be adequate to support our future operations. If we fail to adequately manag e our growth, or to improve our operational, financial and management information systems, or fail to effectively motivate or manage our new and future employees, the quality of our products and the management of our operations could suffer, which could ad versely affect our operating results . We have expanded in the past and may continue to expand in the future through acquisitions of, or investments in, other companies, each of which may divert our management’s attention, result in additional dilution to stockholders or use resources that are necessary to operate our business. In the past, we have grown our business through acquisitions and we may in the future seek to acquire or invest in businesses, products or technologies that we believe could complement or expand our business, enhance our technical capabilities or otherwise offer growth opportunities. For example, in September 2012, we purchased certain flash memory product assets from Atmel Corporation, which brought us a large customer base for products, a world-wide sales and distribution network and products and technology to further broaden our technology platform offerings. Such acquisitions or investments could create risks for us, including: • | difficulties in assimilating acquired personnel, operations and technologies or realizing synergies expected in connection with an acquisition, particularly with acquisitions of companies with large and widespread operations, complex products or that operate in markets in which we historically have had limited experience; --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ • | unanticipated costs or liabilities, including possible litigation, associated with the acquisition; --+---------------------------------------------------------------------------------------------------- • | incurrence of acquisition-related costs; --+----------------------------------------- • | diversion of management’s attention from other business concerns; --+------------------------------------------------------------------ • | use of resources that are needed in other parts of our business; and --+--------------------------------------------------------------------- • | use of substantial portions of our available cash to consummate an acquisition. --+-------------------------------------------------------------------------------- A significant portion of the purchase price of companies we acquire may be allocated to acquired goodwill, which must be assessed for impairment at least annually. If such acquisitions do not yield expected returns, we may be required to take charges to our earnings based on this impairment assessment process, which could harm our results of operations. We may be unable to complete acquisitions at all or on commercially reasonable terms, which could limit our future growth. Acquisitions could also result in dilutive issuances of equity securities or the incurrence of additional debt, which could adversely affect our operating results and result in a decline in our stock price and further restrict our ability to pursue business opportunities, including potential acquisitions. In addition, if an acquired business fails to meet our expectations, our operating results may suffer and our stock price could decline. We have operations outside of the United States and intend to expand our international operations, which exposes us to significant risks. We have limited operations in Europe and Asia. We intend to expand our operations in Asia. The success of our business depends, in large part, on our ability to operate successfully from geographically disparate locations and to further expand our international operations and sales. Operating in international markets requires significant resources and management attention and subjects us to regulatory, economic and political risks that are different from those we face in the United States. We cannot be sure that further international expansion will be successful. In addition, we face risks in doing business internationally that could expose us to reduced demand for our products, lower prices for our products or other adverse effects on our operating results. Among the risks we believe are most likely to affect us are: • | difficulties, inefficiencies and costs associated with staffing and managing foreign operations; --+------------------------------------------------------------------------------------------------- • | longer and more difficult customer qualification and credit checks; --+-------------------------------------------------------------------- • | greater difficulty collecting accounts receivable and longer payment cycles; --+----------------------------------------------------------------------------- • | the need for various local approvals to operate in some countries; --+------------------------------------------------------------------- • | difficulties in entering some foreign markets without larger-scale local operations; --+------------------------------------------------------------------------------------- • | compliance with local laws and regulations; --+-------------------------------------------- • | unexpected changes in regulatory requirements, including the elimination of tax holidays; --+------------------------------------------------------------------------------------------ 43 • | reduced protection for intellectual property rights in some countries; --+----------------------------------------------------------------------- • | adverse tax consequences as a result of repatriating cash generated from foreign operations to the United States; --+------------------------------------------------------------------------------------------------------------------ • | adverse tax consequences, including potential additional tax exposure if we are deemed to have established a permanent establishment outside of the United States; --+------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | the effectiveness of our policies and procedures designed to ensure compliance with the Foreign Corrupt Practices Act of 1977 and similar regulations; --+------------------------------------------------------------------------------------------------------------------------------------------------------- • | fluctuations in currency exchange rates, which could increase the prices of our products to customers outside of the United States, increase the expenses of our international operations by reducing the purchasing power of the U.S. dollar and expose us to foreign currency exchange rate risk if, in the future, we denominate our international sales in currencies other than the U.S. dollar; --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ • | new and different sources of competition; and --+---------------------------------------------- • | political and economic instability, and terrorism. --+--------------------------------------------------- Our failure to manage any of these risks successfully could harm our operations and reduce our revenue. In order to comply with environmental laws and regulations, we may need to modify our activities or incur substantial costs, and if we fail to comply with environmental regulations we could be subject to substantial fines or be required to have our suppliers alter their processes. The semiconductor memory industry is subject to a variety of international, federal, state and local governmental regulations directed at preventing or mitigating environmental harm, as well as to the storage, discharge, handling, generation, disposal and labeling of toxic or other hazardous substances. Failure to comply with environmental regulations could subject us to civil or criminal sanctions and property damage or personal injury claims. Compliance with current or future environmental laws and regulations could restrict our ability to expand our business or require us to modify processes or incur other substantial expenses which could harm our business. In response to environmental concerns, some customers and government agencies impose requirements for the elimination of hazardous substances, such as lead (which is widely used in soldering connections in the process of semiconductor packaging and assembly), from electronic equipment. For example, the European Union, or EU, adopted its Restriction on Hazardous Substance Directive which prohibits, with specified exceptions, the sale in the EU market of new electrical and electronic equipment containing more than agreed levels of lead or other hazardous materials and China has enacted similar regulations. Environmental laws and regulations such as these could become more stringent over time, causing a need to redesign technologies, imposing greater compliance costs and increasing risks and penalties associated with violations, which could seriously harm our business. The issuance of new accounting standards or future interpretations of existing accounting standards could adversely affect our operating results. We prepare our financial statements in accordance with accounting principles generally accepted in the United States of America, or GAAP. A change in those principles could have a significant effect on our reported results and might affect our reporting of transactions completed before a change is announced. GAAP is issued and subject to interpretation by the Financial Accounting Standards Board, the SEC and various other bodies formed to promulgate and interpret accounting principles. A change in these principles or interpretations could have a significant effect on our reported financial results, and could affect the reporting of transactions completed before the announcement of a change. The issuance of new accounting standards or future interpretations of existing accounting standards, or changes in our business practices or estimates, could result in future changes in our revenue recognition or other accounting policies that could have a material adverse effect on our results of operations. Some of our facilities and the facilities of our suppliers are located near known earthquake fault zones, and the occurrence of an earthquake or other catastrophic disaster could damage our facilities, which could cause us to curtail our operations. Our principal offices, and our contract manufacturers’ and suppliers’ facilities in Asia, are located near known earthquake fault zones and, therefore, are vulnerable to damage from earthquakes. We are also vulnerable to damage from other types of disasters, such as power loss, fire, floods and similar events. If any such disaster were to occur, our ability to operate our business could be seriously impaired. In addition, we may not have adequate insurance to cover our losses resulting from disasters or other similar significant business interruptions. Any significant losses that are not recoverable under our insurance policies could seriously impair our business and financial condition. 44 We may not be able to secure additional financing on favorable terms, or at all, to meet our future capital nee ds. We have funded our operations since inception through equity financings, our borrowing arrangements and our initial public offering in October 2015 and a subsequent public offering in June 2017. We have incurred net losses and negative cash flows from operating activities since our inception, and we expect we will continue to incur operating and net losses and negative cash flows from operations for the foreseeable future. We do not know when or if our operations will generate sufficient cash to fund our ongoing operations. In the future, we may require additional capital to fund our ongoing operations, respond to business opportunities, challenges, acquisitions or unforeseen circumstances and may determine to engage in equity or debt financings or enter into credit facilities, but we may not be able to timely secure additional debt or equity financing or raise additional capital in the public market on favorable terms or at all. Our current credit facility limits our ability to incur indebtedness, and these restrictions are subject to a number of qualifications and exceptions subject to the consent of our lender. Any additional debt financing obtained by us in the future could also involve restrictive covenants relating to our capital-raising activities and other financial and operational matters, which may make it more difficult for us to obtain additional capital and to pursue business opportunities, including potential acquisitions. If we raise additional funds through issuances of equity, convertible debt securities or other securities convertible into equity, our existing stockholders could suffer significant dilution in their percentage ownership of our company, and any new equity securities we issue could have rights, preferences and privileges senior to those of holders of our common stock. If we are unable to obtain adequate financing or financing on terms satisfactory to us, when we require it, our ability to continue to grow or support our business and to respond to business challenges could be significantly limited. Provisions of our debt agreements may restrict our ability to pursue our business strategies. Borrowings under our Credit Facility are collateralized by substantially all of our assets excluding our intellectual property. Our credit facility restricts our ability to, among other things: • | dispose of or sell assets; --+--------------------------- • | consolidate or merge with other entities; --+------------------------------------------ • | incur additional indebtedness; --+------------------------------- • | create liens on our assets; --+---------------------------- • | pay dividends; --+--------------- • | make investments; --+------------------ • | enter into transactions with affiliates; and --+--------------------------------------------- • | redeem subordinated indebtedness. --+---------------------------------- These restrictions are subject to certain exceptions. In addition, our credit facility, as amended, requires us to comply with certain financial covenants. The operating and financial restrictions and covenants in the credit facility, as well as any future financing agreements that we may enter into, may restrict our ability to finance our operations, engage in business activities or expand or fully pursue our business strategies. Our ability to comply with these covenants may be affected by events beyond our control, and we may not be able to meet those covenants. A breach of any of these covenants could result in a default under the credit facility (as it did during the months of August, September, October and November, 2016), which could cause, among other things (unless such default is waived by the lender), all or a portion of the outstanding indebtedness thereunder to become immediately due and payable and subject to an increase by 5% of the interest rate charged during the period of the unremedied breach. In addition, the lender would be able to sell or lease our assets in satisfaction of our outstanding indebtedness. Our ability to use net operating losses to offset future taxable income may be subject to certain limitations. In general, under Section 382 of the U.S. Internal Revenue Code of 1986, as amended, or the Code, a corporation that undergoes an “ownership change” is subject to limitations on its ability to utilize its pre-change net operating losses, or NOLs, to offset future taxable income, and tax credits to offset tax. In addition, although we do not expect to undergo an ownership change, we may experience an ownership change in the future, and our ability to utilize our NOLs and tax credits could be further limited by Section 382 of the Code. Future changes in our stock ownership, many of which are outside of our control, could result in an ownership change under Section 382 of the Code. Our net operating losses and tax credits could also be impaired under state laws. As a result, we might not be able to utilize a material portion of our state NOLs and tax credits. 45 If we are unable to implement and maintain effective internal control over financial reporting in the future, investors may lose confidence in the accuracy and completeness of our financial reports and the market price of our common stock may be negatively affected. As a public company, we are required to maintain internal controls over financial reporting and to report any material weaknesses in such internal controls. If and when we no longer meet the definition of an “emerging growth company” as defined by the JOBS Act, we would be required under Section 404 of the Sarbanes-Oxley Act to evaluate and determine the effectiveness of our internal control over financial reporting and, beginning with our annual report for the applicable fiscal year, provide a management report on our internal control over financial reporting, which must be attested to by our independent registered public accounting firm. If we have one or more material weaknesses in our internal control over financial reporting, we may not detect errors on a timely basis and our financial statements may be materially misstated. We are in the process of designing and implementing our internal control over financial reporting required to comply with this obligation, which process will be time consuming, costly and complicated. If we identify material weaknesses in our internal control over financial reporting, if we are unable to comply with the requirements of Section 404 in a timely manner, if we are unable to determine that our internal control over financial reporting is effective, or if our independent registered public accounting firm is unable to express an opinion as to the effectiveness of our internal control over financial reporting, investors may lose confidence in the accuracy and completeness of our financial reports, the market price of our common stock could be negatively affected, and we could become subject to investigations by the NASDAQ Stock Market, the SEC or other regulatory authorities, which could require additional financial and management resources. Regulations related to “conflict minerals” may force us to incur additional expenses, may make our supply chain more complex and may result in damage to our reputation with customers. Pursuant to the Dodd-Frank Act, the SEC has adopted requirements for companies that use certain minerals and metals, known as conflict minerals, in their products, whether or not these products are manufactured by third parties. These requirements will require companies to diligence, disclose and report whether or not such minerals originate from the Democratic Republic of Congo and adjoining countries. The implementation of these requirements could adversely affect the sourcing, availability and pricing of minerals used in the manufacture of our products, and affect our costs and relationships with customers, distributors and suppliers as we must obtain additional information from them to ensure our compliance with the disclosure requirement. In addition, we will incur additional costs to comply with the disclosure requirements, including costs related to determining the source of any of the relevant minerals and metals used in our products. Since our supply chain is complex, we may not be able to sufficiently verify the origins for these minerals and metals used in our products through the due diligence procedures that we implement, which may harm our reputation. In such event, we may also face difficulties in satisfying customers who require that all of the components of our products are certified as conflict mineral free and these customers may discontinue, or materially reduce, purchases of our products, which could result in a material adverse effect on our results of operations and our financial condition may be adversely affected. Risks Related to Ownership of Our Common Stock The market price of our common stock has been and will likely continue to be volatile, and you could lose all or part of your investment. The market price of our common stock has been, and will likely continue to be, volatile. Since shares of our common stock were sold in our initial public offering in October 2015 at a price of $5.00 per share, our stock price has fluctuated significantly. In addition to the factors discussed in this Quarterly Report on Form 10-Q, the market price of our common stock may fluctuate significantly in response to numerous factors, many of which are beyond our control, including: • | overall performance of the equity markets in general, in our industry or in the markets we address; --+---------------------------------------------------------------------------------------------------- • | our operating performance and the performance of other similar companies; --+-------------------------------------------------------------------------- • | changes in the estimates of our results of operations that we provide to the public, our failure to meet these projected results or changes in recommendations by securities analysts that elect to follow our common stock; --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | announcements of technological innovations, new products or enhancements to products, acquisitions, strategic alliances or significant agreements by us or by our competitors; --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | announcements of new business partners, on the termination of existing business partner arrangements or changes to our relationships with such business partners; --+------------------------------------------------------------------------------------------------------------------------------------------------------------------ • | recruitment or departure of key personnel; --+------------------------------------------- • | announcements of litigation or claims against us; --+-------------------------------------------------- • | changes in legal requirements relating to our business; --+-------------------------------------------------------- 46 • | the economy as a whole, market conditions in our industry, and the industries of our customers and end customers; --+------------------------------------------------------------------------------------------------------------------ • | trading activity by our principal stockholders; --+------------------------------------------------ • | the expiration of contractual lock-up or market standoff agreements; and --+------------------------------------------------------------------------- • | sales of shares of our common stock by us or our stockholders. --+--------------------------------------------------------------- In addition, the stock markets have experienced extreme price and volume fluctuations that have affected and continue to affect the market prices of equity securities of many technology companies. Stock prices of many technology companies have fluctuated in a manner unrelated or disproportionate to the operating performance of those companies. In the past, stockholders have filed securities class action litigation following periods of market volatility. If we were to become involved in securities litigation, it could subject us to substantial costs, divert resources and the attention of management from our business, and adversely affect our business. If securities analysts do not publish research or reports about our business or if they downgrade our stock, the price of our stock could decline. The trading market for our common stock rely in part on the research and reports that industry or financial analysts publish about us or our business. We do not control these analysts. If few analysts cover our company, the price and trading volume of our stock could suffer. If one or more of the analysts who cover us downgrade our stock, or publish unfavorable research about our business, our stock price would likely decline rapidly. If one or more of these analysts cease coverage of our company or fail to publish regularly, we could lose visibility in the market, which in turn could cause our stock price to decline. We do not intend to pay dividends for the foreseeable future. We have never declared nor paid cash dividends on our capital stock. We currently intend to retain any future earnings to finance the operation and expansion of our business, and we do not expect to declare or pay any dividends in the foreseeable future. In addition, our ability to pay cash dividends on our capital stock is restricted by the terms of our term loan facility and is likely to be restricted by any future debt financing arrangement. Any return to stockholders will therefore be limited to increases in the price of our common stock, if any. Provisions in our amended and restated certificate of incorporation and bylaws or Delaware law might discourage, delay or prevent a change of control of our company or changes in our management. Delaware corporate law and our amended and restated certificate of incorporation and bylaws contain provisions that could discourage, delay or prevent a change in control of our company or changes in our board of directors that the stockholders of our company may deem advantageous. Among other things, these provisions: • | establish a classified board of directors so that not all members of our board are elected at one time; --+-------------------------------------------------------------------------------------------------------- • | provide that directors may be removed only “for cause” and only with the approval of stockholders representing 66 2/3 percent of our outstanding common stock; --+--------------------------------------------------------------------------------------------------------------------------------------------------------------- • | require super-majority voting to amend some provisions in our amended and restated certificate of incorporation and bylaws; --+---------------------------------------------------------------------------------------------------------------------------- • | authorize the issuance of “blank check” preferred stock that our board could issue to increase the number of outstanding shares and to discourage a takeover attempt; --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | eliminate the ability of our stockholders to call special meetings of stockholders; --+------------------------------------------------------------------------------------ • | prohibit stockholder action by written consent, which means that all stockholder actions will be required to be taken at a meeting of our stockholders; --+-------------------------------------------------------------------------------------------------------------------------------------------------------- • | provide that our board of directors is expressly authorized to make, alter or repeal our bylaws; and --+----------------------------------------------------------------------------------------------------- • | establish advance notice requirements for nominations for election to our board or for proposing matters that can be acted upon by stockholders at stockholder meetings. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------- These provisions may frustrate or prevent any attempts by our stockholders to replace or remove our current management by making it more difficult for stockholders to replace members of our board of directors, which is responsible for appointing the members of our management. In addition, we are governed by the provisions of Section 203 of the Delaware General Corporation Law, which generally prohibits a Delaware corporation from engaging in a broad range of business combinations with any 47 “interested” stockholder for a period of three years following the date on which the stockholder became an “interested” stockholder. Any delay or prevention of a change of control transaction or changes in our management could cause the market price of our common stock to decline. ITEM 1B. | UNRESOLVED STAFF COMMENTS ---------+-------------------------- None. ITEM 2. | UNREGISTERED SALES OF EQUITY AND USE OF PROCEEDS --------+------------------------------------------------- (a) Sales of Unregistered Securities None. (b) Use of Proceeds from Public Offering of Common Stock On October 30, 2015, we completed our initial public offering in which we sold 5,000,000 shares of common stock at a price to the public of $5.00 per share. On November 4, 2015, we completed the sale of an additional 192,184 shares of common stock pursuant to the underwriters’ over-allotment option. The aggregate offering price for shares sold by us in the offering was approximately $26.0 million. The offer of up to 5,750,000 shares in the initial public offering, for a proposed maximum aggregate offering price of $28.75 million, were registered under the Securities Act pursuant to a registration statement on Form S-1 (File No. 333-206940) that was declared effective by the Securities and Exchange Commission on October 26, 2015. Needham & Company, LLC, Oppenheimer & Co. Inc. and Roth Capital Partners, LLC were the underwriters for the offering. Following the sale of 5,192,184 shares in connection with the closing of the initial public offering and the sale of the shares subject to the over-allotment option, the offering terminated. We raised approximately $22.1 million in net proceeds after deducting underwriting discounts and commissions of approximately $1.8 million and other offering expenses of approximately $2.0 million. As of September 30, 2017, we had used approximately $19.7 million of the estimated aggregate net proceeds from our initial public offering to fund working capital and general corporate requirements in the ordinary course of business. The foregoing amounts represent our best estimate of our use of proceeds for the period indicated. No such payments were made, whether directly or indirectly to our directors or officers or their associates, holders of 10% or more of any class of our equity securities or to our affiliates. We intend to use the net proceeds from the initial public offering for additional working capital and other general corporate purposes, including research and development activities, sales and marketing activities and capital expenditures, to enhance existing and develop new products and product families, expand our manufacturing capabilities or fund our growth. ITEM 3. | DEFAULTS UPON SENIOR SECURITIES --------+-------------------------------- None. ITEM 4. | MINE SAFETY DISCLOSURES --------+------------------------ Not applicable. ITEM 5. | OTHER INFORMATION --------+------------------ None. 48 ITEM 6. | Exhibits --------+--------- Number | Description --------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.1 | Form of Principal Officer Change in Control and Severance Agreement. (1) --------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.2 | Change in Control and Severance Agreement dated August 1, 2017, between the Registrant and Tom Spade. (2) --------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.3 | Second Business Financing Modification Agreement, dated September 29, 2017, between the Registrant and Western Alliance Bank. (3) --------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.1 | Certification of Chief Executive Officer pursuant to Securities Exchange Act Rules 13a-14(c) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. --------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.2 | Certification of Chief Financial Officer pursuant to Securities Exchange Act Rules 13a-14(c) and 15d-14(a)-, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. --------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 32.1+ | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. --------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 32.2+ | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. --------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.INS | XBRL Instance Document --------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.SCH | XBRL Taxonomy Extension Schema Document --------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document --------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document --------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.LAB | XBRL Taxonomy Extension Label Linkbase Document --------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document --------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- + | This certification shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or Exchange Act, or otherwise subject to the liability of that Section, nor shall it be deemed incorporated by reference into any filing under the Securities Act of 1933, as amended or the Exchange Act of 1934. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (1) | Exhibit 10.1 is incorporated by reference to Exhibit 10.1 filed with the Registrant’s current report on Form 8-K, filed with the Commission on August 4, 2017. ----+--------------------------------------------------------------------------------------------------------------------------------------------------------------- (2) | Exhibit 10.2 is incorporated by reference to Exhibit 10.2 filed with the Registrant’s current report on Form 8-K, filed with the Commission on August 4, 2017. ----+--------------------------------------------------------------------------------------------------------------------------------------------------------------- (3) | Exhibit 10.3 is incorporated by reference to Exhibit 10.1 filed with the Registrant’s current report on Form 8-K, filed with the Commission on October 5, 2017. ----+---------------------------------------------------------------------------------------------------------------------------------------------------------------- 49 SIGNAT URES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. | | Adesto Technologies Corporation -------------------------+-----+--------------------------------------------------------------------------------- Dated: November 13, 2017 | By: | /s/ Ron Shelton -------------------------+-----+--------------------------------------------------------------------------------- | | Ron Shelton Chief Financial Officer (Principal Financial and Accounting Officer) -------------------------+-----+--------------------------------------------------------------------------------- 50

ADOMANI, INC.

1563568

10-Q

0001171843-17-006913

UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q X | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 --+---------------------------------------------------------------------------------------- FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2017 or ☐ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 --+----------------------------------------------------------------------------------------- For the transition period from ___________ to ___________ Commission file number 001-38078 ADOMANI, INC. (Exact name of registrant as specified in its charter) Delaware | 46-0774222 -----------------------------------------------------------------------+------------------------------------- (State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) -----------------------------------------------------------------------+------------------------------------- 4740 Green River Road, Suite 106 Corona, CA 92880 (Address of principal executive offices, including zip code) (951) 407-9860 (Registrant’s telephone number, including area code) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No ☐ Indicate by check mark whether the Registrant (1) has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ý No ☐ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large accelerated filer | ☐ | Accelerated filer | ☐ ------------------------+-------------------------------------------------+---------------------------+-- Non-accelerated filer | ý (Do not check if a smaller reporting company) | Smaller reporting company | ☐ ------------------------+-------------------------------------------------+---------------------------+-- | | Emerging growth company | ý ------------------------+-------------------------------------------------+---------------------------+-- If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ý Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ý The number of shares outstanding of the Registrant’s only class of common stock as of November 10, 2017 was 68,070,930. ADOMANI, INC. AND SUBSIDIARIES TABLE OF CONTENTS FORM 10-Q FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2017 Note About Forward-Looking Statements Part I. FINANCIAL INFORMATION | | PAGE ----------------------------------------------------------------------------------------------+-----------------------------------------------------------------------------------------------------------------+----- Item 1. Financial Statements: | ----------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------- | Unaudited Consolidated Balance Sheets as of September 30, 2017 and December 31, 2016 | 1 ----------------------------------------------------------------------------------------------+-----------------------------------------------------------------------------------------------------------------+----- | Unaudited Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2017 and 2016 | 2 ----------------------------------------------------------------------------------------------+-----------------------------------------------------------------------------------------------------------------+----- | Unaudited Consolidated Statement of Stockholders’ Equity (Deficit) for the Nine Months Ended September 30, 2017 | 3 ----------------------------------------------------------------------------------------------+-----------------------------------------------------------------------------------------------------------------+----- | Unaudited Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2017 and 2016 | 4 ----------------------------------------------------------------------------------------------+-----------------------------------------------------------------------------------------------------------------+----- | Notes to Unaudited Consolidated Financial Statements | 5 ----------------------------------------------------------------------------------------------+-----------------------------------------------------------------------------------------------------------------+----- Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations | 12 ----------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------- Item 3. Quantitative and Qualitative Disclosure about Market Risk | 21 ----------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------- Item 4. Controls and Procedures | 21 ----------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------- Part II. OTHER INFORMATION --------------------------------------------------------------------------------------------- Item 1. Legal Proceedings | 22 ----------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------- Item 1A. Risk Factors | 22 ----------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------- Item 2. Unregistered Sales of Equity Securities and Use of Proceeds | 23 ----------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------- Item 3. Defaults Upon Senior Securities | 23 ----------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------- Item 4. Mine Safety Disclosures | 23 ----------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------- Item 5. Other Information | 23 ----------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------- Item 6. Exhibits | 23 ----------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------- Signatures | 24 ----------------------------------------------------------------------------------------------+---------------------------------------------------------------------------------------------------------------- CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS This Quarterly Report on Form 10-Q, or Quarterly Report, contains “forward-looking statements” that involve substantial risks and uncertainties. Forward-looking statements relate to future events or our future financial performance or condition and involve known and unknown risks, uncertainties and other factors that could cause our actual results, levels of activity, performance or achievement to differ materially from those expressed or implied by these forward-looking statements. In some cases, you can identify forward-looking statements by terms such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “potential,” “should,” “will” and “would” or the negatives of these terms or other comparable terminology. You should not place undue reliance on forward-looking statements. The cautionary statements set forth in this Quarterly Report, including in “Risk Factors” and elsewhere, identify important factors which you should consider in evaluating our forward-looking statements. These factors include, among other things: · | Our ability to generate demand for our zero-emission or hybrid drivetrains and conversion kits in order to generate revenue; --+----------------------------------------------------------------------------------------------------------------------------- · | Our dependence upon external sources for the financing of our operations, particularly given that our independent registered accounting firm’s report on our consolidated financial statements for the year ended December 31, 2016 contains a statement concerning our ability to continue as a going concern; --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | Our ability to effectively execute our business plan; --+------------------------------------------------------ · | Our ability to scale our assembling and converting processes effectively and quickly from low volume production to high volume production; --+------------------------------------------------------------------------------------------------------------------------------------------- · | Our ability to manage our expansion, growth and operating expenses and reduce and adequately control the costs and expenses associated with operating our business; --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | Our ability to obtain, retain and grow our customers; --+------------------------------------------------------ · | Our ability to enter into, sustain and renew strategic relationships on favorable terms; --+----------------------------------------------------------------------------------------- · | Our ability to achieve and sustain profitability; --+-------------------------------------------------- · | Our ability to evaluate and measure our current business and future prospects; --+------------------------------------------------------------------------------- · | Our ability to compete and succeed in a highly competitive and evolving industry; --+---------------------------------------------------------------------------------- · | Our ability to respond and adapt to changes in electric or hybrid drivetrain technology; and --+--------------------------------------------------------------------------------------------- · | Our ability to protect our intellectual property and to develop, maintain and enhance a strong brand. --+------------------------------------------------------------------------------------------------------ You should read this Quarterly Report and the documents that we reference elsewhere in this Quarterly Report completely and with the understanding that our actual results may differ materially from what we expect as expressed or implied by our forward-looking statements. In light of the significant risks and uncertainties to which our forward-looking statements are subject, you should not place undue reliance on or regard these statements as a representation or warranty by us or any other person that we will achieve our objectives and plans in any specified timeframe, or at all. We discuss many of these risks and uncertainties in greater detail in this Quarterly Report, particularly in Part II. Item 1A. “Risk Factors.” These forward-looking statements represent our estimates and assumptions only as of the date of this Quarterly Report regardless of the time of delivery of this Quarterly Report. Except as required by law, we undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise after the date of this Quarterly Report. Unless expressly indicated or the context requires otherwise, references in this Quarterly Report on Form 10-Q to “ADOMANI,” “Company,” “we,” “our,” and “us” refer to ADOMANI, Inc. and our subsidiaries, unless the context indicates otherwise. PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS ADOMANI, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands, except share data) (unaudited) | September 30, 2017 | | December 31, 2016 ---------------------------------------------------------------------------------------------------------------------------+-------------------------+---------+----------------------- ASSETS | | | ---------------------------------------------------------------------------------------------------------------------------+-------------------------+---------+----------------------- Current assets: | | | | | | ---------------------------------------------------------------------------------------------------------------------------+-------------------------+---------+------------------------+---+---------+-- Cash and cash equivalents | $ | 4,475 | | $ | 938 | ---------------------------------------------------------------------------------------------------------------------------+-------------------------+---------+------------------------+---+---------+-- Notes receivable, net | | 1,000 | | | 454 | ---------------------------------------------------------------------------------------------------------------------------+-------------------------+---------+------------------------+---+---------+-- Inventory | | 704 | | | 314 | ---------------------------------------------------------------------------------------------------------------------------+-------------------------+---------+------------------------+---+---------+-- Other current assets | | 195 | | | 1,039 | ---------------------------------------------------------------------------------------------------------------------------+-------------------------+---------+------------------------+---+---------+-- Total current assets | | 6,374 | | | 2,745 | ---------------------------------------------------------------------------------------------------------------------------+-------------------------+---------+------------------------+---+---------+-- Property, plant and equipment, net | | 501 | | | 417 | ---------------------------------------------------------------------------------------------------------------------------+-------------------------+---------+------------------------+---+---------+-- Other investments | | - | | | 120 | ---------------------------------------------------------------------------------------------------------------------------+-------------------------+---------+------------------------+---+---------+-- Other non-current assets | | 130 | | | 124 | ---------------------------------------------------------------------------------------------------------------------------+-------------------------+---------+------------------------+---+---------+-- Total assets | $ | 7,005 | | $ | 3,406 | ---------------------------------------------------------------------------------------------------------------------------+-------------------------+---------+------------------------+---+---------+-- LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT) | | | | | | ---------------------------------------------------------------------------------------------------------------------------+-------------------------+---------+------------------------+---+---------+-- Current liabilities: | | | | | | ---------------------------------------------------------------------------------------------------------------------------+-------------------------+---------+------------------------+---+---------+-- Accounts payable | $ | 182 | | $ | 107 | ---------------------------------------------------------------------------------------------------------------------------+-------------------------+---------+------------------------+---+---------+-- Accrued liabilities | | 382 | | | 236 | ---------------------------------------------------------------------------------------------------------------------------+-------------------------+---------+------------------------+---+---------+-- Notes payable, net | | 3,195 | | | 5,177 | ---------------------------------------------------------------------------------------------------------------------------+-------------------------+---------+------------------------+---+---------+-- Convertible debt, net | | - | | | 593 | ---------------------------------------------------------------------------------------------------------------------------+-------------------------+---------+------------------------+---+---------+-- Total current liabilities | | 3,759 | | | 6,113 | ---------------------------------------------------------------------------------------------------------------------------+-------------------------+---------+------------------------+---+---------+-- Total liabilities | | 3,759 | | | 6,113 | ---------------------------------------------------------------------------------------------------------------------------+-------------------------+---------+------------------------+---+---------+-- Commitments and contingencies | | | | | | ---------------------------------------------------------------------------------------------------------------------------+-------------------------+---------+------------------------+---+---------+-- Stockholders' equity (deficit): | | | | | | ---------------------------------------------------------------------------------------------------------------------------+-------------------------+---------+------------------------+---+---------+-- Preferred stock, 100,000,000 authorized $0.00001 par value none issued and outstanding, respectively | | - | | | - | ---------------------------------------------------------------------------------------------------------------------------+-------------------------+---------+------------------------+---+---------+-- Common stock, 2,000,000,000 authorized $0.00001 par value, 68,070,930 and 58,542,350 issued and outstanding, respectively | | 1 | | | 1 | ---------------------------------------------------------------------------------------------------------------------------+-------------------------+---------+------------------------+---+---------+-- Additional paid-in capital | | 45,930 | | | 18,366 | ---------------------------------------------------------------------------------------------------------------------------+-------------------------+---------+------------------------+---+---------+-- Accumulated deficit | | (42,685 | ) | | (21,074 | ) ---------------------------------------------------------------------------------------------------------------------------+-------------------------+---------+------------------------+---+---------+-- Total stockholders' equity (deficit) | | 3,246 | | | (2,707 | ) ---------------------------------------------------------------------------------------------------------------------------+-------------------------+---------+------------------------+---+---------+-- Total liabilities and stockholders' equity | $ | 7,005 | | $ | 3,406 | ---------------------------------------------------------------------------------------------------------------------------+-------------------------+---------+------------------------+---+---------+-- See Accompanying Notes to Unaudited Consolidated Financial Statements. 1 - ADOMANI, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited; in thousands, except per share data) | Three Months Ended September 30, | | Nine Months Ended September 30, ---------------------------------------------------------------+--------------------------------------+------------+------------------------------------ | 2017 | | 2016 | 2017 | | 2016 ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+----- Net sales | $ | - | | $ | - | | $ | - | | $ | 68 | ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Cost of sales | | - | | | - | | | - | | | 50 | ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Gross profit | | - | | | - | | | - | | | 18 | ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Operating expenses: | | | | | | | | | | | | ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- General and administrative | | 11,716 | | | 5,872 | | | 18,363 | | | 8,107 | ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Consulting | | 49 | | | - | | | 2,213 | | | 95 | ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Research and development | | 38 | | | 112 | | | 557 | | | 128 | ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Total operating expenses, net | | 11,803 | | | 5,984 | | | 21,133 | | | 8,330 | ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Loss from operations | | (11,803 | ) | | (5,984 | ) | | (21,133 | ) | | (8,312 | ) ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Other income (expense): | | | | | | | | | | | | ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Interest expense, net | | (47 | ) | | (274 | ) | | (362 | ) | | (833 | ) ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Other income (expense) | | (116 | ) | | (11 | ) | | (113 | ) | | (9 | ) ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Total other income (expense) | | (163 | ) | | (285 | ) | | (475 | ) | | (842 | ) ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Loss before income taxes | | (11,966 | ) | | (6,269 | ) | | (21,608 | ) | | (9,154 | ) ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Income tax expense | | (1 | ) | | - | | | (3 | ) | | - | ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Net loss | $ | (11,967 | ) | $ | (6,269 | ) | $ | (21,611 | ) | $ | (9,154 | ) ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Net loss per share to common shareholders: | | | | | | | | | | | | ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Basic and diluted | $ | (0.18 | ) | $ | (0.11 | ) | $ | (0.33 | ) | $ | (0.13 | ) ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Weighted shares used in the computation of net loss per share: | | | | | | | | | | | | ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Basic and diluted | | 68,070,930 | | | 57,163,882 | | | 66,020,773 | | | 69,286,226 | ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- See Accompanying Notes to Unaudited Consolidated Financial Statements. 2 - ADOMANI, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT) (in thousands, except per share data) (unaudited) | Common Stock | | Additional Paid-In | Accumulated | | Stockholders' -------------------------------------------------------------------------+--------------+------------+--------------------+-------------+---+-------------- | Shares | | Amount | Capital | | Deficit | Equity (Deficit) -------------------------------------------------------------------------+--------------+------------+--------------------+-------------+---+---------------+----------------- Balance, December 31, 2016 | | 58,542,350 | | $ | 1 | | $ | 18,366 | | $ | (21,074 | ) | $ | (2,707 | ) -------------------------------------------------------------------------+--------------+------------+--------------------+-------------+---+---------------+------------------+--------+---+---+---------+---+---+---------+-- Common stock issued due to debt conversion | | 6,868,578 | | | - | | | 726 | | | - | | | 726 | -------------------------------------------------------------------------+--------------+------------+--------------------+-------------+---+---------------+------------------+--------+---+---+---------+---+---+---------+-- Common stock issued for cash | | 2,510,002 | | | - | | | 12,550 | | | - | | | 12,550 | -------------------------------------------------------------------------+--------------+------------+--------------------+-------------+---+---------------+------------------+--------+---+---+---------+---+---+---------+-- Offering costs netted against proceeds from common stock issued for cash | | - | | | - | | | (4,437 | ) | | - | | | (4,437 | ) -------------------------------------------------------------------------+--------------+------------+--------------------+-------------+---+---------------+------------------+--------+---+---+---------+---+---+---------+-- Common stock issued for prepaid services cancelled | | (100,000 | ) | | - | | | (100 | ) | | - | | | (100 | ) -------------------------------------------------------------------------+--------------+------------+--------------------+-------------+---+---------------+------------------+--------+---+---+---------+---+---+---------+-- Common stock issued as offering costs | | 250,000 | | | - | | | 1,250 | | | | | | 1,250 | -------------------------------------------------------------------------+--------------+------------+--------------------+-------------+---+---------------+------------------+--------+---+---+---------+---+---+---------+-- Warrants issued for services | | - | | | - | | | 1,241 | | | | | | 1,241 | -------------------------------------------------------------------------+--------------+------------+--------------------+-------------+---+---------------+------------------+--------+---+---+---------+---+---+---------+-- Warrants issued as offering costs | | - | | | - | | | 681 | | | | | | 681 | -------------------------------------------------------------------------+--------------+------------+--------------------+-------------+---+---------------+------------------+--------+---+---+---------+---+---+---------+-- Stock based compensation | | - | | | - | | | 15,653 | | | - | | | 15,653 | -------------------------------------------------------------------------+--------------+------------+--------------------+-------------+---+---------------+------------------+--------+---+---+---------+---+---+---------+-- Net loss | | - | | | - | | | - | | | (21,611 | ) | | (21,611 | ) -------------------------------------------------------------------------+--------------+------------+--------------------+-------------+---+---------------+------------------+--------+---+---+---------+---+---+---------+-- Balance, September 30, 2017 | | 68,070,930 | | $ | 1 | | $ | 45,930 | | $ | (42,685 | ) | $ | 3,246 | -------------------------------------------------------------------------+--------------+------------+--------------------+-------------+---+---------------+------------------+--------+---+---+---------+---+---+---------+-- See Accompanying Notes to Unaudited Consolidated Financial Statements. 3 - ADOMANI, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) (unaudited) | Nine Months Ended September 30, ----------------------------------------------------------------------------+------------------------------------ | 2017 | | 2016 ----------------------------------------------------------------------------+-------------------------------------+---------+----- Cash flows from operating activities: | | | | | | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Net loss | | (21,611 | ) | | (9,154 | ) ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Adjustments to reconcile net loss to net cash used in operating activities: | | | | | | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Depreciation and amortization | | 11 | | | 9 | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Accretion of discount on note receivable | | (46 | ) | | - | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Amortization of debt discount | | 130 | | | 454 | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Stock based compensation expense | | 15,653 | | | 6,920 | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Warrant issued for services | | 1,241 | | | - | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Gain on disposal of property and equipment | | (1 | ) | | - | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Write-off of investment | | 120 | | | - | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Changes in assets and liabilities: | | | | | | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Inventory | | (390 | ) | | - | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Other current assets | | (59 | ) | | (28 | ) ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Other non-current assets | | (5 | ) | | (90 | ) ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Accounts payable | | 75 | | | 165 | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Accrued liabilities | | 226 | | | (315 | ) ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Deferred revenue | | - | | | (68 | ) ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Net cash used in operating activities | | (4,656 | ) | | (2,107 | ) ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Cash flows from investing activities: | | | | | | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Purchases of property, plant and equipment, net | | (94 | ) | | (359 | ) ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Investment in note receivable, net | | (500 | ) | | - | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Other Investments | | - | | | (10 | ) ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Net cash used in investing activities | | (594 | ) | | (369 | ) ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Cash flows from financing activities: | | | | | | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Proceeds from issuance of common stock | | 12,550 | | | 188 | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Payments for stock rescission | | - | | | (54 | ) ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Proceeds from issuance of debt, net of issuance costs | | 500 | | | 42 | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Principal repayments of debt | | (2,560 | ) | | (8 | ) ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Payments for deferred offering costs | | (1,703 | ) | | (492 | ) ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Net cash provided (used) by financing activities | | 8,787 | | | (324 | ) ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Net change in cash and cash equivalents | | 3,537 | | | (2,800 | ) ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Cash and cash equivalents at the beginning of the year | | 938 | | | 4,537 | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Cash and cash equivalents at the end of the year | $ | 4,475 | | $ | 1,737 | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Non-cash transactions: | | | | | | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Debt discount due to BCF | $ | - | | $ | 42 | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Stock issued for third-party services rendered | $ | - | | $ | 98 | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Stock issued for prepaid services | $ | - | | $ | 100 | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Common stock issued for conversion of notes payable | $ | - | | $ | 885 | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Common stock issued due to debt conversion | $ | 726 | | $ | - | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Deferred offering costs reclassified to equity | $ | 838 | | $ | - | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Common stock issued for prepaid services rescinded | $ | 100 | | $ | - | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Common stock issued as offering costs | $ | 1,250 | | $ | - | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Warrants issued as offering costs | $ | 681 | | | - | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Supplemental cash flow disclosures: | | | | | | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Cash paid for interest expense | $ | 288 | | $ | 361 | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- Cash paid for income taxes | $ | - | | $ | - | ----------------------------------------------------------------------------+-------------------------------------+---------+------+---+--------+-- See Accompanying Notes to Unaudited Consolidated Financial Statements. 4 - ADOMANI, INC. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS 1. | Organization and Operations ---+---------------------------- ADOMANI, Inc., or “we”, “us”, “our” or the “Company”, was incorporated in Florida in August 2012 and reincorporated in Delaware in November 2016. The Company is a provider of advanced zero-emission electric and hybrid vehicles and replacement drivetrains that is focused on reducing the total cost of vehicle ownership. The Company’s drivetrain systems are designed to help fleet operators unlock the benefits of green technology and address the challenges of traditional fuel price cost instability and local, state and federal environmental regulatory compliance. The Company’s principal executive offices are located in Corona, California. Our telephone number is (951) 407-9860 and our corporate website address is www.adomanielectric.com. 2. | Summary of Significant Accounting Policies ---+------------------------------------------- Basis of Presentation—The consolidated financial statements and related disclosures as of September 30, 2017 and for the nine months ended September 30, 2017 and 2016, are unaudited, pursuant to the rules and regulations of the United States Securities and Exchange Commission, or SEC. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. In our opinion, these unaudited financial statements include all adjustments (consisting only of normal recurring adjustments) necessary for the fair statement of the results for the interim periods. These unaudited financial statements should be read in conjunction with our audited financial statements for the years ended December 31, 2016 and 2015 included in our 253(g)(2) offering circular filed with the SEC on May 16, 2017. The results of operations for the nine months ended September 30, 2017 are not necessarily indicative of the results to be expected for the full year. The Company has incurred losses for the past several years while developing infrastructure and planning a public offering of equity securities. The Company incurred net losses of $21.6 million and $9.2 million during the nine months ended September 30, 2017 and 2016, respectively. The Company completed an offering of Common Stock under Regulation A on June 9, 2017, as discussed in Note 5 below. The Company’s independent registered public accounting firm expressed in its report on the Company’s financial statements for the year ended December 31, 2016 substantial doubt about the Company’s ability to continue as a going concern. Based on management’s plans and the significant capital raised during the nine months ended September 30, 2017, that substantial doubt has been alleviated. Principles of Consolidation—The accompanying financial statements reflect the consolidation of the individual financial statements of ADOMANI, Inc., ADOMANI California, Inc., Adomani (Nantong) Automotive Technology Co. Ltd., School Bus Sales of California, Inc, and Zero Emission Truck and Bus Sales of Arizona, Inc. All significant intercompany accounts and transactions have been eliminated. Revenue Recognition—The Company recognizes revenue from the sales of advanced zero-emission electric drivetrain systems for fleet vehicles. Revenue is recognized when (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred and title has passed, (iii) the price is fixed or determinable and (iv) collectability is reasonably assured. Stock-Based Compensation—The Company accounts for employee stock-based compensation in accordance with the guidance of Financial Accounting Standards Board, or FASB, Accounting Standards Codification, or ASC, Topic 718, Compensation—Stock Compensation, which requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. The fair value of the equity instrument is charged directly to compensation expense and credited to additional paid-in capital over the period during which services are rendered. The Company follows ASC Topic 505-50, formerly EITF 96-18, “Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring, or in Conjunction with Selling Goods and Services,” for stock options and warrants issued to consultants and other non-employees. In accordance with ASC Topic 505-50, these stock options and warrants issued as compensation for services provided to the Company are accounted for based upon the fair value of the services provided or the estimated fair market value of the option or warrant, whichever can be more clearly determined. The fair value of the equity instrument is charged directly to compensation expense and additional paid-in capital over the period during which services are rendered. 5 - Recent Accounting Pronouncements—In May 2017, the FASB issued ASU No. 2017-09, Compensation-Stock Compensation (Topic 718): “Scope of Modification Accounting.” The amendments provide guidance on determining which changes to the terms and conditions of share-based payment awards require an entity to apply modification accounting under Topic 718. The guidance is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2017. Early adoption is permitted, including any interim period, for reporting periods for which financial statements have not been issued. The Company will adopt this change effective with the financial statements issued for annual periods beginning after December 15, 2017. Reclassification Certain amounts in the 2016 financial statements have been reclassified to conform to the 2017 financial presentation. These reclassifications have no impact on net loss. 3. | Notes Receivable ---+----------------- On June 29, 2017, the Company loaned $500,000 to an unaffiliated third party with engineering expertise in the electric bus technology industry, with whom the Company may seek an alliance at some future date, in order to provide it with working capital. The stated interest rate is 9% per annum, with interest payments due monthly beginning July 31, 2017. The note is secured by the assets of the borrower and matures on December 31, 2017. The Company loaned an additional $500,000 to another third party in December 2016 in connection with its issuance of a promissory note with a principal amount of $500,000 to an unaffiliated third party (see Note 4). 4. | Debt ---+----- During 2016, 2015 and 2014, the Company issued convertible notes for total proceeds of $42,160, $20,275 and $207,465, respectively, to Acaccia Family Trust, or Acaccia, formerly a related party. As of December 31, 2016, the outstanding balance of such convertible notes was $359,000. During 2014, the Company issued convertible notes for total proceeds of $286,000 to various third parties. As of December 31, 2016, the aggregate face value of the convertible notes issued to third and related parties was $645,000. All notes had a three-year maturity and bore interest at rates of 3% or 5% per annum. The terms of such loans permitted conversion of all outstanding principal and accrued interest into shares of common stock, with loans totaling $45,000 convertible at a rate of $0.50 per share and loans totaling $600,000, including the convertible notes issued to Acaccia, convertible at $0.10 per share. During 2016, the Company’s CFO purchased $25,000 of the $645,000 convertible notes outstanding from Acaccia. Effective January 30, 2017, all holders of such convertible debt converted their debt, which totaled $725,584, consisting of the outstanding principal amount and accrued and unpaid interest as of the date of conversion, into 6,868,578 shares of common stock, or Common Stock, in anticipation of our public offering of Common Stock. As of September 30, 2017, all such convertible notes have been converted and no balance remains outstanding thereunder. No gain or loss resulted from the conversion of this debt to equity. As these notes had an effective conversion price that was less than the fair market value of the Common Stock, these notes gave rise to a beneficial conversion feature totaling $42,160 and $20,275 during 2016 and 2015, respectively, which was recognized as an increase to paid-in capital and a corresponding debt discount. The debt discount was being amortized to interest expense on an effective interest basis over the maturity of the notes. For the nine months ended September 30, 2017 and 2016, debt discount amortization associated with these notes was $51,935 and $50,532, respectively, which was recognized as interest expense in the accompanying consolidated statement of operations. The unamortized discount of these convertible notes was $0 and $51,935 at September 30, 2017 and December 31, 2016, respectively. 6 - During 2015, the Company issued two-year secured promissory notes with an aggregate face value of $5,147,525 to third-party lenders for cash. The notes are secured by all the assets of the Company, mature between January and November 2017 and bear interest at 9%. Prior to the maturity dates of the notes, the Company exercised its option to extend the maturity dates six months pursuant to the provisions of such notes. In connection with these notes, the Company incurred debt issuance costs of $514,753, which are being recognized as a debt discount and amortized over the life of the notes. During the nine months ended September 30, 2017 and 2016, the debt discount amortization associated with these notes was $29,006 and $160,688, respectively, which was recognized as interest expense in the accompanying unaudited consolidated statements of operations. As of September 30, 2017, the debt issuance costs associated with these notes have been fully amortized. As of September 30, 2017, the Company has repaid in cash $1,060,000 in principal relative to these notes. In September 2016, the Company authorized the exchange of $884,700 principal amount of these notes for 884,700 shares of Common Stock. There was no gain or loss that resulted from the conversion of the notes to equity. On November 18, 2016, the Company issued a promissory note with a principal amount of $500,000 to a stockholder in order to insure adequate working capital through the close of its offering under Regulation A. The loan evidenced by the note is for a period of one year, at an interest rate of 5% per annum, with the principal and any unpaid interest due and payable in cash at maturity. On March 17, 2017, due to unforeseen delays in the closing of the offering under Regulation A, the Company issued a second promissory note with a principal amount of $500,000 to the same stockholder in order to address additional liquidity concerns. The second note also bears interest at a rate of 5% per annum, with the principal and any unpaid interest due and payable in cash at maturity. The loans mature on November 15, 2017, unless previously repaid in accordance with the terms thereof. On May 12, 2017, the Company repaid both notes, plus accrued and unpaid interest of $15,685, from the proceeds of the initial closing of the offering under Regulation A. In December 2016, the Company borrowed $500,000 from an unaffiliated third party. The loan matured on June 15, 2017. It contains no stipulated interest rate, but the Company was obligated to pay loan fees of $50,000 to the lender. The proceeds of the loan were immediately used to loan $500,000 to a company in the zero-emissions technology industry that specializes in drivetrain solutions for zero emission and hybrid vehicles. The loan, carried as a note receivable on the balance sheet, contains the same provisions, including the loan fees payable to the Company, as the note payable discussed above in this paragraph, and also matured on June 15, 2017. The Company repaid the loan to the unaffiliated third party on May 12, 2017 from the proceeds of the initial closing of the offering under Regulation A. The maturity date for the note receivable has been extended to December 31, 2017. During the nine months ended September 30, 2017, the related amortization expense recognized on this loan amounted to $45,833. In January 2015, in connection with the 2015 9% secured notes payable financing discussed above, the Company agreed to issue a warrant exercisable for 1,250,000 shares of Common Stock of the Company at an exercise price of $4.00 per share. The warrant, issued in September 2016, was valued using the Black-Scholes valuation model and the resulting fair market value of $349,042 was recorded in 2015 as debt discount and is being amortized over the term of the notes. Interest expense relating to the amortization of this discount was $3,347 and $131,010 for the nine months ended September 30, 2017 and 2016, respectively. As of September 30, 2017, the fair market value of the warrant was fully amortized. 7 - Details of notes payable at September 30, 2017 and December 31, 2016 are as follows: | As of September 30, 2017 | | As of December 31, 2016 -----------------------------------------------------------------+--------------------------+-----------+------------------------ Convertible Debt | | | | | | -----------------------------------------------------------------+--------------------------+-----------+-------------------------+---+-----------+-- Principal amount outstanding | $ | - | | $ | 645,000 | -----------------------------------------------------------------+--------------------------+-----------+-------------------------+---+-----------+-- Cumulative discount for notes with beneficial conversion feature | | - | | | (349,560 | ) -----------------------------------------------------------------+--------------------------+-----------+-------------------------+---+-----------+-- Cumulative amortization of debt discount | | - | | | 297,625 | -----------------------------------------------------------------+--------------------------+-----------+-------------------------+---+-----------+-- Subtotal of convertible notes @ $0.10 or $.50/share | | - | | | 593,065 | -----------------------------------------------------------------+--------------------------+-----------+-------------------------+---+-----------+-- Notes Payable | | | | | | -----------------------------------------------------------------+--------------------------+-----------+-------------------------+---+-----------+-- Principal amount outstanding | | 3,195,325 | | | 5,255,325 | -----------------------------------------------------------------+--------------------------+-----------+-------------------------+---+-----------+-- Cumulative discount for finance charges incurred | | (514,753 | ) | | (514,753 | ) -----------------------------------------------------------------+--------------------------+-----------+-------------------------+---+-----------+-- Cumulative discount for warrant | | (349,042 | ) | | (349,042 | ) -----------------------------------------------------------------+--------------------------+-----------+-------------------------+---+-----------+-- Cumulative discount for 9% notes | | (50,000 | ) | | (50,000 | ) -----------------------------------------------------------------+--------------------------+-----------+-------------------------+---+-----------+-- Cumulative amortization of finance charges | | 514,753 | | | 485,747 | -----------------------------------------------------------------+--------------------------+-----------+-------------------------+---+-----------+-- Cumulative amortization of warrant expense | | 349,042 | | | 345,695 | -----------------------------------------------------------------+--------------------------+-----------+-------------------------+---+-----------+-- Cumulative amortization of 9% notes | | 50,000 | | | 4,167 | -----------------------------------------------------------------+--------------------------+-----------+-------------------------+---+-----------+-- Subtotal of notes payable | | 3,195,325 | | | 5,177,139 | -----------------------------------------------------------------+--------------------------+-----------+-------------------------+---+-----------+-- Total of debt | $ | 3,195,325 | | $ | 5,770,204 | -----------------------------------------------------------------+--------------------------+-----------+-------------------------+---+-----------+-- 5. | Common Stock ---+------------- Effective January 30, 2017, all holders of the $645,000 original principal amount of convertible debt converted their debt, which totaled $725,584, consisting of the outstanding principal amount and accrued and unpaid interest as of the date of conversion, into 6,868,578 shares of Common Stock (see Note 4). In March 2017, Dennis Di Ricco, who formerly served as the trustee of Acaccia, along with his family members and trusts, relinquished voting and investment power over all securities of the Company they owned, which constituted approximately 22% of the outstanding Common Stock of the Company. Mr. Di Ricco also surrendered his options to purchase up to 7,000,000 shares of common stock for forfeiture and cancellation, and sold (in a private transaction to which the Company was not a party) all 2,500,000 shares of Common Stock held as of record by his IRA. In connection with the foregoing, the Company and Mr. Di Ricco also terminated their consulting relationship (see Note 7). In March 2016, the Company entered into a consulting agreement with Redwood Group International Limited, or Redwood. In exchange for its services, Redwood received $5,000 per month in retainer payments and was eligible to receive other fees and warrants, as set forth in the consulting agreement. The initial term of the consulting agreement was 12 months, ending on February 28, 2017, although the term would automatically extend for an additional 12 months unless terminated by either party. On September 29, 2016, the Company executed a letter agreement with Redwood, pursuant to which it issued to Redwood an additional 100,000 shares of Common Stock, subject to Redwood satisfying certain performance thresholds. If Redwood failed to meet such performance thresholds, the agreement provided the Company with an exclusive option to reacquire all or a portion of the shares of Common Stock at $0.00001 per share. On November 15, 2016, the Company and Redwood agreed to terminate the original consulting agreement and entered into a new consulting agreement that was set to expire upon thirty days’ written notice by either party following the successful completion of the Company’s offering under Regulation A. The new consulting agreement was substantially similar to the prior agreement with respect to fees and warrants due to Redwood, and provided that the Company would pay Redwood a sum of $800,000 and issue Redwood a warrant to acquire 350,000 shares of Common Stock. In May 2017, the Company and Redwood mutually agreed to terminate this agreement. On June 8, 2017, the Company paid a fee of $800,000 to Redwood and issued Redwood a warrant to purchase 350,000 shares of Common Stock, in connection with which the Company cancelled the 100,000 shares of Common Stock it had previously issued pursuant to the September 2016 letter agreement. The warrant to purchase 350,000 shares of Common Stock was valued using the Black-Scholes method resulting in a fair market value of $1.24 million. The assumptions used in the valuation included the term of 5 years, the exercise price of $5.00 per share, volatility of 92% and a risk-free interest rate of 1.75%. The fair value of the warrant was recorded as consulting expense during the nine months ended September 30, 2017. 8 - On June 9, 2017, the Company consummated the final closing of the offering under Regulation A, as discussed in Note 2 above. The Company sold an aggregate of 2,852,275 shares of Common Stock, of which 342,273 shares were sold on behalf of certain stockholders of the Company who elected to participate in the offering, for aggregate gross proceeds of $14,261,375. Net proceeds received after deducting commissions, expenses and fees of approximately $2.5 million and the $1,711,365, amounted to approximately $10.0 million. The Company remitted the $1,711,365 in aggregate gross proceeds resulting from the sale of shares on behalf of the selling stockholders to such stockholders. As such, the Company issued and sold an aggregate of 2,510,002 shares of Common Stock in connection with the offering under Regulation A, excluding the shares sold by the selling stockholders. In connection with the final closing of the offering under Regulation A on June 9, 2017, the Company issued an additional 250,000 shares of Common Stock, valued at $1,250,000 under the terms of a consulting agreement. Under the terms of the underwriting agreement executed in connection with the offering under Regulation A, the Company issued to Boustead Securities, LLC a warrant to purchase 199,659 shares of Common Stock. The warrant to purchase 199,659 shares of Common Stock was valued using the Black-Scholes method resulting in a fair market value of $680,543. The assumptions used in the valuation included the term of 5 years, the exercise price of $6.00 per share, volatility of 92% and a risk-free interest rate of 1.75%. The fair value of the warrant was recorded as offering costs and netted against additional paid in capital during the nine months ended September 30, 2017. 6. | Stock Warrants ---+--------------- As of September 30, 2017, the Company has issued warrants to purchase 1,799,659 shares of Common Stock, consisting of a warrant to purchase 199,659 shares of Common Stock with a measurement price of $5.00 and an exercise price of $6.00, a warrant to purchase 350,000 shares of Common Stock with a measurement price of $5.00 and an exercise price of $5.00, and a warrant to purchase 1,250,000 shares of Common Stock with a measurement price of $1.00 and an exercise price of $4.00. The Company’s stock warrant activity for the nine months ended September 30, 2017 is summarized as follows: | Number of Shares | | Weighted Average Exercise Price | Weighted Average Remaining Contractual Life (years) ----------------------------------+------------------+-----------+---------------------------------+---------------------------------------------------- Outstanding at December 31, 2016 | | 1,250,000 | | $ | 4.00 | ----------------------------------+------------------+-----------+---------------------------------+-----------------------------------------------------+------+----- Granted | | 549,659 | | | 5.36 | ----------------------------------+------------------+-----------+---------------------------------+-----------------------------------------------------+------+----- Forfeited | | - | | | | ----------------------------------+------------------+-----------+---------------------------------+-----------------------------------------------------+------+----- Outstanding at September 30, 2017 | | 1,799,659 | | $ | 4.42 | 4.12 ----------------------------------+------------------+-----------+---------------------------------+-----------------------------------------------------+------+----- Exercisable at September 30, 2017 | | 1,250,000 | | $ | 4.00 | 3.92 ----------------------------------+------------------+-----------+---------------------------------+-----------------------------------------------------+------+----- As of September 30, 2017, the outstanding warrants have an intrinsic value of approximately $4.58 million. 7. | Stock-Based Compensation ---+------------------------- In March 2017, Dennis Di Ricco surrendered his options to purchase up to 7,000,000 shares of Common Stock for forfeiture or cancellation (see Note 5). In March 2017, the board of directors of the Company, or Board, consented to the grant of options to purchase an aggregate of 3,600,000 shares of Common Stock to 13 people (employees and current and prospective Board members). The options will vest over a three-year period and the exercise price is $10.49, which was determined on the basis of the average of the trading price of the Company’s Common Stock on the Nasdaq Capital Market for the first ten days following the close of its offering under Regulation A. The options were valued using the Black-Scholes method, resulting in a fair market value of $37.6 million. The assumptions used in the valuation included an expected term of 4.75 years; volatility of 86% and a risk-free interest rate of 2.02%. 9 - As of September 30, 2017, the Company has issued stock options to purchase 30,375,000 shares of Common Stock, consisting of options to purchase 16,260,002 shares of Common Stock with a measurement price of $0.10 and an exercise price of $0.10, options to purchase 10,514,998 shares of Common Stock with a measurement price of $1.00 and an exercise price of $0.10, and options to purchase 3,600,000 shares of Common Stock with a measurement price of $14.50 and an exercise price of $10.49. For the three months ended September 30, 2017, the Company recorded a $10.6 million stock-based compensation expense. This expense includes an adjustment due to the remeasurement of the fair market value of non-employee stock options, in accordance with ASC 505. ASC 505 requires a remeasurement of the fair market value of non-employee stock options at each interim vesting period, based on the Company’s stock price on the interim vesting date, and the related stock-based compensation expense is adjusted accordingly at each balance sheet date. Stock option activity for the nine months ended September 30, 2017 is as follows: | Number of Shares | | Weighted Average Exercise Price | Weighted Average Remaining Contractual Life (years) ----------------------------------+------------------+------------+---------------------------------+---------------------------------------------------- Outstanding at December 31, 2016 | | 33,775,000 | | $ | 0.10 | ----------------------------------+------------------+------------+---------------------------------+-----------------------------------------------------+-------+---- Granted | | | | | | ----------------------------------+------------------+------------+---------------------------------+-----------------------------------------------------+-------+---- Forfeited | | (7,000,000 | ) | | | ----------------------------------+------------------+------------+---------------------------------+-----------------------------------------------------+-------+---- Outstanding at March 31, 2017 | | 26,775,000 | | $ | 0.10 | ----------------------------------+------------------+------------+---------------------------------+-----------------------------------------------------+-------+---- Granted | | 3,600,000 | | | 10.49 | ----------------------------------+------------------+------------+---------------------------------+-----------------------------------------------------+-------+---- Forfeited | | | | | | ----------------------------------+------------------+------------+---------------------------------+-----------------------------------------------------+-------+---- Outstanding at September 30, 2017 | | 30,375,000 | | $ | 1.33 | 4.2 ----------------------------------+------------------+------------+---------------------------------+-----------------------------------------------------+-------+---- Exercisable at September 30, 2017 | | 23,237,692 | | $ | 0.40 | 3.7 ----------------------------------+------------------+------------+---------------------------------+-----------------------------------------------------+-------+---- Stock-based compensation expense was $15.7 million and $6.9 million for the nine months ended September 30, 2017 and 2016, respectively, and is included in general and administrative expense in the accompanying unaudited consolidated statements of operations. As of September 30, 2017, the Company expects to recognize $41.4 million of stock-based compensation for the non-vested outstanding options over a weighted-average period of 2.31 years. As of September 30, 2017, the outstanding options have an intrinsic value of approximately $183.7 million. 8. | Commitments ---+------------ Employment Agreements—Effective September 1, 2014, the Company executed an employment agreement with James Reynolds, its Chief Executive Officer. The term of the employment agreement is 5 years, and the agreement provides for an annual base salary of $240,000 and entitles Mr. Reynolds to receive a bonus of five percent of the Company’s net profits on an annual basis. Effective September 1, 2014, the Company executed an employment agreement with Edward Monfort, its Chief Technology Officer. The term of the employment agreement was 5 years, and the agreement provided for an annual base salary of $240,000 and entitled Mr. Monfort to receive a bonus of five percent of the Company’s net profits. In June 2016, Mr. Monfort entered into a new employment agreement with a two-year term, which superseded the 2014 employment agreement, pursuant to which his salary was reduced to $120,000 per annum. Additionally, the Company pays up to $7,000 per month to ELO, LLC, an entity owned by Mr. Monfort, for invoiced expenses relating to research and development pursuant to a consulting relationship, as well as up to $3,000 per month for services to another consultant selected by Mr. Monfort. For the nine months ended September 30, 2017, the Company paid $63,000 to ELO, LLC. Effective January 1, 2017, the Company entered into an employment agreement with Michael Menerey, its Chief Financial Officer. The term of the employment agreement is five years and the agreement provides for an annual base salary of $200,000. 10 -- Operating Leases—In 2015, the Company signed an office and warehouse lease agreement for a facility in Orange, California, to serve as its primary facility for research and development activity. The initial term of the lease expired on February 29, 2016, at which time the Company extended the lease for two additional years, until February 28, 2018. The total amount due annually under the lease was $44,856. Effective August 15, 2017, the Company terminated this lease. The Company signed a one-year office lease for office space in Newport Beach, California, to serve as office space for its headquarters. The initial term of the lease expired on December 31, 2016, at which time the Company extended the lease on a month-to-month basis. The total amount due monthly was approximately $3,400. Effective September 30, 2017, in connection with the execution of the lease for office space in Corona, California, the Company terminated this lease. In 2016, the Company signed a lease for office space in Los Altos, California, to serve as office space for its Northern California operations. The lease expired February 28, 2017 and the Company executed a new one-year lease in February 2017. The total amount due under the lease is $5,676 and the lease period is from March 1, 2017 through February 28, 2018. In April 2017, the Company signed a lease for storage space in Phoenix, Arizona to serve as a location to store vehicles and other equipment utilized for marketing and trade-show purposes. The lease is on a month-to-month basis and can be terminated by either party with 30-days’ notice. The total amount due monthly is $500. In February 2017, the Company signed a lease for storage space in Stockton, California to serve as a location to store vehicles and other equipment utilized for marketing and trade-show purposes. The lease is on a month-to-month basis and can be terminated by either party with 30-days’ notice. The total amount due monthly is $1,000. In October 2017, the Company signed a non-cancellable lease for its corporate office space in Corona, California, to serve as its corporate headquarters. The lease is for a period of 65 months, terminating February 28, 2023. The base rent for the term of the lease is $568,912. The total amount due monthly is $7,600 at commencement and will escalate to $10,560 by its conclusion. Additionally, the lease includes five months in which no rent payment is due. Other Agreements—In 2015, the Company entered into a contract with THINKP3 to provide services with the goal of securing federal grant assistance for development of the Company’s zero-emission and hybrid transportation solutions for school bus, commercial, government and utility fleets. The initial term of this contract was December 1, 2015 through November 30, 2016. On November 21, 2016, the parties renewed the agreement through November 30, 2017. Fees for these services are $8,000 per month. The contract can be terminated by either party with 30-days advance notice. In March 2015, the Company signed a licensing option agreement with Silicon Turbines Systems, Inc. for use of its patent in manufacturing. The option calls for a payment of $10,000 per month, beginning March 1, 2015, up to a full investment amount of $3,000,000. The agreement provided that the original option would terminate on August 31, 2015, but the parties agreed verbally to both extend the date of termination of the option and delay the Company’s obligation to make any monthly payments under the option agreement while both companies evaluate the relationship. As such, no payments have been made in 2017. For the year ended December 31, 2016, the Company made one $10,000 payment. In September 2017, the Company determined that it no longer desired to continue this relationship and, effective September 30, 2017, the $120,000 investment was written off. In 2016, the Company signed an advisor agreement with Dennis Di Ricco, formerly a related party and stockholder, pursuant to which Mr. Di Ricco would provide consulting services to the Company. In March 2017, the Company terminated this agreement (see Note 5). 11 -- The following table summarizes our future minimum payments under contractual commitments, excluding debt, as of September 30, 2017: | Payments due by period ----------------------------+----------------------- | Total | | Less than one year | 1 - 3 years | | 3 - 5 years | More than 5 years ----------------------------+------------------------+-----------+---------------------+-------------+---------+-------------+------------------- Operating lease obligations | | 599,087 | | | 78,815 | | | 224,400 | 243,072 | 52,800 ----------------------------+------------------------+-----------+---------------------+-------------+---------+-------------+--------------------+---------+---------+------- Employment contracts | | 1,470,000 | | | 600,000 | | | 620,000 | 250,000 | - ----------------------------+------------------------+-----------+---------------------+-------------+---------+-------------+--------------------+---------+---------+------- Total | | 2,069,087 | | | 678,815 | | | 844,400 | 493,072 | 52,800 ----------------------------+------------------------+-----------+---------------------+-------------+---------+-------------+--------------------+---------+---------+------- ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward-Looking Statements The following discussion of our financial condition and the results of operations should be read in conjunction with the “Unaudited Consolidated Financial Statements” and notes thereto included elsewhere in this Quarterly Report on Form 10-Q, or Quarterly Report. This discussion contains forward-looking statements that are subject to known and unknown risks, uncertainties, and other factors that may cause our actual results to differ materially from those expressed or implied by such forward-looking statements. These risks, uncertainties, and other factors include, among others, those identified under the “Cautionary Statement Regarding Forward-Looking Statements” above, and elsewhere in this Quarterly Report, particularly in Part II. Item 1A. “Risk Factors,” below. Overview of ADOMANI We are a provider of advanced zero-emission electric and hybrid vehicles and replacement drivetrains that is focused on reducing the total cost of vehicle ownership. Our drivetrain systems are designed to help fleet operators unlock the benefits of green technology and address the challenges of traditional fuel price cost instability and local, state and federal environmental regulatory compliance. We design advanced zero-emission electric and hybrid drivetrain systems for integration in new school buses and medium to heavy-duty commercial fleet vehicles. We also design patented conversion kits to replace conventional drivetrain systems for combustion powered vehicles with zero-emission electric or hybrid drivetrain systems. The hybrid drivetrain systems are available in both an assistive hybrid format and a full-traction format for use in private and commercial fleet vehicles of all sizes. We seek to expand our product offerings to include the sale of zero-emission systems in vehicles manufactured by outside original equipment manufacturer, or OEM, partners, but to be marketed, sold, warrantied and serviced through our developing distribution and service network. Our drivetrain systems can be built with options for remote monitoring, electric power-export and various levels of grid-connectivity. Our zero-emission systems may also grow to include automated charging infrastructure and “intelligent” stationary energy storage that enables fast vehicle charging, emergency back-up facility power, and access to the developing, grid-connected opportunities for the aggregate power available from groups of large battery packs. We generated virtually no revenue from inception through September 30, 2017. For the years ended December 31, 2016 and 2015, our net losses were $10.7 million and $6.0 million, respectively. For the nine months ended September 30, 2017 and 2016, our net losses were $21.6 million and $9.2 million, respectively; and for the three months ended September 30, 2017 and 2016, our net losses were $12.0 million and $6.3 million, respectively. 12 -- Factors Affecting Our Performance We believe that the growth and future success of our business depend on various opportunities, challenges and other factors, including the following: New Customers. We are competing with other companies and technologies to help fleet managers and their districts/companies more efficiently and cost-effectively manage their fleet operations. Once these fleet managers have decided they want to buy from us, we still face challenges helping them obtain financing options to reduce the cost barriers to purchasing. We may also encounter customers with inadequate electrical services at their facilities that may delay their ability to purchase from us. Investment in Growth. We plan to continue to invest for long-term growth. We anticipate that our operating expenses will increase in the foreseeable future as we invest in research and development to enhance our zero-emission systems; design, develop and manufacture our drivetrains and their components; increase our sales and marketing to acquire new customers; and increase our general and administrative functions to support our growing operations. We believe that these investments will contribute to our long-term growth, although they will adversely affect our results of operations in the near term. In addition, the timing of these investments can result in fluctuations in our annual and quarterly operating results. Zero-emission electric and hybrid drivetrain experience. Our dealer and service network is not currently established, although we do have certain agreements in place. One issue they may have, and we may encounter, is finding appropriately trained technicians with zero-emission electric and hybrid drivetrain experience. Our performance will depend on having a robust dealer and service network, which will require appropriately trained technicians to be successful. Because our vehicles are based on a different technology platform than traditional internal combustion engines, individuals with sufficient training in zero-emission electric and hybrid vehicles may not be available to hire, and we may need to expend significant time and expense training the employees we do hire. If we are not able to attract, assimilate, train or retain additional highly qualified personnel in the future, or do so cost-effectively, our performance would be significantly and adversely affected. Market Growth. We believe the market for all-electric and hybrid solutions for alternative fuel technology, specifically all-electric and hybrid vehicles will continue to grow as more purchases of new zero emission vehicles and as more conversions of existing fleet vehicles to zero-emission vehicles are made. However, unless the costs to produce such vehicles decrease dramatically, purchases of our products will continue to depend in large part on financing subsidies from government agencies. We cannot be assured of the continued availability or the amounts of such assistance to our customers. Revenue Growth from Additional Products. We seek to add to our product offerings additional zero-emission vehicles of all sizes manufactured by outside OEM partners, to be marketed, sold, warrantied and serviced through our developing distribution and service network, as well as add other ancillary products discussed elsewhere in this report. Revenue Growth from Additional Geographic Markets. We believe that growth opportunities for our products exist internationally in addition to domestically, and through our wholly-owned subsidiary Adomani (Nantong) Automotive Technology Co. Ltd., or ADOMANI China, we will be pursuing international growth as well. Our future performance will depend in part upon the growth of these additional markets. Accordingly, our business and operating results will be significantly affected by our ability to timely enter and effectively address these emerging markets and the speed with which and extent to which demand for our products in these markets grows. Components of Our Results of Operations Revenue Revenue is recognized from the sales of advanced zero-emission electric and hybrid drivetrain systems for fleet vehicles and from the sale of new, purpose-built zero-emission electric or hybrid vehicles. Revenue is recognized when (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred and title has passed, (iii) the price is fixed or determinable and (iv) collectability is reasonably assured. 13 -- Cost of Sales Cost of sales includes those costs related to the development, manufacture, and distribution of our products. Specifically, we include in cost of sales each of the following: material costs (including commodity costs); freight costs; labor and other costs related to the development and manufacture of our products; and other associated costs. Selling, General and Administrative Expenses Selling, general and administrative costs include all corporate and administrative functions that support our company. These costs also include stock-based compensation expense; warranty, including product recall and customer satisfaction program costs; consulting costs; and other costs that cannot be included in cost of sales. Consulting and Research and Development Costs These costs are substantially related to our research and development activity. Other Income/Expenses, Net Other income/expenses include non-operating income and expenses, including interest expense. Provision for Income Taxes We account for income taxes in accordance with FASB ASC 740 “Income Taxes,” which requires the recognition of deferred income tax assets and liabilities for the future tax consequences attributable to differences between the financial statements carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under FASB ASC 740, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period the enactment occurs. A valuation allowance is provided for certain deferred tax assets if it is more likely than not that we will not realize tax assets through future operations. Because we have incurred only losses to this point, no provision for income taxes has been made. 14 -- Results of Operations The following table compares operating data for the three and nine months ended September 30, 2017 and 2016: ADOMANI, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited; in thousands, except per share data) | Three Months Ended September 30, | | Nine Months Ended September 30, ---------------------------------------------------------------+--------------------------------------+------------+------------------------------------ | 2017 | | 2016 | 2017 | | 2016 ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+----- Net sales | $ | - | | $ | - | | $ | - | | $ | 68 | ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Cost of sales | | - | | | - | | | - | | | 50 | ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Gross profit | | - | | | - | | | - | | | 18 | ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Operating expenses: | | | | | | | | | | | | ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- General and administrative [1] | | 11,716 | | | 5,872 | | | 18,363 | | | 8,107 | ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Consulting | | 49 | | | - | | | 2,213 | | | 95 | ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Research and development | | 38 | | | 112 | | | 557 | | | 128 | ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Total operating expenses, net | | 11,803 | | | 5,984 | | | 21,133 | | | 8,330 | ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Loss from operations | | (11,803 | ) | | (5,984 | ) | | (21,133 | ) | | (8,312 | ) ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Other income (expense): | | | | | | | | | | | | ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Interest expense, net | | (47 | ) | | (274 | ) | | (362 | ) | | (833 | ) ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Other income (expense) | | (116 | ) | | (11 | ) | | (113 | ) | | (9 | ) ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Total other income (expense) | | (163 | ) | | (285 | ) | | (475 | ) | | (842 | ) ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Loss before income taxes | | (11,966 | ) | | (6,269 | ) | | (21,608 | ) | | (9,154 | ) ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Income tax expense | | (1 | ) | | - | | | (3 | ) | | - | ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Net loss | $ | (11,967 | ) | $ | (6,269 | ) | $ | (21,611 | ) | $ | (9,154 | ) ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Net loss per share to common shareholders: | | | | | | | | | | | | ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Basic and diluted | $ | (0.18 | ) | $ | (0.11 | ) | $ | (0.33 | ) | $ | (0.13 | ) ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Weighted shares used in the computation of net loss per share: | | | | | | | | | | | | ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- Basic and diluted | | 68,070,930 | | | 57,163,882 | | | 66,020,773 | | | 69,286,226 | ---------------------------------------------------------------+--------------------------------------+------------+-------------------------------------+------+------------+------+---+------------+---+---+------------+-- [1] Includes stock-based compensation expense as follows: | Three Months Ended September 30, | | Nine Months Ended September 30, ---------------------------------------+--------------------------------------+--------+------------------------------------ | 2017 | | 2016 | 2017 | | 2016 ---------------------------------------+--------------------------------------+--------+-------------------------------------+------+-------+----- General and administrative expenses | | 10,609 | | | 5,645 | | 15,653 | 6,920 ---------------------------------------+--------------------------------------+--------+-------------------------------------+------+-------+------+--------+------ Total stock-based compensation expense | | 10,609 | | | 5,645 | | 15,653 | 6,920 ---------------------------------------+--------------------------------------+--------+-------------------------------------+------+-------+------+--------+------ Revenue Revenue for each of the three and nine months ended September 30, 2017 was $0, as compared to revenue of $0 and $68,000 for the three and nine months ended September 30, 2016, respectively. We expect to begin generating revenues in the fourth quarter of 2017. 15 -- General and Administrative Expenses General and administrative expenses consist primarily of the following: • personnel-related expenses, including stock-based compensation costs; • costs related to investor relations activities; • sales and marketing-related expenses; and • other expenses relating to the operations of the Company. General and administrative expenses increased by $5.8 million and $10.3 million for the three and nine months ended September 30, 2017, respectively, as compared to the prior-year periods. The increases are primarily due to increases in stock-based compensation expense of $5.0 million and $8.7 million for the three and nine months ended September 30, 2017, respectively, as compared to the prior-year periods, due to the additional options granted in March 2017 (see “Options to Purchase Common Stock” below and Note 7 to the unaudited consolidated financial statements included in this report) and also to the requirement to remeasure non-employee stock options, as required by ASC 718 and ASC 505. We anticipate stock-based compensation expense to continue to increase as we expand our infrastructure in order to begin generating revenue. Other increases in the current-year periods over the prior-year periods include payroll, rent, sales and marketing, travel, investor relations expenses, and other general and administrative expenses, which increased by $920,305 and $1.6 million, offset by a decrease in legal and professional fees of $183,124 and $122,906 for the three and nine months ended September 30, 2017, respectively, as compared to the prior-year periods, due to the Company’s need to expand its sales and marketing infrastructure, as well as the incurrence of certain costs associated with its status as a public company. Consulting Expenses Consulting expenses increased by $49,153 and $2.1 million for the three and nine months ended September 30, 2017, respectively, as compared to the prior-year periods. The increase for the three months ended September 30, 2017 as compared to the prior period is due to required payments to various consultants for this period. The increase for the nine months ended September 30, 2017 as compared to the prior period is primarily due to the issuance of a warrant to purchase 350,000 shares of Common Stock as part of a settlement agreement, which was valued at $1.2 million, and a payment of $800,000 required under the same agreement. Additionally, $75,000 previously paid to the party involved in the settlement agreement, and originally classified as deferred offering costs, was reclassified as consulting expense. See Note 5 of the unaudited consolidated financial statements contained in this report. Research and Development Expenses Research and development expenses decreased by $74,213 and increased by $428,516 for the three and nine months ended September 30, 2017, respectively, as compared to the prior-year periods. The decrease for the three months ended September 30, 2017 as compared to the prior period is due to lower expenditures for research and development activity. The increase for the nine months ended September 30, 2017 as compared to the prior period is primarily due to $420,000 incurred in the second quarter of 2017 to build and install our drivetrain system on a chassis of a Type D school bus, on a promotional basis, for a potential customer. The project also enabled us to evaluate a third party firm that performed the work. Liquidity and Capital Resources From our incorporation in 2012 until the completion of our offering of Common Stock under Regulation A in June 2017, we financed our operations and capital expenditures through issuing equity capital, convertible notes and notes payable. A significant portion of this funding has been provided by affiliated stockholders, although significant equity capital was also raised in late 2015, and the majority of the convertible notes outstanding was also raised in 2015 from non-affiliated third parties, as discussed below and in Note 4 to the unaudited consolidated financial statements. 16 -- As of September 30, 2017, we had cash and cash equivalents of $4.5 million. We believe that our existing cash and cash equivalents will be sufficient to fund our operations at least through the end of calendar year 2018. However, there can be no assurance that we will successfully execute our business plan, and if we do not, we may need additional capital to continue our operations. While we have not generated any material revenues to date and do not expect to be able to satisfy our cash requirements solely through product sales in the near future, we have received several purchase orders for zero-emission electric school buses in the second half of 2017 and we expect to begin generating revenue in the fourth quarter of 2017. The sale of additional equity securities in the future could result in additional dilution to our stockholders and those securities may have rights senior to those of our Common Stock. The incurrence of additional indebtedness in the future would result in increased debt service obligations and could result in operating and financing covenants that would restrict our operations. Such capital, if required, may not be available on terms that are favorable to us or at all. We are currently incurring operating deficits that are expected to continue for the foreseeable future, and as we begin to execute our marketing plan, we expect our operating deficit will continue to grow until we begin to generate a sufficient level of revenue from our sales and marketing efforts. Debt As of December 31, 2016, the Company had borrowed $645,000 from Acaccia Family Trust, formerly a related party, and other parties by issuing notes convertible into Common Stock at prices ranging from $0.10 per share to $0.50 per share. On January 30, 2017, the notes plus accrued interest, a total of $725,584, converted into 6,868,578 shares of Common Stock. As of December 31, 2016, we also had outstanding a total of $4,255,325 of secured promissory notes, net of $884,700 principal amount of these secured notes that were exchanged for 884,700 shares of Common Stock on September 1, 2016. In November 2016, we borrowed $500,000 from an unaffiliated stockholder for working capital needs and, in March 2017, borrowed an additional $500,000 from the same stockholder for additional working capital required due to delays in completing our offering under Regulation A. In December 2016, we borrowed $500,000 from a third party pursuant to a secured promissory note, and immediately made a $500,000 loan to another third party who operates in the zero-emissions drivetrain technology industry. All notes referenced in this paragraph were scheduled to mature in 2017. In connection with the initial closing of our offering under Regulation A, on May 12, 2017, we repaid the $1,500,000 outstanding under the three unsecured notes payable. See Note 4 to the unaudited consolidated financial statements contained in this report. Equity Financings In a series of closings during the fiscal years ended 2012, 2013, 2014, 2015 and 2016, the Company sold an aggregate of 58,542,350 shares of Common Stock to certain of its officers, directors and other related parties for an aggregate purchase price of $5,270,860. Regulation A Offering On June 9, 2017, we completed an offering of Common Stock under Regulation A. We sold 2,852,275 shares of Common Stock for gross proceeds of $14,261,375, of which $1,711,365 was paid to the selling stockholders for 342,273 shares they sold in the offering. Options to Purchase Common Stock As of September 30, 2017, we had granted options to purchase 30,375,000 shares of Common Stock. 22,567,619 shares of Common Stock are issuable upon the exercise of options vested as of September 30, 2017, at an exercise price of $0.10 per share, and 670,073 shares of Common Stock are issuable upon the exercise of options vested as of September 30, 2017, at an exercise price of $10.49 per share. If all vested options to purchase Common Stock were exercised, we would receive proceeds of $9,285,828 and we would be required to issue 23,237,692 shares of Common Stock. There can be no assurance, however, that any such options will be exercised. 17 -- In March 2017, a co-founder of the Company (including family members and trusts) relinquished voting and investment power over all securities of the Company they owned. The co-founder surrendered his options to purchase 7,000,000 shares of Common Stock for forfeiture and cancellation, and sold the shares owned by his IRA. 2015 Note Financing and Warrants to Purchase Common Stock During 2015, the Company issued two-year secured promissory notes to third party lenders in an aggregate principal amount of $5,147,525, or the Note Financing. As of September 30, 2017, the Company had repaid $1,060,000 of principal outstanding under such notes. The secured promissory notes are due on various dates between January 31 and November 30, 2017. Prior to the maturity dates of the notes, the Company exercised its option to extend the maturity dates six months pursuant to the provisions of such notes. Any subsequent extension requires the consent of the noteholders. The notes bear interest at an annual rate of 9%, payable monthly in arrears. The note obligations are secured by a lien on all assets of the Company. On September 1, 2016, holders of $884,700 of principal amount of the notes exchanged their notes for 884,700 shares of Common Stock, thereby reducing the principal amount outstanding under the notes to $3,195,325. In connection with the Note Financing, in 2015, the Company agreed to issue a warrant to a third party to purchase 1,250,000 shares of Common Stock at $4.00 per share, exercisable through September 1, 2021. On September 1, 2016, the Company issued the warrant. Credit Facilities We do not have any credit facilities or other access to bank credit. If, however, we elect to repay the secured promissory notes at maturity, or believe that making an acquisition is appropriate, or see that sales of product are more rapidly using working capital than anticipated, we may seek to obtain a credit facility to address these issues. Capital Expenditures We do not have any contractual obligations for ongoing capital expenditures at this time. We do, however, purchase equipment necessary to conduct our operations on an as needed basis. Going Concern As of September 30, 2017, we had working capital of $2.6 million and stockholders’ equity of approximately $3.2 million. During the nine months ended September 30, 2017, we incurred a net loss attributable to holders of our Common Stock of approximately $21.6 million. Of the $21.6 million loss incurred for the nine months ended September 30, 2017, approximately $15.7 million is attributable to non-cash stock-based compensation expense, and another $1.2 million is related to non-cash consulting expense discussed above. The foregoing non-cash expenses had no impact on our cash flows during the nine months ended September 30, 2017. Stock-based compensation expense represents the amortization of the fair market value of stock options granted over their respective vesting period. The fair market value for both items is determined using the Black-Scholes model. Because some of these stock options were granted to non-employees, ASC 505 also require that we remeasure the fair market value of each of these options for each interim vesting period based on the market value of our stock on the interim vesting date. Therefore, the expense associated with these options is sensitive to changes in our stock price. We have not generated any material revenues and have incurred net losses since inception. Our recurring operating losses and our need for additional sources of capital to fund our ongoing operations raise substantial doubt about our ability to continue as a going concern. As a result, our independent registered public accounting firm included an explanatory paragraph in its report on our audited consolidated financial statements as of December 31, 2016 and 2015 and for the years then ended with respect to this uncertainty. However, on June 9, 2017, we completed our offering under Regulation A . We sold 2,852,275 shares of Common Stock for gross proceeds of $14,261,375, of which $1,711,365 was paid to the selling stockholders for 342,273 shares they sold in the offering. Based on our management’s plans and the significant capital raised, that substantial doubt has been alleviated. 18 -- Cash Flows The following table summarizes our cash flows from operating, investing, and financing activities for the nine months ended September 30, 2017 and 2016. | Nine Months Ended September 30, ------------------------------------------------------+------------------------------------ | 2017 | | 2016 ------------------------------------------------------+-------------------------------------+--------+----- Consolidated Statements of Cash Flow Data: | | | | | | ------------------------------------------------------+-------------------------------------+--------+------+---+--------+-- Cash flows used in operating activities | $ | (4,656 | ) | $ | (2,107 | ) ------------------------------------------------------+-------------------------------------+--------+------+---+--------+-- Cash flows used in investing activities | | (474 | ) | | (369 | ) ------------------------------------------------------+-------------------------------------+--------+------+---+--------+-- Cash flows provided by (used in) financing activities | | 8,787 | | | (324 | ) ------------------------------------------------------+-------------------------------------+--------+------+---+--------+-- Increase (decrease) in cash and cash equivalents | $ | 3,657 | | $ | (2,800 | ) ------------------------------------------------------+-------------------------------------+--------+------+---+--------+-- Operating Activities Cash used in operating activities is primarily the result of our operating losses, reduced by the impact of the non-cash stock-based compensation and warrant amounts. These numbers are further impacted by adjustments for non-cash interest expense. Net cash used in operating activities during the nine months ended September 30, 2017 was $4.7 million, as a result of a net loss of $21.6 million, stock-based compensation of $15.7 million, other non-cash charges of $1.4 million, and changes in operating assets and liabilities that used $152,241 in cash. Inventory increased by $390,000, accrued liabilities increased by $226,225, accounts payable increased by $75,716, other current assets increased by $59,202, and other non-current assets increased by $4,980. Net cash used in operating activities during the nine months ended September 30, 2016 was $2.1 million, as a result of a net loss of $9.2 million, stock-based compensation of $6.9 million, other non-cash charges of $463,248, and changes in operating assets and liabilities that used $336,797 in cash. We expect cash used in operating activities to fluctuate significantly in future periods as a result of a number of factors, some of which are outside of our control, including, among others: the success we achieve in generating revenue; the success we have in helping our customers obtain financing to subsidize their purchases of our products; our ability to efficiently develop our dealer and service network; the costs of batteries and other materials utilized to make our products; the extent to which we need to invest additional funds in research and development; and the amount of expense we incur to satisfy future warranty claims. Investing Activities Net cash used in investing activities during the nine months ended September 30, 2017 was $593,573. This was due to the acquisition of property and equipment relating to the lease of our new office facility, and issuing a note to a third party. See Notes 4 and 8 to the unaudited consolidated financial statements contained in this report. Net cash used in investing activities during the nine months ended September 30, 2016 was $368,939. This was primarily due to the acquisition of $358,939 of property and equipment and a $10,000 investment in Silicon Turbine Solutions. Financing Activities Net cash provided by financing activities during the nine months ended September 30, 2017 was $8.8 million. This is due to net proceeds of $12.6 million received from the closing of our offering under Regulation A , a $2.6 million repayment of notes payable principal and related accrued and unpaid interest, and net notes payable proceeds of $500,000. This is reduced by payments for costs related to our offering under Regulation A of $1.7 million. See Note 5 to the unaudited consolidated financial statements contained in this report. Net cash used by financing activities during the nine months ended September 30, 2016 was $324,219. This is due to net proceeds of $187,827 from sales of capital stock, $54,000 paid for a stock rescission, notes payable proceeds of $42,160, and to a $7,500 repayment of notes payable principal, reduced by payments for costs related to our offering under Regulation A of $492,706. 19 -- Contractual Obligations Except as set forth below, during the nine months ended September 30, 2017, there were no material changes in our contractual obligations and commitments. During the three months ended September 30, 2017, we entered into a lease for our corporate office space in Corona, California, to serve as our corporate headquarters. The lease is for a period of 65 months, terminating February 28, 2023. The base rent for the term of the lease is $568,912. The total amount due monthly is $7,600 at commencement and will escalate to $10,560 by its conclusion. Additionally, the lease includes five months in which no rent payment is due. Off-Balance Sheet Arrangements We did not have during the periods presented, and we do not currently have, any off-balance sheet arrangements, as defined in the rules and regulations of the SEC. Jumpstart Our Business Startups Act of 2012 (JOBS Act) We are an “emerging growth company,” or an EGC, as defined in the JOBS Act. The JOBS Act contains provisions that, among other things, reduce certain reporting requirements for EGCs. We have irrevocably elected not to avail ourselves of this exemption from new or revised accounting standards, and, therefore, will be subject to the same new or revised accounting standards as other public companies that are not emerging growth companies. We have chosen to rely on the other exemptions and reduced reporting requirements provided by the JOBS Act. Subject to certain conditions set forth in the JOBS Act, as an EGC we are not required to, among other things, (i) being permitted to provide only two years of audited financial statements, in addition to any required unaudited interim financial statements, with correspondingly reduced “Management’s Discussion and Analysis of Financial Condition and Results of Operations” disclosure, (ii) not being required to comply with the auditor attestation requirements in the assessment of our internal control over financial reporting, (iii) not being required to comply with any requirement that may be adopted by the Public Company Accounting Oversight Board regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements, (iv) reduced disclosure obligations regarding executive compensation or (v) exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved. We will retain our EGC status until the first to occur of: (i) the end of the fiscal year in which the fifth anniversary of the completion of our initial public offering occurs, (ii) the end of the fiscal year in which our annual revenues exceed $1 billion, (iii) the date on which we issue more than $1 billion in non-convertible debt during any three-year period or (iv) the date on which we qualify as a “large accelerated filer.” Critical Accounting Policies Judgments and Estimates Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses and related disclosures. We evaluate our estimates and assumptions on an ongoing basis. Our estimates are based on historical experience and various other assumptions that we believe to be reasonable under the circumstances. Our actual results could differ from these estimates. We believe that the assumptions and estimates associated with the preparation of the financial statement information presented in this Quarterly Report are not significant because we have not generated any appreciable revenue. Therefore, we have not had to make assumptions or estimates related to a reserve for bad debt expense, or for future warranty costs to be incurred, two items that will have the greatest potential impact on our consolidated financial statements in the future. We also have no significant current litigation on which we have to provide reserves or estimate accruals and our investment to date in property, plant and equipment has not been significant. We therefore have not had to rely on estimates related to impairment. We have not generated any taxable income to date, so have not had to make any decisions about future profitability that would impact recording income tax expense. Assuming we are able to generate future profits by executing our business plan, these areas, among others, will most likely be our critical accounting policies and estimates. For further information on all of our significant accounting policies, see Note 2 to our unaudited consolidated financial statements. There have been no material changes to the critical accounting policies disclosed in the Company’s Form 1-A, which was declared qualified by the Securities and Exchange Commission, or SEC, on April 25, 2017. 20 -- Recent Accounting Pronouncements In May 2017, the FASB issued ASU No. 2017-09, Compensation-Stock Compensation (Topic 718): “Scope of Modification Accounting.” The amendments provide guidance on determining which changes to the terms and conditions of share-based payment awards require an entity to apply modification accounting under Topic 718. The guidance is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2017. Early adoption is permitted, including any interim period, for reporting periods for which financial statements have not been issued. The Company is currently evaluating the provisions of this guidance and assessing its impact on the Company’s financial statements and disclosures. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK We are exposed to market risks in the ordinary course of our business. We do not currently face material market risks such as interest rate fluctuation risk and foreign currency exchange risk. Our cash and cash equivalents include cash in readily available checking and money market accounts. These investments are not dependent on interest rate fluctuations that may cause the principal amount of these investments to fluctuate, and we do not expect such fluctuation will have a material impact on our financial conditions. If we issue additional debt in the future, we will be subject to interest rate risk. The majority of our expenses are denominated in the U.S. dollar. As we continue our commercialization efforts internationally, we may generate revenue and incur expenses denominated in currencies other than the U.S. dollar, a majority of which we expect to be denominated in Chinese Yuan. As a result, as operations of ADOMANI China expand in the future, our revenue may be significantly impacted by fluctuations in foreign currency exchange rates. We may face risks associated with the costs of raw materials, primarily batteries, as we go into production. To the extent these and other risks materialize, they could have a material effect on our operating results or financial condition. We currently anticipate that our international selling, marketing and administrative costs related to foreign sales will be largely denominated in the same foreign currency, which may mitigate our foreign currency exchange risk exposure. ITEM 4. CONTROLS AND PROCEDURES In designing and evaluating our disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply judgment in evaluating the benefits of possible controls and procedures relative to their costs. Our management, with the participation of our chief executive officer and chief financial officer, evaluated, as of the end of the period covered by this Quarterly Report on Form 10-Q, the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, which we refer to as the Exchange Act). Based on that evaluation, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were not effective as of September 30, 2017 due to the material weaknesses in internal control over financial reporting which existed since December 31, 2016. Specifically, these material weaknesses are as follows: (1) limited segregation of duties; (2) lack of system in place to keep appropriate records for expenses incurred, specifically for operations in China; and (3) need for training and expertise to account for complex equity transactions, which may result in a greater than normal risk that material errors may occur in the financial statements and not be detected timely. The Company has not conducted an evaluation of the effectiveness of internal control over financial reporting. We will be required to assess internal control over financial reporting for the year ending December 31, 2018, and report any material weaknesses in such internal control, but we intend to address this issue prior to such date. Effective June 9, 2017, we added three independent directors to our Board to replace three employee directors. We created concurrently three committees of the Board, including an audit committee, on which the three independent directors serve. There were no changes to our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter ended September 30, 2017. 21 -- PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS We know of no material, existing or pending, legal proceedings against our Company, nor are we involved as a plaintiff in any material proceeding or pending litigation. There are no proceedings in which any of our directors, officers or affiliates, or any registered or beneficial stockholder, is an adverse party or has a material interest adverse to our interest. ITEM 1A. RISK FACTORS Except as set forth below, there were no material changes from the risk factors previously disclosed in our Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2017, as filed with the SEC on June 19, 2017. We may face risks associated with our international business. We plan to develop our business internationally, including the pursuit of certain opportunities in China through our wholly-owned subsidiary, ADOMANI China. The sale and shipment of our products across international borders, as well as the purchase of components and products from international sources, would subject us to extensive United States, European Economic Area and other foreign governmental trade, import and export and customs regulations and laws. Compliance with these regulations and laws would be costly and may expose us to penalties for non-compliance. If we are successful in developing our international activities, we expect that such operations would be subject to a variety of risks, including: · | difficulties in staffing and managing foreign and geographically dispersed operations; --+--------------------------------------------------------------------------------------- · | having to comply with various United States and international laws, including export control laws and the U.S. Foreign Corrupt Practices Act of 1977 and anti-money laundering laws; --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | differing regulatory requirements for obtaining clearances or approvals to market our products; --+------------------------------------------------------------------------------------------------ · | changes in, or uncertainties relating to, foreign rules and regulations that may impact our ability to sell our products, perform services or repatriate profits to the United States; --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | tariffs and trade barriers, export regulations and other regulatory and contractual limitations on our ability to sell our products in certain foreign markets; --+---------------------------------------------------------------------------------------------------------------------------------------------------------------- · | fluctuations in foreign currency exchange rates; --+------------------------------------------------- · | imposition of limitations on or increase of withholding and other taxes on remittances and other payments by foreign subsidiaries or joint ventures; --+----------------------------------------------------------------------------------------------------------------------------------------------------- · | imposition of differing labor laws and standards; --+-------------------------------------------------- · | economic, political or social instability in foreign countries and regions; --+---------------------------------------------------------------------------- · | an inability, or reduced ability, to protect our intellectual property, including our patented zero-emission drivetrain design, including any effect of compulsory licensing imposed by government action; and --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | availability of government subsidies or other incentives that benefit competitors in their local markets that are not available to us. --+--------------------------------------------------------------------------------------------------------------------------------------- While we plan to expand into other markets in the future, our expansion plans may not be realized, or if realized, may not be successful. We expect each market to have particular regulatory and funding hurdles to overcome and future developments in these markets, including the uncertainty relating to governmental policies and regulations, could harm our business. If we expend significant time and resources on expansion plans that fail or are delayed, our reputation, business and financial condition may be harmed. 22 -- If we are unable to implement and maintain effective internal control over financial reporting and effective disclosure controls and procedures, investors may lose confidence in the accuracy and completeness of our financial reports and the market price of our Common Stock may be negatively affected. As a public company, we will not be required to comply with the requirements to assess and report on internal control over financial reporting until the filing of our annual report for the year ending December 31, 2018. Section 404 of the Sarbanes-Oxley Act of 2002, or the Sarbanes-Oxley Act, requires that we evaluate and determine the effectiveness of our internal control over financial reporting and, beginning with our annual report for the fiscal year ending December 31, 2018, provide a management report on the internal control over financial reporting. Once we are no longer either an “emerging growth company” or a smaller reporting company, such report must be attested to by our independent registered public accounting firm. While we have not conducted an evaluation of our the effectiveness of our internal control over financial reporting under Section 404 of the Sarbanes-Oxley Act, in connection with its audit of our financial statements for the fiscal year ended December 31, 2016, our independent registered public accounting firm identified material weaknesses in our internal controls that are standard for companies of our size, including limited segregation of duties and lack of systems in place to keep appropriate records for expenses incurred, specifically regarding operations in China. The Sarbanes-Oxley Act also requires that our principal executive officer and principal financial officer conclude as to the effectiveness of our disclosure controls and procedures on a quarterly basis. As of September 30, 2017, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were ineffective due to the presence of such material weaknesses in our internal controls. Due to our size, we rely heavily on key management for day-to-day operations and internal controls, and our size and correspondingly limited resources give rise to additional internal control weaknesses, including our disclosure controls. If we fail to remediate our material weaknesses or find additional material weaknesses in our internal control over financial reporting, we may not detect errors on a timely basis and our financial statements may be materially misstated. We are in the process of designing and implementing the internal control over financial reporting required to comply with this obligation, which process may be time consuming, costly, and complicated. While we have taken steps to remediate our material weaknesses, if we fail to remediate our material weaknesses or find additional material weaknesses in our internal control over financial reporting, if we are unable to comply with the requirements of Section 404 of the Sarbanes-Oxley Act in a timely manner, if we are unable to assert that our internal control over financial reporting are effective, or if our independent registered public accounting firm is unable to express an opinion as to the effectiveness of our internal control over financial reporting, if and when required, investors may lose confidence in the accuracy and completeness of our financial reports and the market price of our Common Stock could be negatively affected, and we could become subject to investigations by the stock exchange on which our securities are listed, the SEC, or other regulatory authorities, which could require additional financial and management resources. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS None. ITEM 3. DEFAULTS UPON SENIOR SECURITIES None. ITEM 4. MINE SAFETY DISCLOSURES Not applicable. ITEM 5. OTHER INFORMATION None. ITEM 6. EXHIBITS A list of exhibits is set forth on the Exhibit Index immediately following the signature page of this Quarterly Report on Form 10-Q, and is incorporated herein by reference. 23 -- SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. | ADOMANI, INC. ------------------------+-------------- Date: November 13, 2017 | By: | /s/ James L. Reynolds ------------------------+---------------+---------------------------------------------------------------------------------------- | | James L. Reynolds President and Chief Executive Officer (Principal Executive Officer) ------------------------+---------------+---------------------------------------------------------------------------------------- Date: November 13, 2017 | By: | /s/ Michael K. Menerey ------------------------+---------------+---------------------------------------------------------------------------------------- | | Michael K. Menerey Chief Financial Officer (Principal Financial and Accounting Officer) ------------------------+---------------+---------------------------------------------------------------------------------------- 24 -- Exhibit Index | | Incorporated by Reference | ----------------+---------------------------------------------------------------------------------------------------------------------------------------+---------------------------+----------- Exhibit Number | Exhibit Description | Form | File No. | Exhibit | Filing Date | Filed Herewith ----------------+---------------------------------------------------------------------------------------------------------------------------------------+---------------------------+------------+---------+--------------+---------------- 10.1 | Office Lease, dated July 11, 2017, by and between HGN Corona Partners, LLC and the Company | S-1 | 333-220983 | 10.14 | 10/16/2017 | ----------------+---------------------------------------------------------------------------------------------------------------------------------------+---------------------------+------------+---------+--------------+---------------- 31.1 | Rule 13a-14(a) / 15d-14(a) Certification of Chief Executive Officer | | | | | X ----------------+---------------------------------------------------------------------------------------------------------------------------------------+---------------------------+------------+---------+--------------+---------------- 31.2 | Rule 13a-14(a) / 15d-14(a) Certification of Chief Financial Officer | | | | | X ----------------+---------------------------------------------------------------------------------------------------------------------------------------+---------------------------+------------+---------+--------------+---------------- 32.1# | 18 U.S.C. Section 1350 Certification of Chief Executive Officer, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | | | | | X ----------------+---------------------------------------------------------------------------------------------------------------------------------------+---------------------------+------------+---------+--------------+---------------- 32.2# | 18 U.S.C. Section 1350 Certification of Chief Financial Officer, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | | | | | X ----------------+---------------------------------------------------------------------------------------------------------------------------------------+---------------------------+------------+---------+--------------+---------------- 101.INS | XBRL Instance Document* | | | | | X ----------------+---------------------------------------------------------------------------------------------------------------------------------------+---------------------------+------------+---------+--------------+---------------- 101.SCH | XBRL Taxonomy Extension Schema Document* | | | | | X ----------------+---------------------------------------------------------------------------------------------------------------------------------------+---------------------------+------------+---------+--------------+---------------- 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document* | | | | | X ----------------+---------------------------------------------------------------------------------------------------------------------------------------+---------------------------+------------+---------+--------------+---------------- 101.LAB | XBRL Taxonomy Extension Label Linkbase Document* | | | | | X ----------------+---------------------------------------------------------------------------------------------------------------------------------------+---------------------------+------------+---------+--------------+---------------- 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document* | | | | | X ----------------+---------------------------------------------------------------------------------------------------------------------------------------+---------------------------+------------+---------+--------------+---------------- 101.DEF | XBRL Taxonomy Extension Definitions Linkbase Document* | | | | | X ----------------+---------------------------------------------------------------------------------------------------------------------------------------+---------------------------+------------+---------+--------------+---------------- # The information in Exhibits 32.1 and 32.2 shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), or otherwise subject to the liabilities of that section, nor shall they be deemed incorporated by reference in any filing under the Securities Act of 1933, as amended (the “Securities Act”), or the Exchange Act (including this report), unless the Registrant specifically incorporates the foregoing information into those documents by reference. * In accordance with Rule 402 of Regulation S-T, this interactive data file is deemed not filed or part of this Quarterly Report for purposes of Sections 11 or 12 of the Securities Act or Section 18 of the Exchange Act and otherwise is not subject to liability under these sections. 25

ADVANCED MEDICAL ISOTOPE Corp

1449349

10-Q

0001493152-17-012763

UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 Form 10-Q (Mark One) -------------- [X] | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 ---------------+-------------------------------------------------------------------------------------------- | FOR THE QUARTERLY PERIOD ENDED: September 30, 2017 ---------------+-------------------------------------------------------------------------------------------- OR -------------- [ ] | TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 ---------------+-------------------------------------------------------------------------------------------- | FOR THE TRANSITION PERIOD FROM __________ TO __________ ---------------+-------------------------------------------------------------------------------------------- COMMISSION FILE NUMBER 000-53497 ADVANCED MEDICAL ISOTOPE CORPORATION (Exact name of registrant as specified in its charter) Delaware | 80-0138937 -------------------------------------------------------------------------------+---------------------------------------------- (State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) -------------------------------------------------------------------------------+---------------------------------------------- 719 Jadwin Avenue, Richland, WA 99352 (Address of principal executive offices, Zip Code) (509) 736-4000 (Registrant’s telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes [X] No [ ] Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer | [ ] | Accelerated filer | [ ] --------------------------------------------------+------+-------------------------------+----- Non-accelerated filer | [ ] | Smaller reporting company | [X] --------------------------------------------------+------+-------------------------------+----- (Do not check if a smaller reporting company) | | --------------------------------------------------+------+------------------------------ | | Emerging growth company | [ ] --------------------------------------------------+------+-------------------------------+----- If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. [ ] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X] As of October 31, 2017, there were 53,768,563 shares of the registrant’s common stock, par value $0.001 per share, outstanding. TABLE OF CONTENTS | | Page ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----- | PART I – FINANCIAL INFORMATION | 3 ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----- Item 1. | Condensed Financial Statements | 3 ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----- | Condensed Balance Sheets as of September 30, 2017 (unaudited) and December 31, 2016 | 3 ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----- | Condensed Statements of Operations for the Three Months and the Nine Months ended September 30, 2017 (unaudited) and the Three Months and the Nine Months ended September 30, 2016 (unaudited) | 4 ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----- | Condensed Statements of Cash Flow for the Nine Months ended September 30, 2017 (unaudited) and the Nine Months ended September 30, 2016 (unaudited) | 5 ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----- | Notes to Condensed Financial Statements (unaudited) | 6 ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----- Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations | 15 ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----- Item 3. | Quantitative and Qualitative Disclosures About Market Risk | 21 ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----- Item 4. | Controls and Procedures | 21 ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----- | PART II – OTHER INFORMATION | 22 ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----- Item 1. | Legal Proceedings | 22 ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----- Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | 22 ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----- Item 6. | Exhibits | 23 ------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----- SIGNATURES | 24 ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 2 - PART I – FINANCIAL INFORMATION Item 1. Financial Statements. Advanced Medical Isotope Corporation Condensed Balance Sheets | September 30, 2017 | | | December 31, 2016 | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+-- | (unaudited) | | | | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+-- ASSETS | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Current assets: | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Cash | $ | 22,110 | | | $ | 27,889 | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Prepaid expenses | | 6,767 | | | | 11,990 | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Total current assets | | 28,877 | | | | 39,879 | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Fixed assets, net of accumulated depreciation | | - | | | | 1,473 | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Other assets: | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Deposits | | 669 | | | | 644 | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Total other assets | | 669 | | | | 644 | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Total assets | $ | 29,546 | | | $ | 41,996 | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT) | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Current liabilities: | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Accounts payable and accrued expenses | $ | 794,627 | | | $ | 1,137,086 | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Related party accounts payable | | 71,297 | | | | 109,718 | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Accrued interest payable | | 319,372 | | | | 114,755 | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Payroll liabilities payable | | 44,441 | | | | 499,502 | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Convertible notes payable, net | | 1,959,276 | | | | 544,508 | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Derivative liability | | - | | | | 324,532 | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Related party promissory note | | 383,771 | | | | 332,195 | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Total current liabilities | | 3,572,784 | | | | 3,062,296 | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Total liabilities | | 3,572,784 | | | | 3,062,296 | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Commitments and contingencies | | - | | | | - | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Stockholders’ equity (deficit): | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Preferred stock, $.001 par value, 20,000,000 shares authorized; 3,583,860 and 3,773,592 shares issued and outstanding, respectively | | 3,584 | | | | 3,774 | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Paid in capital, preferred stock | | 12,907,354 | | | | 14,140,797 | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Common stock, $.001 par value; 2,000,000,000 shares authorized; 53,468,563 and 31,743,797 shares issued and outstanding, respectively | | 53,469 | | | | 31,744 | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Paid in capital, common stock | | 45,155,762 | | | | 40,672,825 | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Accumulated deficit | | (61,663,407 | ) | | | (57,869,440 | ) --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Total stockholders’ equity (deficit) | | (3,543,238 | ) | | | (3,020,300 | ) --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Total liabilities and stockholders’ equity (deficit) | $ | 29,546 | | | $ | 41,996 | --------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- The accompanying notes are an integral part of these condensed financial statements. 3 - Advanced Medical Isotope Corporation Condensed Statements of Operations (unaudited) | Three Months Ended September 30, | | | Nine Months Ended September 30, | -------------------------------------------------+----------------------------------+------------+---+---------------------------------+-- | 2017 | | | 2016 | | | 2017 | | 2016 | -------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+-- Revenues | $ | - | | | $ | 4,054 | | $ | 4,054 | | $ | 8,108 | -------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+-------------+-- Operating expenses | | | | | | | | | | | | | -------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+-------------+-- Sales and marketing expenses | | 52,620 | | | | 65,995 | | | 93,870 | | | 213,539 | -------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+-------------+-- Depreciation and amortization | | - | | | | 738 | | | 1,473 | | | 2,212 | -------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+-------------+-- Professional fees | | 211,954 | | | | 265,497 | | | 642,101 | | | 1,968,084 | -------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+-------------+-- Reserved stock units granted | | 169,650 | | | | - | | | 169,650 | | | - | -------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+-------------+-- Stock options granted | | 24,283 | | | | 27,427 | | | 79,582 | | | 612,343 | -------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+-------------+-- Payroll expenses | | 436,319 | | | | 160,500 | | | 722,594 | | | 492,077 | -------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+-------------+-- Loan fees | | - | | | | 8,664 | | | - | | | 603,861 | -------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+-------------+-- General and administrative expenses | | 66,973 | | | | 137,593 | | | 240,469 | | | 683,788 | -------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+-------------+-- Total operating expenses | | 961,799 | | | | 666,414 | | | 1,949,739 | | | 4,575,904 | -------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+-------------+-- Operating loss | | (961,799 | ) | | | (666,414 | ) | | (1,945,685 | ) | | (4,567,796 | ) -------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+-------------+-- Non-operating income (expense) | | | | | | | | | | | | | -------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+-------------+-- Interest expense | | (527,188 | ) | | | (85,830 | ) | | (1,836,279 | ) | | (535,563 | ) -------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+-------------+-- Net gain on sale of assets | | - | | | | - | | | 2,800 | | | - | -------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+-------------+-- Net gain (loss) on settlement of debt | | - | | | | (111,328 | ) | | - | | | (1,877,959 | ) -------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+-------------+-- Loss on sale of stock | | - | | | | (54,561 | ) | | - | | | (54,561 | ) -------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+-------------+-- Net gain (loss) on debt extinguishment | | (369,428 | ) | | | - | | | (423,291 | ) | | - | -------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+-------------+-- Gain (loss) on derivative liability | | 9 | | | | 762,151 | | | 408,488 | | | (3,108,889 | ) -------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+-------------+-- Non-operating income (expense), net | | (896,607 | ) | | | 510,432 | | | (1,848,282 | ) | | (5,576,972 | ) -------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+-------------+-- Income (Loss) before Income Taxes | | (1,858,406 | ) | | | (155,982 | ) | | (3,793,967 | ) | | (10,144,768 | ) -------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+-------------+-- Income Tax Provision | | - | | | | - | | | - | | | - | -------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+-------------+-- Net Income (Loss) | $ | (1,858,406 | ) | | $ | (155,982 | ) | $ | (3,793,967 | ) | $ | (10,144,168 | ) -------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+-------------+-- Basic and Diluted Income (Loss) per Common Share | $ | (0.04 | ) | | $ | (0.01 | ) | $ | (0.08 | ) | $ | (0.51 | ) -------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+-------------+-- Weighted average common shares outstanding | | 52,471,896 | | | | 19,999,985 | | | 45,777,689 | | | 19,987,347 | -------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+-------------+-- The accompanying notes are an integral part of these condensed financial statements. 4 - Advanced Medical Isotope Corporation Condensed Statements of Cash Flow (Unaudited) | Nine months ended September 30, | -------------------------------------------------------------------------------------+---------------------------------+----------- | 2017 | | | 2016 | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+-- CASH FLOW FROM OPERATING ACTIVITIES: | | | | | | | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Net Income (Loss) | $ | (3,793,967 | ) | | $ | (10,144,768 | ) -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Adjustments to reconcile net income (loss) to net cash used by operating activities: | | | | | | | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Depreciation of fixed assets | | 1,473 | | | | 2,213 | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Amortization of licenses and intangible assets | | - | | | | - | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Amortization of convertible debt discount | | 1,473,205 | | | | 379,290 | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Gain on sale of assets | | (2,800 | ) | | | - | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Preferred stock issued for loan fees | | - | | | | 603,861 | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Common stock issued for services | | 250,393 | | | | - | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Common stock issued for wages | | 365,989 | | | | - | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Preferred stock for services | | - | | | | 357,403 | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Preferred stock for wages | | - | | | | 64,982 | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Restricted stock units granted | | 169,650 | | | | - | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Stock options for services | | 79,582 | | | | 782,226 | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Warrants issued for services | | - | | | | 1,069,353 | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- (Gain) loss on derivative liability | | (408,488 | ) | | | 3,108,889 | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- (Gain) loss on settlement of debt | | 423,291 | | | | 1,877,959 | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Changes in operating assets and liabilities: | | | | | | | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Prepaid expenses | | 5,198 | | | | (4,240 | ) -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Accounts payable | | 22,226 | | | | 36,964 | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Related party accounts payable | | (4,675 | ) | | | (11,725 | ) -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Payroll liabilities | | (67,310 | ) | | | 144,503 | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Accrued interest | | 361,951 | | | | 87,265 | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Net cash used by operating activities | | (1,124,282 | ) | | | 1,645,825 | ) -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- CASH FLOWS FROM INVESTING ACTIVITIES | | | | | | | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Sale of fixed assets | | 2,800 | | | | - | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Net cash from vesting activities | | 2,800 | | | | - | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- CASH FLOWS FROM FINANCING ACTIVITIES: | | | | | | | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Payments made for loan fees | | (101,631 | ) | | | - | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Proceeds from shareholder advances | | 137,000 | | | | - | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Proceeds from exercise of warrants | | - | | | | 250 | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Payments on convertible debt | | - | | | | (10,000 | ) -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Proceeds from convertible debt | | 1,080,334 | | | | 1,476,558 | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Net cash provided by financing activities | | 1,115,703 | | | | 1,466,808 | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Net increase (decrease) in cash | | (5,779 | ) | | | (179,017 | ) -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Cash, beginning of period | | 27,889 | | | | 179,032 | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- CASH, END OF PERIOD | $ | 22,110 | | | $ | 15 | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Supplemental disclosures of cash flow information: | | | | | | | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Cash paid for interest | $ | - | | | $ | - | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- Cash paid for income taxes | $ | - | | | $ | - | -------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+-------------+-- The accompanying notes are an integral part of these condensed financial statements. 5 - Advanced Medical Isotope Corporation Notes to Condensed Financial Statements (Unaudited) NOTE 1: BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES The accompanying condensed financial statements of Advanced Medical Isotope Corporation (the “Company”) have been prepared without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and disclosures required by accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations. These condensed financial statements reflect all adjustments that, in the opinion of management, are necessary to present fairly the results of operations of the Company for the period presented. The results of operations for the nine months ended September 30, 2017, are not necessarily indicative of the results that may be expected for any future period or the fiscal year ending December 31, 2017 and should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2016, filed with the Securities and Exchange Commission on March 9, 2017. In April of 2017, the Company filed a Certificate of Merger with the Delaware Division of Corporations in order to merge the Company’s wholly-owned subsidiary, IsoPet Solutions Corporation, with and into the Company. The Company therefore no longer prepares Consolidated Financial Statements. Use of Estimates The preparation of financial statements in accordance with generally accepted accounting principles requires management to make estimates and assumptions that effect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Fair Value of Financial Instruments Fair value of financial instruments requires disclosure of the fair value information, whether or not recognized in the balance sheet, where it is practicable to estimate that value. As of September 30, 2017 and December 31, 2016, the balances reported for cash, prepaid expenses, accounts payable, and accrued expenses, approximate the fair value because of their short maturities. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) Topic 820, “Fair Value Measurements,” established a three-tier fair value hierarchy to prioritize the inputs used in measuring fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1 measurements) and the lowest priority to unobservable inputs (level 3 measurements). These tiers include: Level 1, defined as observable inputs such as quoted prices for identical instruments in active markets; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable such as quoted prices for similar instruments in active markets or quoted prices for identical or similar instruments in markets that are not active; and Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions, such as valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable. The Company measures certain financial instruments at fair value on a recurring basis. Assets and liabilities measured at fair value on a recurring basis were calculated using the Black-Scholes pricing model and are as follows at September 30, 2017 and December 31, 2016: September 30, 2017 | | | | | | | | ---------------------------------------------+-------+---+-------------+---+---+-------------+---+------------ | Total | | Level 1 | | | Level 2 | | Level 3 ---------------------------------------------+-------+---+-------------+---+---+-------------+---+------------ Liabilities: | | | | | | | | | | ---------------------------------------------+-------+---+-------------+---+---+-------------+---+-------------+---+-- Derivative Liability | $ | | | $ | | | $ | | $ | ---------------------------------------------+-------+---+-------------+---+---+-------------+---+-------------+---+-- Total Liabilities Measured at Fair Value | $ | - | | $ | - | | $ | - | $ | - ---------------------------------------------+-------+---+-------------+---+---+-------------+---+-------------+---+-- December 31, 2016 | | | | | | | | ---------------------------------------------+-------+---------+-------------+---+---+-------------+---+------------ | Total | | Level 1 | | | Level 2 | | Level 3 ---------------------------------------------+-------+---------+-------------+---+---+-------------+---+------------ Liabilities: | | | | | | | | | | ---------------------------------------------+-------+---------+-------------+---+---+-------------+---+-------------+---+-------- Derivative Liability | $ | 324,532 | | $ | | | $ | | $ | 324,532 ---------------------------------------------+-------+---------+-------------+---+---+-------------+---+-------------+---+-------- Total Liabilities Measured at Fair Value | $ | 324,532 | | $ | - | | $ | - | $ | 324,532 ---------------------------------------------+-------+---------+-------------+---+---+-------------+---+-------------+---+-------- Reclassifications Certain account balances from prior periods have been reclassified in the current period financial statements so as to conform to current period classifications. Recent Accounting Pronouncements There are no recently issued accounting pronouncements that the Company believes are applicable or would have a material impact on the financial statements of the Company. 6 - NOTE 2: GOING CONCERN The accompanying financial statements have been prepared on a going concern basis, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. As shown in the accompanying financial statements, the Company has suffered recurring losses and has used significant cash in support of its operating activities and the Company’s cash position is not sufficient to support the Company’s operations. Historically, the Company has relied upon outside investor funds to maintain the Company’s operations and develop the Company’s business. The Company anticipates it will continue to require funding from investors for working capital, as well as business expansion during this fiscal year and it can provide no assurance that additional investor funds will be available on acceptable terms. These factors, among others, indicate that there is substantial doubt regarding the Company’s ability to continue as a going concern within one year of the date these financial statements are issued. In addition, the Company’s ability to continue as a going concern must be considered in light of the problems, expenses and complications frequently encountered by entrance into established markets and the competitive environment in which it operates. The Company anticipates a requirement of $1.5 million over the next twelve months to maintain current operating activities. The Company may also require up to approximately $4.6 million to retire outstanding debt and past due payables. As of September 30, 2017 the Company had convertible promissory notes in the aggregate principal amount of $3,188,081 outstanding (the “Outstanding Notes”), of which approximately $45,000 are currently due and payable. Over the next 12 to 24 months, the Company believes it will cost approximately $5 million to $10 million to fund: (1) the Food and Drug Administration (“FDA”) approval process and initial deployment of the brachytherapy products and (2) initiate regulatory approval processes outside of the United States. The continued deployment of the brachytherapy products and a worldwide regulatory approval effort will require additional resources and personnel. The principal variables in the timing and amount of spending for the brachytherapy products in the next 12 to 24 months will be the FDA’s classification of the Company’s brachytherapy products as Class II or Class III devices (or otherwise) and any requirements for additional studies, which may include clinical studies. Thereafter, the principal variables in the amount of the Company’s spending and its financing requirements are timing of any approvals and the nature of the Company’s arrangements with third parties for manufacturing, sales, distribution and licensing of those products and the products’ success in the U.S. and elsewhere. The Company intends to fund its activities through strategic transactions such as licensing and partnership agreements and/or additional capital raises. As of September 30, 2017, the Company has $22,110 cash on hand. There are currently commitments to vendors for products and services purchased, accrued compensation expenses and the Company’s current lease commitments that, in the absence of additional capital, would result in a liquidation of the Company. The current level of cash is not sufficient to cover the fixed and variable obligations of the Company. Assuming the Company is successful in its development efforts, the Company believes that it will be able to raise additional funds through strategic agreements or the sale of the Company’s securities to either current stockholders or new investors. However, there is no guarantee that the Company will be able to raise additional funds or to do so on favorable terms. The financial statements do not include any adjustments relating to the recoverability and classification of liabilities that might be necessary should the Company be unable to continue as a going concern. The Company’s continuation as a going concern is dependent upon its ability to generate sufficient cash flow to meet its obligations on a timely basis and ultimately to attain profitability. The Company plans to seek additional funding to maintain its operations through debt and equity financing and to improve operating performance through a focus on strategic products and increased efficiencies in business processes and improvements to the cost structure. There is no assurance that the Company will be successful in its efforts to raise additional working capital or achieve profitable operations. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. 7 - NOTE 3: FIXED ASSETS Fixed assets consist of the following at September 30, 2017 and December 31, 2016: | September 30, 2017 | | | December 31, 2016 ------------------------------+--------------------+---------+---+------------------ Production equipment | $ | 15,182 | | | $ | 1,938,532 | ------------------------------+--------------------+---------+---+-------------------+---+------------+-- Office equipment | | - | | | | 32,769 | ------------------------------+--------------------+---------+---+-------------------+---+------------+-- | | 15,182 | | | | 1,971,301 | ------------------------------+--------------------+---------+---+-------------------+---+------------+-- Less accumulated depreciation | | (15,182 | ) | | | (1,969,828 | ) ------------------------------+--------------------+---------+---+-------------------+---+------------+-- | $ | - | | | $ | 1,473 | ------------------------------+--------------------+---------+---+-------------------+---+------------+-- Depreciation expense for the above fixed assets for the three months ended September 30, 2017 and 2016, respectively was $0 and $738 and for the nine months ended September 30, 2017 and 2016, respectively, was $1,473 and $2,212. NOTE 4: INTANGIBLE ASSETS Intangible assets consist of the following at September 30, 2017 and December 31, 2016: | September 30, 2017 | | December 31, 2016 | --------------------------------------------------+--------------------+---+-------------------+-- License Fee | $ | - | | $ | 112,500 | --------------------------------------------------+--------------------+---+-------------------+---+----------+-- Less accumulated amortization | | - | | | (112,500 | ) --------------------------------------------------+--------------------+---+-------------------+---+----------+-- Patents and intellectual property | | - | | | - | --------------------------------------------------+--------------------+---+-------------------+---+----------+-- Intangible assets net of accumulated amortization | $ | - | | $ | - | --------------------------------------------------+--------------------+---+-------------------+---+----------+-- The Company did not incur any amortization expense during the three and nine months ended September 30, 2017 and 2016. 8 - NOTE 5: RELATED PARTY TRANSACTIONS Related Party Convertible Notes Payable In March 2017, the Company combined Outstanding Notes owed to a director and major stockholder, along with $51,576 of accrued interest payable, into one promissory note (the “Related Party Note”). The Related Party Note accrues interest at a rate of 10% and will become due and payable on December 31, 2017. As of September 30, 2017 and December 31, 2016 the balance of the Related Party Note was $383,771 and $332,195, respectively. Rent Expenses The Company was renting office space from a significant shareholder and director of the Company on a month-to-month basis with a monthly payment of $1,500. This rental agreement was terminated as of April 1, 2017. Rental expense was $0 and $4,500 for each of the three months ended September 30, 2017 and 2016 and is recorded in general and administrative expense. Rental expense was $4,500 and $13,500 for the nine months ending September 30, 2017 and 2016, respectively, and is recorded in general and administrative expense. 9 - NOTE 6: CONVERTIBLE NOTES PAYABLE As of September 30, 2017 and December 31, 2016, the Company had the following convertible notes outstanding: | September 30, 2017 | | December 31, 2016 | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------+-----------+-----------------------+-- | Principal (net) | | Accrued Interest | | | Principal (net) | | Accrued Interest ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------+-----------+-----------------------+---+---------+--------------------------+---+--------------------- July and August 2012 $1,060,000 Notes convertible into common stock at $4.60 per share, 12% interest, due December 2013 and January 2014, respectively | $ | 45,000 | | $ | 27,861 | | $ | 95,000 | | 50,365 ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------+-----------+-----------------------+---+---------+--------------------------+---+----------------------+---+------- May through October 2015 $605,000 Notes convertible into preferred stock at $1 per share, 8-10% interest, due September 30, 2015 | | - | | | 17,341 | | | - | | 17,341 ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------+-----------+-----------------------+---+---------+--------------------------+---+----------------------+---+------- October through December 2015 $613,000 Notes convertible into preferred stock at $1 per share, 8% interest, due June 30, 2016, net of debt discount of $0 and $560,913, respectively | | - | | | 5,953 | | | - | | 5,953 ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------+-----------+-----------------------+---+---------+--------------------------+---+----------------------+---+------- January through March 2016 $345,000 Notes convertible into preferred stock at $1 per share, 8% interest, due June 30, 2016 | | - | | | 696 | | | - | | 696 ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------+-----------+-----------------------+---+---------+--------------------------+---+----------------------+---+------- November 2016 $979,162 Notes convertible into common stock at a variable conversion price, 10% interest, due May 2017, net of debt discounts of $0 and $540,720, respectively | | - | | | - | | | 438,442 | | 12,397 ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------+-----------+-----------------------+---+---------+--------------------------+---+----------------------+---+------- January and March 2017 $335,838 Notes convertible into common stock at a variable conversion price, 10% interest, due May 2017, net of debt discounts of $0 and $0, respectively | | - | | | - | | | - | | - ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------+-----------+-----------------------+---+---------+--------------------------+---+----------------------+---+------- May 2017 $2,378,155 Notes convertible into common stock after December 15, 2017 at a $0.20 conversion price (subject to adjustment), 7.5% interest, due May 2018, net of debt discounts of $933,417 and $0, respectively | | 1,444,738 | | | 178,304 | | | - | | - ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------+-----------+-----------------------+---+---------+--------------------------+---+----------------------+---+------- May 2017 $648,039 Notes convertible into common stock after December 15, 2017 at a $0.12 conversion price (subject to adjustment), 7.5% interest, due May 2018, net of debt discounts of $252,412 and $0, respectively | | 395,627 | | | 52,831 | | | - | | - ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------+-----------+-----------------------+---+---------+--------------------------+---+----------------------+---+------- May 2017 $110,312 Notes convertible after December 31, 2017 into common stock at a $0.13 conversion price (subject to adjustment), 7.5% interest, due May 2018, net of debt discounts of $42,976 and $0, respectively | | 67,336 | | | 15,773 | | | - | | - ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------+-----------+-----------------------+---+---------+--------------------------+---+----------------------+---+------- Penalties on notes in default | | 6,575 | | | - | | | 11,066 | | - ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------+-----------+-----------------------+---+---------+--------------------------+---+----------------------+---+------- Total Convertible Notes Payable, Net | $ | 1,959,276 | | $ | 298,759 | | $ | 544,508 | $ | 86,752 ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------+-----------+-----------------------+---+---------+--------------------------+---+----------------------+---+------- 10 -- During the nine months ending September 30, 2017, the Company received proceeds from the issuance of 10% Convertible Notes (“Convertible Notes”) and 7.5% Original Issue Discount Senior Secured Convertible Debentures (“Debentures”) of $1,080,334 and obtained advances from shareholders of $137,000 that were reclassified into Convertible Notes. The Company also assigned or exchanged $1,358,750 worth of Convertible Notes and Notes that were outstanding as of December 31, 2016 into Debentures, while also reclassifying $69,279 worth of accrued interest to convertible note principal. Each of the Company’s Convertible Notes had a conversion rate that was variable or had adjustment provisions. As a result of recording derivative liabilities at note inception, the Company increased the debt discount recorded on Convertible Notes by $99,661 during the nine months ending September 30, 2017.The Company also recorded original issue discounts and loan fees on Convertible Notes and Debentures of $757,696 and $386,758, respectively, which also increased the debt discounts recorded on the Convertible Notes and Debentures. The Company recorded $322,381 of conversions on certain outstanding notes, $272,381 of which was voluntarily allowed by the Company despite the conversion feature of the notes not yet being in effect, and a total gain on settlement of $135,432 representing the write-off of outstanding note principal and debt discount. The Company also recorded amortization of $1,473,208 on outstanding note debt discounts. Lastly, the Company paid $101,631 in cash for loan fees and issued 743,699 shares of the Company’s Series A Convertible Preferred Stock (“Series A Preferred”) as loan fees in connection with the issuance of the Convertible Notes and Debentures. The Company therefore increased its debt discount by $1,116,110, which represented the portion of the proceeds from the Convertible Notes and Debentures that were allocated to preferred stock. NOTE 7: COMMON STOCK OPTIONS, WARRANTS, AND RESTRICTED STOCK UNITS The Company recognizes in the financial statements compensation related to all stock-based awards, including stock options, warrants, and restricted stock units (“RSUs”) based on their estimated grant-date fair value. The Company has estimated expected forfeitures and is recognizing compensation expense only for those awards expected to vest. All compensation is recognized by the time the award vests. 11 -- Common Stock Options The following schedule summarizes the changes in the Company’s stock options: | | | | Weighted | | | | Weighted --------------------------------------+-------------------------+------------+---+---------------+---+-----------+-------------+--------------- | Options Outstanding | | | Average | | | | Average --------------------------------------+-------------------------+------------+---+---------------+---+-----------+-------------+--------------- | Number | | | Exercise | | | Remaining | Aggregate | Exercise | --------------------------------------+-------------------------+------------+---+---------------+---+-----------+-------------+----------------+---------------+-- | Of | | | Price | | | Contractual | Intrinsic | Price | --------------------------------------+-------------------------+------------+---+---------------+---+-----------+-------------+----------------+---------------+-- | Shares | | | Per Share | | | Life | Value | Per Share | --------------------------------------+-------------------------+------------+---+---------------+---+-----------+-------------+----------------+---------------+-- Balance at December 31, 2016 | | 2,402,500 | | | $ | 0.50-15 | | 4.05 years | $ | - | $ | 0.81 --------------------------------------+-------------------------+------------+---+---------------+---+-----------+-------------+----------------+---------------+---+---+----- Options granted | | - | | | $ | - | | - | | | $ | - --------------------------------------+-------------------------+------------+---+---------------+---+-----------+-------------+----------------+---------------+---+---+----- Options exercised | | - | | | $ | - | | - | | | $ | - --------------------------------------+-------------------------+------------+---+---------------+---+-----------+-------------+----------------+---------------+---+---+----- Options expired | | (1,180,000 | ) | | $ | 0.50-1.00 | | - | | | $ | 0.53 --------------------------------------+-------------------------+------------+---+---------------+---+-----------+-------------+----------------+---------------+---+---+----- Balance at September 30, 2017 | | 1,222,500 | | | $ | 0.50-15 | | 3.16 years | $ | - | $ | 1.08 --------------------------------------+-------------------------+------------+---+---------------+---+-----------+-------------+----------------+---------------+---+---+----- Exercisable at September 30, 2017 | | 1,030,829 | | | $ | 0.50-15 | | 3.06 years | $ | - | $ | 1.18 --------------------------------------+-------------------------+------------+---+---------------+---+-----------+-------------+----------------+---------------+---+---+----- During the nine months ended September 30, 2017 the Company recognized $79,582 worth of expense related to the vesting of its previously issued stock options. As of September 30, 2017, the Company had $69,681 worth of expense yet to be recognized for options not yet vested. Common Stock Warrants The following schedule summarizes the changes in the Company’s stock warrants: | | | | | | | Weighted | | Weighted | --------------------------------------+--------------------------+------------+---+---------------+---+-----------+-------------+----------------+---------------+---- | Warrants Outstanding | | | Average | | | | Average --------------------------------------+--------------------------+------------+---+---------------+---+-----------+-------------+--------------- | Number | | | Exercise | | | Remaining | Aggregate | Exercise | --------------------------------------+--------------------------+------------+---+---------------+---+-----------+-------------+----------------+---------------+---- | Of | | | Price | | | Contractual | Intrinsic | Price | --------------------------------------+--------------------------+------------+---+---------------+---+-----------+-------------+----------------+---------------+---- | Shares | | | Per Share | | | Life | Value | Per Share | --------------------------------------+--------------------------+------------+---+---------------+---+-----------+-------------+----------------+---------------+---- Balance at December 31, 2016 | | 3,579,505 | | | $ | 0.10-10 | | 0.52 years | $ | 749 | $ | 4.45 --------------------------------------+--------------------------+------------+---+---------------+---+-----------+-------------+----------------+---------------+-----+---+----- Warrants granted | | - | | | $ | - | | - | | | $ | - --------------------------------------+--------------------------+------------+---+---------------+---+-----------+-------------+----------------+---------------+-----+---+----- Warrants exercised | | - | | | $ | - | | - | | | $ | - --------------------------------------+--------------------------+------------+---+---------------+---+-----------+-------------+----------------+---------------+-----+---+----- Warrants expired/cancelled | | (3,274,055 | ) | | $ | 0.10-4.60 | | - | | | $ | 4.62 --------------------------------------+--------------------------+------------+---+---------------+---+-----------+-------------+----------------+---------------+-----+---+----- Balance at September 30, 2017 | | 305,450 | | | $ | 0.40-10 | | 1.44 years | $ | - | $ | 2.64 --------------------------------------+--------------------------+------------+---+---------------+---+-----------+-------------+----------------+---------------+-----+---+----- Exercisable at September 30, 2017 | | 305,450 | | | $ | 0.40-10 | | 1.44 years | $ | - | $ | 2.64 --------------------------------------+--------------------------+------------+---+---------------+---+-----------+-------------+----------------+---------------+-----+---+----- Restricted Stock Units The following schedule summarizes the changes in the Company’s restricted stock units: 12 -- | | | Weighted | | ----------------------------------+--------+------------+----------------+---+----- | Number | | Average | | ----------------------------------+--------+------------+----------------+---+----- | Of | | Grant Date | | ----------------------------------+--------+------------+----------------+---+----- | Shares | | Fair Value | | ----------------------------------+--------+------------+----------------+---+----- Balance at December 31, 2016 | | - | | $ | - ----------------------------------+--------+------------+----------------+---+----- RSU’s granted | | 12,560,000 | | $ | 0.07 ----------------------------------+--------+------------+----------------+---+----- RSU’s vested | | - | | $ | - ----------------------------------+--------+------------+----------------+---+----- RSU’s forfeited | | - | | $ | - ----------------------------------+--------+------------+----------------+---+----- Balance at September 30, 2017 | | 12,560,000 | | $ | 0.07 ----------------------------------+--------+------------+----------------+---+----- During the nine months ended September 30, 2017 the Company recognized $169,650 worth of expense related to the vesting of its RSU’s. As of September 30, 2017, the Company had $759,790 worth of expense yet to be recognized for RSU’s not yet vested. NOTE 8: STOCKHOLDERS’ EQUITY Common Stock The Company has 2,000,000,000 shares of common stock authorized, with a par value of $0.001, and as of September 30, 2017, the Company has 53,468,563 shares issued and outstanding. During the nine months ending September 30, 2017, the Company issued 3,040,239 shares of its common stock valued at $334,048 for the settlement of debt, 2,220,944 shares of its common stock valued at $250,392 for services, and 13,367,100 shares of its common stock valued at $3,361,540 for conversions of 1,276,710 shares of Series A Preferred. Additionally, during the nine months ending September 30, 2017 the Company issued 3,096,483 shares of common stock valued at $309,450 and 343,279 shares of Series A Preferred valued at $1,011,797 for the reduction of $272,976 of accounts payable, the reduction of $387,751 of accrued payroll, while recording $294,530 as a gain on extinguishment of debt and $365,990 worth of services. Preferred Stock As of September 31, 2017 the Company has 20,000,000 shares of Series A Preferred authorized with a par value of $0.001. The Company’s Board of Directors is authorized to provide for the issuance of shares of preferred stock in one or more series, to establish the number of shares in each series, and to determine the designations, preferences and rights through a resolution of the Board of Directors. Effective June of 2015, the Board of Directors designated the Series A Preferred as a new series of preferred stock. As of September 30, 2017, the Company has 5,000,000 shares of Series A Preferred authorized, with a par value of $0.001, and has 3,583,860 shares issued and outstanding. Each Series A Preferred share is convertible into shares of the Company’s common stock. Each holder of Series A Preferred is entitled to the equivalent of five votes for every conversion share, where the conversion shares are the number of common stock the Series A Preferred would be convertible into. The holders of the Series A Preferred have a liquidation preference equal to $5.00 per share. During the nine months ending September 30, 2017 the Company issued 743,699 shares of Series A Preferred valued at $1,116,110 as loan fees in connection with the issuance of the Debentures, and 343,279 shares of Series A Preferred valued at $1,011,797 for accrued payroll and accounts payable. 13 -- NOTE 9: SUPPLEMENTAL CASH FLOW INFORMATION During the nine months ending September 30, 2017, the Company had the following non-cash investing and financing activities: ● | Increased convertible notes payable by $69,279, increased related party notes payable by $51,576, and decreased accrued interest by $120,855 for the reclassification of accrued interest to principal. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ● | Increased derivative liabilities for $99,661 to record a debt discount on convertible notes payable. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ● | Increased convertible notes payable and decreased loan from shareholder by $137,000 to roll proceeds from shareholder advances to a formal convertible note payable. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ● | Issued 743,699 shares of Series A Preferred for loan fees that increased the convertible note debt discount by $1,116,110. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ● | Issued 13,367,100 shares of common stock in exchange for 1,276,710 shares of Series A Preferred decreasing preferred stock by $3,361,540, increasing common stock by $13,367, and increasing paid in capital by $3,348,173. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ● | Issued 3,096,483 shares of common stock valued at $309,450 and 343,279 shares of Series A Preferred valued at $1,011,797 for the reduction of $272,976 of accounts payable, the reduction of $387,751 of accrued payroll, while recording $294,530 as a gain on extinguishment of debt and $365,990 worth of services. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ● | Issued 3,040,239 shares of common stock valued at $334,048 for the reduction of $322,381 of convertible notes payable and $36,479 of accrued interest, reducing debt discount by $159,299, and recording $134,487 as a gain on extinguishment of debt. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- NOTE 10: COMMITMENTS AND CONTINGENCIES Effective June 21, 2017, the Company entered into a separation agreement with an individual previously associated with the Company, at times as a consultant and as an employee at other times. Pursuant to the agreement, the Company agreed to pay regular bi-weekly checks beginning July 7, 2017 and ending September 15, 2017, for a total of six checks in the aggregate amount of $28,846. This obligation was fully paid as of September 30, 2017. NOTE 11: SUBSEQUENT EVENTS In October 2017 the Company exchanged 300,000 common stock shares for 30,000 Series A Preferred shares. In November 2017 the Company received $150,000 in exchange for a 10% convertible promissory note due April 15, 2018. The Company issued 100,000 Series A Preferred shares as an origination fee on this note. The Company has evaluated subsequent events pursuant to ASC Topic 855 and has determined that there are no additional subsequent events to disclose. 14 -- Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations. Except for statements of historical fact, certain information described in this Form 10-Q report contains “forward-looking statements” that involve substantial risks and uncertainties. You can identify these statements by forward-looking words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “should,” “will,” “would” or similar words. The statements that contain these or similar words should be read carefully because these statements discuss the Company’s future expectations, including its expectations of its future results of operations or financial position, or state other “forward-looking” information. Advanced Medical Isotope Corporation believes that it is important to communicate its future expectations to its investors. However, there may be events in the future that the Company is not able to accurately predict or to control. Further, the Company urges you to be cautious of the forward-looking statements which are contained in this Form 10-Q report because they involve risks, uncertainties and other factors affecting its operations, market growth, service, products and licenses. The risk factors in the section captioned “Risk Factors” in Item 1A of the Company’s previously filed Form 10-K for the year ended December 31, 2016, filed with the Securities and Exchange Commission on March 9, 2017, as well as other cautionary language in this report on Form 10-Q, describe such risks, uncertainties and events that may cause the Company’s actual results and achievements, whether expressed or implied, to differ materially from the expectations the Company describes in its forward-looking statements. The occurrence of any of the events described as risk factors could have a material adverse effect on the Company’s business, results of operations and financial position. General Statement of Business Advanced Medical Isotope Corporation (the “Company,” “AMI” or “we”) was incorporated under the laws of Delaware on December 23, 1994 as Savage Mountain Sports Corporation (“SMSC”). On September 6, 2006, the Company changed its name to Advanced Medical Isotope Corporation. AMI has authorized capital of 2,000,000,000 shares of common stock, $0.001 par value per share and 20,000,000 shares of preferred stock, $0.001 par value per share. Our common stock is quoted on the OTC PINK Marketplace under the symbol, “ADMD”. Recent Developments On or about May 10, 2017, the Company entered into Securities Purchase Agreements (the “Purchase Agreement”) with certain accredited investors to purchase 7.5% Original issue Discount Senior Secured Convertible Debentures (“Debentures”) in the aggregate principal amount of $1,179,581, including an original issue discount of $235,916 and loan fees of $30,000. The principal, original issue discount, and loan fees accrue interest at a rate of 7.5% per annum, and will become due and payable one year from the issuance date. Holders of the Debentures may elect to convert the principal and original issue discount, as well as any accrued by unpaid interest (the “Outstanding Balance”), into that number of shares of the Company’s common stock equal to the Outstanding Balance, divided by $0.20 (the “Conversion Price”). On the same date, the Company also entered into Securities Exchange Agreements (the “Exchange Agreement”) with certain holders of outstanding convertible promissory notes to exchange such notes and their accrued interest for Debentures, resulting in the issuance of Debentures in the aggregate principal amount of $2,229,306 including an original issue discount of $445,961 and loan fees of $356,758. The Debentures issued pursuant to the Exchange Agreement have terms substantially similar to those issued pursuant to the Purchase Agreement, expect that certain of the Debentures issued pursuant to Exchange Agreements have a Conversion Price of $0.13 and $0.12 per share. The Company paid loan fees in connection with the issuance of the Debentures, both pursuant to the Purchase Agreements and Exchange Agreements, of 20% of the principal and original issue discount of the Debentures in shares of its Series A Preferred Stock (“Series A Preferred”). In addition, the Company granted to each of the holders of the Debentures a continuing security interest in substantially all of the Company’s assets, pursuant to the terms and conditions of a Security Agreement. Overview The Company is a late stage radiation oncology medical device company engaged in the development of its yttrium-90 based brachytherapy device, RadioGel™, for the treatment of non-resectable tumors. A prominent team of radiochemists, scientists and engineers, collaborating with strategic partners, including national laboratories, universities and private corporations, lead the Company’s development efforts. The Company’s overall vision is to globally empower physicians, medical researchers and patients by providing them with new isotope technologies that offer safe and effective treatments for cancer. The Company’s current focus is on the development of its RadioGel™ device. RadioGel™ is an injectable particle-gel for brachytherapy radiation treatment of cancerous tumors in people and animals. RadioGel™ is comprised of a hydrogel, or a substance that is liquid at room temperature and then gels when reaching body temperature after injection into a tumor. In the gel are small, one micron, yttrium-90 phosphate particles (“Y-90”). Once injected, these inert particles are locked in place inside the tumor by the gel, delivering a very high local radiation dose. The radiation is beta, consisting of high-speed electrons. These electrons only travel a short distance so the device can deliver high radiation to the tumor with minimal dose to the surrounding tissue. Optimally, patients can go home immediately following treatment without the risk of radiation exposure to family members. Since Y-90 has a half-life of 2.7 days, the radioactively drops to 5% of its original value after ten days. 15 -- The Company’s lead brachytherapy product, RadioGel™, incorporates patented technology developed for Battelle Memorial Institute (“Battelle”) at Pacific Northwest National Laboratory, a leading research institute for government and commercial customers. Battelle has granted the Company an exclusive license to patents covering the manufacturing, processing and applications of RadioGel™ (the “Battelle License”). Other intellectual property protection includes proprietary production processes and trademark protection in 17 countries. The Company plans to continue efforts to develop new refinements on the production process, and the product and application hardware, as a basis for future patents. The Company is currently focusing on obtaining approval from the Food and Drug Administration (“FDA”) to market and sell RadioGel™ as a Class II medical device. The Company first requested FDA approval of RadioGel™ in June 2013, at which time the FDA classified RadioGel™ as a medical device. The Company then followed with a 510(k) submission which the FDA responded, in turn, with a request for a physician letter of substantial equivalence and a reformatted 510(k) summary, which the Company provided January 2014. In February 2014 the FDA ruled the device as not substantially equivalent due to a lack of predicate device and it was classified to Class III. The Company is currently developing test plans to address issues raised by the FDA in connection with the Company’s previous submissions regarding RadioGel™, including developing specific test plans and specific indication of use. The Company intends to request FDA approval to apply for de novo classification of RadioGel™, which would reclassify the device from a Class III device to a Class II device, further simplifying the path to FDA approval. In previous FDA submittals, the Company proposed applying RadioGel™ for a very broad range of cancer therapies, referred to as Indication for Use. The FDA has requested that the Company reduce its Indications for Use. To comply with that request, the Company has expanded its Medical Advisory Board (“MAB”) and engaged doctors from respected hospitals who have evaluated the candidate cancer therapies based on three criteria: (1) potential for FDA approval and successful therapy; (2) notable advantage over current therapies; and (3) probability of wide spread acceptance by the medical community. The MAB selected eighteen applications for RadioGel™, each of which meet the criteria described above. This large number confirms the wide applicability of the device and defines the path for future business growth. The Company intends to apply to the FDA for a single Indication for Use, treatment of basal cell and squamous cell skin cancers, followed by subsequent applications for additional Indications for Use. We anticipate that this initial application will facilitate each subsequent application, and the testing for many of the subsequent applications could be conducted in parallel, depending on available resources. The Company’s IsoPet Solutions division was established in May 2016 to focus on the veterinary oncology market, namely engagement of university veterinarian hospital to develop the detailed therapy procedures to treat animal tumors and ultimately use of the technology in private clinics. The Company has engaged four different university veterinarian hospitals to begin using RadioGel™ for treatment of four different cancer types in dogs and cats. Washington State University Veterinary Hospital has tested one cat to demonstrate the procedures and the absence of any significant toxicity effect. The other three centers are expected to begin therapy during the fourth quarter of 2017 after their internal administrative review process is completed. These animal therapies will focus on creating labels that describe the procedures in detail as a guide to future veterinarians. The labels will be voluntarily submitted to the FDA for review. They will then be used as data for future FDA applications in the medical sector and as key intellectual property for licensing to private veterinary clinics. Dr. Alice Villalobos, the Chair of our Veterinarian Advisory Board, has expressed an interest in being the first to utilize RadioGel™ in her private clinic, but is also introducing the Company to other clinics with an interest in utilizing RadioGel™ and to demonstrate the business model. The Company anticipates that future profit will be derived from direct sales of RadioGel™ and related services, and from licensing to private medical and veterinary clinics in the U.S. and internationally. 16 -- Based on the Company’s financial history since inception, its auditor has expressed substantial doubt as to the Company’s ability to continue as a going concern. The Company has limited revenue, nominal cash, and has accumulated deficits since inception. If the Company cannot obtain sufficient additional capital, the Company will be required to delay the implementation of its business strategy and not be able to continue operations. Results of Operations Comparison of the Three Months Ended September 30, 2017 and 2016 The following table sets forth information from our statements of operations for the three months ended September 30, 2017 and 2016. | Three Months Ended September 30, 2017 | | | Three Months Ended September 30, 2016 | ------------------------------------------+------------------------------------------------+------------+---+------------------------------------------------+-- Revenues | $ | - | | | $ | - | ------------------------------------------+------------------------------------------------+------------+---+------------------------------------------------+---+----------+-- Operating expenses | | 961,799 | | | | 666,414 | ------------------------------------------+------------------------------------------------+------------+---+------------------------------------------------+---+----------+-- Operating loss | | (961,799 | ) | | | (666,414 | ) ------------------------------------------+------------------------------------------------+------------+---+------------------------------------------------+---+----------+-- Non-operating income (expense): | | | | | | | ------------------------------------------+------------------------------------------------+------------+---+------------------------------------------------+---+----------+-- Gain (loss) on derivative liability | | 9 | | | | 762,151 | ------------------------------------------+------------------------------------------------+------------+---+------------------------------------------------+---+----------+-- Gain (loss) on debt extinguishment | | (369,428 | ) | | | - | ------------------------------------------+------------------------------------------------+------------+---+------------------------------------------------+---+----------+-- Net gain (loss) on settlement of debt | | - | | | | (111,328 | ) ------------------------------------------+------------------------------------------------+------------+---+------------------------------------------------+---+----------+-- Loss on sale of stock | | - | | | | (54,561 | ) ------------------------------------------+------------------------------------------------+------------+---+------------------------------------------------+---+----------+-- Interest expense | | (527,188 | ) | | | (85,830 | ) ------------------------------------------+------------------------------------------------+------------+---+------------------------------------------------+---+----------+-- Net income (loss) | $ | (1,858,406 | ) | | $ | (155,982 | ) ------------------------------------------+------------------------------------------------+------------+---+------------------------------------------------+---+----------+-- Revenue Revenue was $0 for the three months ended September 30, 2017 and September 30, 2016. Management does not anticipate that the Company will generate revenue sufficient to sustain operations until such time as the Company secures revenue-generating arrangements with respect to RadioGel™ and/or any of our other brachytherapy technologies. Operating Expenses Operating expenses for the three months ended September 30, 2017 and 2016 consists of the following: | Three months ended September 30, 2017 | | Three months ended September 30, 2016 | ------------------------------------------+-------------------------------------------------+---------+-------------------------------------------------+-- Depreciation and amortization expense | $ | - | | $ | 738 ------------------------------------------+-------------------------------------------------+---------+-------------------------------------------------+---+-------- Professional fees | | 211,954 | | | 265,497 ------------------------------------------+-------------------------------------------------+---------+-------------------------------------------------+---+-------- Restricted stock units granted | | 169,650 | | | - ------------------------------------------+-------------------------------------------------+---------+-------------------------------------------------+---+-------- Stock options granted | | 24,283 | | | 27,427 ------------------------------------------+-------------------------------------------------+---------+-------------------------------------------------+---+-------- Payroll expenses | | 436,319 | | | 160,500 ------------------------------------------+-------------------------------------------------+---------+-------------------------------------------------+---+-------- General and administrative expenses | | 66,973 | | | 146,257 ------------------------------------------+-------------------------------------------------+---------+-------------------------------------------------+---+-------- Sales and marketing expense | | 52,620 | | | 65,995 ------------------------------------------+-------------------------------------------------+---------+-------------------------------------------------+---+-------- | $ | 912,799 | | $ | 666,414 ------------------------------------------+-------------------------------------------------+---------+-------------------------------------------------+---+-------- Operating expenses for the three months ended September 30, 2017 and 2016 was $961,799 and $666,414, respectively. The increase in operating expenses from 2016 to 2017 can be attributed to the increase in payroll expenses from 2016 to 2017 ($160,500 for the three months ended September 30, 2016 versus $436,319 for the three months ended September 30, 2017), attributable to the settlement of prior payroll obligations with the issuance of stock; and the increase in restricted stock units granted from 2016 to 2017 ($169,650 for the three months ended September 30, 2017 versus $0 for the three months ended September 30, 2016). The increase in operating expenses was partially offset by a decrease in sales and marketing expense from 2016 to 2017 ($65,995 for the three months ended September 30, 2016 versus $52,620 for the three months ended September 30, 2017); a decrease in stock options granted from 2016 to 2017 ($27,427 for the three months ended September 30, 2016 versus $24,283 for the three months ended September 30, 2017); a decrease in professional fees from 2016 to 2017 ($265,497 for the three months ended September 30, 2016 versus $212,878 for the three months ended September 30, 2017); and the decrease in general and administrative expense ($146,257 for the three months ended September 30, 2016 versus $66,973 for the three months ended September 30, 2017). The main contributors to the decrease in general and administrative expense was a decrease in loan fees ($0 for the three months ended September 30, 2017 versus $8,663 for the three months ended September 30, 2016); rent ($0 for the three months ended September 30, 2017 versus $4,500 for the three months ended September 30, 2016); and a decrease in research expense ($43,758 for the three months ended September 30, 2017 versus $102,691 for the three months ended September 30, 2016). 17 -- Non-Operating Income (Expense) Non-operating income (expense) for the three months ended September 30, 2017 and 2016 consists of the following: | Three months ended September 30, 2017 | | | Three months ended September 30, 2016 | ---------------------------------------+----------------------------------------+----------+---+---------------------------------------+-- Interest expense | $ | (527,188 | ) | | $ | (85,830 | ) ---------------------------------------+----------------------------------------+----------+---+---------------------------------------+---+----------+-- Net gain on sale of assets | | - | | | | - | ---------------------------------------+----------------------------------------+----------+---+---------------------------------------+---+----------+-- Net gain (loss) on settlement of debt | | - | | | | (111,328 | ) ---------------------------------------+----------------------------------------+----------+---+---------------------------------------+---+----------+-- Net gain (loss) on debt extinguishment | | (369,428 | ) | | | - | ---------------------------------------+----------------------------------------+----------+---+---------------------------------------+---+----------+-- Loss on sale of stock | | - | | | | (54,561 | ) ---------------------------------------+----------------------------------------+----------+---+---------------------------------------+---+----------+-- Gain (loss) on derivative liability | | 9 | | | | 762,151 | ---------------------------------------+----------------------------------------+----------+---+---------------------------------------+---+----------+-- | $ | (896,607 | ) | | $ | (510,432 | ) ---------------------------------------+----------------------------------------+----------+---+---------------------------------------+---+----------+-- Non-operating income (expense) increased during the three months ended September 30, 2017, when compared to the three months ended September 30, 2016. This increase is primarily due to an increase in interest expense from $85,830 for the three months ended September 30, 2016 to $527,188 for the three months ended September 30, 2017; and an increase in loss on debt extinguishment for the three months ended September 30, 2017 of $369,428 versus $0 for the three months ended September 30, 2016. These increases were offset by a decrease in the gain on derivative liability of $762,151 for the three months ended September 30, 2016 versus a gain of $9 for the three months ended September 30, 2017; and a decrease in loss on settlement of debt for the three months ended September 30, 2017 of $0 versus a loss of $111,328 for the three months ended September 30, 2016. Net Loss Our net income (loss) for the three months ended September 30, 2017 and 2016 was $1,858,406 and $155,982 respectively. Comparison of the Nine Months Ended September 30, 2017 and 2016 The following table sets forth information from our statements of operations for the nine months ended September 30, 2017 and 2016. | Nine Months Ended September 30, 2017 | | | Nine Months Ended September 30, 2016 | ---------------------------------------+---------------------------------------+------------+---+---------------------------------------+-- Revenues | $ | 4,054 | | | $ | 8,108 | ---------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+-------------+-- Operating expenses | | 1,949,739 | | | | 4,575,904 | ---------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+-------------+-- Operating loss | | (1,945,685 | ) | | | (4,567,796 | ) ---------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+-------------+-- Non-operating income (expense) | | | | | | | ---------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+-------------+-- Interest expense | | (1,836,279 | ) | | | (535,563 | ) ---------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+-------------+-- Net gain on sale of assets | | 2,800 | | | | - | ---------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+-------------+-- Net gain (loss) on settlement of debt | | - | | | | (1,877,959 | ) ---------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+-------------+-- Net gain (loss) on debt extinguishment | | (423,291 | ) | | | - | ---------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+-------------+-- Loss on sale of stock | | - | | | | (54,561 | ) ---------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+-------------+-- Gain (loss) on derivative liability | | 408,488 | | | | (3,108,889 | ) ---------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+-------------+-- Net Gain (Loss) | $ | (3,793,967 | ) | | $ | (10,144,768 | ) ---------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+-------------+-- 18 -- Revenue Revenue was $4,054 for the nine months ended September 30, 2017, compared to $8,108 for the nine months ended September 30, 2016, a period over period decrease of $4,054. The decrease was a result of a loss of consulting revenue, which was our only source of revenue during the nine months ended September 30, 2016 and 2017. Consulting revenue consists of providing clients with assistance in strategic targetry services, and research into production of radiopharmaceuticals and the operations of radioisotope production facilities. No proprietary information belonging to our Company is shared during the process of this consulting. Consulting services had been our only source of revenue. The Company does not have any current contracts or arrangements for consulting services, and, until such time as the Company secures contracts or arrangements to provide consulting services, the Company does not expect to generate any additional revenue during the fourth quarter of 2017 and beyond. Management does not anticipate that the Company will generate revenue sufficient to sustain operations until such time as the Company secures revenue-generating arrangements with respect to RadioGel™ and/or any of our other brachytherapy technologies. Operating Expense Operating expenses for the nine months ended September 30, 2017 and 2016 consists of the following: | Nine months ended September 30, 2017 | | Nine months ended September 30, 2016 | --------------------------------------+--------------------------------------+-----------+--------------------------------------+-- Depreciation and amortization expense | $ | - | | $ | 2,212 --------------------------------------+--------------------------------------+-----------+--------------------------------------+---+---------- Professional fees | | 642,101 | | | 1,968,084 --------------------------------------+--------------------------------------+-----------+--------------------------------------+---+---------- Restricted stock units granted | | 169,650 | | | - --------------------------------------+--------------------------------------+-----------+--------------------------------------+---+---------- Stock options granted | | 79,582 | | | 612,343 --------------------------------------+--------------------------------------+-----------+--------------------------------------+---+---------- Payroll expenses | | 722,594 | | | 492,077 --------------------------------------+--------------------------------------+-----------+--------------------------------------+---+---------- General and administrative expenses | | 240,469 | | | 1,287,649 --------------------------------------+--------------------------------------+-----------+--------------------------------------+---+---------- Sales and marketing expense | | 93,870 | | | 213,539 --------------------------------------+--------------------------------------+-----------+--------------------------------------+---+---------- | $ | 1,949,739 | | $ | 4,575,904 --------------------------------------+--------------------------------------+-----------+--------------------------------------+---+---------- Operating expenses for the nine months ended September 30, 2017 and 2016 was $1,949,739 and $4,575,904, respectively. The decrease in operating expenses from 2016 to 2017 can be attributed to the decrease in professional fees expense ($1,968,084 for the nine months ended September 30, 2016 versus $642,101 for the nine months ended September 30, 2017); a decrease in sales and marketing expense from 2016 to 2017 ($213,539 for the nine months ended September 30, 2016 versus $93,870 for the nine months ended September 30, 2017); a decrease in stock options granted from 2016 to 2017 ($612,343 for the nine months ended September 30, 2016 versus $79,582 for the nine months ended September 30, 2017); and the decrease in general and administrative expense ($1,287,649 for the nine months ended September 30, 2016 versus $240,469 for the nine months ended September 30, 2017). The main contributors to the decrease in general and administrative expense was a decrease in loan fees ($603,861 for the nine months ended September 30, 2016 versus $0 for the nine months ended September 30, 2017); rent ($53,500 for the nine months ended September 30, 2016 versus $4,500 for the nine months ended September 30, 2017); repairs and maintenance ($226,655 for the nine months ended September 30, 2016 versus $5,050 for the nine months ended September 30, 2017); and research expense ($309,539 for the nine months ended June 30, 2016 versus $157,168 for the nine months ended September 30, 2017). The decrease in operating expenses was partially offset by an increase in restricted stock units granted (($169,650 for the nine months ended September 30, 2017 versus $0 for the nine months ended September 30, 2016). Non-Operating Income (Expense) Non-Operating income (expense) for the nine months ended September 30, 2017 and 2016 consists of the following: | Nine months ended September 30, 2017 | | | Nine months ended September 30, 2016 | ---------------------------------------+--------------------------------------+------------+---+--------------------------------------+-- Interest expense | $ | (1,836,279 | ) | | $ | (535,563 | ) ---------------------------------------+--------------------------------------+------------+---+--------------------------------------+---+------------+-- Net gain on sale of assets | | 2,800 | | | | - | ---------------------------------------+--------------------------------------+------------+---+--------------------------------------+---+------------+-- Net gain (loss) on settlement of debt | | - | | | | (1,877,959 | ) ---------------------------------------+--------------------------------------+------------+---+--------------------------------------+---+------------+-- Net gain (loss) on debt extinguishment | | (423,291 | ) | | | - | ---------------------------------------+--------------------------------------+------------+---+--------------------------------------+---+------------+-- Loss on sale of stock | | - | | | | (54,561 | ) ---------------------------------------+--------------------------------------+------------+---+--------------------------------------+---+------------+-- Gain (loss) on derivative liability | | 408,488 | | | | (3,108,889 | ) ---------------------------------------+--------------------------------------+------------+---+--------------------------------------+---+------------+-- | $ | (1,848,282 | ) | | $ | (5,576,972 | ) ---------------------------------------+--------------------------------------+------------+---+--------------------------------------+---+------------+-- 19 -- The Company had non-operating expense of $5,576,972 during the nine months ended September 30, 2016, as compared to non-operating expense of $1,848,282 during the nine months ended September 30, 2017. As shown above, this decrease in non-operating expense is primarily due to a loss on derivative liability of $3,108,889 for the nine months ended September 30, 2016, as compared to a gain of $408,488 during the same period in 2017. The $3,108,889 loss on derivative liability was due to an increase in the Company’s stock price from September 30, 2016 ($0.02) to September 30, 2017 ($0.07) and an increase in preferred shares value which is also used to value derivatives. The Company’s stock price is used in the Black Scholes calculations to compute the derivative liability at the end of the quarter. Additionally, the Company experienced a decrease in non-operating expense due to a loss on settlement of debt of $1,877,959 for the nine months ended September 30, 2016, as compared to a loss on settlement of debt of $0 for the nine months ended September 30, 2017. Net Gain (Loss) Our net income (loss) for the nine months ended September 30, 2017 and 2016 was $(3,793,967) and $(10,144,168) respectively. Liquidity and Capital Resources At September 30, 2017, the Company had negative working capital of $3,543,907, as compared to $4,126,519 at September 30, 2016. During the nine months ended September 30, 2017 the Company experienced negative cash flow from operations of $1,124,282, received $2,800 for investing activities and added $1,115,703 of cash flows from financing activities. As of September 30, 2017, the Company had $0 commitments for capital expenditures. Cash used in operating activities decreased from $1,645,825 for the nine month period ending September 30, 2016 to $1,124,282 for the nine month period ending September 30, 2017. Cash used in operating activities was primarily a result of the Company’s net loss and the non-cash gain (loss) on derivative liability, partially offset by non-cash item amortization of convertible debt discount, and depreciation, included in that net loss and preferred and common stock issued for services and other expenses. The Company had no cash used in investing activities for the nine month period ended September 30, 2017 and received $2,800 in investing activities for the nine month period ending September 30, 2017. Cash provided from financing activities decreased from $1,466,808 for the nine month period ending September 30, 2016 to $1,124,282 for the nine month period ending September 30, 2017. The decrease in cash provided from financing activities was primarily a result of decrease in proceeds from convertible debt. The Company has generated material operating losses since inception. The Company had a net loss of $3,793,967 for the nine months ended September 30, 2017, and $10,144,168 for the nine months ended September 30, 2016. The Company expects to continue to experience net operating losses. Historically, the Company has relied upon investor funds to maintain its operations and develop the Company’s business. The Company anticipates raising additional capital within the next twelve months from investors for working capital as well as business expansion, although the Company can provide no assurance that additional investor funds will be available on terms acceptable to the Company. If the Company is unable to obtain additional financing to meet its working capital requirements, it may have to curtail its business. The Company anticipates raising additional capital within the next twelve months from investors for working capital as well as business expansion, although the Company can provide no assurance that additional investor funds will be available on terms acceptable to the Company. If the Company is unable to obtain additional financing to meet its working capital requirements, it may have to cease operations. 20 -- The Company requires at least $1.5 million per year to maintain current operating activities. Over the next 12-24 months, the Company believes it will cost approximately $5 million to $10 million to fund: (1) the FDA approval process and initial deployment of the brachytherapy products and (2) initiate regulatory approval processes outside of the United States. The continued deployment of the brachytherapy products and a worldwide regulatory approval effort will require additional resources and personnel. The principal variables in the timing and amount of spending for the brachytherapy products in the next 12-24 months will be the FDA’s classification of the Company’s brachytherapy products as Class II or Class III devices (or otherwise) and any requirements for additional studies which may possibly include clinical studies. Thereafter, the principal variables in the amount of the Company’s spending and its financing requirements would be the timing of any approvals and the nature of the Company’s arrangements with third parties for manufacturing, sales, distribution and licensing of those products and the products’ success in the U.S. and elsewhere. The Company intends to fund its activities through strategic transactions such as licensing and partnership agreements or additional capital raises. Although the Company is seeking the foregoing funding and has engaged in numerous discussions with potential finders, investment bankers and investors with respect to the initial portion thereof, the Company has not received firm commitments for the required funding. Based upon its discussions, the Company anticipates that if the Company is able to obtain the funding required to retire outstanding debt, pay past due payables and maintain its current operating activities that the terms thereof will be materially dilutive to existing shareholders. The recent economic events, including the inherent instability and volatility in global capital markets, as well as the lack of liquidity in the capital markets, could impact the Company’s ability to obtain financing and its ability to execute its business plan. The Company believes healthcare institutions will continue to purchase the medical solutions that it distributes. Accounting Policies and Estimates The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the unaudited condensed financial statements and accompanying notes. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results could differ from these estimates under different assumptions or conditions. During the period ended September 30, 2017, we believe there have been no significant changes to the items disclosed as significant accounting policies in management’s notes to the condensed financial statements in our Annual Report on Form 10-K for the year ended December 31, 2016, filed on March 9, 2017. Off-Balance Sheet Arrangements The Company does not have any off balance sheet arrangements that are reasonably likely to have a current or future effect on the Company’s financial condition, revenues, results of operations, liquidity or capital expenditures. Item 3. Quantitative and Qualitative Disclosures About Market Risk. This item is not applicable to us because we are a smaller reporting company as defined by Rule 12b-2 under the Securities Exchange Act of 1934. Item 4. Controls and Procedures. Disclosure Controls and Procedures Based on an evaluation as of the date of the end of the period covered by this report, the Company’s Chief Executive Officer and Chief Financial Officer conducted an evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures, as required by Exchange Act Rule 13a-15. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that, because of the previously disclosed material weaknesses in the Company’s internal control over financial reporting, the Company’s disclosure controls and procedures were ineffective as of the end of the period covered by this report to ensure that information required to be disclosed by the Company in the reports that the Company files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified by the SEC’s rules and forms. Disclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in the Company’s reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in the Company’s reports filed under the Exchange Act is accumulated and communicated to management, including the Company’s Chief Executive Officer and the Company’s Chief Financial Officer, to allow timely decisions regarding required disclosure. 21 -- Changes in Internal Control Over Financial Reporting There have been no changes in the Company’s internal control over financial reporting that occurred during the Company’s last fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. The term “internal control over financial reporting” is defined as a process designed by, or under the supervision of, the registrant’s principal executive and principal financial officers, or persons performing similar functions, and effected by the registrant’s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that: (a) | Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the registrant; ----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (b) | Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the registrant are being made only in accordance with authorizations of management and directors of the registrant; and ----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (c) | Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the registrant’s assets that could have a material effect on the financial statements. ----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- PART II Item 1. Legal Proceedings On March 6, 2015, Robert and Maribeth Myers filed a lawsuit against the Company and BancLeasing, Inc., owner of a linear accelerator and other equipment leased by the Company, in the Superior Court of the State of Washington, in and for Benton County (Case No. 15-2-0054101), asserting various claims related to the Company’s five-year lease of production center space owned by Mr. and Mrs. Myers. The Company subsequently filed counterclaims against Mr. and Mrs. Myers, BancLeasing and Washington Trust Bank, alleging misapplication of lease payments to the principal loan amount for a linear accelerator and other equipment stored on the production center property, as well as certain building improvements made by the Company. During 2016, the Company entered into a Settlement Agreement with Robert and Maribeth Myers, pursuant to which the Company agreed to pay a settlement amount of $438,830 in exchange for the release of all claims related to the matter, which amount was paid by the Company during the year ended December 31, 2016. In 2016, the Company was awarded in the Superior Court of the State of Washington a total sum of $527,876 against BancLeasing. The Company is pursuing its options for collection of the awarded amount, however there can be no assurance as to any eventual collection. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds. During the nine months ending September 30, 2017 the Company issued 743,699 shares of its Series A Preferred as loan fees on Debentures totaling $3,019,256 of Debentures. During the nine months ending September 30, 2017 the Company issued 1,298,677 common shares in satisfaction of $232,481 of accounts payable. During the nine months ending September 30, 2017 the Company issued 2,100,000 common shares and 160,000 Series A Preferred shares in satisfaction of $272,164 of accrued payroll. During the nine months ending September 30, 2017 the Company issued 183,279 Series A Preferred shares in satisfaction of $115,587 of accrued payroll and $67,692 of accounts payable owed to officers of the Company. 22 -- During the nine months ending September 30, 2017 the Company issued 3,040,239 common shares in satisfaction of $358,860 of convertible note payable including $36,479 of accrued interest, resulting in a $134,487 net loss on debt extinguishment. During the nine months ending September 30, 2017 the Company issued 1,918,750 common shares for services valued at $226,160. In connection with the above stock sales, we did not pay any underwriting discounts or commissions. None of the sales of securities described or referred to above was registered under the Securities Act of 1933, as amended (the “Securities Act”). We had or one of our affiliates had a prior business relationship with each of the purchasers, and no general solicitation was used in connection with the sales. In making the sales without registration under the Securities Act, we relied upon the exemption from registration contained in Section 4(a)(2) of the Securities Act. Item 6. Exhibits. Exhibit | --------+-------------------------------------------------------------------------------------------------------- Number | Description --------+-------------------------------------------------------------------------------------------------------- 31.1 | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes – Oxley Act of 2002 --------+-------------------------------------------------------------------------------------------------------- 31.2 | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes – Oxley Act of 2002 --------+-------------------------------------------------------------------------------------------------------- 32.1 | Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350 --------+-------------------------------------------------------------------------------------------------------- 101.INS | XBRL Instance Document --------+-------------------------------------------------------------------------------------------------------- 101.SCH | XBRL Taxonomy Extension Schema --------+-------------------------------------------------------------------------------------------------------- 101.CAL | XBRL Taxonomy Extension Calculation Linkbase --------+-------------------------------------------------------------------------------------------------------- 101.DEF | XBRL Taxonomy Extension Definition Linkbase --------+-------------------------------------------------------------------------------------------------------- 101.LAB | XBRL Taxonomy Extension Label Linkbase --------+-------------------------------------------------------------------------------------------------------- 101.PRE | XBRL Taxonomy Extension Presentation Linkbase --------+-------------------------------------------------------------------------------------------------------- 23 -- SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized. | ADVANCED MEDICAL ISOTOPE CORPORATION ----------------------------+----------------------------------------- Date: November 13, 2017 | By: | /s/ Michael Korenko ----------------------------+------------------------------------------+----------------------------------------- | Name: | Michael Korenko ----------------------------+------------------------------------------+----------------------------------------- | Title: | Chairman and Chief Executive Officer ----------------------------+------------------------------------------+----------------------------------------- | | (Principal Executive Officer) ----------------------------+------------------------------------------+----------------------------------------- Date: November 13, 2017 | By: | /s/ L. Bruce Jolliff ----------------------------+--------+------------------------------------------------- | Name: | L. Bruce Jolliff ----------------------------+--------+------------------------------------------------- | Title: | Chief Financial Officer ----------------------------+--------+------------------------------------------------- | | (Principal Financial and Accounting Officer) ----------------------------+--------+------------------------------------------------- 24 --

AEI INCOME & GROWTH FUND 24 LLC

1130758

10-Q

0001130758-17-000057

UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended: September 30, 2017 Commission File Number: 000-49653 AEI INCOME & GROWTH FUND 24 LLC (Exact name of registrant as specified in its charter) State of Delaware | 41-1990952 ---------------------------------------------------------------+------------------------------------- (State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) ---------------------------------------------------------------+------------------------------------- 30 East 7th Street, Suite 1300 St. Paul, Minnesota 55101 | (651) 227-7333 ---------------------------------------------------------------+------------------------------------- (Address of principal executive offices) | (Registrant's telephone number) ---------------------------------------------------------------+------------------------------------- Not Applicable ---------------------------------------------------------------------------------- (Former name, former address and former fiscal year, if changed since last report) ---------------------------------------------------------------------------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. ☒ Yes ☐ No Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). ☒ Yes ☐ No Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. ☐ Large accelerated filer | ☐ Accelerated filer --------------------------+---------------------------- ☐ Non-accelerated filer | ☒ Smaller reporting company --------------------------+---------------------------- ☐ Emerging growth company | --------------------------+---------------------------- If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ☐ Yes ☒ No AEI INCOME & GROWTH FUND 24 LLC INDEX | | Page -------------------------------+----------+-------------------------------------------------------------- Part I – Financial Information | -------------------------------+--------- | Item 1. | Financial Statements: | -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | | Balance Sheets as of September 30, 2017 and December 31, 2016 | 3 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | | Statements for the Periods ended September 30, 2017 and 2016: | -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | | | Income | 4 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------+-------- | | | Cash Flows | 5 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------+-------- | | | Changes in Members' Equity (Deficit) | 6 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------+-------- | | Notes to Financial Statements | 7 - 9 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | Item 2. | Management's Discussion and Analysis of Financial | -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | | | Condition and Results of Operations | 10 - 14 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------+-------- | Item 3. | Quantitative and Qualitative Disclosures About Market Risk | 14 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | Item 4. | Controls and Procedures | 14 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- Part II – Other Information | -------------------------------+--------- | Item 1. | Legal Proceedings | 15 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | Item 1A. | Risk Factors | 15 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | 15 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | Item 3. | Defaults Upon Senior Securities | 15 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | Item 4. | Mine Safety Disclosures | 15 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | Item 5. | Other Information | 15 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | Item 6. | Exhibits | 16 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- Signatures | 16 -------------------------------+--------- Page 2 of 16 AEI INCOME & GROWTH FUND 24 LLC BALANCE SHEETS ASSETS | September 30, | | | December 31, | ------------------------------------------+---------------+------------+---+--------------+-- | 2017 | | | 2016 | ------------------------------------------+---------------+------------+---+--------------+-- | (unaudited) | | | | ------------------------------------------+---------------+------------+---+--------------+-- Current Assets: | | | | | ------------------------------------------+---------------+------------+---+--------------+-- Cash | $ | 1,263,767 | | | $ | 1,320,236 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Real Estate Investments: | | | | | | | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Land | | 4,934,814 | | | | 4,934,814 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Buildings | | 12,213,592 | | | | 12,175,342 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Acquired Intangible Lease Assets | | 1,207,484 | | | | 1,207,484 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Real Estate Held for Investment, at cost | | 18,355,890 | | | | 18,317,640 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Accumulated Depreciation and Amortization | | (4,518,275 | ) | | | (4,058,525 | ) ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Real Estate Held for Investment, Net | | 13,837,615 | | | | 14,259,115 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Total Assets | $ | 15,101,382 | | | $ | 15,579,351 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- LIABILITIES AND MEMBERS' EQUITY Current Liabilities: | | | | -----------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+-- Payable to AEI Fund Management, Inc. | $ | 86,332 | | $ | 66,539 | -----------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Distributions Payable | | 307,732 | | | 308,862 | -----------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Unearned Rent | | 19,654 | | | 9,620 | -----------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Total Current Liabilities | | 413,718 | | | 385,021 | -----------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Members' Equity (Deficit): | | | | | | -----------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Managing Members | | (49,492 | ) | | (35,707 | ) -----------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Limited Members – 50,000 Units authorized; 23,806 and 23,928 Units issued and outstanding as of 9/30/17 and 12/31/16, respectively | | 14,737,156 | | | 15,230,037 | -----------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Total Members' Equity | | 14,687,664 | | | 15,194,330 | -----------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Total Liabilities and Members' Equity | $ | 15,101,382 | | $ | 15,579,351 | -----------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- The accompanying Notes to Financial Statements are an integral part of these statements. Page 3 of 16 AEI INCOME & GROWTH FUND 24 LLC STATEMENTS OF INCOME (unaudited) | Three Months Ended September 30 | | Nine Months Ended September 30 | ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+-- | 2017 | | 2016 | | | 2017 | | 2016 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------- Rental Income | $ | 348,554 | | $ | 343,592 | | $ | 1,045,065 | $ | 1,029,820 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Expenses: | | | | | | | | | | ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- LLC Administration – Affiliates | | 28,558 | | | 42,277 | | | 110,411 | | 133,361 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- LLC Administration and Property Management – Unrelated Parties | | 3,298 | | | 6,170 | | | 20,159 | | 33,438 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Depreciation and Amortization | | 142,304 | | | 141,347 | | | 424,998 | | 424,041 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Total Expenses | | 174,160 | | | 189,794 | | | 555,568 | | 590,840 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Operating Income | | 174,394 | | | 153,798 | | | 489,497 | | 438,980 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Other Income: | | | | | | | | | | ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Interest Income | | 866 | | | 939 | | | 2,661 | | 2,866 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Net Income | $ | 175,260 | | $ | 154,737 | | $ | 492,158 | $ | 441,846 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Net Income Allocated: | | | | | | | | | | ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Managing Members | $ | 5,258 | | $ | 4,642 | | $ | 14,765 | $ | 13,255 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Limited Members | | 170,002 | | | 150,095 | | | 477,393 | | 428,591 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Total | $ | 175,260 | | $ | 154,737 | | $ | 492,158 | $ | 441,846 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Net Income per LLC Unit | $ | 7.14 | | $ | 6.26 | | $ | 20.02 | $ | 17.86 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Weighted Average Units Outstanding – Basic and Diluted | | 23,806 | | | 23,958 | | | 23,847 | | 23,998 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- The accompanying Notes to Financial Statements are an integral part of these statements. Page 4 of 16 AEI INCOME & GROWTH FUND 24 LLC STATEMENTS OF CASH FLOWS (unaudited) | Nine Months Ended September 30 | ----------------------------------------------------------------------------------+--------------------------------+---------- | 2017 | | | 2016 | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+-- Cash Flows from Operating Activities: | | | | | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+-- Net Income | $ | 492,158 | | | $ | 441,846 | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Adjustments to Reconcile Net Income To Net Cash Provided by Operating Activities: | | | | | | | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Depreciation and Amortization | | 459,750 | | | | 458,793 | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Increase (Decrease) in Payable to AEI Fund Management, Inc. | | 19,793 | | | | (12,775 | ) ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Increase (Decrease) in Unearned Rent | | 10,034 | | | | 45,640 | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Total Adjustments | | 489,577 | | | | 491,658 | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Net Cash Provided By (Used For) Operating Activities | | 981,735 | | | | 933,504 | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Cash Flows from Investing Activities: | | | | | | | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Investments in Real Estate | | (38,250 | ) | | | 0 | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Payments Received on Note Receivable | | 0 | | | | 50,826 | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Net Cash Provided By (Used For) Investing Activities | | (38,250 | ) | | | 50,826 | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Cash Flows from Financing Activities: | | | | | | | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Distributions Paid to Members | | (924,415 | ) | | | (923,255 | ) ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Repurchase of LLC Units | | (75,539 | ) | | | (78,493 | ) ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Net Cash Provided By (Used For) Financing Activities | | (999,954 | ) | | | (1,001,748 | ) ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Net Increase (Decrease) in Cash | | (56,469 | ) | | | (17,418 | ) ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Cash, beginning of period | | 1,320,236 | | | | 1,406,324 | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Cash, end of period | $ | 1,263,767 | | | $ | 1,388,906 | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- The accompanying Notes to Financial Statements are an integral part of these statements. Page 5 of 16 AEI INCOME & GROWTH FUND 24 LLC STATEMENTS OF CHANGES IN MEMBERS' EQUITY (DEFICIT) (unaudited) | Managing Members | | | Limited Members | | | Total | | Limited Member Units Outstanding | ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+-- Balance, December 31, 2015 | $ | (16,248 | ) | | $ | 15,933,297 | | $ | 15,917,049 | | 24,077.98 | ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+---+-----------+-- Distributions Declared | | (25,961 | ) | | | (900,002 | ) | | (925,963 | ) | | ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+---+-----------+-- Repurchase of LLC Units | | (2,355 | ) | | | (76,138 | ) | | (78,493 | ) | (119.50 | ) ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+---+-----------+-- Net Income | | 13,255 | | | | 428,591 | | | 441,846 | | | ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+---+-----------+-- Balance, September 30, 2016 | $ | (31,309 | ) | | $ | 15,385,748 | | $ | 15,354,439 | | 23,958.48 | ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+---+-----------+-- Balance, December 31, 2016 | $ | (35,707 | ) | | $ | 15,230,037 | | $ | 15,194,330 | | 23,928.48 | ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+---+-----------+-- Distributions Declared | | (26,284 | ) | | | (897,001 | ) | | (923,285 | ) | | ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+---+-----------+-- Repurchase of LLC Units | | (2,266 | ) | | | (73,273 | ) | | (75,539 | ) | (122.40 | ) ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+---+-----------+-- Net Income | | 14,765 | | | | 477,393 | | | 492,158 | | | ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+---+-----------+-- Balance, September 30, 2017 | $ | (49,492 | ) | | $ | 14,737,156 | | $ | 14,687,664 | | 23,806.08 | ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+---+-----------+-- The accompanying Notes to Financial Statements are an integral part of these statements. Page 6 of 16 AEI INCOME & GROWTH FUND 24 LLC NOTES TO FINANCIAL STATEMENTS SEPTEMBER 30, 2017 (unaudited) (1) The condensed statements included herein have been prepared by the registrant, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission, and reflect all adjustments which are, in the opinion of management, necessary to a fair statement of the results of operations for the interim period, on a basis consistent with the annual audited statements. The adjustments made to these condensed statements consist only of normal recurring adjustments. Certain information, accounting policies, and footnote disclosures normally included in financial statements prepared in accordance with United States Generally Accepted Accounting Principles (US GAAP) have been condensed or omitted pursuant to such rules and regulations, although the registrant believes that the disclosures are adequate to make the information presented not misleading. It is suggested that these condensed financial statements be read in conjunction with the financial statements and the summary of significant accounting policies and notes thereto included in the registrant's latest annual report on Form 10‑K. (2) Organization – AEI Income & Growth Fund 24 LLC ("Company"), a Limited Liability Company, was formed on November 21, 2000 to acquire and lease commercial properties to operating tenants. The Company's operations are managed by AEI Fund Management XXI, Inc. ("AFM"), the Managing Member. Robert P. Johnson, the President and sole director of AFM, serves as the Special Managing Member. AFM is a wholly owned subsidiary of AEI Capital Corporation of which Mr. Johnson is the majority shareholder. AEI Fund Management, Inc. ("AEI"), an affiliate of AFM, performs the administrative and operating functions for the Company. The terms of the offering called for a subscription price of $1,000 per LLC Unit, payable on acceptance of the offer. The Company commenced operations on October 31, 2001 when minimum subscriptions of 1,500 LLC Units ($1,500,000) were accepted. The offering terminated May 17, 2003 when the extended offering period expired. The Company received subscriptions for 24,831.283 Units. Under the terms of the Operating Agreement, the Limited Members and Managing Members contributed funds of $24,831,283 and $1,000, respectively. The Company shall continue until December 31, 2051, unless dissolved, terminated and liquidated prior to that date. During operations, any Net Cash Flow, as defined, which the Managing Members determine to distribute will be distributed 97% to the Limited Members and 3% to the Managing Members. Distributions to Limited Members will be made pro rata by Units. Page 7 of 16 AEI INCOME & GROWTH FUND 24 LLC NOTES TO FINANCIAL STATEMENTS (Continued) (2) Organization – (Continued) Any Net Proceeds of Sale, as defined, from the sale or financing of properties which the Managing Members determine to distribute will, after provisions for debts and reserves, be paid in the following manner: (i) first, 99% to the Limited Members and 1% to the Managing Members until the Limited Members receive an amount equal to: (a) their Adjusted Capital Contribution plus (b) an amount equal to 7% of their Adjusted Capital Contribution per annum, cumulative but not compounded, to the extent not previously distributed from Net Cash Flow; (ii) any remaining balance will be distributed 90% to the Limited Members and 10% to the Managing Members. Distributions to the Limited Members will be made pro rata by Units. For tax purposes, profits from operations, other than profits attributable to the sale, exchange, financing, refinancing or other disposition of property, will be allocated 97% to the Limited Members and 3% to the Managing Members. Net losses from operations will be allocated 99% to the Limited Members and 1% to the Managing Members. For tax purposes, profits arising from the sale, financing, or other disposition of property will be allocated in accordance with the Operating Agreement as follows: (i) first, to those Members with deficit balances in their capital accounts in an amount equal to the sum of such deficit balances; (ii) second, 99% to the Limited Members and 1% to the Managing Members until the aggregate balance in the Limited Members' capital accounts equals the sum of the Limited Members' Adjusted Capital Contributions plus an amount equal to 7% of their Adjusted Capital Contributions per annum, cumulative but not compounded, to the extent not previously allocated; (iii) third, the balance of any remaining gain will then be allocated 90% to the Limited Members and 10% to the Managing Members. Losses will be allocated 99% to the Limited Members and 1% to the Managing Members. The Managing Members are not required to currently fund a deficit capital balance. Upon liquidation of the Company or withdrawal by a Managing Member, the Managing Members will contribute to the Company an amount equal to the lesser of the deficit balances in their capital accounts or 1.01% of the total capital contributions of the Limited Members over the amount previously contributed by the Managing Members. (3) Real Estate Investments – In April 2017, the Company entered into an agreement with the tenant of the Fresenius Medical Center in Shreveport, Louisiana to extend the lease term nine years to expire on June 30, 2027. The annual rent will remain the same throughout the remainder of the extended lease term. As part of the agreement, the Company paid a tenant improvement allowance of $38,250 that was capitalized and will be depreciated. Page 8 of 16 AEI INCOME & GROWTH FUND 24 LLC NOTES TO FINANCIAL STATEMENTS (Continued) (4) Payable to AEI Fund Management, Inc. – AEI Fund Management, Inc. performs the administrative and operating functions for the Company. The payable to AEI Fund Management represents the balance due for those services. This balance is non-interest bearing and unsecured and is to be paid in the normal course of business. (5) Members' Capital – For the nine months ended September 30, 2017 and 2016, the Company declared distributions of $923,285 and $925,963, respectively. The Limited Members received distributions of $897,001 and $900,002 and the Managing Members received distributions of $26,284 and $25,961 for the periods, respectively. The Limited Members' distributions represented $37.61 and $37.50 per LLC Unit outstanding using 23,847 and 23,998 weighted average Units in 2017 and 2016, respectively. The distributions represented $16.94 and $14.68 per Unit of Net Income and $20.67 and $22.82 per Unit of return of contributed capital in 2017 and 2016, respectively. As part of the distributions discussed above, the Company distributed net sale proceeds (from property sales completed in 2014) of $70,707 and $90,909 in 2017 and 2016, respectively. The Limited Members received distributions of $70,000 and $90,000 and the Managing Members received distributions of $707 and $909 for the periods, respectively. The Limited Members' distributions represented $2.94 and $3.76 per Unit for the periods, respectively. On April 1, 2017, the Company repurchased a total of 122.40 Units for $73,273 from five Limited Members in accordance with the Operating Agreement. On April 1, 2016, the Company repurchased a total of 119.50 Units for $76,138 from two Limited Members. The Company acquired these Units using Net Cash Flow from operations. The repurchases increase the remaining Limited Members' ownership interest in the Company. As a result of these repurchases and pursuant to the Operating Agreement, the Managing Members received distributions of $2,266 and $2,355 in 2017 and 2016, respectively. (6) Fair Value Measurements – As of September 30, 2017 and December 31, 2016, the Company had no assets or liabilities measured at fair value on a recurring basis or nonrecurring basis. Page 9 of 16 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. This section contains "forward-looking statements" which represent management's expectations or beliefs concerning future events, including statements regarding anticipated application of cash, expected returns from rental income, growth in revenue, the sufficiency of cash to meet operating expenses, rates of distribution, and other matters. These, and other forward-looking statements, should be evaluated in the context of a number of factors that may affect the Company's financial condition and results of operations, including the following: — | Market and economic conditions which affect the value of the properties the Company owns and the cash from rental income such properties generate; --+--------------------------------------------------------------------------------------------------------------------------------------------------- — | the federal income tax consequences of rental income, deductions, gain on sales and other items and the effects of these consequences for Members; --+--------------------------------------------------------------------------------------------------------------------------------------------------- — | resolution by the Managing Members of conflicts with which they may be confronted; --+----------------------------------------------------------------------------------- — | the success of the Managing Members of locating properties with favorable risk return characteristics; --+------------------------------------------------------------------------------------------------------- — | the effect of tenant defaults; and --+----------------------------------- — | the condition of the industries in which the tenants of properties owned by the Company operate. --+------------------------------------------------------------------------------------------------- Application of Critical Accounting Policies The Company's financial statements have been prepared in accordance with US GAAP. Preparing the financial statements requires management to use judgment in the application of these accounting policies, including making estimates and assumptions. These judgments will affect the reported amounts of the Company's assets and liabilities and the disclosure of contingent assets and liabilities as of the dates of the financial statements and will affect the reported amounts of revenue and expenses during the reporting periods. It is possible that the carrying amount of the Company's assets and liabilities, or the results of reported operations, will be affected if management's estimates or assumptions prove inaccurate. Management of the Company evaluates the following accounting estimates on an ongoing basis, and has discussed the development and selection of these estimates and the management discussion and analysis disclosures regarding them with the managing member of the Company. Allocation of Purchase Price of Acquired Properties Upon acquisition of real properties, the Company records them in the financial statements at cost. The purchase price is allocated to tangible assets, consisting of land and building, and to identified intangible assets and liabilities, which may include the value of above market and below market leases and the value of in-place leases. The allocation of the purchase price is based upon the fair value of each component of the property. Although independent appraisals may be used to assist in the determination of fair value, in many cases these values will be based upon management's assessment of each property, the selling prices of comparable properties and the discounted value of cash flows from the asset. Page 10 of 16 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS. (Continued) The fair values of above market and below market in-place leases will be recorded based on the present value (using an interest rate which reflects the risks associated with the leases acquired) of the difference between (i) the contractual amounts to be paid pursuant to the in-place leases and (ii) an estimate of fair market lease rates for the corresponding in-place leases measured over a period equal to the non-cancelable term of the lease including any bargain renewal periods. The above market and below market lease values will be capitalized as intangible lease assets or liabilities. Above market lease values will be amortized as an adjustment of rental income over the remaining term of the respective leases. Below market lease values will be amortized as an adjustment of rental income over the remaining term of the respective leases, including any bargain renewal periods. If a lease were to be terminated prior to its stated expiration, all unamortized amounts of above market and below market in-place lease values relating to that lease would be recorded as an adjustment to rental income. The fair values of in-place leases will include estimated direct costs associated with obtaining a new tenant, and opportunity costs associated with lost rentals which are avoided by acquiring an in-place lease. Direct costs associated with obtaining a new tenant may include commissions, tenant improvements, and other direct costs and are estimated, in part, by management's consideration of current market costs to execute a similar lease. These direct costs will be included in intangible lease assets on the balance sheet and will be amortized to expense over the remaining term of the respective leases. The value of opportunity costs will be calculated using the contractual amounts to be paid pursuant to the in-place leases over a market absorption period for a similar lease. These intangibles will be included in intangible lease assets on the balance sheet and will be amortized to expense over the remaining term of the respective leases. If a lease were to be terminated prior to its stated expiration, all unamortized amounts of in-place lease assets relating to that lease would be expensed. The determination of the fair values of the assets and liabilities acquired will require the use of significant assumptions with regard to the current market rental rates, rental growth rates, discount and capitalization rates, interest rates and other variables. If management's estimates or assumptions prove inaccurate, the result would be an inaccurate allocation of purchase price, which could impact the amount of reported net income. Carrying Value of Properties Properties are carried at original cost, less accumulated depreciation and amortization. The Company tests long-lived assets for recoverability when events or changes in circumstances indicate that the carrying value may not be recoverable. For properties the Company will hold and operate, management determines whether impairment has occurred by comparing the property's probability-weighted future undiscounted cash flows to its current carrying value. For properties held for sale, management determines whether impairment has occurred by comparing the property's estimated fair value less cost to sell to its current carrying value. If the carrying value is greater than the net realizable value, an impairment loss is recorded to reduce the carrying value of the property to its net realizable value. Changes in these assumptions or analysis may cause material changes in the carrying value of the properties. Page 11 of 16 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS. (Continued) Allocation of Expenses AEI Fund Management, Inc. allocates expenses to each of the funds they manage primarily on the basis of the number of hours devoted by their employees to each fund's affairs. They also allocate expenses at the end of each month that are not directly related to a fund's operations based upon the number of investors in the fund and the fund's capitalization relative to other funds they manage. The Company reimburses these expenses subject to detailed limitations contained in the Operating Agreement. Results of Operations For the nine months ended September 30, 2017 and 2016, the Company recognized rental income of $1,045,065 and $1,029,820, respectively. In 2017, rental income increased due to rent increases on three properties. Based on the scheduled rent for the properties as of October 31, 2017, the Company expects to recognize rental income of approximately $1,394,000 and $1,397,000 in 2017 and 2018, respectively. For the nine months ended September 30, 2017 and 2016, the Company incurred LLC administration expenses from affiliated parties of $110,411 and $133,361, respectively. These administration expenses include costs associated with the management of the properties, processing distributions, reporting requirements and communicating with the Limited Members. During the same periods, the Company incurred LLC administration and property management expenses from unrelated parties of $20,159 and $33,438, respectively. These expenses represent direct payments to third parties for legal and filing fees, direct administrative costs, outside audit costs, taxes, insurance and other property costs. For the nine months ended September 30, 2017 and 2016, the Company recognized interest income of $2,661 and $2,866, respectively. Management believes inflation has not significantly affected income from operations. Leases may contain rent increases, based on the increase in the Consumer Price Index over a specified period, which will result in an increase in rental income over the term of the leases. Inflation also may cause the real estate to appreciate in value. However, inflation and changing prices may have an adverse impact on the operating margins of the properties' tenants, which could impair their ability to pay rent and subsequently reduce the Net Cash Flow available for distributions. Liquidity and Capital Resources During the nine months ended September 30, 2017, the Company's cash balances decreased $56,469 as a result of cash paid for a tenant improvement allowance, and distributions paid to the Members and cash used to repurchase Units in excess of cash generated from operating activities. During the nine months ended September 30, 2016, the Company's cash balances decreased $17,418 as a result of distributions paid to the Members and cash used to repurchase Units in excess of cash generated from operating activities, which was partially offset by a payment received on a note receivable. Page 12 of 16 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS. (Continued) Net cash provided by operating activities increased from $933,504 in 2016 to $981,735 in 2017 as a result of an increase in total rental and interest income in 2017 and a decrease in LLC administration and property management expenses in 2017, which were partially offset by net timing differences in the collection of payments from the tenants and the payment of expenses. The Company's primary use of cash flow, other than investment in real estate, is distribution payments to Members and cash used to repurchase Units. The Company declares its regular quarterly distributions before the end of each quarter and pays the distribution in the first week after the end of each quarter. The Company attempts to maintain a stable distribution rate from quarter to quarter. The Company may repurchase tendered Units on April 1st and October 1st of each year subject to limitations. For the nine months ended September 30, 2017 and 2016, the Company declared distributions of $923,285 and $925,963, respectively. Pursuant to the Operating Agreement, distributions of Net Cash Flow were allocated 97% to the Limited Members and 3% to the Managing Members. Distributions of Net Proceeds of Sale were allocated 99% to the Limited Members and 1% to the Managing Members. The Limited Members received distributions of $897,001 and $900,002 and the Managing Members received distributions of $26,284 and $25,961 for the periods, respectively. As part of the distributions discussed above, the Company distributed net sale proceeds (from property sales completed in 2014) of $70,707 and $90,909 in 2017 and 2016, respectively. The Limited Members received distributions of $70,000 and $90,000 and the Managing Members received distributions of $707 and $909 for the periods, respectively. The Limited Members' distributions represented $2.94 and $3.76 per Unit for the periods, respectively. The Company may repurchase Units from Limited Members who have tendered their Units to the Company. Such Units may be acquired at a discount. The Company will not be obligated to purchase in any year any number of Units that, when aggregated with all other transfers of Units that have occurred since the beginning of the same calendar year (excluding Permitted Transfers as defined in the Operating Agreement), would exceed 2% of the total number of Units outstanding on January 1 of such year. In no event shall the Company be obligated to purchase Units if, in the sole discretion of the Managing Member, such purchase would impair the capital or operation of the Company. On April 1, 2017, the Company repurchased a total of 122.40 Units for $73,273 from five Limited Members in accordance with the Operating Agreement. On April 1, 2016, the Company repurchased a total of 119.50 Units for $76,138 from two Limited Members. The Company acquired these Units using Net Cash Flow from operations. The repurchases increase the remaining Limited Members' ownership interest in the Company. As a result of these repurchases and pursuant to the Operating Agreement, the Managing Members received distributions of $2,266 and $2,355 in 2017 and 2016, respectively. Page 13 of 16 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS. (Continued) The continuing rent payments from the properties, together with cash generated from property sales, should be adequate to fund continuing distributions and meet other Company obligations on both a short-term and long-term basis. Off-Balance Sheet Arrangements As of September 30, 2017 and December 31, 2016, the Company had no material off-balance sheet arrangements that had or are reasonably likely to have current or future effects on its financial condition, results of operations, liquidity or capital resources. ITEM 3. QUANTITATIVE & QUALITATIVE DISCLOSURES ABOUT MARKET RISK. Not required for a smaller reporting company. ITEM 4. CONTROLS AND PROCEDURES. (a) Disclosure Controls and Procedures. Under the supervision and with the participation of management, including its President and Chief Financial Officer, the Managing Member of the Company evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the "Exchange Act")). Based upon that evaluation, the President and Chief Financial Officer of the Managing Member concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective in ensuring that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in applicable rules and forms and that such information is accumulated and communicated to management, including the President and Chief Financial Officer of the Managing Member, in a manner that allows timely decisions regarding required disclosure. (b) Changes in Internal Control Over Financial Reporting. During the most recent period covered by this report, there has been no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. Page 14 of 16 PART II – OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS. There are no material pending legal proceedings to which the Company is a party or of which the Company's property is subject. ITEM 1A. RISK FACTORS. Not required for a smaller reporting company. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES & USE OF PROCEEDS. (a) None. (b) Not applicable. (c) Pursuant to Section 7.7 of the Operating Agreement, each Limited Member has the right to present Units to the Company for purchase by submitting notice to the Managing Member during January or July of each year. The purchase price of the Units is equal to 80% of the net asset value per Unit, as of the first business day of January or July of each year, as determined by the Managing Member in accordance with the provisions of the Operating Agreement. Units tendered to the Company during January and July may be repurchased on April 1st and October 1st, respectively, of each year subject to the following limitations. The Company will not be obligated to purchase in any year any number of Units that, when aggregated with all other transfers of Units that have occurred since the beginning of the same calendar year (excluding Permitted Transfers as defined in the Operating Agreement), would exceed 2% of the total number of Units outstanding on January 1 of such year. In no event shall the Company be obligated to purchase Units if, in the sole discretion of the Managing Member, such purchase would impair the capital or operation of the Company. During the period covered by this report, the Company did not purchase any Units. ITEM 3. DEFAULTS UPON SENIOR SECURITIES. None. ITEM 4. MINE SAFETY DISCLOSURES. Not Applicable. ITEM 5. OTHER INFORMATION. None. Page 15 of 16 ITEM 6. EXHIBITS. 31.1 | Certification of Chief Executive Officer of Managing Member pursuant to Rule 15d-14(a)(17 CFR 240.15d-14(a)) and Section 302 of the Sarbanes-Oxley Act of 2002. -----+---------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.2 | Certification of Chief Financial Officer of Managing Member pursuant to Rule 15d-14(a)(17 CFR 240.15d-14(a)) and Section 302 of the Sarbanes-Oxley Act of 2002. -----+---------------------------------------------------------------------------------------------------------------------------------------------------------------- 32 | Certification of Chief Executive Officer and Chief Financial Officer of Managing Member pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. ---+--------------------------------------------------------------------------------------------------------------------------------------------------- SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Dated: November 13, 2017 | AEI Income & Growth Fund 24 LLC --------------------------+-------------------------------- | By: | AEI Fund Management XXI, Inc. --------------------------+---------------------------------+------------------------------- | Its: | Managing Member --------------------------+---------------------------------+------------------------------- | By: | /s/ ROBERT P JOHNSON --------------------------+---------------------------------+------------------------------- | | Robert P. Johnson --------------------------+---------------------------------+------------------------------- | | President --------------------------+---------------------------------+------------------------------- | | (Principal Executive Officer) --------------------------+---------------------------------+------------------------------- | By: | /s/ PATRICK W KEENE --------------------------+---------------------------------+------------------------------- | | Patrick W. Keene --------------------------+---------------------------------+------------------------------- | | Chief Financial Officer --------------------------+---------------------------------+------------------------------- | | (Principal Accounting Officer) --------------------------+---------------------------------+------------------------------- Page 16 of 16

AEI INCOME & GROWTH FUND 25 LLC

1185198

10-Q

0001130758-17-000058

UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended: September 30, 2017 Commission File Number: 000-50609 AEI INCOME & GROWTH FUND 25 LLC (Exact name of registrant as specified in its charter) State of Delaware | 75-3074973 ---------------------------------------------------------------+------------------------------------- (State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) ---------------------------------------------------------------+------------------------------------- 30 East 7th Street, Suite 1300 St. Paul, Minnesota 55101 | (651) 227-7333 ---------------------------------------------------------------+------------------------------------- (Address of principal executive offices) | (Registrant's telephone number) ---------------------------------------------------------------+------------------------------------- Not Applicable ---------------------------------------------------------------------------------- (Former name, former address and former fiscal year, if changed since last report) ---------------------------------------------------------------------------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. ☒ Yes ☐ No Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). ☒ Yes ☐ No Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. ☐ Large accelerated filer | ☐ Accelerated filer --------------------------+---------------------------- ☐ Non-accelerated filer | ☒ Smaller reporting company --------------------------+---------------------------- ☐ Emerging growth company | --------------------------+---------------------------- If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ☐ Yes ☒ No AEI INCOME & GROWTH FUND 25 LLC INDEX | | Page -------------------------------+----------+-------------------------------------------------------------- Part I – Financial Information | -------------------------------+--------- | Item 1. | Financial Statements: | -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | | Balance Sheets as of September 30, 2017 and December 31, 2016 | 3 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | | Statements for the Periods ended September 30, 2017 and 2016: | -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | | | Income | 4 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------+-------- | | | Cash Flows | 5 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------+-------- | | | Changes in Members' Equity (Deficit) | 6 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------+-------- | | Notes to Financial Statements | 7 - 11 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | Item 2. | Management's Discussion and Analysis of Financial | -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | | | Condition and Results of Operations | 12 - 17 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------+-------- | Item 3. | Quantitative and Qualitative Disclosures About Market Risk | 17 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | Item 4. | Controls and Procedures | 18 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- Part II – Other Information | -------------------------------+--------- | Item 1. | Legal Proceedings | 18 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | Item 1A. | Risk Factors | 18 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | 19 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | Item 3. | Defaults Upon Senior Securities | 19 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | Item 4. | Mine Safety Disclosures | 19 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | Item 5. | Other Information | 19 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | Item 6. | Exhibits | 19 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- Signatures | 20 -------------------------------+--------- Page 2 of 20 AEI INCOME & GROWTH FUND 25 LLC BALANCE SHEETS ASSETS | September 30, | | | December 31, | ------------------------------------------+---------------+------------+---+--------------+-- | 2017 | | | 2016 | ------------------------------------------+---------------+------------+---+--------------+-- | (unaudited) | | | | ------------------------------------------+---------------+------------+---+--------------+-- Current Assets: | | | | | ------------------------------------------+---------------+------------+---+--------------+-- Cash | $ | 2,334,208 | | | $ | 2,139,205 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Real Estate Investments: | | | | | | | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Land | | 8,005,563 | | | | 9,055,563 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Buildings | | 18,386,544 | | | | 19,871,184 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Acquired Intangible Lease Assets | | 1,405,652 | | | | 2,327,904 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Real Estate Held for Investment, at cost | | 27,797,759 | | | | 31,254,651 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Accumulated Depreciation and Amortization | | (7,955,512 | ) | | | (7,475,332 | ) ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Real Estate Held for Investment, Net | | 19,842,247 | | | | 23,779,319 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Real Estate Held for Sale | | 3,181,690 | | | | 0 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Total Real Estate Investments | | 23,023,937 | | | | 23,779,319 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Total Assets | $ | 25,358,145 | | | $ | 25,918,524 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- LIABILITIES AND MEMBERS' EQUITY Current Liabilities: | | | | -----------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+-- Payable to AEI Fund Management, Inc. | $ | 130,694 | | $ | 66,273 -----------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+----------- Distributions Payable | | 427,320 | | | 425,214 -----------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+----------- Unearned Rent | | 26,786 | | | 15,485 -----------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+----------- Total Current Liabilities | | 584,800 | | | 506,972 -----------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+----------- Long-term Liabilities: | | | | | -----------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+----------- Acquired Below-Market Lease Intangibles, Net | | 63,072 | | | 73,209 -----------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+----------- Members' Equity (Deficit): | | | | | -----------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+----------- Managing Members | | (17,963 | ) | | 879 -----------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+----------- Limited Members – 50,000 Units authorized; 40,197 and 40,217 Units issued and outstanding as of 9/30/17 and 12/31/16, respectively | | 24,728,236 | | | 25,337,464 -----------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+----------- Total Members' Equity | | 24,710,273 | | | 25,338,343 -----------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+----------- Total Liabilities and Members' Equity | $ | 25,358,145 | | $ | 25,918,524 -----------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+----------- The accompanying Notes to Financial Statements are an integral part of these statements. Page 3 of 20 AEI INCOME & GROWTH FUND 25 LLC STATEMENTS OF INCOME (unaudited) | Three Months Ended September 30 | | Nine Months Ended September 30 | ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+-- | 2017 | | 2016 | | | 2017 | | 2016 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------- Rental Income | $ | 564,891 | | $ | 562,394 | | $ | 1,690,909 | $ | 1,823,871 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Expenses: | | | | | | | | | | ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- LLC Administration – Affiliates | | 69,027 | | | 73,249 | | | 207,301 | | 231,442 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- LLC Administration and Property Management – Unrelated Parties | | 35,142 | | | 57,699 | | | 118,089 | | 164,077 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Depreciation and Amortization | | 234,152 | | | 234,075 | | | 702,456 | | 702,225 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Total Expenses | | 338,321 | | | 365,023 | | | 1,027,846 | | 1,097,744 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Operating Income | | 226,570 | | | 197,371 | | | 663,063 | | 726,127 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Other Income: | | | | | | | | | | ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Interest Income | | 1,651 | | | 1,515 | | | 4,802 | | 3,911 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Income from Continuing Operations | | 228,221 | | | 198,886 | | | 667,865 | | 730,038 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Income from Discontinued Operations | | 0 | | | 93,580 | | | 0 | | 95,373 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Net Income | $ | 228,221 | | $ | 292,466 | | $ | 667,865 | $ | 825,411 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Net Income Allocated: | | | | | | | | | | ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Managing Members | $ | 6,847 | | $ | 24,956 | | $ | 20,036 | $ | 40,944 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Limited Members | | 221,374 | | | 267,510 | | | 647,829 | | 784,467 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Total | $ | 228,221 | | $ | 292,466 | | $ | 667,865 | $ | 825,411 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Income per LLC Unit: | | | | | | | | | | ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Continuing Operations | $ | 5.51 | | $ | 4.76 | | $ | 16.11 | $ | 17.45 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Discontinued Operations | | .00 | | | 1.83 | | | .00 | | 1.89 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Total – Basic and Diluted | $ | 5.51 | | $ | 6.59 | | $ | 16.11 | $ | 19.34 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Weighted Average Units Outstanding – Basic and Diluted | | 40,197 | | | 40,570 | | | 40,203 | | 40,570 ------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- The accompanying Notes to Financial Statements are an integral part of these statements. Page 4 of 20 AEI INCOME & GROWTH FUND 25 LLC STATEMENTS OF CASH FLOWS (unaudited) | Nine Months Ended September 30 | ----------------------------------------------------------------------------------+--------------------------------+----------- | 2017 | | | 2016 | ----------------------------------------------------------------------------------+--------------------------------+------------+---+------+-- Cash Flows from Operating Activities: | | | | | ----------------------------------------------------------------------------------+--------------------------------+------------+---+------+-- Net Income | $ | 667,865 | | | $ | 825,411 | ----------------------------------------------------------------------------------+--------------------------------+------------+---+------+---+------------+-- Adjustments to Reconcile Net Income To Net Cash Provided by Operating Activities: | | | | | | | ----------------------------------------------------------------------------------+--------------------------------+------------+---+------+---+------------+-- Depreciation and Amortization | | 745,245 | | | | 745,014 | ----------------------------------------------------------------------------------+--------------------------------+------------+---+------+---+------------+-- Gain on Sale of Real Estate | | 0 | | | | (99,867 | ) ----------------------------------------------------------------------------------+--------------------------------+------------+---+------+---+------------+-- (Increase) Decrease in Receivables | | 0 | | | | (7,748 | ) ----------------------------------------------------------------------------------+--------------------------------+------------+---+------+---+------------+-- Increase (Decrease) in Payable to AEI Fund Management, Inc. | | 64,421 | | | | 47,452 | ----------------------------------------------------------------------------------+--------------------------------+------------+---+------+---+------------+-- Increase (Decrease) in Unearned Rent | | 11,301 | | | | 44,751 | ----------------------------------------------------------------------------------+--------------------------------+------------+---+------+---+------------+-- Total Adjustments | | 820,967 | | | | 729,602 | ----------------------------------------------------------------------------------+--------------------------------+------------+---+------+---+------------+-- Net Cash Provided By (Used For) Operating Activities | | 1,488,832 | | | | 1,555,013 | ----------------------------------------------------------------------------------+--------------------------------+------------+---+------+---+------------+-- Cash Flows from Investing Activities: | | | | | | | ----------------------------------------------------------------------------------+--------------------------------+------------+---+------+---+------------+-- Proceeds from Sale of Real Estate | | 0 | | | | 749,867 | ----------------------------------------------------------------------------------+--------------------------------+------------+---+------+---+------------+-- Cash Flows from Financing Activities: | | | | | | | ----------------------------------------------------------------------------------+--------------------------------+------------+---+------+---+------------+-- Distributions Paid to Members | | (1,279,856 | ) | | | (1,610,067 | ) ----------------------------------------------------------------------------------+--------------------------------+------------+---+------+---+------------+-- Repurchase of LLC Units | | (13,973 | ) | | | 0 | ----------------------------------------------------------------------------------+--------------------------------+------------+---+------+---+------------+-- Net Cash Provided By (Used For) Financing Activities | | (1,293,829 | ) | | | (1,610,067 | ) ----------------------------------------------------------------------------------+--------------------------------+------------+---+------+---+------------+-- Net Increase (Decrease) in Cash | | 195,003 | | | | 694,813 | ----------------------------------------------------------------------------------+--------------------------------+------------+---+------+---+------------+-- Cash, beginning of period | | 2,139,205 | | | | 1,780,591 | ----------------------------------------------------------------------------------+--------------------------------+------------+---+------+---+------------+-- Cash, end of period | $ | 2,334,208 | | | $ | 2,475,404 | ----------------------------------------------------------------------------------+--------------------------------+------------+---+------+---+------------+-- The accompanying Notes to Financial Statements are an integral part of these statements. Page 5 of 20 AEI INCOME & GROWTH FUND 25 LLC STATEMENTS OF CHANGES IN MEMBERS' EQUITY (DEFICIT) (unaudited) | Managing Members | | | Limited Members | | | Total | | Limited Member Units Outstanding | ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+-- Balance, December 31, 2015 | $ | 3,950 | | | $ | 26,437,245 | | $ | 26,441,195 | | 40,569.95 | ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+---+-----------+-- Distributions Declared | | (44,079 | ) | | | (1,458,897 | ) | | (1,502,976 | ) | | ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+---+-----------+-- Net Income | | 40,944 | | | | 784,467 | | | 825,411 | | | ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+---+-----------+-- Balance, September 30, 2016 | $ | 815 | | | $ | 25,762,815 | | $ | 25,763,630 | | 40,569.95 | ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+---+-----------+-- Balance, December 31, 2016 | $ | 879 | | | $ | 25,337,464 | | $ | 25,338,343 | | 40,216.65 | ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+---+-----------+-- Distributions Declared | | (38,459 | ) | | | (1,243,503 | ) | | (1,281,962 | ) | | ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+---+-----------+-- Repurchase of LLC Units | | (419 | ) | | | (13,554 | ) | | (13,973 | ) | (20.00 | ) ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+---+-----------+-- Net Income | | 20,036 | | | | 647,829 | | | 667,865 | | | ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+---+-----------+-- Balance, September 30, 2017 | $ | (17,963 | ) | | $ | 24,728,236 | | $ | 24,710,273 | | 40,196.65 | ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+---+-----------+-- The accompanying Notes to Financial Statements are an integral part of these statements. Page 6 of 20 AEI INCOME & GROWTH FUND 25 LLC NOTES TO FINANCIAL STATEMENTS SEPTEMBER 30, 2017 (unaudited) (1) The condensed statements included herein have been prepared by the registrant, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission, and reflect all adjustments which are, in the opinion of management, necessary to a fair statement of the results of operations for the interim period, on a basis consistent with the annual audited statements. The adjustments made to these condensed statements consist only of normal recurring adjustments. Certain information, accounting policies, and footnote disclosures normally included in financial statements prepared in accordance with United States Generally Accepted Accounting Principles (US GAAP) have been condensed or omitted pursuant to such rules and regulations, although the registrant believes that the disclosures are adequate to make the information presented not misleading. It is suggested that these condensed financial statements be read in conjunction with the financial statements and the summary of significant accounting policies and notes thereto included in the registrant's latest annual report on Form 10‑K. (2) Organization – AEI Income & Growth Fund 25 LLC ("Company"), a Limited Liability Company, was formed on June 24, 2002 to acquire and lease commercial properties to operating tenants. The Company's operations are managed by AEI Fund Management XXI, Inc. ("AFM"), the Managing Member. Robert P. Johnson, the President and sole director of AFM, serves as the Special Managing Member. AFM is a wholly owned subsidiary of AEI Capital Corporation of which Mr. Johnson is the majority shareholder. AEI Fund Management, Inc. ("AEI"), an affiliate of AFM, performs the administrative and operating functions for the Company. The terms of the offering called for a subscription price of $1,000 per LLC Unit, payable on acceptance of the offer. The Company commenced operations on September 11, 2003 when minimum subscriptions of 1,500 LLC Units ($1,500,000) were accepted. The offering terminated May 12, 2005, when the extended offering period expired. The Company received subscriptions for 42,434.763 Units. Under the terms of the Operating Agreement, the Limited Members and Managing Members contributed funds of $42,434,763 and $1,000, respectively. The Company shall continue until December 31, 2053, unless dissolved, terminated and liquidated prior to that date. During operations, any Net Cash Flow, as defined, which the Managing Members determine to distribute will be distributed 97% to the Limited Members and 3% to the Managing Members. Distributions to Limited Members will be made pro rata by Units. Page 7 of 20 AEI INCOME & GROWTH FUND 25 LLC NOTES TO FINANCIAL STATEMENTS (Continued) (2) Organization – (Continued) Any Net Proceeds of Sale, as defined, from the sale or financing of properties which the Managing Members determine to distribute will, after provisions for debts and reserves, be paid in the following manner: (i) first, 99% to the Limited Members and 1% to the Managing Members until the Limited Members receive an amount equal to: (a) their Adjusted Capital Contribution plus (b) an amount equal to 7% of their Adjusted Capital Contribution per annum, cumulative but not compounded, to the extent not previously distributed from Net Cash Flow; (ii) any remaining balance will be distributed 90% to the Limited Members and 10% to the Managing Members. Distributions to the Limited Members will be made pro rata by Units. For tax purposes, profits from operations, other than profits attributable to the sale, exchange, financing, refinancing or other disposition of property, will be allocated 97% to the Limited Members and 3% to the Managing Members. Net losses from operations will be allocated 99% to the Limited Members and 1% to the Managing Members. For tax purposes, profits arising from the sale, financing, or other disposition of property will be allocated in accordance with the Operating Agreement as follows: (i) first, to those Members with deficit balances in their capital accounts in an amount equal to the sum of such deficit balances; (ii) second, 99% to the Limited Members and 1% to the Managing Members until the aggregate balance in the Limited Members' capital accounts equals the sum of the Limited Members' Adjusted Capital Contributions plus an amount equal to 7% of their Adjusted Capital Contributions per annum, cumulative but not compounded, to the extent not previously allocated; (iii) third, the balance of any remaining gain will then be allocated 90% to the Limited Members and 10% to the Managing Members. Losses will be allocated 99% to the Limited Members and 1% to the Managing Members. The Managing Members are not required to currently fund a deficit capital balance. Upon liquidation of the Company or withdrawal by a Managing Member, the Managing Members will contribute to the Company an amount equal to the lesser of the deficit balances in their capital accounts or 1.01% of the total capital contributions of the Limited Members over the amount previously contributed by the Managing Members. Page 8 of 20 AEI INCOME & GROWTH FUND 25 LLC NOTES TO FINANCIAL STATEMENTS (Continued) (3) Real Estate Investments – The Company owns a 60% interest in the Sports Authority store in Wichita, Kansas. On March 2, 2016, the tenant, TSA Stores, Inc., and its parent company, The Sports Authority, Inc., the guarantor of the lease, filed for Chapter 11 bankruptcy reorganization. In June 2016, the tenant filed a motion with the bankruptcy court to reject the lease for this store effective June 30, 2016, at which time the tenant returned possession of the property to the owners. As of September 30, 2017, the tenant owed $29,049 of past due rent, which was not accrued for financial reporting purposes. The owners listed the property for lease with a real estate broker in the Wichita area. While the property is vacant, the Company is responsible for its 60% share of real estate taxes and other costs associated with maintaining the property. The annual rent from this property represented approximately 13% of the total annual rent of the Company's property portfolio. The loss of rent and increased expenses related to this property decreased the Company's cash flow. Consequently, beginning with the third quarter of 2016, the Company reduced its regular quarterly cash distribution rate from $12.85 per Unit to $10.27 per Unit. On September 21, 2017, the Company entered into a lease agreement with a primary term of 10 years with Biomat USA, Inc. ("Biomat") as a replacement tenant for 28% of the square footage of the property. The tenant will operate a Biomat USA Plasma Center in the space. Biomat may terminate the lease within 90 days if it is unable to obtain governmental approvals and building permits. The Company's 60% share of annual rent is $55,607 and is expected to commence on June 18, 2018. Biomat has agreed to pay for the costs to divide the building into two separate spaces, the costs of tenant improvements to remodel the Biomat space and 28% of the cost to replace the roof. The Company will be responsible for paying its 60% share of the remaining cost to replace the roof, which is expected to be approximately $170,000. As part of the lease transaction, the Company will pay its 60% share of lease commissions to real estate brokers totaling $81,440 that will be capitalized and amortized over the term of the lease. The Company is continuing to pursue additional tenants for the remaining space. In the third quarter of 2017, the Company decided to sell the Fresenius Medical Center in Gretna, Louisiana. In October 2017, the Company entered into an agreement to sell the property to an unrelated third party. The sale is subject to contingencies and may not be completed. If the sale is completed, the Company expects to receive net proceeds of approximately $3,950,000, which will result in a net gain of approximately $768,300. At September 30, 2017, the property was classified as Real Estate Held for Sale with a carrying value of $3,181,690. (4) Payable to AEI Fund Management, Inc. – AEI Fund Management, Inc. performs the administrative and operating functions for the Company. The payable to AEI Fund Management represents the balance due for those services. This balance is non-interest bearing and unsecured and is to be paid in the normal course of business. Page 9 of 20 AEI INCOME & GROWTH FUND 25 LLC NOTES TO FINANCIAL STATEMENTS (Continued) (5) Discontinued Operations – The tenant of the Johnny Carino's restaurants was experiencing financial difficulties and closed the restaurants in Pueblo, Colorado (October 2013) and Lake Charles, Louisiana (January 2014). On March 27, 2014, the tenant filed for Chapter 11 bankruptcy reorganization. Shortly thereafter, the tenant filed a motion with the bankruptcy court to reject the leases and returned possession of the properties to the Company. As of the date of the bankruptcy filing, the tenant owed $97,680 of past due rent, which was not accrued for financial reporting purposes. While the properties were vacant, the Company was responsible for the real estate taxes and other costs associated with maintaining the properties. The Company submitted a Proof of Claim for damages to the bankruptcy court for each property. The tenant's reorganization plan was approved by the bankruptcy court effective February 2, 2015. In August 2015, the Company received payments totaling $137,474 on its claims from the plan. In 2016, the Company received final claim payments totaling $27,258. In September 2013, the Company decided to sell both Johnny Carino's restaurants and classified them as Real Estate Held for Sale. On August 1, 2014, the Company sold the Lake Charles property to an unrelated third party. In late March 2016, the Company entered into an agreement to sell the Pueblo property to an unrelated third party. On August 4, 2016, the sale closed with the Company receiving net proceeds of $749,867, which resulted in a net gain of $99,867. At the time of sale, the carrying value of the property was $650,000. The financial results for these properties are reflected as Discontinued Operations in the accompanying financial statements. The following are the results of discontinued operations: | | Three Months Ended September 30 | | Nine Months Ended September 30 ------------------------------------+---+---------------------------------+---+------------------------------- | | 2017 | | 2016 | | 2017 | | 2016 ------------------------------------+---+---------------------------------+---+--------------------------------+---+------+---+--------- Bankruptcy Claim Payments Received | $ | 0 | $ | 0 | $ | 0 | $ | 26,843 ------------------------------------+---+---------------------------------+---+--------------------------------+---+------+---+--------- Property Management Expenses | | 0 | | (6,287) | | 0 | | (31,337) ------------------------------------+---+---------------------------------+---+--------------------------------+---+------+---+--------- Gain on Disposal of Real Estate | | 0 | | 99,867 | | 0 | | 99,867 ------------------------------------+---+---------------------------------+---+--------------------------------+---+------+---+--------- Income from Discontinued Operations | $ | 0 | $ | 93,580 | $ | 0 | $ | 95,373 ------------------------------------+---+---------------------------------+---+--------------------------------+---+------+---+--------- | | Three Months Ended September 30 | | Nine Months Ended September 30 -----------------------------------------+---+---------------------------------+---+------------------------------- | | 2017 | | 2016 | | 2017 | | 2016 -----------------------------------------+---+---------------------------------+---+--------------------------------+---+------+---+-------- Cash Flows from Discontinued Operations: | | | | | | | | -----------------------------------------+---+---------------------------------+---+--------------------------------+---+------+---+-------- Operating Activities | $ | 0 | $ | (6,287) | $ | 0 | $ | (4,494) -----------------------------------------+---+---------------------------------+---+--------------------------------+---+------+---+-------- Investing Activities | $ | 0 | $ | 749,867 | $ | 0 | $ | 749,867 -----------------------------------------+---+---------------------------------+---+--------------------------------+---+------+---+-------- Page 10 of 20 AEI INCOME & GROWTH FUND 25 LLC NOTES TO FINANCIAL STATEMENTS (Continued) (6) Members' Capital – For the nine months ended September 30, 2017 and 2016, the Company declared distributions of $1,281,962 and $1,502,976, respectively. The Limited Members received distributions of $1,243,503 and $1,458,897 and the Managing Members received distributions of $38,459 and $44,079 for the periods, respectively. The Limited Members' distributions represented $30.93 and $35.96 per LLC Unit outstanding using 40,203 and 40,570 weighted average Units in 2017 and 2016, respectively. The distributions represented $15.77 and $19.34 per Unit of Net Income and $15.16 and $16.62 per Unit of return of contributed capital in 2017 and 2016, respectively. As part of the distributions discussed above, the Company distributed net sale proceeds of $50,505 in 2016. The Limited Members received distributions of $50,000 and the Managing Members received distributions of $505. The Limited Members' distributions represented $1.23 per Unit. On April 1, 2017, the Company repurchased a total of 20.00 Units for $13,554 from one Limited Member in accordance with the Operating Agreement. The Company acquired these Units using Net Cash Flow from operations. During the first nine months of 2016, the Company did not repurchase any Units from the Limited Members. The repurchases increase the remaining Limited Members' ownership interest in the Company. As a result of these repurchases and pursuant to the Operating Agreement, the Managing Members received distributions of $419 in 2017. (7) Fair Value Measurements – As of September 30, 2017 and December 31, 2016, the Company had no assets or liabilities measured at fair value on a recurring basis or nonrecurring basis. Page 11 of 20 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. This section contains "forward-looking statements" which represent management's expectations or beliefs concerning future events, including statements regarding anticipated application of cash, expected returns from rental income, growth in revenue, the sufficiency of cash to meet operating expenses, rates of distribution, and other matters. These, and other forward-looking statements, should be evaluated in the context of a number of factors that may affect the Company's financial condition and results of operations, including the following: — | Market and economic conditions which affect the value of the properties the Company owns and the cash from rental income such properties generate; --+--------------------------------------------------------------------------------------------------------------------------------------------------- — | the federal income tax consequences of rental income, deductions, gain on sales and other items and the effects of these consequences for Members; --+--------------------------------------------------------------------------------------------------------------------------------------------------- — | resolution by the Managing Members of conflicts with which they may be confronted; --+----------------------------------------------------------------------------------- — | the success of the Managing Members of locating properties with favorable risk return characteristics; --+------------------------------------------------------------------------------------------------------- — | the effect of tenant defaults; and --+----------------------------------- — | the condition of the industries in which the tenants of properties owned by the Company operate. --+------------------------------------------------------------------------------------------------- Application of Critical Accounting Policies The Company's financial statements have been prepared in accordance with US GAAP. Preparing the financial statements requires management to use judgment in the application of these accounting policies, including making estimates and assumptions. These judgments will affect the reported amounts of the Company's assets and liabilities and the disclosure of contingent assets and liabilities as of the dates of the financial statements and will affect the reported amounts of revenue and expenses during the reporting periods. It is possible that the carrying amount of the Company's assets and liabilities, or the results of reported operations, will be affected if management's estimates or assumptions prove inaccurate. Management of the Company evaluates the following accounting estimates on an ongoing basis, and has discussed the development and selection of these estimates and the management discussion and analysis disclosures regarding them with the managing member of the Company. Allocation of Purchase Price of Acquired Properties Upon acquisition of real properties, the Company records them in the financial statements at cost. The purchase price is allocated to tangible assets, consisting of land and building, and to identified intangible assets and liabilities, which may include the value of above market and below market leases and the value of in-place leases. The allocation of the purchase price is based upon the fair value of each component of the property. Although independent appraisals may be used to assist in the determination of fair value, in many cases these values will be based upon management's assessment of each property, the selling prices of comparable properties and the discounted value of cash flows from the asset. Page 12 of 20 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS. (Continued) The fair values of above market and below market in-place leases will be recorded based on the present value (using an interest rate which reflects the risks associated with the leases acquired) of the difference between (i) the contractual amounts to be paid pursuant to the in-place leases and (ii) an estimate of fair market lease rates for the corresponding in-place leases measured over a period equal to the non-cancelable term of the lease including any bargain renewal periods. The above market and below market lease values will be capitalized as intangible lease assets or liabilities. Above market lease values will be amortized as an adjustment of rental income over the remaining term of the respective leases. Below market lease values will be amortized as an adjustment of rental income over the remaining term of the respective leases, including any bargain renewal periods. If a lease were to be terminated prior to its stated expiration, all unamortized amounts of above market and below market in-place lease values relating to that lease would be recorded as an adjustment to rental income. The fair values of in-place leases will include estimated direct costs associated with obtaining a new tenant, and opportunity costs associated with lost rentals which are avoided by acquiring an in-place lease. Direct costs associated with obtaining a new tenant may include commissions, tenant improvements, and other direct costs and are estimated, in part, by management's consideration of current market costs to execute a similar lease. These direct costs will be included in intangible lease assets on the balance sheet and will be amortized to expense over the remaining term of the respective leases. The value of opportunity costs will be calculated using the contractual amounts to be paid pursuant to the in-place leases over a market absorption period for a similar lease. These intangibles will be included in intangible lease assets on the balance sheet and will be amortized to expense over the remaining term of the respective leases. If a lease were to be terminated prior to its stated expiration, all unamortized amounts of in-place lease assets relating to that lease would be expensed. The determination of the fair values of the assets and liabilities acquired will require the use of significant assumptions with regard to the current market rental rates, rental growth rates, discount and capitalization rates, interest rates and other variables. If management's estimates or assumptions prove inaccurate, the result would be an inaccurate allocation of purchase price, which could impact the amount of reported net income. Carrying Value of Properties Properties are carried at original cost, less accumulated depreciation and amortization. The Company tests long-lived assets for recoverability when events or changes in circumstances indicate that the carrying value may not be recoverable. For properties the Company will hold and operate, management determines whether impairment has occurred by comparing the property's probability-weighted future undiscounted cash flows to its current carrying value. For properties held for sale, management determines whether impairment has occurred by comparing the property's estimated fair value less cost to sell to its current carrying value. If the carrying value is greater than the net realizable value, an impairment loss is recorded to reduce the carrying value of the property to its net realizable value. Changes in these assumptions or analysis may cause material changes in the carrying value of the properties. Page 13 of 20 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS. (Continued) Allocation of Expenses AEI Fund Management, Inc. allocates expenses to each of the funds they manage primarily on the basis of the number of hours devoted by their employees to each fund's affairs. They also allocate expenses at the end of each month that are not directly related to a fund's operations based upon the number of investors in the fund and the fund's capitalization relative to other funds they manage. The Company reimburses these expenses subject to detailed limitations contained in the Operating Agreement. Results of Operations For the nine months ended September 30, 2017 and 2016, the Company recognized rental income from continuing operations of $1,690,909 and 1,823,871, respectively. In 2017, rental income decreased due to rent that was not received from the tenant of the Sports Authority store, as discussed below. This decrease was partially offset by rent increases on three properties. Based on the scheduled rent for the properties as of October 31, 2017, the Company expects to recognize rental income from continuing operations of approximately $2,264,000 and $2,307,000 in 2017 and 2018, respectively. For the nine months ended September 30, 2017 and 2016, the Company incurred LLC administration expenses from affiliated parties of $207,301 and $231,442, respectively. These administration expenses include costs associated with the management of the properties, processing distributions, reporting requirements and communicating with the Limited Members. During the same periods, the Company incurred LLC administration and property management expenses from unrelated parties of $118,089 and $164,077, respectively. These expenses represent direct payments to third parties for legal and filing fees, direct administrative costs, outside audit costs, taxes, insurance and other property costs. The Company owns a 60% interest in the Sports Authority store in Wichita, Kansas. On March 2, 2016, the tenant, TSA Stores, Inc., and its parent company, The Sports Authority, Inc., the guarantor of the lease, filed for Chapter 11 bankruptcy reorganization. In June 2016, the tenant filed a motion with the bankruptcy court to reject the lease for this store effective June 30, 2016, at which time the tenant returned possession of the property to the owners. As of September 30, 2017, the tenant owed $29,049 of past due rent, which was not accrued for financial reporting purposes. The owners listed the property for lease with a real estate broker in the Wichita area. While the property is vacant, the Company is responsible for its 60% share of real estate taxes and other costs associated with maintaining the property. The annual rent from this property represented approximately 13% of the total annual rent of the Company's property portfolio. The loss of rent and increased expenses related to this property decreased the Company's cash flow. Consequently, beginning with the third quarter of 2016, the Company reduced its regular quarterly cash distribution rate from $12.85 per Unit to $10.27 per Unit. Page 14 of 20 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS. (Continued) On September 21, 2017, the Company entered into a lease agreement with a primary term of 10 years with Biomat USA, Inc. ("Biomat") as a replacement tenant for 28% of the square footage of the property. The tenant will operate a Biomat USA Plasma Center in the space. Biomat may terminate the lease within 90 days if it is unable to obtain governmental approvals and building permits. The Company's 60% share of annual rent is $55,607 and is expected to commence on June 18, 2018. Biomat has agreed to pay for the costs to divide the building into two separate spaces, the costs of tenant improvements to remodel the Biomat space and 28% of the cost to replace the roof. The Company will be responsible for paying its 60% share of the remaining cost to replace the roof, which is expected to be approximately $170,000. As part of the lease transaction, the Company will pay its 60% share of lease commissions to real estate brokers totaling $81,440 that will be capitalized and amortized over the term of the lease. The Company is continuing to pursue additional tenants for the remaining space. For the nine months ended September 30, 2017 and 2016, the Company recognized interest income of $4,802 and $3,911, respectively. If a property was classified as Real Estate Held for Sale at December 31, 2013, the Company included the results from operating and selling the property in discontinued operations under prior accounting guidance. For the nine months ended September 30, 2016, the Company recognized income from discontinued operations of $95,373, representing a gain on disposal of real estate of $99,867 and bankruptcy claim payments received of $26,843, which were partially offset by property management expenses of $31,337. The tenant of the Johnny Carino's restaurants was experiencing financial difficulties and closed the restaurants in Pueblo, Colorado (October 2013) and Lake Charles, Louisiana (January 2014). On March 27, 2014, the tenant filed for Chapter 11 bankruptcy reorganization. Shortly thereafter, the tenant filed a motion with the bankruptcy court to reject the leases and returned possession of the properties to the Company. As of the date of the bankruptcy filing, the tenant owed $97,680 of past due rent, which was not accrued for financial reporting purposes. While the properties were vacant, the Company was responsible for the real estate taxes and other costs associated with maintaining the properties. The Company submitted a Proof of Claim for damages to the bankruptcy court for each property. The tenant's reorganization plan was approved by the bankruptcy court effective February 2, 2015. In August 2015, the Company received payments totaling $137,474 on its claims from the plan. In 2016, the Company received final claim payments totaling $27,258. In September 2013, the Company decided to sell both Johnny Carino's restaurants and classified them as Real Estate Held for Sale. On August 1, 2014, the Company sold the Lake Charles property to an unrelated third party. In late March 2016, the Company entered into an agreement to sell the Pueblo property to an unrelated third party. On August 4, 2016, the sale closed with the Company receiving net proceeds of $749,867, which resulted in a net gain of $99,867. At the time of sale, the carrying value of the property was $650,000. Page 15 of 20 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS. (Continued) Management believes inflation has not significantly affected income from operations. Leases may contain rent increases, based on the increase in the Consumer Price Index over a specified period, which will result in an increase in rental income over the term of the leases. Inflation also may cause the real estate to appreciate in value. However, inflation and changing prices may have an adverse impact on the operating margins of the properties' tenants, which could impair their ability to pay rent and subsequently reduce the Net Cash Flow available for distributions. Liquidity and Capital Resources During the nine months ended September 30, 2017, the Company's cash balances increased $195,003 as a result of cash generated from operating activities in excess of distributions paid to the Members and cash used to repurchase Units. During the nine months ended September 30, 2016, the Company's cash balances increased $694,813 as a result of cash generated from the sale of property, which was partially offset by distributions paid to the Members in excess of cash generated from operating activities. Net cash provided by operating activities decreased from $1,555,013 in 2016 to $1,488,832 in 2017 as a result of a decrease in total rental and interest income in 2017 and net timing differences in the collection of payments from the tenants and the payment of expenses, which were partially offset by a decrease in LLC administration and property management expenses in 2017. The major components of the Company's cash flow from investing activities are investments in real estate and proceeds from the sale of real estate. During the nine months ended September 30, 2016, the Company generated cash flow from the sale of real estate of $749,867. In the third quarter of 2017, the Company decided to sell the Fresenius Medical Center in Gretna, Louisiana. In October 2017, the Company entered into an agreement to sell the property to an unrelated third party. The sale is subject to contingencies and may not be completed. If the sale is completed, the Company expects to receive net proceeds of approximately $3,950,000, which will result in a net gain of approximately $768,300. At September 30, 2017, the property was classified as Real Estate Held for Sale with a carrying value of $3,181,690. The Company's primary use of cash flow, other than investment in real estate, is distribution payments to Members and cash used to repurchase Units. The Company declares its regular quarterly distributions before the end of each quarter and pays the distribution in the first week after the end of each quarter. The Company attempts to maintain a stable distribution rate from quarter to quarter. The Company may repurchase tendered Units on April 1st and October 1st of each year subject to limitations. Page 16 of 20 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS. (Continued) For the nine months ended September 30, 2017 and 2016, the Company declared distributions of $1,281,962 and $1,502,976, respectively. Pursuant to the Operating Agreement, distributions of Net Cash Flow were allocated 97% to the Limited Members and 3% to the Managing Members. Distributions of Net Proceeds of Sale were allocated 99% to the Limited Members and 1% to the Managing Members. The Limited Members received distributions of $1,243,503 and $1,458,897 and the Managing Members received distributions of $38,459 and $44,079 for the periods, respectively. As part of the distributions discussed above, the Company distributed net sale proceeds of $50,505 in 2016. The Limited Members received distributions of $50,000 and the Managing Members received distributions of $505. The Limited Members' distributions represented $1.23 per Unit. The Company may repurchase Units from Limited Members who have tendered their Units to the Company. Such Units may be acquired at a discount. The Company will not be obligated to purchase in any year more than 2% of the total number of Units outstanding on January 1 of such year. In no event shall the Company be obligated to purchase Units if, in the sole discretion of the Managing Member, such purchase would impair the capital or operation of the Company. On April 1, 2017, the Company repurchased a total of 20.00 Units for $13,554 from one Limited Member in accordance with the Operating Agreement. The Company acquired these Units using Net Cash Flow from operations. During the first nine months of 2016, the Company did not repurchase any Units from the Limited Members. The repurchases increase the remaining Limited Members' ownership interest in the Company. As a result of these repurchases and pursuant to the Operating Agreement, the Managing Members received distributions of $419 in 2017. The continuing rent payments from the properties, together with cash generated from property sales, should be adequate to fund continuing distributions and meet other Company obligations on both a short-term and long-term basis. Off-Balance Sheet Arrangements As of September 30, 2017 and December 31, 2016, the Company had no material off-balance sheet arrangements that had or are reasonably likely to have current or future effects on its financial condition, results of operations, liquidity or capital resources. ITEM 3. QUANTITATIVE & QUALITATIVE DISCLOSURES ABOUT MARKET RISK. Not required for a smaller reporting company. Page 17 of 20 ITEM 4. CONTROLS AND PROCEDURES. (a) Disclosure Controls and Procedures. Under the supervision and with the participation of management, including its President and Chief Financial Officer, the Managing Member of the Company evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the "Exchange Act")). Based upon that evaluation, the President and Chief Financial Officer of the Managing Member concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective in ensuring that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in applicable rules and forms and that such information is accumulated and communicated to management, including the President and Chief Financial Officer of the Managing Member, in a manner that allows timely decisions regarding required disclosure. (b) Changes in Internal Control Over Financial Reporting. During the most recent period covered by this report, there has been no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. PART II – OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS. There are no material pending legal proceedings to which the Company is a party or of which the Company's property is subject. ITEM 1A. RISK FACTORS. Not required for a smaller reporting company. Page 18 of 20 ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES & USE OF PROCEEDS. (a) None. (b) Not applicable. (c) Pursuant to Section 7.7 of the Operating Agreement, each Limited Member has the right to present Units to the Company for purchase by submitting notice to the Managing Member during January or July of each year. The purchase price of the Units is equal to 80% of the net asset value per Unit, as of the first business day of January or July of each year, as determined by the Managing Member in accordance with the provisions of the Operating Agreement. Units tendered to the Company during January and July may be repurchased on April 1st and October 1st, respectively, of each year subject to the following limitations. The Company will not be obligated to purchase in any year more than 2% of the total number of Units outstanding on January 1 of such year. In no event shall the Company be obligated to purchase Units if, in the sole discretion of the Managing Member, such purchase would impair the capital or operation of the Company. During the period covered by this report, the Company did not purchase any Units. ITEM 3. DEFAULTS UPON SENIOR SECURITIES. None. ITEM 4. MINE SAFETY DISCLOSURES. Not Applicable. ITEM 5. OTHER INFORMATION. None. ITEM 6. EXHIBITS. 31.1 | Certification of Chief Executive Officer of Managing Member pursuant to Rule 15d-14(a)(17 CFR 240.15d-14(a)) and Section 302 of the Sarbanes-Oxley Act of 2002. -----+---------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.2 | Certification of Chief Financial Officer of Managing Member pursuant to Rule 15d-14(a)(17 CFR 240.15d-14(a)) and Section 302 of the Sarbanes-Oxley Act of 2002. -----+---------------------------------------------------------------------------------------------------------------------------------------------------------------- 32 | Certification of Chief Executive Officer and Chief Financial Officer of Managing Member pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. ---+--------------------------------------------------------------------------------------------------------------------------------------------------- Page 19 of 20 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Dated: November 13, 2017 | AEI Income & Growth Fund 25 LLC --------------------------+-------------------------------- | By: | AEI Fund Management XXI, Inc. --------------------------+---------------------------------+------------------------------- | Its: | Managing Member --------------------------+---------------------------------+------------------------------- | By: | /s/ ROBERT P JOHNSON --------------------------+---------------------------------+------------------------------- | | Robert P. Johnson --------------------------+---------------------------------+------------------------------- | | President --------------------------+---------------------------------+------------------------------- | | (Principal Executive Officer) --------------------------+---------------------------------+------------------------------- | By: | /s/ PATRICK W KEENE --------------------------+---------------------------------+------------------------------- | | Patrick W. Keene --------------------------+---------------------------------+------------------------------- | | Chief Financial Officer --------------------------+---------------------------------+------------------------------- | | (Principal Accounting Officer) --------------------------+---------------------------------+------------------------------- Page 20 of 20

AEI INCOME & GROWTH FUND XXI LTD PARTNERSHIP

931755

10-Q

0001130758-17-000055

UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended: September 30, 2017 Commission File Number: 000-29274 AEI INCOME & GROWTH FUND XXI LIMITED PARTNERSHIP (Exact name of registrant as specified in its charter) State of Minnesota | 41-1789725 ---------------------------------------------------------------+------------------------------------- (State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) ---------------------------------------------------------------+------------------------------------- 30 East 7th Street, Suite 1300 St. Paul, Minnesota 55101 | (651) 227-7333 ---------------------------------------------------------------+------------------------------------- (Address of principal executive offices) | (Registrant's telephone number) ---------------------------------------------------------------+------------------------------------- Not Applicable ---------------------------------------------------------------------------------- (Former name, former address and former fiscal year, if changed since last report) ---------------------------------------------------------------------------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. ☒ Yes ☐ No Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). ☒ Yes ☐ No Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. ☐ Large accelerated filer | ☐ Accelerated filer --------------------------+---------------------------- ☐ Non-accelerated filer | ☒ Smaller reporting company --------------------------+---------------------------- ☐ Emerging growth company | --------------------------+---------------------------- If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ☐ Yes ☒ No AEI INCOME & GROWTH FUND XXI LIMITED PARTNERSHIP INDEX | | Page -------------------------------+----------+-------------------------------------------------------------- Part I – Financial Information | -------------------------------+--------- | Item 1. | Financial Statements: | -------------------------------+----------+---------------------------------------------------------------+--------------------------------------- | | Balance Sheets as of September 30, 2017 and December 31, 2016 | 3 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------- | | Statements for the Periods ended September 30, 2017 and 2016: | -------------------------------+----------+---------------------------------------------------------------+--------------------------------------- | | | Income | 4 -------------------------------+----------+---------------------------------------------------------------+----------------------------------------+-------- | | | Cash Flows | 5 -------------------------------+----------+---------------------------------------------------------------+----------------------------------------+-------- | | | Changes in Partners' Capital (Deficit) | 6 -------------------------------+----------+---------------------------------------------------------------+----------------------------------------+-------- | | Notes to Financial Statements | 7 - 10 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------- | Item 2. | Management's Discussion and Analysis of Financial | -------------------------------+----------+---------------------------------------------------------------+--------------------------------------- | | | Condition and Results of Operations | 11 - 16 -------------------------------+----------+---------------------------------------------------------------+----------------------------------------+-------- | Item 3. | Quantitative and Qualitative Disclosures About Market Risk | 16 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------- | Item 4. | Controls and Procedures | 16 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------- Part II – Other Information | -------------------------------+--------- | Item 1. | Legal Proceedings | 17 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------- | Item 1A. | Risk Factors | 17 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------- | Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | 17 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------- | Item 3. | Defaults Upon Senior Securities | 17 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------- | Item 4. | Mine Safety Disclosures | 17 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------- | Item 5. | Other Information | 17 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------- | Item 6. | Exhibits | 18 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------- Signatures | 18 -------------------------------+--------- Page 2 of 18 AEI INCOME & GROWTH FUND XXI LIMITED PARTNERSHIP BALANCE SHEETS ASSETS | September 30, | | | December 31, | ------------------------------------------+---------------+------------+---+--------------+-- | 2017 | | | 2016 | ------------------------------------------+---------------+------------+---+--------------+-- | (unaudited) | | | | ------------------------------------------+---------------+------------+---+--------------+-- Current Assets: | | | | | ------------------------------------------+---------------+------------+---+--------------+-- Cash | $ | 502,495 | | | $ | 691,125 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Real Estate Investments: | | | | | | | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Land | | 3,659,461 | | | | 3,839,216 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Buildings | | 10,339,539 | | | | 11,377,241 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Acquired Intangible Lease Assets | | 807,178 | | | | 807,178 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Real Estate Held for Investment, at cost | | 14,806,178 | | | | 16,023,635 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Accumulated Depreciation and Amortization | | (3,651,584 | ) | | | (3,650,418 | ) ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Real Estate Held for Investment, Net | | 11,154,594 | | | | 12,373,217 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Real Estate Held for Sale | | 652,572 | | | | 0 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Total Real Estate Investments | | 11,807,166 | | | | 12,373,217 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Total Assets | $ | 12,309,661 | | | $ | 13,064,342 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- LIABILITIES AND PARTNERS' CAPITAL Current Liabilities: | | | | ------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+-- Payable to AEI Fund Management, Inc. | $ | 238 | | $ | 27,151 | ------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Distributions Payable | | 208,282 | | | 261,212 | ------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Unearned Rent | | 34,520 | | | 12,121 | ------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Total Current Liabilities | | 243,040 | | | 300,484 | ------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Long-term Liabilities: | | | | | | ------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Acquired Below-Market Lease Intangibles, Net | | 111,530 | | | 125,855 | ------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Partners' Capital (Deficit): | | | | | | ------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- General Partners | | (25,382 | ) | | (18,553 | ) ------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Limited Partners – 24,000 Units authorized; 19,616 and 19,636 Units issued and outstanding as of 9/30/17 and 12/31/16, respectively | | 11,980,473 | | | 12,656,556 | ------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Total Partners' Capital | | 11,955,091 | | | 12,638,003 | ------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Total Liabilities and Partners' Capital | $ | 12,309,661 | | $ | 13,064,342 | ------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- The accompanying Notes to Financial Statements are an integral part of these statements. Page 3 of 18 AEI INCOME & GROWTH FUND XXI LIMITED PARTNERSHIP STATEMENTS OF INCOME (unaudited) | Three Months Ended September 30 | | Nine Months Ended September 30 | --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+-- | 2017 | | 2016 | | | 2017 | | 2016 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-------- Rental Income | $ | 292,215 | | $ | 328,755 | | $ | 924,167 | $ | 971,456 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- Expenses: | | | | | | | | | | --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- Partnership Administration – Affiliates | | 41,384 | | | 41,010 | | | 128,126 | | 127,367 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- Partnership Administration and Property Management – Unrelated Parties | | 51,348 | | | 7,891 | | | 88,753 | | 40,075 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- Property Acquisition | | 0 | | | 27 | | | 0 | | 56,760 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- Depreciation and Amortization | | 117,621 | | | 132,964 | | | 642,801 | | 389,933 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- Total Expenses | | 210,353 | | | 181,892 | | | 859,680 | | 614,135 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- Operating Income | | 81,862 | | | 146,863 | | | 64,487 | | 357,321 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- Other Income: | | | | | | | | | | --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- Interest Income | | 302 | | | 549 | | | 1,097 | | 2,361 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- Net Income | $ | 82,164 | | $ | 147,412 | | $ | 65,584 | $ | 359,682 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- Net Income Allocated: | | | | | | | | | | --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- General Partners | $ | 822 | | $ | 1,474 | | $ | 656 | $ | 3,597 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- Limited Partners | | 81,342 | | | 145,938 | | | 64,928 | | 356,085 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- Total | $ | 82,164 | | $ | 147,412 | | $ | 65,584 | $ | 359,682 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- Net Income per Limited Partnership Unit | $ | 4.15 | | $ | 7.36 | | $ | 3.31 | $ | 17.87 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- Weighted Average Units Outstanding – Basic and Diluted | | 19,616 | | | 19,841 | | | 19,622 | | 19,929 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- The accompanying Notes to Financial Statements are an integral part of these statements. Page 4 of 18 AEI INCOME & GROWTH FUND XXI LIMITED PARTNERSHIP STATEMENTS OF CASH FLOWS (unaudited) | Nine Months Ended September 30 | ----------------------------------------------------------------------------------+--------------------------------+--------- | 2017 | | | 2016 | ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+-- Cash Flows from Operating Activities: | | | | | ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+-- Net Income | $ | 65,584 | | | $ | 359,682 | ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Adjustments to Reconcile Net Income To Net Cash Provided by Operating Activities: | | | | | | | ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Depreciation and Amortization | | 628,476 | | | | 376,959 | ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Increase (Decrease) in Payable to AEI Fund Management, Inc. | | (26,913 | ) | | | 6,829 | ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Increase (Decrease) in Unearned Rent | | 22,399 | | | | 22,400 | ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Total Adjustments | | 623,962 | | | | 406,188 | ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Net Cash Provided By (Used For) Operating Activities | | 689,546 | | | | 765,870 | ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Cash Flows from Investing Activities: | | | | | | | ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Investments in Real Estate | | (76,750 | ) | | | (1,809,915 | ) ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Cash Flows from Financing Activities: | | | | | | | ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Distributions Paid to Partners | | (783,632 | ) | | | (789,501 | ) ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Repurchase of Partnership Units | | (17,794 | ) | | | (235,431 | ) ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Net Cash Provided By (Used For) Financing Activities | | (801,426 | ) | | | (1,024,932 | ) ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Net Increase (Decrease) in Cash | | (188,630 | ) | | | (2,068,977 | ) ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Cash, beginning of period | | 691,125 | | | | 2,925,122 | ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Cash, end of period | $ | 502,495 | | | $ | 856,145 | ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- The accompanying Notes to Financial Statements are an integral part of these statements. Page 5 of 18 AEI INCOME & GROWTH FUND XXI LIMITED PARTNERSHIP STATEMENTS OF CHANGES IN PARTNERS' CAPITAL (DEFICIT) (unaudited) | General Partners | | | Limited Partners | | | Total | | Limited Partnership Units Outstanding | --------------------------------+------------------+---------+---+------------------+---+------------+-------+---+---------------------------------------+-- Balance, December 31, 2015 | $ | (9,126 | ) | | $ | 13,589,851 | | $ | 13,580,725 | | 20,104.88 | --------------------------------+------------------+---------+---+------------------+---+------------+-------+---+---------------------------------------+---+-----------+-- Distributions Declared | | (7,866 | ) | | | (778,703 | ) | | (786,569 | ) | | --------------------------------+------------------+---------+---+------------------+---+------------+-------+---+---------------------------------------+---+-----------+-- Repurchase of Partnership Units | | (2,355 | ) | | | (233,076 | ) | | (235,431 | ) | (264.01 | ) --------------------------------+------------------+---------+---+------------------+---+------------+-------+---+---------------------------------------+---+-----------+-- Net Income | | 3,597 | | | | 356,085 | | | 359,682 | | | --------------------------------+------------------+---------+---+------------------+---+------------+-------+---+---------------------------------------+---+-----------+-- Balance, September 30, 2016 | $ | (15,750 | ) | | $ | 12,934,157 | | $ | 12,918,407 | | 19,840.87 | --------------------------------+------------------+---------+---+------------------+---+------------+-------+---+---------------------------------------+---+-----------+-- Balance, December 31, 2016 | $ | (18,553 | ) | | $ | 12,656,556 | | $ | 12,638,003 | | 19,635.64 | --------------------------------+------------------+---------+---+------------------+---+------------+-------+---+---------------------------------------+---+-----------+-- Distributions Declared | | (7,307 | ) | | | (723,395 | ) | | (730,702 | ) | | --------------------------------+------------------+---------+---+------------------+---+------------+-------+---+---------------------------------------+---+-----------+-- Repurchase of Partnership Units | | (178 | ) | | | (17,616 | ) | | (17,794 | ) | (20.00 | ) --------------------------------+------------------+---------+---+------------------+---+------------+-------+---+---------------------------------------+---+-----------+-- Net Income | | 656 | | | | 64,928 | | | 65,584 | | | --------------------------------+------------------+---------+---+------------------+---+------------+-------+---+---------------------------------------+---+-----------+-- Balance, September 30, 2017 | $ | (25,382 | ) | | $ | 11,980,473 | | $ | 11,955,091 | | 19,615.64 | --------------------------------+------------------+---------+---+------------------+---+------------+-------+---+---------------------------------------+---+-----------+-- The accompanying Notes to Financial Statements are an integral part of these statements. Page 6 of 18 AEI INCOME & GROWTH FUND XXI LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS SEPTEMBER 30, 2017 (unaudited) (1) The condensed statements included herein have been prepared by the registrant, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission, and reflect all adjustments which are, in the opinion of management, necessary to a fair statement of the results of operations for the interim period, on a basis consistent with the annual audited statements. The adjustments made to these condensed statements consist only of normal recurring adjustments. Certain information, accounting policies, and footnote disclosures normally included in financial statements prepared in accordance with United States Generally Accepted Accounting Principles (US GAAP) have been condensed or omitted pursuant to such rules and regulations, although the registrant believes that the disclosures are adequate to make the information presented not misleading. It is suggested that these condensed financial statements be read in conjunction with the financial statements and the summary of significant accounting policies and notes thereto included in the registrant's latest annual report on Form 10‑K. (2) Organization – AEI Income & Growth Fund XXI Limited Partnership ("Partnership") was formed to acquire and lease commercial properties to operating tenants. The Partnership's operations are managed by AEI Fund Management XXI, Inc. ("AFM"), the Managing General Partner. Robert P. Johnson, the President and sole director of AFM, serves as the Individual General Partner. AFM is a wholly owned subsidiary of AEI Capital Corporation of which Mr. Johnson is the majority shareholder. AEI Fund Management, Inc. ("AEI"), an affiliate of AFM, performs the administrative and operating functions for the Partnership. The terms of the Partnership offering called for a subscription price of $1,000 per Limited Partnership Unit, payable on acceptance of the offer. The Partnership commenced operations on April 14, 1995 when minimum subscriptions of 1,500 Limited Partnership Units ($1,500,000) were accepted. On January 31, 1997, the offering terminated when the maximum subscription limit of 24,000 Limited Partnership Units was reached. Under the terms of the Limited Partnership Agreement, the Limited Partners and General Partners contributed funds of $24,000,000 and $1,000, respectively. During operations, any Net Cash Flow, as defined, which the General Partners determine to distribute will be distributed 90% to the Limited Partners and 10% to the General Partners; provided, however, that such distributions to the General Partners will be subordinated to the Limited Partners first receiving an annual, noncumulative distribution of Net Cash Flow equal to 10% of their Adjusted Capital Contribution, as defined, and, provided further, that in no event will the General Partners receive less than 1% of such Net Cash Flow per annum. Distributions to Limited Partners will be made pro rata by Units. Page 7 of 18 AEI INCOME & GROWTH FUND XXI LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS (Continued) (2) Organization – (Continued) Any Net Proceeds of Sale, as defined, from the sale or financing of properties which the General Partners determine to distribute will, after provisions for debts and reserves, be paid in the following manner: (i) first, 99% to the Limited Partners and 1% to the General Partners until the Limited Partners receive an amount equal to: (a) their Adjusted Capital Contribution plus (b) an amount equal to 10% of their Adjusted Capital Contribution per annum, cumulative but not compounded, to the extent not previously distributed from Net Cash Flow; (ii) any remaining balance will be distributed 90% to the Limited Partners and 10% to the General Partners. Distributions to the Limited Partners will be made pro rata by Units. For tax purposes, profits from operations, other than profits attributable to the sale, exchange, financing, refinancing or other disposition of property, will be allocated first in the same ratio in which, and to the extent, Net Cash Flow is distributed to the Partners for such year. Any additional profits will be allocated in the same ratio as the last dollar of Net Cash Flow is distributed. Net losses from operations will be allocated 99% to the Limited Partners and 1% to the General Partners. For tax purposes, profits arising from the sale, financing, or other disposition of property will be allocated in accordance with the Partnership Agreement as follows: (i) first, to those partners with deficit balances in their capital accounts in an amount equal to the sum of such deficit balances; (ii) second, 99% to the Limited Partners and 1% to the General Partners until the aggregate balance in the Limited Partners' capital accounts equals the sum of the Limited Partners' Adjusted Capital Contributions plus an amount equal to 10% of their Adjusted Capital Contributions per annum, cumulative but not compounded, to the extent not previously allocated; (iii) third, the balance of any remaining gain will then be allocated 90% to the Limited Partners and 10% to the General Partners. Losses will be allocated 98% to the Limited Partners and 2% to the General Partners. The General Partners are not required to currently fund a deficit capital balance. Upon liquidation of the Partnership or withdrawal by a General Partner, the General Partners will contribute to the Partnership an amount equal to the lesser of the deficit balances in their capital accounts or 1% of total Limited Partners' and General Partners' capital contributions. In January 2014, the Managing General Partner mailed a Consent Statement (Proxy) seeking the consent of the Limited Partners to continue the Partnership for an additional 60 months or to initiate the final disposition, liquidation and distribution of all of the Partnership's properties and assets. On February 14, 2014, the proposal to continue the Partnership was approved with a majority of Units voted in favor of the continuation proposal. As a result, the Managing General Partner will continue the operations of the Partnership for an additional 60 months at which time it will again ask the Limited Partners to vote on the same two proposals. Page 8 of 18 AEI INCOME & GROWTH FUND XXI LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS (Continued) (3) Real Estate Investments – On February 3, 2016, the Partnership purchased a Dollar Tree store in Cincinnati, Ohio for $1,809,915. The Partnership allocated $285,049 of the purchase price to Acquired Intangible Lease Assets, representing in-place lease intangibles, and allocated $80,404 to Acquired Below-Market Lease Intangibles. The Partnership incurred $56,760 of acquisition expenses related to the purchase that were expensed. The property is leased to Dollar Tree Stores, Inc. under a lease agreement with a remaining primary term of 10 years (as of the date of purchase) and annual rent of $122,169. The Partnership owns a 30% interest in the Gander Mountain store in Champaign, Illinois. The remaining interests in the property are owned by affiliates of the Partnership. On March 10, 2017, Gander Mountain Company filed for Chapter 11 reorganization and announced it was closing the store, following a liquidation sale of its on‑site assets. In June 2017, the tenant filed a motion with the bankruptcy court to reject the lease for this store effective June 30, 2017. At this time, the tenant returned possession of the property to the owners and the Partnership became responsible for its 30% share of real estate taxes and other costs associated with maintaining the property. The tenant paid rent through June 2017. The owners have listed the property for lease with a real estate broker in the Champaign area. The annual rent from this property represented approximately 13% of the total annual rent of the Partnership's property portfolio. The loss of rent and increased expenses related to this property decreased the Partnership's cash flow. Consequently, beginning with the third quarter of 2017, the Partnership reduced its regular quarterly cash distribution rate from $13.18 per Unit to $10.51 per Unit. As a result of the bankruptcy court terminating the lease for the Gander Mountain store, the Partnership included an additional $270,097 in Depreciation and Amortization in the second quarter of 2017, which represented the unamortized balance of the in-place lease intangible that was created when the property was purchased in 2014. In March 2017, the Partnership entered into an agreement with the tenant of the KinderCare daycare center in Andover, Minnesota to extend the lease term five years to expire on June 30, 2022. The annual rent will remain the same throughout the remainder of the extended lease term. As part of the agreement, the Partnership paid a tenant improvement allowance of $30,000 that was capitalized. In addition, beginning on April 1, 2017, the tenant received free rent for three months that equaled $36,362. In the first quarter of 2017, the Partnership decided to sell the property. At September 30, 2017, the property was classified as Real Estate Held for Sale with a carrying value of $652,572. In October 2017, the Partnership entered into an agreement to sell the KinderCare to an unrelated third party. The sale is subject to contingencies and may not be completed. If the sale is completed, the Partnership expects to receive net proceeds of approximately $1,695,000, which will result in a net gain of approximately $1,042,400. Page 9 of 18 AEI INCOME & GROWTH FUND XXI LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS (Continued) (3) Real Estate Investments – (Continued) In April 2017, the Partnership entered into an agreement with the tenant of the Fresenius Medical Center in Shreveport, Louisiana to extend the lease term nine years to expire on June 30, 2027. The annual rent will remain the same throughout the remainder of the extended lease term. As part of the agreement, the Partnership paid a tenant improvement allowance of $46,750 that was capitalized and will be depreciated. (4) Payable to AEI Fund Management, Inc. – AEI Fund Management, Inc. performs the administrative and operating functions for the Partnership. The payable to AEI Fund Management represents the balance due for those services. This balance is non-interest bearing and unsecured and is to be paid in the normal course of business. (5) Partners' Capital – For the nine months ended September 30, 2017 and 2016, the Partnership declared distributions of $730,702 and $786,569, respectively. The Limited Partners received distributions of $723,395 and $778,703 and the General Partners received distributions of $7,307 and $7,866 for the periods, respectively. The Limited Partners' distributions represented $36.87 and $39.07 per Limited Partnership Unit outstanding using 19,622 and 19,929 weighted average Units in 2017 and 2016, respectively. The distributions represented $2.41 and $17.87 per Unit of Net Income and $34.46 and $21.20 per Unit of return of contributed capital in 2017 and 2016, respectively. As part of the distributions discussed above, the Partnership distributed net sale proceeds (from property sales completed in 2014) of $68,812 in 2017. The Limited Partners received distributions of $68,124 and the General Partners received distributions of $688. The Limited Partners' distributions represented $3.47 per Unit. On April 1, 2017, the Partnership repurchased a total of 20.00 Units for $17,616 from one Limited Partner in accordance with the Partnership Agreement. The Partnership acquired these Units using Net Cash Flow from operations. On April 1, 2016, the Partnership repurchased a total of 264.01 Units for $233,076 from 12 Limited Partners. The Partnership acquired these Units using net sale proceeds. The repurchases increase the remaining Limited Partners' ownership interest in the Partnership. As a result of these repurchases and pursuant to the Partnership Agreement, the General Partners received distributions of $178 and $2,355 in 2017 and 2016, respectively. (6) Fair Value Measurements – As of September 30, 2017 and December 31, 2016, the Partnership had no assets or liabilities measured at fair value on a recurring basis or nonrecurring basis. Page 10 of 18 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. This section contains "forward-looking statements" which represent management's expectations or beliefs concerning future events, including statements regarding anticipated application of cash, expected returns from rental income, growth in revenue, the sufficiency of cash to meet operating expenses, rates of distribution, and other matters. These, and other forward-looking statements, should be evaluated in the context of a number of factors that may affect the Partnership's financial condition and results of operations, including the following: — | Market and economic conditions which affect the value of the properties the Partnership owns and the cash from rental income such properties generate; --+------------------------------------------------------------------------------------------------------------------------------------------------------- — | the federal income tax consequences of rental income, deductions, gain on sales and other items and the effects of these consequences for the Partners; --+-------------------------------------------------------------------------------------------------------------------------------------------------------- — | resolution by the General Partners of conflicts with which they may be confronted; --+----------------------------------------------------------------------------------- — | the success of the General Partners of locating properties with favorable risk return characteristics; --+------------------------------------------------------------------------------------------------------- — | the effect of tenant defaults; and --+----------------------------------- — | the condition of the industries in which the tenants of properties owned by the Partnership operate. --+----------------------------------------------------------------------------------------------------- Application of Critical Accounting Policies The Partnership's financial statements have been prepared in accordance with US GAAP. Preparing the financial statements requires management to use judgment in the application of these accounting policies, including making estimates and assumptions. These judgments will affect the reported amounts of the Partnership's assets and liabilities and the disclosure of contingent assets and liabilities as of the dates of the financial statements and will affect the reported amounts of revenue and expenses during the reporting periods. It is possible that the carrying amount of the Partnership's assets and liabilities, or the results of reported operations, will be affected if management's estimates or assumptions prove inaccurate. Management of the Partnership evaluates the following accounting estimates on an ongoing basis, and has discussed the development and selection of these estimates and the management discussion and analysis disclosures regarding them with the managing partner of the Partnership. Allocation of Purchase Price of Acquired Properties Upon acquisition of real properties, the Partnership records them in the financial statements at cost. The purchase price is allocated to tangible assets, consisting of land and building, and to identified intangible assets and liabilities, which may include the value of above market and below market leases and the value of in-place leases. The allocation of the purchase price is based upon the fair value of each component of the property. Although independent appraisals may be used to assist in the determination of fair value, in many cases these values will be based upon management's assessment of each property, the selling prices of comparable properties and the discounted value of cash flows from the asset. Page 11 of 18 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS. (Continued) The fair values of above market and below market in-place leases will be recorded based on the present value (using an interest rate which reflects the risks associated with the leases acquired) of the difference between (i) the contractual amounts to be paid pursuant to the in-place leases and (ii) an estimate of fair market lease rates for the corresponding in-place leases measured over a period equal to the non-cancelable term of the lease including any bargain renewal periods. The above market and below market lease values will be capitalized as intangible lease assets or liabilities. Above market lease values will be amortized as an adjustment of rental income over the remaining term of the respective leases. Below market lease values will be amortized as an adjustment of rental income over the remaining term of the respective leases, including any bargain renewal periods. If a lease were to be terminated prior to its stated expiration, all unamortized amounts of above market and below market in-place lease values relating to that lease would be recorded as an adjustment to rental income. The fair values of in-place leases will include estimated direct costs associated with obtaining a new tenant, and opportunity costs associated with lost rentals which are avoided by acquiring an in-place lease. Direct costs associated with obtaining a new tenant may include commissions, tenant improvements, and other direct costs and are estimated, in part, by management's consideration of current market costs to execute a similar lease. These direct costs will be included in intangible lease assets on the balance sheet and will be amortized to expense over the remaining term of the respective leases. The value of opportunity costs will be calculated using the contractual amounts to be paid pursuant to the in-place leases over a market absorption period for a similar lease. These intangibles will be included in intangible lease assets on the balance sheet and will be amortized to expense over the remaining term of the respective leases. If a lease were to be terminated prior to its stated expiration, all unamortized amounts of in-place lease assets relating to that lease would be expensed. The determination of the fair values of the assets and liabilities acquired will require the use of significant assumptions with regard to the current market rental rates, rental growth rates, discount and capitalization rates, interest rates and other variables. If management's estimates or assumptions prove inaccurate, the result would be an inaccurate allocation of purchase price, which could impact the amount of reported net income. Carrying Value of Properties Properties are carried at original cost, less accumulated depreciation and amortization. The Partnership tests long-lived assets for recoverability when events or changes in circumstances indicate that the carrying value may not be recoverable. For properties the Partnership will hold and operate, management determines whether impairment has occurred by comparing the property's probability-weighted future undiscounted cash flows to its current carrying value. For properties held for sale, management determines whether impairment has occurred by comparing the property's estimated fair value less cost to sell to its current carrying value. If the carrying value is greater than the net realizable value, an impairment loss is recorded to reduce the carrying value of the property to its net realizable value. Changes in these assumptions or analysis may cause material changes in the carrying value of the properties. Page 12 of 18 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS. (Continued) Allocation of Expenses AEI Fund Management, Inc. allocates expenses to each of the funds they manage primarily on the basis of the number of hours devoted by their employees to each fund's affairs. They also allocate expenses at the end of each month that are not directly related to a fund's operations based upon the number of investors in the fund and the fund's capitalization relative to other funds they manage. The Partnership reimburses these expenses subject to detailed limitations contained in the Partnership Agreement. Results of Operations For the nine months ended September 30, 2017 and 2016, the Partnership recognized rental income of $924,167 and $971,456, respectively. In 2017, rental income decreased due to the tenant of the KinderCare daycare center receiving free rent, and the Gander Mountain situation, as discussed below. These decreases were partially offset by additional rent received from one property acquisition in 2016 and rent increases on two properties. Based on the scheduled rent for the properties as of October 31, 2017, the Partnership expects to recognize rental income of approximately $1,216,000 and $1,182,000 in 2017 and 2018, respectively. For the nine months ended September 30, 2017 and 2016, the Partnership incurred Partnership administration expenses from affiliated parties of $128,126 and $127,367, respectively. These administration expenses include costs associated with the management of the properties, processing distributions, reporting requirements and communicating with the Limited Partners. During the same periods, the Partnership incurred Partnership administration and property management expenses from unrelated parties of $88,753 and $40,075, respectively. These expenses represent direct payments to third parties for legal and filing fees, direct administrative costs, outside audit costs, taxes, insurance and other property costs. These expenses were higher in 2017, when compared to 2016, due to expenses related to the Gander Mountain store. For the nine months ended September 30, 2016, the Partnership incurred property acquisition expenses of $56,760 related to the purchase of the Dollar Tree store in Cincinnati, Ohio. The Partnership owns a 30% interest in the Gander Mountain store in Champaign, Illinois. The remaining interests in the property are owned by affiliates of the Partnership. On March 10, 2017, Gander Mountain Company filed for Chapter 11 reorganization and announced it was closing the store, following a liquidation sale of its on‑site assets. In June 2017, the tenant filed a motion with the bankruptcy court to reject the lease for this store effective June 30, 2017. At this time, the tenant returned possession of the property to the owners and the Partnership became responsible for its 30% share of real estate taxes and other costs associated with maintaining the property. The tenant paid rent through June 2017. The owners have listed the property for lease with a real estate broker in the Champaign area. The annual rent from this property represented approximately 13% of the total annual rent of the Partnership's property portfolio. The loss of rent and increased expenses related to this property decreased the Partnership's cash flow. Consequently, beginning with the third quarter of 2017, the Partnership reduced its regular quarterly cash distribution rate from $13.18 per Unit to $10.51 per Unit. Page 13 of 18 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS. (Continued) As a result of the bankruptcy court terminating the lease for the Gander Mountain store, the Partnership included an additional $270,097 in Depreciation and Amortization in the second quarter of 2017, which represented the unamortized balance of the in-place lease intangible that was created when the property was purchased in 2014. In March 2017, the Partnership entered into an agreement with the tenant of the KinderCare daycare center in Andover, Minnesota to extend the lease term five years to expire on June 30, 2022. The annual rent will remain the same throughout the remainder of the extended lease term. As part of the agreement, the Partnership paid a tenant improvement allowance of $30,000 that was capitalized. In addition, beginning on April 1, 2017, the tenant received free rent for three months that equaled $36,362. In the first quarter of 2017, the Partnership decided to sell the property. At September 30, 2017, the property was classified as Real Estate Held for Sale with a carrying value of $652,572. In October 2017, the Partnership entered into an agreement to sell the KinderCare to an unrelated third party. The sale is subject to contingencies and may not be completed. If the sale is completed, the Partnership expects to receive net proceeds of approximately $1,695,000, which will result in a net gain of approximately $1,042,400. For the nine months ended September 30, 2017 and 2016, the Partnership recognized interest income of $1,097 and $2,361, respectively. Management believes inflation has not significantly affected income from operations. Leases may contain rent increases, based on the increase in the Consumer Price Index over a specified period, which will result in an increase in rental income over the term of the leases. Inflation also may cause the real estate to appreciate in value. However, inflation and changing prices may have an adverse impact on the operating margins of the properties' tenants, which could impair their ability to pay rent and subsequently reduce the Net Cash Flow available for distributions. Liquidity and Capital Resources During the nine months ended September 30, 2017, the Partnership's cash balances decreased $188,630 as a result of cash paid for tenant improvement allowances, and distributions paid to the Partners and cash used to repurchase Units in excess of cash generated from operating activities. During the nine months ended September 30, 2016, the Partnership's cash balances decreased $2,068,977 as a result of cash used to purchase property, and distributions paid to the Partners and cash used to repurchase Units in excess of cash generated from operating activities. Net cash provided by operating activities decreased from $765,870 in 2016 to $689,546 in 2017 as a result of a decrease in total rental and interest income in 2017, an increase in Partnership administration and property management expenses in 2017 and net timing differences in the collection of payments from the tenants and the payment of expenses. During 2016, cash from operations was reduced by $56,760 of acquisition expenses related to the purchase of real estate. Pursuant to accounting guidance, these expenses were reflected as operating cash outflows. However, pursuant to the Partnership Agreement, acquisition expenses were funded with proceeds from property sales. Page 14 of 18 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS. (Continued) The major components of the Partnership's cash flow from investing activities are investments in real estate and proceeds from the sale of real estate. During the nine months ended September 30, 2017 and 2016, the Partnership expended $76,750 and $1,809,915, respectively, to invest in real properties as the Partnership reinvested cash generated from property sales completed in 2014. On February 3, 2016, the Partnership purchased a Dollar Tree store in Cincinnati, Ohio for $1,809,915. The property is leased to Dollar Tree Stores, Inc. under a lease agreement with a remaining primary term of 10 years (as of the date of purchase) and annual rent of $122,169. In April 2017, the Partnership entered into an agreement with the tenant of the Fresenius Medical Center in Shreveport, Louisiana to extend the lease term nine years to expire on June 30, 2027. The annual rent will remain the same throughout the remainder of the extended lease term. As part of the agreement, the Partnership paid a tenant improvement allowance of $46,750 that was capitalized and will be depreciated. The Partnership's primary use of cash flow, other than investment in real estate, is distribution payments to Partners and cash used to repurchase Units. The Partnership declares its regular quarterly distributions before the end of each quarter and pays the distribution in the first week after the end of each quarter. The Partnership attempts to maintain a stable distribution rate from quarter to quarter. The Partnership may repurchase tendered Units on April 1st and October 1st of each year subject to limitations. For the nine months ended September 30, 2017 and 2016, the Partnership declared distributions of $730,702 and $786,569, respectively, which were distributed 99% to the Limited Partners and 1% to the General Partners. The Limited Partners received distributions of $723,395 and $778,703 and the General Partners received distributions of $7,307 and $7,866 for the periods, respectively. As part of the distributions discussed above, the Partnership distributed net sale proceeds (from property sales completed in 2014) of $68,812 in 2017. The Limited Partners received distributions of $68,124 and the General Partners received distributions of $688. The Limited Partners' distributions represented $3.47 per Unit. The Partnership may repurchase Units from Limited Partners who have tendered their Units to the Partnership. Such Units may be acquired at a discount. The Partnership will not be obligated to purchase in any year more than 5% of the total number of Units outstanding on January 1 of such year. In no event shall the Partnership be obligated to purchase Units if, in the sole discretion of the Managing General Partner, such purchase would impair the capital or operation of the Partnership. Page 15 of 18 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS. (Continued) On April 1, 2017, the Partnership repurchased a total of 20.00 Units for $17,616 from one Limited Partner in accordance with the Partnership Agreement. The Partnership acquired these Units using Net Cash Flow from operations. On April 1, 2016, the Partnership repurchased a total of 264.01 Units for $233,076 from 12 Limited Partners. The Partnership acquired these Units using net sale proceeds. The repurchases increase the remaining Limited Partners' ownership interest in the Partnership. As a result of these repurchases and pursuant to the Partnership Agreement, the General Partners received distributions of $178 and $2,355 in 2017 and 2016, respectively. The continuing rent payments from the properties, together with cash generated from property sales, should be adequate to fund continuing distributions and meet other Partnership obligations on both a short-term and long-term basis. Off-Balance Sheet Arrangements As of September 30, 2017 and December 31, 2016, the Partnership had no material off-balance sheet arrangements that had or are reasonably likely to have current or future effects on its financial condition, results of operations, liquidity or capital resources. ITEM 3. QUANTITATIVE & QUALITATIVE DISCLOSURES ABOUT MARKET RISK. Not required for a smaller reporting company. ITEM 4. CONTROLS AND PROCEDURES. (a) Disclosure Controls and Procedures. Under the supervision and with the participation of management, including its President and Chief Financial Officer, the Managing General Partner of the Partnership evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the "Exchange Act")). Based upon that evaluation, the President and Chief Financial Officer of the Managing General Partner concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective in ensuring that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in applicable rules and forms and that such information is accumulated and communicated to management, including the President and Chief Financial Officer of the Managing General Partner, in a manner that allows timely decisions regarding required disclosure. (b) Changes in Internal Control Over Financial Reporting. During the most recent period covered by this report, there has been no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. Page 16 of 18 PART II – OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS. There are no material pending legal proceedings to which the Partnership is a party or of which the Partnership's property is subject. ITEM 1A. RISK FACTORS. Not required for a smaller reporting company. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES & USE OF PROCEEDS. (a) None. (b) Not applicable. (c) Pursuant to Section 7.7 of the Partnership Agreement, as amended, each Limited Partner has the right to present Units to the Partnership for purchase by submitting notice to the Managing General Partner during January or July of each year. The purchase price of the Units is equal to 95% of the net asset value per Unit, as of the first business day of January or July of each year, as determined by the Managing General Partner in accordance with the provisions of the Partnership Agreement. Units tendered to the Partnership during January and July may be repurchased on April 1st and October 1st, respectively, of each year subject to the following limitations. The Partnership will not be obligated to purchase in any year more than 5% of the total number of Units outstanding on January 1 of such year. In no event shall the Partnership be obligated to purchase Units if, in the sole discretion of the Managing General Partner, such purchase would impair the capital or operation of the Partnership. During the period covered by this report, the Partnership did not purchase any Units. ITEM 3. DEFAULTS UPON SENIOR SECURITIES. None. ITEM 4. MINE SAFETY DISCLOSURES. Not Applicable. ITEM 5. OTHER INFORMATION. None. Page 17 of 18 ITEM 6. EXHIBITS. 31.1 | Certification of Chief Executive Officer of General Partner pursuant to Rule 15d-14(a)(17 CFR 240.15d-14(a)) and Section 302 of the Sarbanes-Oxley Act of 2002. -----+---------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.2 | Certification of Chief Financial Officer of General Partner pursuant to Rule 15d-14(a)(17 CFR 240.15d-14(a)) and Section 302 of the Sarbanes-Oxley Act of 2002. -----+---------------------------------------------------------------------------------------------------------------------------------------------------------------- 32 | Certification of Chief Executive Officer and Chief Financial Officer of General Partner pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. ---+--------------------------------------------------------------------------------------------------------------------------------------------------- SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Dated: November 13, 2017 | AEI Income & Growth Fund XXI --------------------------+----------------------------- | Limited Partnership --------------------------+----------------------------- | By: | AEI Fund Management XXI, Inc. --------------------------+------------------------------+------------------------------- | Its: | Managing General Partner --------------------------+------------------------------+------------------------------- | By: | /s/ ROBERT P JOHNSON --------------------------+------------------------------+------------------------------- | | Robert P. Johnson --------------------------+------------------------------+------------------------------- | | President --------------------------+------------------------------+------------------------------- | | (Principal Executive Officer) --------------------------+------------------------------+------------------------------- | By: | /s/ PATRICK W KEENE --------------------------+------------------------------+------------------------------- | | Patrick W. Keene --------------------------+------------------------------+------------------------------- | | Chief Financial Officer --------------------------+------------------------------+------------------------------- | | (Principal Accounting Officer) --------------------------+------------------------------+------------------------------- Page 18 of 18

AEI INCOME & GROWTH FUND XXII LTD PARTNERSHIP

1023458

10-Q

0001130758-17-000056

UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended: September 30, 2017 Commission File Number: 000-24003 AEI INCOME & GROWTH FUND XXII LIMITED PARTNERSHIP (Exact name of registrant as specified in its charter) State of Minnesota | 41-1848181 ---------------------------------------------------------------+------------------------------------- (State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) ---------------------------------------------------------------+------------------------------------- 30 East 7th Street, Suite 1300 St. Paul, Minnesota 55101 | (651) 227-7333 ---------------------------------------------------------------+------------------------------------- (Address of principal executive offices) | (Registrant's telephone number) ---------------------------------------------------------------+------------------------------------- Not Applicable ---------------------------------------------------------------------------------- (Former name, former address and former fiscal year, if changed since last report) ---------------------------------------------------------------------------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. ☒ Yes ☐ No Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). ☒ Yes ☐ No Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. ☐ Large accelerated filer | ☐ Accelerated filer --------------------------+---------------------------- ☐ Non-accelerated filer | ☒ Smaller reporting company --------------------------+---------------------------- ☐ Emerging growth company | --------------------------+---------------------------- If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ☐ Yes ☒ No AEI INCOME & GROWTH FUND XXII LIMITED PARTNERSHIP INDEX | | Page -------------------------------+----------+-------------------------------------------------------------- Part I – Financial Information | -------------------------------+--------- | Item 1. | Financial Statements: | -------------------------------+----------+---------------------------------------------------------------+--------------------------------------- | | Balance Sheets as of September 30, 2017 and December 31, 2016 | 3 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------- | | Statements for the Periods ended September 30, 2017 and 2016: | -------------------------------+----------+---------------------------------------------------------------+--------------------------------------- | | | Income | 4 -------------------------------+----------+---------------------------------------------------------------+----------------------------------------+-------- | | | Cash Flows | 5 -------------------------------+----------+---------------------------------------------------------------+----------------------------------------+-------- | | | Changes in Partners' Capital (Deficit) | 6 -------------------------------+----------+---------------------------------------------------------------+----------------------------------------+-------- | | Notes to Financial Statements | 7 - 9 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------- | Item 2. | Management's Discussion and Analysis of Financial | -------------------------------+----------+---------------------------------------------------------------+--------------------------------------- | | | Condition and Results of Operations | 10 - 14 -------------------------------+----------+---------------------------------------------------------------+----------------------------------------+-------- | Item 3. | Quantitative and Qualitative Disclosures About Market Risk | 14 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------- | Item 4. | Controls and Procedures | 14 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------- Part II – Other Information | -------------------------------+--------- | Item 1. | Legal Proceedings | 14 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------- | Item 1A. | Risk Factors | 14 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------- | Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | 15 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------- | Item 3. | Defaults Upon Senior Securities | 15 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------- | Item 4. | Mine Safety Disclosures | 15 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------- | Item 5. | Other Information | 15 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------- | Item 6. | Exhibits | 15 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------- Signatures | 16 -------------------------------+--------- Page 2 of 16 AEI INCOME & GROWTH FUND XXII LIMITED PARTNERSHIP BALANCE SHEETS ASSETS | September 30, | | | December 31, | ------------------------------------------+---------------+------------+---+--------------+-- | 2017 | | | 2016 | ------------------------------------------+---------------+------------+---+--------------+-- | (unaudited) | | | | ------------------------------------------+---------------+------------+---+--------------+-- Current Assets: | | | | | ------------------------------------------+---------------+------------+---+--------------+-- Cash | $ | 1,092,523 | | | $ | 1,117,341 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Real Estate Investments: | | | | | | | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Land | | 2,367,033 | | | | 2,367,033 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Buildings | | 6,631,829 | | | | 6,631,829 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Acquired Intangible Lease Assets | | 932,882 | | | | 932,882 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Real Estate Held for Investment, at cost | | 9,931,744 | | | | 9,931,744 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Accumulated Depreciation and Amortization | | (2,781,994 | ) | | | (2,513,257 | ) ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Real Estate Held for Investment, Net | | 7,149,750 | | | | 7,418,487 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Total Assets | $ | 8,242,273 | | | $ | 8,535,828 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- LIABILITIES AND PARTNERS' CAPITAL Current Liabilities: | | | | ------------------------------------------------------------------------------------------------------------------------------------------+---+-----------+---+-- Payable to AEI Fund Management, Inc. | $ | 10,922 | | $ | 24,914 | ------------------------------------------------------------------------------------------------------------------------------------------+---+-----------+---+---+-----------+-- Distributions Payable | | 144,948 | | | 144,948 | ------------------------------------------------------------------------------------------------------------------------------------------+---+-----------+---+---+-----------+-- Unearned Rent | | 38,865 | | | 9,620 | ------------------------------------------------------------------------------------------------------------------------------------------+---+-----------+---+---+-----------+-- Total Current Liabilities | | 194,735 | | | 179,482 | ------------------------------------------------------------------------------------------------------------------------------------------+---+-----------+---+---+-----------+-- Partners' Capital (Deficit): | | | | | | ------------------------------------------------------------------------------------------------------------------------------------------+---+-----------+---+---+-----------+-- General Partners | | (20,862 | ) | | (13,011 | ) ------------------------------------------------------------------------------------------------------------------------------------------+---+-----------+---+---+-----------+-- Limited Partners – 24,000 Units authorized; 13,879 and 14,002 Units issued and outstanding as of 9/30/17 and 12/31/16, respectively | | 8,068,400 | | | 8,369,357 | ------------------------------------------------------------------------------------------------------------------------------------------+---+-----------+---+---+-----------+-- Total Partners' Capital | | 8,047,538 | | | 8,356,346 | ------------------------------------------------------------------------------------------------------------------------------------------+---+-----------+---+---+-----------+-- Total Liabilities and Partners' Capital | $ | 8,242,273 | | $ | 8,535,828 | ------------------------------------------------------------------------------------------------------------------------------------------+---+-----------+---+---+-----------+-- The accompanying Notes to Financial Statements are an integral part of these statements. Page 3 of 16 AEI INCOME & GROWTH FUND XXII LIMITED PARTNERSHIP STATEMENTS OF INCOME (unaudited) | Three Months Ended September 30 | | Nine Months Ended September 30 | --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+-- | 2017 | | 2016 | | | 2017 | | 2016 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-------- Rental Income | $ | 188,647 | | $ | 184,322 | | $ | 565,213 | $ | 561,522 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- Expenses: | | | | | | | | | | --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- Partnership Administration – Affiliates | | 27,574 | | | 28,676 | | | 85,650 | | 88,719 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- Partnership Administration and Property Management – Unrelated Parties | | 8,197 | | | 8,413 | | | 26,227 | | 30,886 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- Depreciation and Amortization | | 77,141 | | | 77,111 | | | 231,423 | | 231,333 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- Total Expenses | | 112,912 | | | 114,200 | | | 343,300 | | 350,938 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- Operating Income | | 75,735 | | | 70,122 | | | 221,913 | | 210,584 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- Other Income: | | | | | | | | | | --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- Interest Income | | 761 | | | 929 | | | 2,295 | | 2,790 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- Net Income | $ | 76,496 | | $ | 71,051 | | $ | 224,208 | $ | 213,374 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- Net Income Allocated: | | | | | | | | | | --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- General Partners | $ | 2,295 | | $ | 2,131 | | $ | 6,726 | $ | 6,401 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- Limited Partners | | 74,201 | | | 68,920 | | | 217,482 | | 206,973 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- Total | $ | 76,496 | | $ | 71,051 | | $ | 224,208 | $ | 213,374 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- Net Income per Limited Partnership Unit | $ | 5.35 | | $ | 4.83 | | $ | 15.62 | $ | 14.48 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- Weighted Average Units Outstanding – Basic and Diluted | | 13,879 | | | 14,256 | | | 13,920 | | 14,289 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------+---+-------- The accompanying Notes to Financial Statements are an integral part of these statements. Page 4 of 16 AEI INCOME & GROWTH FUND XXII LIMITED PARTNERSHIP STATEMENTS OF CASH FLOWS (unaudited) | Nine Months Ended September 30 | ----------------------------------------------------------------------------------+--------------------------------+---------- | 2017 | | | 2016 | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+-- Cash Flows from Operating Activities: | | | | | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+-- Net Income | $ | 224,208 | | | $ | 213,374 | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+-----------+-- Adjustments to Reconcile Net Income To Net Cash Provided by Operating Activities: | | | | | | | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+-----------+-- Depreciation and Amortization | | 268,737 | | | | 268,647 | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+-----------+-- Increase (Decrease) in Payable to AEI Fund Management, Inc. | | (13,992 | ) | | | (1,234 | ) ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+-----------+-- Increase (Decrease) in Unearned Rent | | 29,245 | | | | 34,349 | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+-----------+-- Total Adjustments | | 283,990 | | | | 301,762 | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+-----------+-- Net Cash Provided By (Used For) Operating Activities | | 508,198 | | | | 515,136 | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+-----------+-- Cash Flows from Financing Activities: | | | | | | | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+-----------+-- Distributions Paid to Partners | | (433,386 | ) | | | (440,412 | ) ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+-----------+-- Repurchase of Partnership Units | | (99,630 | ) | | | (77,331 | ) ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+-----------+-- Net Cash Provided By (Used For) Financing Activities | | (533,016 | ) | | | (517,743 | ) ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+-----------+-- Net Increase (Decrease) in Cash | | (24,818 | ) | | | (2,607 | ) ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+-----------+-- Cash, beginning of period | | 1,117,341 | | | | 1,315,575 | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+-----------+-- Cash, end of period | $ | 1,092,523 | | | $ | 1,312,968 | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+-----------+-- The accompanying Notes to Financial Statements are an integral part of these statements. Page 5 of 16 AEI INCOME & GROWTH FUND XXII LIMITED PARTNERSHIP STATEMENTS OF CHANGES IN PARTNERS' CAPITAL (DEFICIT) (unaudited) | General Partners | | | Limited Partners | | | Total | | Limited Partnership Units Outstanding | --------------------------------+------------------+---------+---+------------------+---+-----------+-------+---+---------------------------------------+-- Balance, December 31, 2015 | $ | 30 | | | $ | 8,921,357 | | $ | 8,921,387 | | 14,354.66 | --------------------------------+------------------+---------+---+------------------+---+-----------+-------+---+---------------------------------------+---+-----------+-- Distributions Declared | | (13,212 | ) | | | (427,203 | ) | | (440,415 | ) | | --------------------------------+------------------+---------+---+------------------+---+-----------+-------+---+---------------------------------------+---+-----------+-- Repurchase of Partnership Units | | (2,320 | ) | | | (75,011 | ) | | (77,331 | ) | (98.51 | ) --------------------------------+------------------+---------+---+------------------+---+-----------+-------+---+---------------------------------------+---+-----------+-- Net Income | | 6,401 | | | | 206,973 | | | 213,374 | | | --------------------------------+------------------+---------+---+------------------+---+-----------+-------+---+---------------------------------------+---+-----------+-- Balance, September 30, 2016 | $ | (9,101 | ) | | $ | 8,626,116 | | $ | 8,617,015 | | 14,256.15 | --------------------------------+------------------+---------+---+------------------+---+-----------+-------+---+---------------------------------------+---+-----------+-- Balance, December 31, 2016 | $ | (13,011 | ) | | $ | 8,369,357 | | $ | 8,356,346 | | 14,001.92 | --------------------------------+------------------+---------+---+------------------+---+-----------+-------+---+---------------------------------------+---+-----------+-- Distributions Declared | | (11,588 | ) | | | (421,798 | ) | | (433,386 | ) | | --------------------------------+------------------+---------+---+------------------+---+-----------+-------+---+---------------------------------------+---+-----------+-- Repurchase of Partnership Units | | (2,989 | ) | | | (96,641 | ) | | (99,630 | ) | (123.00 | ) --------------------------------+------------------+---------+---+------------------+---+-----------+-------+---+---------------------------------------+---+-----------+-- Net Income | | 6,726 | | | | 217,482 | | | 224,208 | | | --------------------------------+------------------+---------+---+------------------+---+-----------+-------+---+---------------------------------------+---+-----------+-- Balance, September 30, 2017 | $ | (20,862 | ) | | $ | 8,068,400 | | $ | 8,047,538 | | 13,878.92 | --------------------------------+------------------+---------+---+------------------+---+-----------+-------+---+---------------------------------------+---+-----------+-- The accompanying Notes to Financial Statements are an integral part of these statements. Page 6 of 16 AEI INCOME & GROWTH FUND XXII LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS SEPTEMBER 30, 2017 (unaudited) (1) The condensed statements included herein have been prepared by the registrant, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission, and reflect all adjustments which are, in the opinion of management, necessary to a fair statement of the results of operations for the interim period, on a basis consistent with the annual audited statements. The adjustments made to these condensed statements consist only of normal recurring adjustments. Certain information, accounting policies, and footnote disclosures normally included in financial statements prepared in accordance with United States Generally Accepted Accounting Principles (US GAAP) have been condensed or omitted pursuant to such rules and regulations, although the registrant believes that the disclosures are adequate to make the information presented not misleading. It is suggested that these condensed financial statements be read in conjunction with the financial statements and the summary of significant accounting policies and notes thereto included in the registrant's latest annual report on Form 10‑K. (2) Organization – AEI Income & Growth Fund XXII Limited Partnership ("Partnership") was formed to acquire and lease commercial properties to operating tenants. The Partnership's operations are managed by AEI Fund Management XXI, Inc. ("AFM"), the Managing General Partner. Robert P. Johnson, the President and sole director of AFM, serves as the Individual General Partner. AFM is a wholly owned subsidiary of AEI Capital Corporation of which Mr. Johnson is the majority shareholder. AEI Fund Management, Inc. ("AEI"), an affiliate of AFM, performs the administrative and operating functions for the Partnership. The terms of the Partnership offering called for a subscription price of $1,000 per Limited Partnership Unit, payable on acceptance of the offer. The Partnership commenced operations on May 1, 1997 when minimum subscriptions of 1,500 Limited Partnership Units ($1,500,000) were accepted. The offering terminated January 9, 1999 when the extended offering period expired. The Partnership received subscriptions for 16,917.222 Limited Partnership Units. Under the terms of the Limited Partnership Agreement, the Limited Partners and General Partners contributed funds of $16,917,222 and $1,000, respectively. During operations, any Net Cash Flow, as defined, which the General Partners determine to distribute will be distributed 97% to the Limited Partners and 3% to the General Partners. Distributions to Limited Partners will be made pro rata by Units. Any Net Proceeds of Sale, as defined, from the sale or financing of properties which the General Partners determine to distribute will, after provisions for debts and reserves, be paid in the following manner: (i) first, 99% to the Limited Partners and 1% to the General Partners until the Limited Partners receive an amount equal to: (a) their Adjusted Capital Contribution plus (b) an amount equal to 9% of their Adjusted Capital Contribution per annum, cumulative but not compounded, to the extent not previously distributed from Net Cash Flow; (ii) any remaining balance will be distributed 90% to the Limited Partners and 10% to the General Partners. Distributions to the Limited Partners will be made pro rata by Units. Page 7 of 16 AEI INCOME & GROWTH FUND XXII LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS (Continued) (2) Organization – (Continued) For tax purposes, profits from operations, other than profits attributable to the sale, exchange, financing, refinancing or other disposition of property, will be allocated first in the same ratio in which, and to the extent, Net Cash Flow is distributed to the Partners for such year. Any additional profits will be allocated in the same ratio as the last dollar of Net Cash Flow is distributed. Net losses from operations will be allocated 99% to the Limited Partners and 1% to the General Partners. For tax purposes, profits arising from the sale, financing, or other disposition of property will be allocated in accordance with the Partnership Agreement as follows: (i) first, to those partners with deficit balances in their capital accounts in an amount equal to the sum of such deficit balances; (ii) second, 99% to the Limited Partners and 1% to the General Partners until the aggregate balance in the Limited Partners' capital accounts equals the sum of the Limited Partners' Adjusted Capital Contributions plus an amount equal to 9% of their Adjusted Capital Contributions per annum, cumulative but not compounded, to the extent not previously allocated; (iii) third, the balance of any remaining gain will then be allocated 90% to the Limited Partners and 10% to the General Partners. Losses will be allocated 98% to the Limited Partners and 2% to the General Partners. The General Partners are not required to currently fund a deficit capital balance. Upon liquidation of the Partnership or withdrawal by a General Partner, the General Partners will contribute to the Partnership an amount equal to the lesser of the deficit balances in their capital accounts or 1% of total Limited Partners' and General Partners' capital contributions. In May 2015, the Managing General Partner mailed a Consent Statement (Proxy) seeking the consent of the Limited Partners to continue the Partnership for an additional 60 months or to initiate the final disposition, liquidation and distribution of all of the Partnership's properties and assets. Approval of either proposal required the affirmative vote of holders of a majority of the outstanding units. On June 17, 2015, the votes were counted and neither proposal received the required majority vote. As a result, the Partnership will not liquidate and will continue in operation until the Limited Partners vote to authorize the sale of all of the Partnership's properties or December 31, 2046, as stated in the Limited Partnership Agreement. However, in approximately five years, the Managing General Partner expects to again submit the question to liquidate to a vote by the Limited Partners. (3) Reclassification – Certain items related to discontinued operations in the prior year's financial statements have been reclassified to conform to 2017 presentation. These reclassifications had no effect on Partners' capital, net income or cash flows. Page 8 of 16 AEI INCOME & GROWTH FUND XXII LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS (Continued) (4) Payable to AEI Fund Management, Inc. – AEI Fund Management, Inc. performs the administrative and operating functions for the Partnership. The payable to AEI Fund Management represents the balance due for those services. This balance is non-interest bearing and unsecured and is to be paid in the normal course of business. (5) Partners' Capital – For the nine months ended September 30, 2017 and 2016, the Partnership declared distributions of $433,386 and $440,415, respectively. The Limited Partners received distributions of $421,798 and $427,203 and the General Partners received distributions of $11,588 and $13,212 for the periods, respectively. The Limited Partners' distributions represented $30.30 and $29.90 per Limited Partnership Unit outstanding using 13,920 and 14,289 weighted average Units in 2017 and 2016, respectively. The distributions represented $8.66 and $9.22 per Unit of Net Income and $21.64 and $20.68 per Unit of return of contributed capital in 2017 and 2016, respectively. As part of the distributions discussed above, the Partnership distributed net sale proceeds of $70,707 in 2017. The Limited Partners received distributions of $70,000 and the General Partners received distributions of $707. The Limited Partners' distributions represented $5.04 per Unit. On April 1, 2017, the Partnership repurchased a total of 123.00 Units for $96,641 from four Limited Partners in accordance with the Partnership Agreement. On April 1, 2016, the Partnership repurchased a total of 98.51 Units for $75,011 from seven Limited Partners. The Partnership acquired these Units using Net Cash Flow from operations. The repurchases increase the remaining Limited Partners' ownership interest in the Partnership. As a result of these repurchases and pursuant to the Partnership Agreement, the General Partners received distributions of $2,989 and $2,320 in 2017 and 2016, respectively. (6) Fair Value Measurements – As of September 30, 2017 and December 31, 2016, the Partnership had no assets or liabilities measured at fair value on a recurring basis or nonrecurring basis. Page 9 of 16 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. This section contains "forward-looking statements" which represent management's expectations or beliefs concerning future events, including statements regarding anticipated application of cash, expected returns from rental income, growth in revenue, the sufficiency of cash to meet operating expenses, rates of distribution, and other matters. These, and other forward-looking statements, should be evaluated in the context of a number of factors that may affect the Partnership's financial condition and results of operations, including the following: — | Market and economic conditions which affect the value of the properties the Partnership owns and the cash from rental income such properties generate; --+------------------------------------------------------------------------------------------------------------------------------------------------------- — | the federal income tax consequences of rental income, deductions, gain on sales and other items and the effects of these consequences for the Partners; --+-------------------------------------------------------------------------------------------------------------------------------------------------------- — | resolution by the General Partners of conflicts with which they may be confronted; --+----------------------------------------------------------------------------------- — | the success of the General Partners of locating properties with favorable risk return characteristics; --+------------------------------------------------------------------------------------------------------- — | the effect of tenant defaults; and --+----------------------------------- — | the condition of the industries in which the tenants of properties owned by the Partnership operate. --+----------------------------------------------------------------------------------------------------- Application of Critical Accounting Policies The Partnership's financial statements have been prepared in accordance with US GAAP. Preparing the financial statements requires management to use judgment in the application of these accounting policies, including making estimates and assumptions. These judgments will affect the reported amounts of the Partnership's assets and liabilities and the disclosure of contingent assets and liabilities as of the dates of the financial statements and will affect the reported amounts of revenue and expenses during the reporting periods. It is possible that the carrying amount of the Partnership's assets and liabilities, or the results of reported operations, will be affected if management's estimates or assumptions prove inaccurate. Management of the Partnership evaluates the following accounting estimates on an ongoing basis, and has discussed the development and selection of these estimates and the management discussion and analysis disclosures regarding them with the managing partner of the Partnership. Allocation of Purchase Price of Acquired Properties Upon acquisition of real properties, the Partnership records them in the financial statements at cost. The purchase price is allocated to tangible assets, consisting of land and building, and to identified intangible assets and liabilities, which may include the value of above market and below market leases and the value of in-place leases. The allocation of the purchase price is based upon the fair value of each component of the property. Although independent appraisals may be used to assist in the determination of fair value, in many cases these values will be based upon management's assessment of each property, the selling prices of comparable properties and the discounted value of cash flows from the asset. Page 10 of 16 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS. (Continued) The fair values of above market and below market in-place leases will be recorded based on the present value (using an interest rate which reflects the risks associated with the leases acquired) of the difference between (i) the contractual amounts to be paid pursuant to the in-place leases and (ii) an estimate of fair market lease rates for the corresponding in-place leases measured over a period equal to the non-cancelable term of the lease including any bargain renewal periods. The above market and below market lease values will be capitalized as intangible lease assets or liabilities. Above market lease values will be amortized as an adjustment of rental income over the remaining term of the respective leases. Below market lease values will be amortized as an adjustment of rental income over the remaining term of the respective leases, including any bargain renewal periods. If a lease were to be terminated prior to its stated expiration, all unamortized amounts of above market and below market in-place lease values relating to that lease would be recorded as an adjustment to rental income. The fair values of in-place leases will include estimated direct costs associated with obtaining a new tenant, and opportunity costs associated with lost rentals which are avoided by acquiring an in-place lease. Direct costs associated with obtaining a new tenant may include commissions, tenant improvements, and other direct costs and are estimated, in part, by management's consideration of current market costs to execute a similar lease. These direct costs will be included in intangible lease assets on the balance sheet and will be amortized to expense over the remaining term of the respective leases. The value of opportunity costs will be calculated using the contractual amounts to be paid pursuant to the in-place leases over a market absorption period for a similar lease. These intangibles will be included in intangible lease assets on the balance sheet and will be amortized to expense over the remaining term of the respective leases. If a lease were to be terminated prior to its stated expiration, all unamortized amounts of in-place lease assets relating to that lease would be expensed. The determination of the fair values of the assets and liabilities acquired will require the use of significant assumptions with regard to the current market rental rates, rental growth rates, discount and capitalization rates, interest rates and other variables. If management's estimates or assumptions prove inaccurate, the result would be an inaccurate allocation of purchase price, which could impact the amount of reported net income. Carrying Value of Properties Properties are carried at original cost, less accumulated depreciation and amortization. The Partnership tests long-lived assets for recoverability when events or changes in circumstances indicate that the carrying value may not be recoverable. For properties the Partnership will hold and operate, management determines whether impairment has occurred by comparing the property's probability-weighted future undiscounted cash flows to its current carrying value. For properties held for sale, management determines whether impairment has occurred by comparing the property's estimated fair value less cost to sell to its current carrying value. If the carrying value is greater than the net realizable value, an impairment loss is recorded to reduce the carrying value of the property to its net realizable value. Changes in these assumptions or analysis may cause material changes in the carrying value of the properties. Page 11 of 16 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS. (Continued) Allocation of Expenses AEI Fund Management, Inc. allocates expenses to each of the funds they manage primarily on the basis of the number of hours devoted by their employees to each fund's affairs. They also allocate expenses at the end of each month that are not directly related to a fund's operations based upon the number of investors in the fund and the fund's capitalization relative to other funds they manage. The Partnership reimburses these expenses subject to detailed limitations contained in the Partnership Agreement. Results of Operations For the nine months ended September 30, 2017 and 2016, the Partnership recognized rental income of $565,213 and $561,522, respectively. In 2017, rental income increased due to rent increases on three properties. These increases were partially offset by a decrease in rental income in 2017, when compared to 2016, due to payments received from a prior tenant's bankruptcy plan in 2016. Based on the scheduled rent for the properties as of October 31, 2017, the Partnership expects to recognize rental income of approximately $755,000 and $760,000 in 2017 and 2018, respectively. For the nine months ended September 30, 2017 and 2016, the Partnership incurred Partnership administration expenses from affiliated parties of $85,650 and $88,719, respectively. These administration expenses include costs associated with the management of the properties, processing distributions, reporting requirements and communicating with the Limited Partners. During the same periods, the Partnership incurred Partnership administration and property management expenses from unrelated parties of $26,227 and $30,886, respectively. These expenses represent direct payments to third parties for legal and filing fees, direct administrative costs, outside audit costs, taxes, insurance and other property costs. For the nine months ended September 30, 2017 and 2016, the Partnership recognized interest income of $2,295 and $2,790, respectively. Management believes inflation has not significantly affected income from operations. Leases may contain rent increases, based on the increase in the Consumer Price Index over a specified period, which will result in an increase in rental income over the term of the leases. Inflation also may cause the real estate to appreciate in value. However, inflation and changing prices may have an adverse impact on the operating margins of the properties' tenants, which could impair their ability to pay rent and subsequently reduce the Net Cash Flow available for distributions. Liquidity and Capital Resources During the nine months ended September 30, 2017 and 2016, the Partnership's cash balances decreased $24,818 and $2,607, respectively, as a result of distributions paid to the Partners and cash used to repurchase Units in excess of cash generated from operating activities. Page 12 of 16 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS. (Continued) Net cash provided by operating activities decreased from $515,136 in 2016 to $508,198 in 2017 as a result of net timing differences in the collection of payments from the tenants and the payment of expenses, which were partially offset by an increase in total rental and interest income in 2017 and a decrease in Partnership administration and property management expenses in 2017. The Partnership's primary use of cash flow, other than investment in real estate, is distribution payments to Partners and cash used to repurchase Units. The Partnership declares its regular quarterly distributions before the end of each quarter and pays the distribution in the first week after the end of each quarter. The Partnership attempts to maintain a stable distribution rate from quarter to quarter. The Partnership may repurchase tendered Units on April 1st and October 1st of each year subject to limitations. For the nine months ended September 30, 2017 and 2016, the Partnership declared distributions of $433,386 and $440,415, respectively. Pursuant to the Partnership Agreement, distributions of Net Cash Flow were allocated 97% to the Limited Partners and 3% to the General Partners. Distributions of Net Proceeds of Sale were allocated 99% to the Limited Partners and 1% to the General Partners. The Limited Partners received distributions of $421,798 and $427,203 and the General Partners received distributions of $11,588 and $13,212 for the periods, respectively. As part of the distributions discussed above, the Partnership distributed net sale proceeds of $70,707 in 2017. The Limited Partners received distributions of $70,000 and the General Partners received distributions of $707. The Limited Partners' distributions represented $5.04 per Unit. The Partnership may repurchase Units from Limited Partners who have tendered their Units to the Partnership. Such Units may be acquired at a discount. The Partnership will not be obligated to purchase in any year any number of Units that, when aggregated with all other transfers of Units that have occurred since the beginning of the same calendar year (excluding Permitted Transfers as defined in the Partnership Agreement), would exceed 5% of the total number of Units outstanding on January 1 of such year. In no event shall the Partnership be obligated to purchase Units if, in the sole discretion of the Managing General Partner, such purchase would impair the capital or operation of the Partnership. On April 1, 2017, the Partnership repurchased a total of 123.00 Units for $96,641 from four Limited Partners in accordance with the Partnership Agreement. On April 1, 2016, the Partnership repurchased a total of 98.51 Units for $75,011 from seven Limited Partners. The Partnership acquired these Units using Net Cash Flow from operations. The repurchases increase the remaining Limited Partners' ownership interest in the Partnership. As a result of these repurchases and pursuant to the Partnership Agreement, the General Partners received distributions of $2,989 and $2,320 in 2017 and 2016, respectively. The continuing rent payments from the properties, together with cash generated from property sales, should be adequate to fund continuing distributions and meet other Partnership obligations on both a short-term and long-term basis. Page 13 of 16 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS. (Continued) Off-Balance Sheet Arrangements As of September 30, 2017 and December 31, 2016, the Partnership had no material off-balance sheet arrangements that had or are reasonably likely to have current or future effects on its financial condition, results of operations, liquidity or capital resources. ITEM 3. QUANTITATIVE & QUALITATIVE DISCLOSURES ABOUT MARKET RISK. Not required for a smaller reporting company. ITEM 4. CONTROLS AND PROCEDURES. (a) Disclosure Controls and Procedures. Under the supervision and with the participation of management, including its President and Chief Financial Officer, the Managing General Partner of the Partnership evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the "Exchange Act")). Based upon that evaluation, the President and Chief Financial Officer of the Managing General Partner concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective in ensuring that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in applicable rules and forms and that such information is accumulated and communicated to management, including the President and Chief Financial Officer of the Managing General Partner, in a manner that allows timely decisions regarding required disclosure. (b) Changes in Internal Control Over Financial Reporting. During the most recent period covered by this report, there has been no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. PART II – OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS. There are no material pending legal proceedings to which the Partnership is a party or of which the Partnership's property is subject. ITEM 1A. RISK FACTORS. Not required for a smaller reporting company. Page 14 of 16 ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES & USE OF PROCEEDS. (a) None. (b) Not applicable. (c) Pursuant to Section 7.7 of the Partnership Agreement, each Limited Partner has the right to present Units to the Partnership for purchase by submitting notice to the Managing General Partner during January or July of each year. The purchase price of the Units is equal to 90% of the net asset value per Unit, as of the first business day of January or July of each year, as determined by the Managing General Partner in accordance with the provisions of the Partnership Agreement. Units tendered to the Partnership during January and July may be repurchased on April 1st and October 1st, respectively, of each year subject to the following limitations. The Partnership will not be obligated to purchase in any year any number of Units that, when aggregated with all other transfers of Units that have occurred since the beginning of the same calendar year (excluding Permitted Transfers as defined in the Partnership Agreement), would exceed 5% of the total number of Units outstanding on January 1 of such year. In no event shall the Partnership be obligated to purchase Units if, in the sole discretion of the Managing General Partner, such purchase would impair the capital or operation of the Partnership. During the period covered by this report, the Partnership did not purchase any Units. ITEM 3. DEFAULTS UPON SENIOR SECURITIES. None. ITEM 4. MINE SAFETY DISCLOSURES. Not Applicable. ITEM 5. OTHER INFORMATION. None. ITEM 6. EXHIBITS. 31.1 | Certification of Chief Executive Officer of General Partner pursuant to Rule 15d-14(a)(17 CFR 240.15d-14(a)) and Section 302 of the Sarbanes-Oxley Act of 2002. -----+---------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.2 | Certification of Chief Financial Officer of General Partner pursuant to Rule 15d-14(a)(17 CFR 240.15d-14(a)) and Section 302 of the Sarbanes-Oxley Act of 2002. -----+---------------------------------------------------------------------------------------------------------------------------------------------------------------- 32 | Certification of Chief Executive Officer and Chief Financial Officer of General Partner pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. ---+--------------------------------------------------------------------------------------------------------------------------------------------------- Page 15 of 16 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Dated: November 13, 2017 | AEI Income & Growth Fund XXII --------------------------+------------------------------ | Limited Partnership --------------------------+------------------------------ | By: | AEI Fund Management XXI, Inc. --------------------------+-------------------------------+------------------------------- | Its: | Managing General Partner --------------------------+-------------------------------+------------------------------- | By: | /s/ ROBERT P JOHNSON --------------------------+-------------------------------+------------------------------- | | Robert P. Johnson --------------------------+-------------------------------+------------------------------- | | President --------------------------+-------------------------------+------------------------------- | | (Principal Executive Officer) --------------------------+-------------------------------+------------------------------- | By: | /s/ PATRICK W KEENE --------------------------+-------------------------------+------------------------------- | | Patrick W. Keene --------------------------+-------------------------------+------------------------------- | | Chief Financial Officer --------------------------+-------------------------------+------------------------------- | | (Principal Accounting Officer) --------------------------+-------------------------------+------------------------------- Page 16 of 16

AEI Income & Growth Fund 26 LLC

1326321

10-Q

0001130758-17-000059

UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended: September 30, 2017 Commission File Number: 000-51823 AEI INCOME & GROWTH FUND 26 LLC (Exact name of registrant as specified in its charter) State of Delaware | 41-2173048 ---------------------------------------------------------------+------------------------------------- (State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) ---------------------------------------------------------------+------------------------------------- 30 East 7th Street, Suite 1300 St. Paul, Minnesota 55101 | (651) 227-7333 ---------------------------------------------------------------+------------------------------------- (Address of principal executive offices) | (Registrant's telephone number) ---------------------------------------------------------------+------------------------------------- Not Applicable ---------------------------------------------------------------------------------- (Former name, former address and former fiscal year, if changed since last report) ---------------------------------------------------------------------------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. ☒ Yes ☐ No Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). ☒ Yes ☐ No Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. ☐ Large accelerated filer | ☐ Accelerated filer --------------------------+---------------------------- ☐ Non-accelerated filer | ☒ Smaller reporting company --------------------------+---------------------------- ☐ Emerging growth company | --------------------------+---------------------------- If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ☐ Yes ☒ No AEI INCOME & GROWTH FUND 26 LLC INDEX | | Page -------------------------------+----------+-------------------------------------------------------------- Part I – Financial Information | -------------------------------+--------- | Item 1. | Financial Statements: | -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | | Balance Sheets as of September 30, 2017 and December 31, 2016 | 3 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | | Statements for the Periods ended September 30, 2017 and 2016: | -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | | | Income | 4 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------+-------- | | | Cash Flows | 5 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------+-------- | | | Changes in Members' Equity (Deficit) | 6 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------+-------- | | Notes to Financial Statements | 7 - 10 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | Item 2. | Management's Discussion and Analysis of Financial | -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | | | Condition and Results of Operations | 11 - 16 -------------------------------+----------+---------------------------------------------------------------+--------------------------------------+-------- | Item 3. | Quantitative and Qualitative Disclosures About Market Risk | 16 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | Item 4. | Controls and Procedures | 16 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- Part II – Other Information | -------------------------------+--------- | Item 1. | Legal Proceedings | 17 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | Item 1A. | Risk Factors | 17 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | 17 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | Item 3. | Defaults Upon Senior Securities | 17 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | Item 4. | Mine Safety Disclosures | 17 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | Item 5. | Other Information | 17 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- | Item 6. | Exhibits | 18 -------------------------------+----------+---------------------------------------------------------------+------------------------------------- Signatures | 18 -------------------------------+--------- Page 2 of 18 AEI INCOME & GROWTH FUND 26 LLC BALANCE SHEETS ASSETS | September 30, | | | December 31, | ------------------------------------------+---------------+------------+---+--------------+-- | 2017 | | | 2016 | ------------------------------------------+---------------+------------+---+--------------+-- Current Assets: | | | | | ------------------------------------------+---------------+------------+---+--------------+-- Cash | $ | 582,297 | | | $ | 603,691 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Real Estate Investments: | | | | | | | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Land | | 4,553,261 | | | | 4,553,261 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Buildings | | 9,879,009 | | | | 9,849,009 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Acquired Intangible Lease Assets | | 652,025 | | | | 652,025 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Real Estate Held for Investment, at cost | | 15,084,295 | | | | 15,054,295 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Accumulated Depreciation and Amortization | | (3,408,200 | ) | | | (3,063,551 | ) ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Real Estate Held for Investment, Net | | 11,676,095 | | | | 11,990,744 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Total Assets | $ | 12,258,392 | | | $ | 12,594,435 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- LIABILITIES AND MEMBERS' EQUITY Current Liabilities: | | | | ---------------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+-- Payable to AEI Fund Management, Inc. | $ | 53,497 | | $ | 21,359 | ---------------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Distributions Payable | | 170,104 | | | 170,102 | ---------------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Unearned Rent | | 19,015 | | | 0 | ---------------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Total Current Liabilities | | 242,616 | | | 191,461 | ---------------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Long-term Liabilities: | | | | | | ---------------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Acquired Below-Market Lease Intangibles, Net | | 236,655 | | | 258,843 | ---------------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Members' Equity (Deficit): | | | | | | ---------------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Managing Members | | (20,866 | ) | | (10,319 | ) ---------------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Limited Members – 10,000,000 Units authorized; 1,738,006 and 1,744,006 Units issued and outstanding as of 9/30/17 and 12/31/16, respectively | | 11,799,987 | | | 12,154,450 | ---------------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Total Members' Equity | | 11,779,121 | | | 12,144,131 | ---------------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Total Liabilities and Members' Equity | $ | 12,258,392 | | $ | 12,594,435 | ---------------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- The accompanying Notes to Financial Statements are an integral part of these statements. Page 3 of 18 AEI INCOME & GROWTH FUND 26 LLC STATEMENTS OF INCOME (unaudited) | Three Months Ended September 30 | | Nine Months Ended September 30 | ------------------------------------------------------------------+---------------------------------+-----------+--------------------------------+-- | 2017 | | 2016 | | | 2017 | | 2016 ------------------------------------------------------------------+---------------------------------+-----------+--------------------------------+---+-----------+------+---+---------- Rental Income | $ | 233,129 | | $ | 242,912 | | $ | 711,183 | $ | 807,033 ------------------------------------------------------------------+---------------------------------+-----------+--------------------------------+---+-----------+------+---+-----------+---+---------- Expenses: | | | | | | | | | | ------------------------------------------------------------------+---------------------------------+-----------+--------------------------------+---+-----------+------+---+-----------+---+---------- LLC Administration – Affiliates | | 35,339 | | | 36,493 | | | 109,788 | | 115,853 ------------------------------------------------------------------+---------------------------------+-----------+--------------------------------+---+-----------+------+---+-----------+---+---------- LLC Administration and Property Management – Unrelated Parties | | 16,539 | | | 28,594 | | | 81,287 | | 80,813 ------------------------------------------------------------------+---------------------------------+-----------+--------------------------------+---+-----------+------+---+-----------+---+---------- Property Acquisition | | 0 | | | 55 | | | 0 | | 55,479 ------------------------------------------------------------------+---------------------------------+-----------+--------------------------------+---+-----------+------+---+-----------+---+---------- Depreciation and Amortization | | 112,989 | | | 112,989 | | | 338,967 | | 330,528 ------------------------------------------------------------------+---------------------------------+-----------+--------------------------------+---+-----------+------+---+-----------+---+---------- Total Expenses | | 164,867 | | | 178,131 | | | 530,042 | | 582,673 ------------------------------------------------------------------+---------------------------------+-----------+--------------------------------+---+-----------+------+---+-----------+---+---------- Operating Income | | 68,262 | | | 64,781 | | | 181,141 | | 224,360 ------------------------------------------------------------------+---------------------------------+-----------+--------------------------------+---+-----------+------+---+-----------+---+---------- Other Income: | | | | | | | | | | ------------------------------------------------------------------+---------------------------------+-----------+--------------------------------+---+-----------+------+---+-----------+---+---------- Interest Income | | 383 | | | 427 | | | 1,199 | | 1,809 ------------------------------------------------------------------+---------------------------------+-----------+--------------------------------+---+-----------+------+---+-----------+---+---------- Net Income | $ | 68,645 | | $ | 65,208 | | $ | 182,340 | $ | 226,169 ------------------------------------------------------------------+---------------------------------+-----------+--------------------------------+---+-----------+------+---+-----------+---+---------- Net Income Allocated: | | | | | | | | | | ------------------------------------------------------------------+---------------------------------+-----------+--------------------------------+---+-----------+------+---+-----------+---+---------- Managing Members | $ | 2,059 | | $ | 1,956 | | $ | 5,470 | $ | 6,785 ------------------------------------------------------------------+---------------------------------+-----------+--------------------------------+---+-----------+------+---+-----------+---+---------- Limited Members | | 66,586 | | | 63,252 | | | 176,870 | | 219,384 ------------------------------------------------------------------+---------------------------------+-----------+--------------------------------+---+-----------+------+---+-----------+---+---------- Total | $ | 68,645 | | $ | 65,208 | | $ | 182,340 | $ | 226,169 ------------------------------------------------------------------+---------------------------------+-----------+--------------------------------+---+-----------+------+---+-----------+---+---------- Net Income per LLC Unit | $ | .04 | | $ | .04 | | $ | .10 | $ | .13 ------------------------------------------------------------------+---------------------------------+-----------+--------------------------------+---+-----------+------+---+-----------+---+---------- Weighted Average Units Outstanding – Basic and Diluted | | 1,738,006 | | | 1,744,006 | | | 1,740,006 | | 1,747,618 ------------------------------------------------------------------+---------------------------------+-----------+--------------------------------+---+-----------+------+---+-----------+---+---------- The accompanying Notes to Financial Statements are an integral part of these statements. Page 4 of 18 AEI INCOME & GROWTH FUND 26 LLC STATEMENTS OF CASH FLOWS (unaudited) | Nine Months Ended September 30 | ----------------------------------------------------------------------------------+--------------------------------+--------- | 2017 | | | 2016 | ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+-- Cash Flows from Operating Activities: | | | | | ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+-- Net Income | $ | 182,340 | | | $ | 226,169 | ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Adjustments to Reconcile Net Income To Net Cash Provided by Operating Activities: | | | | | | | ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Depreciation and Amortization | | 322,461 | | | | 318,954 | ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- (Increase) Decrease in Receivables | | 0 | | | | 22,487 | ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Increase (Decrease) in Payable to AEI Fund Management, Inc. | | 32,138 | | | | 30,586 | ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Increase (Decrease) in Unearned Rent | | 19,015 | | | | 45,743 | ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Total Adjustments | | 373,614 | | | | 417,770 | ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Net Cash Provided By (Used For) Operating Activities | | 555,954 | | | | 643,939 | ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Cash Flows from Investing Activities: | | | | | | | ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Investments in Real Estate | | (30,000 | ) | | | (1,535,714 | ) ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Cash Flows from Financing Activities: | | | | | | | ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Distributions Paid to Members | | (509,892 | ) | | | (704,915 | ) ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Repurchase of LLC Units | | (37,456 | ) | | | (77,729 | ) ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Net Cash Provided By (Used For) Financing Activities | | (547,348 | ) | | | (782,644 | ) ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Net Increase (Decrease) in Cash | | (21,394 | ) | | | (1,674,419 | ) ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Cash, beginning of period | | 603,691 | | | | 2,331,283 | ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- Cash, end of period | $ | 582,297 | | | $ | 656,864 | ----------------------------------------------------------------------------------+--------------------------------+----------+---+------+---+------------+-- The accompanying Notes to Financial Statements are an integral part of these statements. Page 5 of 18 AEI INCOME & GROWTH FUND 26 LLC STATEMENTS OF CHANGES IN MEMBERS' EQUITY (DEFICIT) (unaudited) | Managing Members | | | Limited Members | | | Total | | Limited Member Units Outstanding | ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+-- Balance, December 31, 2015 | $ | 4,799 | | | $ | 12,724,078 | | $ | 12,728,877 | | 1,754,841.5 | ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+---+-------------+-- Distributions Declared | | (16,768 | ) | | | (622,999 | ) | | (639,767 | ) | | ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+---+-------------+-- Repurchase of LLC Units | | (2,332 | ) | | | (75,397 | ) | | (77,729 | ) | (10,835.5 | ) ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+---+-------------+-- Net Income | | 6,785 | | | | 219,384 | | | 226,169 | | | ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+---+-------------+-- Balance, September 30, 2016 | $ | (7,516 | ) | | $ | 12,245,066 | | $ | 12,237,550 | | 1,744,006.0 | ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+---+-------------+-- Balance, December 31, 2016 | $ | (10,319 | ) | | $ | 12,154,450 | | $ | 12,144,131 | | 1,744,006.0 | ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+---+-------------+-- Distributions Declared | | (14,893 | ) | | | (495,001 | ) | | (509,894 | ) | | ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+---+-------------+-- Repurchase of LLC Units | | (1,124 | ) | | | (36,332 | ) | | (37,456 | ) | (6,000.0 | ) ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+---+-------------+-- Net Income | | 5,470 | | | | 176,870 | | | 182,340 | | | ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+---+-------------+-- Balance, September 30, 2017 | $ | (20,866 | ) | | $ | 11,799,987 | | $ | 11,779,121 | | 1,738,006.0 | ----------------------------+------------------+---------+---+-----------------+---+------------+-------+---+----------------------------------+---+-------------+-- The accompanying Notes to Financial Statements are an integral part of these statements. Page 6 of 18 AEI INCOME & GROWTH FUND 26 LLC NOTES TO FINANCIAL STATEMENTS SEPTEMBER 30, 2017 (unaudited) (1) The condensed statements included herein have been prepared by the registrant, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission, and reflect all adjustments which are, in the opinion of management, necessary to a fair statement of the results of operations for the interim period, on a basis consistent with the annual audited statements. The adjustments made to these condensed statements consist only of normal recurring adjustments. Certain information, accounting policies, and footnote disclosures normally included in financial statements prepared in accordance with United States Generally Accepted Accounting Principles (US GAAP) have been condensed or omitted pursuant to such rules and regulations, although the registrant believes that the disclosures are adequate to make the information presented not misleading. It is suggested that these condensed financial statements be read in conjunction with the financial statements and the summary of significant accounting policies and notes thereto included in the registrant's latest annual report on Form 10‑K. (2) Organization – AEI Income & Growth Fund 26 LLC ("Company"), a Limited Liability Company, was formed on March 14, 2005 to acquire and lease commercial properties to operating tenants. The Company's operations are managed by AEI Fund Management XXI, Inc. ("AFM"), the Managing Member. Robert P. Johnson, the President and sole director of AFM, serves as the Special Managing Member. AFM is a wholly owned subsidiary of AEI Capital Corporation of which Mr. Johnson is the majority shareholder. AEI Fund Management, Inc. ("AEI"), an affiliate of AFM, performs the administrative and operating functions for the Company. The terms of the offering called for a subscription price of $10 per LLC Unit, payable on acceptance of the offer. The Company commenced operations on April 3, 2006 when minimum subscriptions of 150,000 LLC Units ($1,500,000) were accepted. The offering terminated October 19, 2007, when the extended offering period expired. The Company received subscriptions for 1,832,736 Units. Under the terms of the Operating Agreement, the Limited Members and Managing Members contributed funds of $18,327,360 and $1,000, respectively. The Company shall continue until December 31, 2055, unless dissolved, terminated and liquidated prior to that date. During operations, any Net Cash Flow, as defined, which the Managing Members determine to distribute will be distributed 97% to the Limited Members and 3% to the Managing Members. Distributions to Limited Members will be made pro rata by Units. Page 7 of 18 AEI INCOME & GROWTH FUND 26 LLC NOTES TO FINANCIAL STATEMENTS (Continued) (2) Organization – (Continued) Any Net Proceeds of Sale, as defined, from the sale or financing of properties which the Managing Members determine to distribute will, after provisions for debts and reserves, be paid in the following manner: (i) first, 99% to the Limited Members and 1% to the Managing Members until the Limited Members receive an amount equal to: (a) their Adjusted Capital Contribution plus (b) an amount equal to 6.5% of their Adjusted Capital Contribution per annum, cumulative but not compounded, to the extent not previously distributed from Net Cash Flow; (ii) any remaining balance will be distributed 90% to the Limited Members and 10% to the Managing Members. Distributions to the Limited Members will be made pro rata by Units. For tax purposes, profits from operations, other than profits attributable to the sale, exchange, financing, refinancing or other disposition of property, will be allocated 97% to the Limited Members and 3% to the Managing Members. Net losses from operations will be allocated 99% to the Limited Members and 1% to the Managing Members. For tax purposes, profits arising from the sale, financing, or other disposition of property will be allocated in accordance with the Operating Agreement as follows: (i) first, to those Members with deficit balances in their capital accounts in an amount equal to the sum of such deficit balances; (ii) second, 99% to the Limited Members and 1% to the Managing Members until the aggregate balance in the Limited Members' capital accounts equals the sum of the Limited Members' Adjusted Capital Contributions plus an amount equal to 6.5% of their Adjusted Capital Contributions per annum, cumulative but not compounded, to the extent not previously allocated; (iii) third, the balance of any remaining gain will then be allocated 90% to the Limited Members and 10% to the Managing Members. Losses will be allocated 99% to the Limited Members and 1% to the Managing Members. The Managing Members are not required to currently fund a deficit capital balance. Upon liquidation of the Company or withdrawal by a Managing Member, the Managing Members will contribute to the Company an amount equal to the lesser of the deficit balances in their capital accounts or 1.01% of the total capital contributions of the Limited Members over the amount previously contributed by the Managing Members. (3) Real Estate Investments – On February 3, 2016, the Company purchased a Dollar Tree store in West Point, Mississippi for $1,535,714. The Company allocated $232,977 of the purchase price to Acquired Intangible Lease Assets, representing in-place lease intangibles, and allocated $283,495 to Acquired Below-Market Lease Intangibles. The Company incurred $55,479 of acquisition expenses related to the purchase that were expensed. The property is leased to Dollar Tree Stores, Inc. under a lease agreement with a remaining primary term of 9.7 years (as of the date of purchase) and annual rent of $107,500. Page 8 of 18 AEI INCOME & GROWTH FUND 26 LLC NOTES TO FINANCIAL STATEMENTS (Continued) (3) Real Estate Investments – (Continued) The Company owns a 40% interest in the Sports Authority store in Wichita, Kansas. On March 2, 2016, the tenant, TSA Stores, Inc., and its parent company, The Sports Authority, Inc., the guarantor of the lease, filed for Chapter 11 bankruptcy reorganization. In June 2016, the tenant filed a motion with the bankruptcy court to reject the lease for this store effective June 30, 2016, at which time the tenant returned possession of the property to the owners. As of September 30, 2017, the tenant owed $19,366 of past due rent, which was not accrued for financial reporting purposes. The owners listed the property for lease with a real estate broker in the Wichita area. While the property is vacant, the Company is responsible for its 40% share of real estate taxes and other costs associated with maintaining the property. The annual rent from this property represented approximately 19% of the total annual rent of the Company's property portfolio. The loss of rent and increased expenses related to this property decreased the Company's cash flow. Consequently, beginning with the third quarter of 2016, the Company reduced its regular quarterly cash distribution rate from $0.1313 per Unit to $0.0946 per Unit. On September 21, 2017, the Company entered into a lease agreement with a primary term of 10 years with Biomat USA, Inc. ("Biomat") as a replacement tenant for 28% of the square footage of the property. The tenant will operate a Biomat USA Plasma Center in the space. Biomat may terminate the lease within 90 days if it is unable to obtain governmental approvals and building permits. The Company's 40% share of annual rent is $37,071 and is expected to commence on June 18, 2018. Biomat has agreed to pay for the costs to divide the building into two separate spaces, the costs of tenant improvements to remodel the Biomat space and 28% of the cost to replace the roof. The Company will be responsible for paying its 40% share of the remaining cost to replace the roof, which is expected to be approximately $113,000. As part of the lease transaction, the Company will pay its 40% share of lease commissions to real estate brokers totaling $54,294 that will be capitalized and amortized over the term of the lease. The Company is continuing to pursue additional tenants for the remaining space. On March 31, 2017, the lease term expired for the Starbucks store in Bluffton, Indiana. Effective April 1, 2017, the Company entered into a lease agreement with a primary term of six years with The Cellular Connection LLC, a cell phone retailer that was subleasing the property from Starbucks Corporation. The tenant is scheduled to pay annual rent of $39,156 during the base lease term. As part of the lease transaction, the Company paid a tenant improvement allowance of $30,000 that was capitalized and will be depreciated. (4) Payable to AEI Fund Management, Inc. – AEI Fund Management, Inc. performs the administrative and operating functions for the Company. The payable to AEI Fund Management represents the balance due for those services. This balance is non-interest bearing and unsecured and is to be paid in the normal course of business. Page 9 of 18 AEI INCOME & GROWTH FUND 26 LLC NOTES TO FINANCIAL STATEMENTS (Continued) (5) Members' Capital – For the nine months ended September 30, 2017 and 2016, the Company declared distributions of $509,894 and $639,767, respectively. The Limited Members received distributions of $495,001 and $622,999 and the Managing Members received distributions of $14,893 and $16,768 for the periods, respectively. The Limited Members' distributions represented $0.28 and $0.36 per LLC Unit outstanding using 1,740,006 and 1,747,618 weighted average Units in 2017 and 2016, respectively. The distributions represented $0.08 and $0.09 per Unit of Net Income and $0.20 and $0.27 per Unit of return of contributed capital in 2017 and 2016, respectively. As part of the distributions discussed above, the Company distributed net sale proceeds (from property sales completed in 2015) of $20,202 and $121,212 in 2017 and 2016, respectively. The Limited Members received distributions of $20,000 and $120,000 and the Managing Members received distributions of $202 and $1,212 for the periods, respectively. The Limited Members' distributions represented $0.01 and $0.07 per Unit for the periods, respectively. On April 1, 2017, the Company repurchased a total of 6,000.0 Units for $36,332 from three Limited Members in accordance with the Operating Agreement. On April 1, 2016, the Company repurchased a total of 10,835.5 Units for $75,397 from six Limited Members. The Company acquired these Units using Net Cash Flow from operations. The repurchases increase the remaining Limited Members' ownership interest in the Company. As a result of these repurchases and pursuant to the Operating Agreement, the Managing Members received distributions of $1,124 and $2,332 in 2017 and 2016, respectively. (6) Fair Value Measurements – As of September 30, 2017 and December 31, 2016, the Company had no assets or liabilities measured at fair value on a recurring basis or nonrecurring basis. Page 10 of 18 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. This section contains "forward-looking statements" which represent management's expectations or beliefs concerning future events, including statements regarding anticipated application of cash, expected returns from rental income, growth in revenue, the sufficiency of cash to meet operating expenses, rates of distribution, and other matters. These, and other forward-looking statements, should be evaluated in the context of a number of factors that may affect the Company's financial condition and results of operations, including the following: — | Market and economic conditions which affect the value of the properties the Company owns and the cash from rental income such properties generate; --+--------------------------------------------------------------------------------------------------------------------------------------------------- — | the federal income tax consequences of rental income, deductions, gain on sales and other items and the effects of these consequences for Members; --+--------------------------------------------------------------------------------------------------------------------------------------------------- — | resolution by the Managing Members of conflicts with which they may be confronted; --+----------------------------------------------------------------------------------- — | the success of the Managing Members of locating properties with favorable risk return characteristics; --+------------------------------------------------------------------------------------------------------- — | the effect of tenant defaults; and --+----------------------------------- — | the condition of the industries in which the tenants of properties owned by the Company operate. --+------------------------------------------------------------------------------------------------- Application of Critical Accounting Policies The Company's financial statements have been prepared in accordance with US GAAP. Preparing the financial statements requires management to use judgment in the application of these accounting policies, including making estimates and assumptions. These judgments will affect the reported amounts of the Company's assets and liabilities and the disclosure of contingent assets and liabilities as of the dates of the financial statements and will affect the reported amounts of revenue and expenses during the reporting periods. It is possible that the carrying amount of the Company's assets and liabilities, or the results of reported operations, will be affected if management's estimates or assumptions prove inaccurate. Management of the Company evaluates the following accounting estimates on an ongoing basis, and has discussed the development and selection of these estimates and the management discussion and analysis disclosures regarding them with the managing member of the Company. Allocation of Purchase Price of Acquired Properties Upon acquisition of real properties, the Company records them in the financial statements at cost. The purchase price is allocated to tangible assets, consisting of land and building, and to identified intangible assets and liabilities, which may include the value of above market and below market leases and the value of in-place leases. The allocation of the purchase price is based upon the fair value of each component of the property. Although independent appraisals may be used to assist in the determination of fair value, in many cases these values will be based upon management's assessment of each property, the selling prices of comparable properties and the discounted value of cash flows from the asset. Page 11 of 18 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS. (Continued) The fair values of above market and below market in-place leases will be recorded based on the present value (using an interest rate which reflects the risks associated with the leases acquired) of the difference between (i) the contractual amounts to be paid pursuant to the in-place leases and (ii) an estimate of fair market lease rates for the corresponding in-place leases measured over a period equal to the non-cancelable term of the lease including any bargain renewal periods. The above market and below market lease values will be capitalized as intangible lease assets or liabilities. Above market lease values will be amortized as an adjustment of rental income over the remaining term of the respective leases. Below market lease values will be amortized as an adjustment of rental income over the remaining term of the respective leases, including any bargain renewal periods. If a lease were to be terminated prior to its stated expiration, all unamortized amounts of above market and below market in-place lease values relating to that lease would be recorded as an adjustment to rental income. The fair values of in-place leases will include estimated direct costs associated with obtaining a new tenant, and opportunity costs associated with lost rentals which are avoided by acquiring an in-place lease. Direct costs associated with obtaining a new tenant may include commissions, tenant improvements, and other direct costs and are estimated, in part, by management's consideration of current market costs to execute a similar lease. These direct costs will be included in intangible lease assets on the balance sheet and will be amortized to expense over the remaining term of the respective leases. The value of opportunity costs will be calculated using the contractual amounts to be paid pursuant to the in-place leases over a market absorption period for a similar lease. These intangibles will be included in intangible lease assets on the balance sheet and will be amortized to expense over the remaining term of the respective leases. If a lease were to be terminated prior to its stated expiration, all unamortized amounts of in-place lease assets relating to that lease would be expensed. The determination of the fair values of the assets and liabilities acquired will require the use of significant assumptions with regard to the current market rental rates, rental growth rates, discount and capitalization rates, interest rates and other variables. If management's estimates or assumptions prove inaccurate, the result would be an inaccurate allocation of purchase price, which could impact the amount of reported net income. Carrying Value of Properties Properties are carried at original cost, less accumulated depreciation and amortization. The Company tests long-lived assets for recoverability when events or changes in circumstances indicate that the carrying value may not be recoverable. For properties the Company will hold and operate, management determines whether impairment has occurred by comparing the property's probability-weighted future undiscounted cash flows to its current carrying value. For properties held for sale, management determines whether impairment has occurred by comparing the property's estimated fair value less cost to sell to its current carrying value. If the carrying value is greater than the net realizable value, an impairment loss is recorded to reduce the carrying value of the property to its net realizable value. Changes in these assumptions or analysis may cause material changes in the carrying value of the properties. Page 12 of 18 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS. (Continued) Allocation of Expenses AEI Fund Management, Inc. allocates expenses to each of the funds they manage primarily on the basis of the number of hours devoted by their employees to each fund's affairs. They also allocate expenses at the end of each month that are not directly related to a fund's operations based upon the number of investors in the fund and the fund's capitalization relative to other funds they manage. The Company reimburses these expenses subject to detailed limitations contained in the Operating Agreement. Results of Operations For the nine months ended September 30, 2017 and 2016, the Company recognized rental income of $711,183 and $807,033, respectively. In 2017, rental income decreased due to leasing a property to a new tenant at a lower annual rent and rent that was not received from the tenant of the Sports Authority store, as discussed below. These decreases were partially offset by additional rent received from one property acquisition in 2016 and rent increases on two properties. Based on the scheduled rent for the properties as of October 31, 2017, the Company expects to recognize rental income of approximately $944,000 and $941,000 in 2017 and 2018, respectively. For the nine months ended September 30, 2017 and 2016, the Company incurred LLC administration expenses from affiliated parties of $109,788 and $115,853, respectively. These administration expenses include costs associated with the management of the properties, processing distributions, reporting requirements and communicating with the Limited Members. During the same periods, the Company incurred LLC administration and property management expenses from unrelated parties of $81,287 and $80,813, respectively. These expenses represent direct payments to third parties for legal and filing fees, direct administrative costs, outside audit costs, taxes, insurance and other property costs. For the nine months ended September 30, 2016, the Company incurred property acquisition expenses of $55,479 related to the purchase of the Dollar Tree store in West Point, Mississippi. The Company owns a 40% interest in the Sports Authority store in Wichita, Kansas. On March 2, 2016, the tenant, TSA Stores, Inc., and its parent company, The Sports Authority, Inc., the guarantor of the lease, filed for Chapter 11 bankruptcy reorganization. In June 2016, the tenant filed a motion with the bankruptcy court to reject the lease for this store effective June 30, 2016, at which time the tenant returned possession of the property to the owners. As of September 30, 2017, the tenant owed $19,366 of past due rent, which was not accrued for financial reporting purposes. The owners listed the property for lease with a real estate broker in the Wichita area. While the property is vacant, the Company is responsible for its 40% share of real estate taxes and other costs associated with maintaining the property. The annual rent from this property represented approximately 19% of the total annual rent of the Company's property portfolio. The loss of rent and increased expenses related to this property decreased the Company's cash flow. Consequently, beginning with the third quarter of 2016, the Company reduced its regular quarterly cash distribution rate from $0.1313 per Unit to $0.0946 per Unit. Page 13 of 18 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS. (Continued) On September 21, 2017, the Company entered into a lease agreement with a primary term of 10 years with Biomat USA, Inc. ("Biomat") as a replacement tenant for 28% of the square footage of the property. The tenant will operate a Biomat USA Plasma Center in the space. Biomat may terminate the lease within 90 days if it is unable to obtain governmental approvals and building permits. The Company's 40% share of annual rent is $37,071 and is expected to commence on June 18, 2018. Biomat has agreed to pay for the costs to divide the building into two separate spaces, the costs of tenant improvements to remodel the Biomat space and 28% of the cost to replace the roof. The Company will be responsible for paying its 40% share of the remaining cost to replace the roof, which is expected to be approximately $113,000. As part of the lease transaction, the Company will pay its 40% share of lease commissions to real estate brokers totaling $54,294 that will be capitalized and amortized over the term of the lease. The Company is continuing to pursue additional tenants for the remaining space. For the nine months ended September 30, 2017 and 2016, the Company recognized interest income of $1,199 and $1,809, respectively. Management believes inflation has not significantly affected income from operations. Leases may contain rent increases, based on the increase in the Consumer Price Index over a specified period, which will result in an increase in rental income over the term of the leases. Inflation also may cause the real estate to appreciate in value. However, inflation and changing prices may have an adverse impact on the operating margins of the properties' tenants, which could impair their ability to pay rent and subsequently reduce the Net Cash Flow available for distributions. Liquidity and Capital Resources During the nine months ended September 30, 2017, the Company's cash balances decreased $21,394 as a result of cash paid for a tenant improvement allowance, which was partially offset by cash generated from operating activities in excess of distributions paid to the Members and cash used to repurchase Units. During the nine months ended September 30, 2016, the Company's cash balances decreased $1,674,419 as a result of cash used to purchase property, and distributions paid to the Members and cash used to repurchase Units in excess of cash generated from operating activities. Net cash provided by operating activities decreased from $643,939 in 2016 to $555,954 in 2017 as a result of a decrease in total rental and interest income in 2017, and a decrease in net timing differences in the collection of payments from the tenants and the payment of expenses, which were partially offset by a decrease in LLC administration and property management expenses in 2017. During 2016, cash from operations was reduced by $55,479 of acquisition expenses related to the purchase of real estate. Pursuant to accounting guidance, these expenses were reflected as operating cash outflows. However, pursuant to the Company's Operating Agreement, acquisition expenses were funded with proceeds from property sales. Page 14 of 18 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS. (Continued) The major components of the Company's cash flow from investing activities are investments in real estate and proceeds from the sale of real estate. During the nine months ended September 30, 2017 and 2016, the Partnership expended $30,000 and $1,535,714, respectively, to invest in real properties as the Partnership reinvested cash generated from property sales completed in 2015. On February 3, 2016, the Company purchased a Dollar Tree store in West Point, Mississippi for $1,535,714. The property is leased to Dollar Tree Stores, Inc. under a lease agreement with a remaining primary term of 9.7 years (as of the date of purchase) and annual rent of $107,500. On March 31, 2017, the lease term expired for the Starbucks store in Bluffton, Indiana. Effective April 1, 2017, the Company entered into a lease agreement with a primary term of six years with The Cellular Connection LLC, a cell phone retailer that was subleasing the property from Starbucks Corporation. The tenant is scheduled to pay annual rent of $39,156 during the base lease term. As part of the lease transaction, the Company paid a tenant improvement allowance of $30,000 that was capitalized and will be depreciated. The Company's primary use of cash flow, other than investment in real estate, is distribution payments to Members and cash used to repurchase Units. The Company declares its regular quarterly distributions before the end of each quarter and pays the distribution in the first week after the end of each quarter. The Company attempts to maintain a stable distribution rate from quarter to quarter. The Company may repurchase tendered Units on April 1st and October 1st of each year subject to limitations. For the nine months ended September 30, 2017 and 2016, the Company declared distributions of $509,894 and $639,767, respectively. Pursuant to the Operating Agreement, distributions of Net Cash Flow were allocated 97% to the Limited Members and 3% to the Managing Members. Distributions of Net Proceeds of Sale were allocated 99% to the Limited Members and 1% to the Managing Members. The Limited Members received distributions of $495,001 and $622,999 and the Managing Members received distributions of $14,893 and $16,768 for the periods, respectively. As part of the distributions discussed above, the Company distributed net sale proceeds (from property sales completed in 2015) of $20,202 and $121,212 in 2017 and 2016, respectively. The Limited Members received distributions of $20,000 and $120,000 and the Managing Members received distributions of $202 and $1,212 for the periods, respectively. The Limited Members' distributions represented $0.01 and $0.07 per Unit for the periods, respectively. The Company may repurchase Units from Limited Members who have tendered their Units to the Company. Such Units may be acquired at a discount. The Company will not be obligated to purchase in any year more than 2% of the total number of Units outstanding on January 1 of such year. In no event shall the Company be obligated to purchase Units if, in the sole discretion of the Managing Member, such purchase would impair the capital or operation of the Company. Page 15 of 18 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS. (Continued) On April 1, 2017, the Company repurchased a total of 6,000.0 Units for $36,332 from three Limited Members in accordance with the Operating Agreement. On April 1, 2016, the Company repurchased a total of 10,835.5 Units for $75,397 from six Limited Members. The Company acquired these Units using Net Cash Flow from operations. The repurchases increase the remaining Limited Members' ownership interest in the Company. As a result of these repurchases and pursuant to the Operating Agreement, the Managing Members received distributions of $1,124 and $2,332 in 2017 and 2016, respectively. The continuing rent payments from the properties, together with cash generated from property sales, should be adequate to fund continuing distributions and meet other Company obligations on both a short-term and long-term basis. Off-Balance Sheet Arrangements As of September 30, 2017 and December 31, 2016, the Company had no material off-balance sheet arrangements that had or are reasonably likely to have current or future effects on its financial condition, results of operations, liquidity or capital resources. ITEM 3. QUANTITATIVE & QUALITATIVE DISCLOSURES ABOUT MARKET RISK. Not required for a smaller reporting company. ITEM 4. CONTROLS AND PROCEDURES. (a) Disclosure Controls and Procedures. Under the supervision and with the participation of management, including its President and Chief Financial Officer, the Managing Member of the Company evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the "Exchange Act")). Based upon that evaluation, the President and Chief Financial Officer of the Managing Member concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective in ensuring that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in applicable rules and forms and that such information is accumulated and communicated to management, including the President and Chief Financial Officer of the Managing Member, in a manner that allows timely decisions regarding required disclosure. (b) Changes in Internal Control Over Financial Reporting. During the most recent period covered by this report, there has been no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. Page 16 of 18 PART II – OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS. There are no material pending legal proceedings to which the Company is a party or of which the Company's property is subject. ITEM 1A. RISK FACTORS. Not required for a smaller reporting company. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES & USE OF PROCEEDS. (a) None. (b) Not applicable. (c) Pursuant to Section 7.7 of the Operating Agreement, each Limited Member has the right to present Units to the Company for purchase by submitting notice to the Managing Member during January or July of each year. The purchase price of the Units is equal to 85% of the net asset value per Unit, as of the first business day of January or July of each year, as determined by the Managing Member in accordance with the provisions of the Operating Agreement. The purchase price is equal to 100% of the net asset value per Unit in the case of Units of a deceased investor, who purchased the Units in the initial offering and who is a natural person, including Units held by an investor that is an IRA or other qualified plan for which the deceased person was the primary beneficiary, or Units held by an investor that is a grantor trust for which the deceased person was the grantor. Units tendered to the Company during January and July may be repurchased on April 1st and October 1st, respectively, of each year subject to the following limitations. The Company will not be obligated to purchase in any year more than 2% of the total number of Units outstanding on January 1 of such year. In no event shall the Company be obligated to purchase Units if, in the sole discretion of the Managing Member, such purchase would impair the capital or operation of the Company. During the period covered by this report, the Company did not purchase any Units. ITEM 3. DEFAULTS UPON SENIOR SECURITIES. None. ITEM 4. MINE SAFETY DISCLOSURES. Not Applicable. ITEM 5. OTHER INFORMATION. None. Page 17 of 18 ITEM 6. EXHIBITS. 31.1 | Certification of Chief Executive Officer of Managing Member pursuant to Rule 15d-14(a)(17 CFR 240.15d-14(a)) and Section 302 of the Sarbanes-Oxley Act of 2002. -----+---------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.2 | Certification of Chief Financial Officer of Managing Member pursuant to Rule 15d-14(a)(17 CFR 240.15d-14(a)) and Section 302 of the Sarbanes-Oxley Act of 2002. -----+---------------------------------------------------------------------------------------------------------------------------------------------------------------- 32 | Certification of Chief Executive Officer and Chief Financial Officer of Managing Member pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. ---+--------------------------------------------------------------------------------------------------------------------------------------------------- SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Dated: November 13, 2017 | AEI Income & Growth Fund 26 LLC --------------------------+-------------------------------- | By: | AEI Fund Management XXI, Inc. --------------------------+---------------------------------+------------------------------- | Its: | Managing Member --------------------------+---------------------------------+------------------------------- | By: | /s/ ROBERT P JOHNSON --------------------------+---------------------------------+------------------------------- | | Robert P. Johnson --------------------------+---------------------------------+------------------------------- | | President --------------------------+---------------------------------+------------------------------- | | (Principal Executive Officer) --------------------------+---------------------------------+------------------------------- | By: | /s/ PATRICK W KEENE --------------------------+---------------------------------+------------------------------- | | Patrick W. Keene --------------------------+---------------------------------+------------------------------- | | Chief Financial Officer --------------------------+---------------------------------+------------------------------- | | (Principal Accounting Officer) --------------------------+---------------------------------+------------------------------- Page 18 of 18

AEI NET LEASE INCOME & GROWTH FUND XX LIMITED PARTNERSHIP

894245

10-Q

0001130758-17-000054

UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended: September 30, 2017 Commission File Number: 000-23778 AEI NET LEASE INCOME & GROWTH FUND XX LIMITED PARTNERSHIP (Exact name of registrant as specified in its charter) State of Minnesota | 41-1729121 ---------------------------------------------------------------+------------------------------------- (State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) ---------------------------------------------------------------+------------------------------------- 30 East 7th Street, Suite 1300 St. Paul, Minnesota 55101 | (651) 227-7333 ---------------------------------------------------------------+------------------------------------- (Address of principal executive offices) | (Registrant's telephone number) ---------------------------------------------------------------+------------------------------------- Not Applicable ---------------------------------------------------------------------------------- (Former name, former address and former fiscal year, if changed since last report) ---------------------------------------------------------------------------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. ☒ Yes ☐ No Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). ☒ Yes ☐ No Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. ☐ Large accelerated filer | ☐ Accelerated filer --------------------------+---------------------------- ☐ Non-accelerated filer | ☒ Smaller reporting company --------------------------+---------------------------- ☐ Emerging growth company | --------------------------+---------------------------- If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ☐ Yes ☒ No AEI NET LEASE INCOME & GROWTH FUND XX LIMITED PARTNERSHIP INDEX | | Page -------------------------------+----------+-------------------------------------------------------------- Part I – Financial Information | -------------------------------+--------- | Item 1. | Financial Statements: | -------------------------------+----------+---------------------------------------------------------------+------------------------------------ | | Balance Sheets as of September 30, 2017 and December 31, 2016 | 3 -------------------------------+----------+---------------------------------------------------------------+------------------------------------ | | Statements for the Periods ended September 30, 2017 and 2016: | -------------------------------+----------+---------------------------------------------------------------+------------------------------------ | | | Income | 4 -------------------------------+----------+---------------------------------------------------------------+-------------------------------------+-------- | | | Cash Flows | 5 -------------------------------+----------+---------------------------------------------------------------+-------------------------------------+-------- | | | Changes in Partners' Capital | 6 -------------------------------+----------+---------------------------------------------------------------+-------------------------------------+-------- | | Notes to Financial Statements | 7 - 10 -------------------------------+----------+---------------------------------------------------------------+------------------------------------ | Item 2. | Management's Discussion and Analysis of Financial | -------------------------------+----------+---------------------------------------------------------------+------------------------------------ | | | Condition and Results of Operations | 11 - 16 -------------------------------+----------+---------------------------------------------------------------+-------------------------------------+-------- | Item 3. | Quantitative and Qualitative Disclosures About Market Risk | 16 -------------------------------+----------+---------------------------------------------------------------+------------------------------------ | Item 4. | Controls and Procedures | 16 -------------------------------+----------+---------------------------------------------------------------+------------------------------------ Part II – Other Information | -------------------------------+--------- | Item 1. | Legal Proceedings | 17 -------------------------------+----------+---------------------------------------------------------------+------------------------------------ | Item 1A. | Risk Factors | 17 -------------------------------+----------+---------------------------------------------------------------+------------------------------------ | Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | 17 -------------------------------+----------+---------------------------------------------------------------+------------------------------------ | Item 3. | Defaults Upon Senior Securities | 17 -------------------------------+----------+---------------------------------------------------------------+------------------------------------ | Item 4. | Mine Safety Disclosures | 17 -------------------------------+----------+---------------------------------------------------------------+------------------------------------ | Item 5. | Other Information | 17 -------------------------------+----------+---------------------------------------------------------------+------------------------------------ | Item 6. | Exhibits | 18 -------------------------------+----------+---------------------------------------------------------------+------------------------------------ Signatures | 18 -------------------------------+--------- Page 2 of 18 AEI NET LEASE INCOME & GROWTH FUND XX LIMITED PARTNERSHIP BALANCE SHEETS ASSETS | September 30, | | | December 31, | ------------------------------------------+---------------+------------+---+--------------+-- | 2017 | | | 2016 | ------------------------------------------+---------------+------------+---+--------------+-- | (unaudited) | | | | ------------------------------------------+---------------+------------+---+--------------+-- Current Assets: | | | | | ------------------------------------------+---------------+------------+---+--------------+-- Cash | $ | 1,187,635 | | | $ | 1,152,822 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Real Estate Investments: | | | | | | | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Land | | 3,759,032 | | | | 4,048,298 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Buildings | | 8,724,155 | | | | 9,841,947 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Acquired Intangible Lease Assets | | 959,720 | | | | 959,720 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Real Estate Held for Investment, at cost | | 13,442,907 | | | | 14,849,965 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Accumulated Depreciation and Amortization | | (3,034,587 | ) | | | (3,285,703 | ) ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Real Estate Held for Investment, Net | | 10,408,320 | | | | 11,564,262 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Real Estate Held for Sale | | 899,271 | | | | 0 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Total Real Estate Investments | | 11,307,591 | | | | 11,564,262 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- Total Assets | $ | 12,495,226 | | | $ | 12,717,084 | ------------------------------------------+---------------+------------+---+--------------+---+------------+-- LIABILITIES AND PARTNERS' CAPITAL Current Liabilities: | | | | ----------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+-- Payable to AEI Fund Management, Inc. | $ | 127,467 | | $ | 94,166 | ----------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Distributions Payable | | 279,801 | | | 282,119 | ----------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Unearned Rent | | 67,604 | | | 13,474 | ----------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Total Current Liabilities | | 474,872 | | | 389,759 | ----------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Partners' Capital (Deficit): | | | | | | ----------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- General Partners | | (4,918 | ) | | (1,848 | ) ----------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Limited Partners – 24,000 Units authorized; 20,134 and 20,163 Units issued and outstanding as of 9/30/2017 and 12/31/2016, respectively | | 12,025,272 | | | 12,329,173 | ----------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Total Partners' Capital | | 12,020,354 | | | 12,327,325 | ----------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- Total Liabilities and Partners' Capital | $ | 12,495,226 | | $ | 12,717,084 | ----------------------------------------------------------------------------------------------------------------------------------------------+---+------------+---+---+------------+-- The accompanying Notes to Financial Statements are an integral part of these statements. Page 3 of 18 AEI NET LEASE INCOME & GROWTH FUND XX LIMITED PARTNERSHIP STATEMENTS OF INCOME (unaudited) | Three Months Ended September 30 | | Nine Months Ended September 30 | --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+-- | 2017 | | 2016 | | | 2017 | | 2016 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+---------- Rental Income | $ | 307,881 | | $ | 344,428 | | $ | 1,004,134 | $ | 1,028,149 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Expenses: | | | | | | | | | | --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Partnership Administration – Affiliates | | 41,554 | | | 42,023 | | | 131,892 | | 134,476 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Partnership Administration and Property Management – Unrelated Parties | | 9,792 | | | 11,850 | | | 73,312 | | 58,983 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Property Acquisition | | 0 | | | 0 | | | 0 | | 47,902 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Depreciation and Amortization | | 89,728 | | | 99,043 | | | 278,499 | | 293,539 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Total Expenses | | 141,074 | | | 152,916 | | | 483,703 | | 534,900 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Operating Income | | 166,807 | | | 191,512 | | | 520,431 | | 493,249 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Other Income: | | | | | | | | | | --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Miscellaneous Income | | 0 | | | 0 | | | 35,705 | | 0 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Interest Income | | 758 | | | 822 | | | 2,293 | | 2,641 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Total Other Income | | 758 | | | 822 | | | 37,998 | | 2,641 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Net Income | $ | 167,565 | | $ | 192,334 | | $ | 558,429 | $ | 495,890 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Net Income Allocated: | | | | | | | | | | --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- General Partners | $ | 1,675 | | $ | 1,923 | | $ | 5,584 | $ | 4,959 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Limited Partners | | 165,890 | | | 190,411 | | | 552,845 | | 490,931 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Total | $ | 167,565 | | $ | 192,334 | | $ | 558,429 | $ | 495,890 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Net Income per Limited Partnership Unit | $ | 8.24 | | $ | 9.40 | | $ | 27.44 | $ | 24.18 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- Weighted Average Units Outstanding – Basic and Diluted | | 20,134 | | | 20,265 | | | 20,144 | | 20,303 --------------------------------------------------------------------------+---------------------------------+---------+--------------------------------+---+---------+------+---+-----------+---+---------- The accompanying Notes to Financial Statements are an integral part of these statements. Page 4 of 18 AEI NET LEASE INCOME & GROWTH FUND XX LIMITED PARTNERSHIP STATEMENTS OF CASH FLOWS (unaudited) | Nine Months Ended September 30 | ----------------------------------------------------------------------------------+--------------------------------+---------- | 2017 | | | 2016 | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+-- Cash Flows from Operating Activities: | | | | | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+-- Net Income | $ | 558,429 | | | $ | 495,890 | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Adjustments to Reconcile Net Income To Net Cash Provided by Operating Activities: | | | | | | | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Depreciation and Amortization | | 300,021 | | | | 315,061 | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- (Increase) Decrease in Receivables | | 0 | | | | 9,031 | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Increase (Decrease) in Payable to AEI Fund Management, Inc. | | 33,301 | | | | (6,264 | ) ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Increase (Decrease) in Unearned Rent | | 54,130 | | | | 54,130 | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Total Adjustments | | 387,452 | | | | 371,958 | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Net Cash Provided By (Used For) Operating Activities | | 945,881 | | | | 867,848 | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Cash Flows from Investing Activities: | | | | | | | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Investments in Real Estate | | (43,350 | ) | | | (1,739,074 | ) ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Cash Flows from Financing Activities: | | | | | | | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Distributions Paid to Partners | | (841,720 | ) | | | (850,093 | ) ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Repurchase of Partnership Units | | (25,998 | ) | | | (99,294 | ) ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Net Cash Provided By (Used For) Financing Activities | | (867,718 | ) | | | (949,387 | ) ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Net Increase (Decrease) in Cash | | 34,813 | | | | (1,820,613 | ) ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Cash, beginning of period | | 1,152,822 | | | | 3,069,560 | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- Cash, end of period | $ | 1,187,635 | | | $ | 1,248,947 | ----------------------------------------------------------------------------------+--------------------------------+-----------+---+------+---+------------+-- The accompanying Notes to Financial Statements are an integral part of these statements. Page 5 of 18 AEI NET LEASE INCOME & GROWTH FUND XX LIMITED PARTNERSHIP STATEMENTS OF CHANGES IN PARTNERS' CAPITAL (unaudited) | General Partners | | | Limited Partners | | | Total | | Limited Partnership Units Outstanding | --------------------------------+------------------+--------+---+------------------+---+------------+-------+---+---------------------------------------+-- Balance, December 31, 2015 | $ | 4,508 | | | $ | 12,958,439 | | $ | 12,962,947 | | 20,380.05 | --------------------------------+------------------+--------+---+------------------+---+------------+-------+---+---------------------------------------+---+-----------+-- Distributions Declared | | (8,464 | ) | | | (837,890 | ) | | (846,354 | ) | | --------------------------------+------------------+--------+---+------------------+---+------------+-------+---+---------------------------------------+---+-----------+-- Repurchase of Partnership Units | | (993 | ) | | | (98,301 | ) | | (99,294 | ) | (115.00 | ) --------------------------------+------------------+--------+---+------------------+---+------------+-------+---+---------------------------------------+---+-----------+-- Net Income | | 4,959 | | | | 490,931 | | | 495,890 | | | --------------------------------+------------------+--------+---+------------------+---+------------+-------+---+---------------------------------------+---+-----------+-- Balance, September 30, 2016 | $ | 10 | | | $ | 12,513,179 | | $ | 12,513,189 | | 20,265.05 | --------------------------------+------------------+--------+---+------------------+---+------------+-------+---+---------------------------------------+---+-----------+-- Balance, December 31, 2016 | $ | (1,848 | ) | | $ | 12,329,173 | | $ | 12,327,325 | | 20,163.04 | --------------------------------+------------------+--------+---+------------------+---+------------+-------+---+---------------------------------------+---+-----------+-- Distributions Declared | | (8,394 | ) | | | (831,008 | ) | | (839,402 | ) | | --------------------------------+------------------+--------+---+------------------+---+------------+-------+---+---------------------------------------+---+-----------+-- Repurchase of Partnership Units | | (260 | ) | | | (25,738 | ) | | (25,998 | ) | (28.72 | ) --------------------------------+------------------+--------+---+------------------+---+------------+-------+---+---------------------------------------+---+-----------+-- Net Income | | 5,584 | | | | 552,845 | | | 558,429 | | | --------------------------------+------------------+--------+---+------------------+---+------------+-------+---+---------------------------------------+---+-----------+-- Balance, September 30, 2017 | $ | (4,918 | ) | | $ | 12,025,272 | | $ | 12,020,354 | | 20,134.32 | --------------------------------+------------------+--------+---+------------------+---+------------+-------+---+---------------------------------------+---+-----------+-- The accompanying Notes to Financial Statements are an integral part of these statements. Page 6 of 18 AEI NET LEASE INCOME & GROWTH FUND XX LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS SEPTEMBER 30, 2017 (unaudited) (1) The condensed statements included herein have been prepared by the registrant, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission, and reflect all adjustments which are, in the opinion of management, necessary to a fair statement of the results of operations for the interim period, on a basis consistent with the annual audited statements. The adjustments made to these condensed statements consist only of normal recurring adjustments. Certain information, accounting policies, and footnote disclosures normally included in financial statements prepared in accordance with United States Generally Accepted Accounting Principles (US GAAP) have been condensed or omitted pursuant to such rules and regulations, although the registrant believes that the disclosures are adequate to make the information presented not misleading. It is suggested that these condensed financial statements be read in conjunction with the financial statements and the summary of significant accounting policies and notes thereto included in the registrant's latest annual report on Form 10‑K. (2) Organization – AEI Net Lease Income & Growth Fund XX Limited Partnership ("Partnership") was formed to acquire and lease commercial properties to operating tenants. The Partnership's operations are managed by AEI Fund Management XX, Inc. ("AFM"), the Managing General Partner. Robert P. Johnson, the President and sole director of AFM, serves as the Individual General Partner. AFM is a wholly owned subsidiary of AEI Capital Corporation of which Mr. Johnson is the majority shareholder. AEI Fund Management, Inc. ("AEI"), an affiliate of AFM, performs the administrative and operating functions for the Partnership. The terms of the Partnership offering called for a subscription price of $1,000 per Limited Partnership Unit, payable on acceptance of the offer. The Partnership commenced operations on June 30, 1993 when minimum subscriptions of 1,500 Limited Partnership Units ($1,500,000) were accepted. On January 19, 1995, the offering terminated when the maximum subscription limit of 24,000 Limited Partnership Units was reached. Under the terms of the Limited Partnership Agreement, the Limited Partners and General Partners contributed funds of $24,000,000 and $1,000, respectively. During operations, any Net Cash Flow, as defined, which the General Partners determine to distribute will be distributed 90% to the Limited Partners and 10% to the General Partners; provided, however, that such distributions to the General Partners will be subordinated to the Limited Partners first receiving an annual, noncumulative distribution of Net Cash Flow equal to 10% of their Adjusted Capital Contribution, as defined, and, provided further, that in no event will the General Partners receive less than 1% of such Net Cash Flow per annum. Distributions to Limited Partners will be made pro rata by Units. Page 7 of 18 AEI NET LEASE INCOME & GROWTH FUND XX LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS (Continued) (2) Organization – (Continued) Any Net Proceeds of Sale, as defined, from the sale or financing of properties which the General Partners determine to distribute will, after provisions for debts and reserves, be paid in the following manner: (i) first, 99% to the Limited Partners and 1% to the General Partners until the Limited Partners receive an amount equal to: (a) their Adjusted Capital Contribution plus (b) an amount equal to 12% of their Adjusted Capital Contribution per annum, cumulative but not compounded, to the extent not previously distributed from Net Cash Flow; (ii) any remaining balance will be distributed 90% to the Limited Partners and 10% to the General Partners. Distributions to the Limited Partners will be made pro rata by Units. For tax purposes, profits from operations, other than profits attributable to the sale, exchange, financing, refinancing or other disposition of property, will be allocated first in the same ratio in which, and to the extent, Net Cash Flow is distributed to the Partners for such year. Any additional profits will be allocated in the same ratio as the last dollar of Net Cash Flow is distributed. Net losses from operations will be allocated 99% to the Limited Partners and 1% to the General Partners. For tax purposes, profits arising from the sale, financing, or other disposition of property will be allocated in accordance with the Partnership Agreement as follows: (i) first, to those partners with deficit balances in their capital accounts in an amount equal to the sum of such deficit balances; (ii) second, 99% to the Limited Partners and 1% to the General Partners until the aggregate balance in the Limited Partners' capital accounts equals the sum of the Limited Partners' Adjusted Capital Contributions plus an amount equal to 12% of their Adjusted Capital Contributions per annum, cumulative but not compounded, to the extent not previously allocated; (iii) third, the balance of any remaining gain will then be allocated 90% to the Limited Partners and 10% to the General Partners. Losses will be allocated 98% to the Limited Partners and 2% to the General Partners. The General Partners are not required to currently fund a deficit capital balance. Upon liquidation of the Partnership or withdrawal by a General Partner, the General Partners will contribute to the Partnership an amount equal to the lesser of the deficit balances in their capital accounts or 1% of total Limited Partners' and General Partners' capital contributions. In June 2014, the Managing General Partner mailed a Consent Statement (Proxy) seeking the consent of the Limited Partners to continue the Partnership for an additional 60 months or to initiate the final disposition, liquidation and distribution of all of the Partnership's properties and assets within 24 to 36 months. Approval of either proposal required the affirmative vote of holders of a majority of the outstanding units. On July 23, 2014, the votes were counted and neither proposal received the required majority vote. As a result, the Partnership will not liquidate and will continue in operation until the Limited Partners vote to authorize the sale of all of the Partnership's properties or December 31, 2043, as stated in the Limited Partnership Agreement. However, in approximately five years, the Managing General Partner expects to again submit the question to liquidate to a vote by the Limited Partners. Page 8 of 18 AEI NET LEASE INCOME & GROWTH FUND XX LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS (Continued) (3) Real Estate Investments – On January 8, 2016, the Partnership purchased a Dollar Tree store in Indianapolis, Indiana for $1,739,074. The Partnership allocated $241,360 of the purchase price to Acquired Intangible Lease Assets, representing in-place lease intangibles. The Partnership incurred $47,902 of acquisition expenses related to the purchase that were expensed. The property is leased to Dollar Tree Stores, Inc. under a lease agreement with a remaining primary term of 9.7 years (as of the date of purchase) and annual rent of $117,387. In March 2017, the Partnership entered into an agreement with the tenant of the KinderCare daycare center in Mayfield Heights, Ohio to extend the lease term five years to expire on June 30, 2022. The annual rent will remain the same throughout the remainder of the extended lease term. As part of the agreement, the Partnership paid a tenant improvement allowance of $43,350 that was capitalized. In addition, beginning on July 1, 2017, the tenant received free rent for three months that equaled $40,421. In the first quarter of 2017, the Partnership decided to sell the property. At September 30, 2017, the property was classified as Real Estate Held for Sale with a carrying value of $899,271. The Partnership owned a 40.1354% interest in a HomeTown Buffet restaurant in Albuquerque, New Mexico. The remaining interests in this property were owned by unrelated third parties, who owned the property with the Partnership as tenants-in-common. On November 10, 2015, the Partnership sold the property to an unrelated third party. In December 2014, the Partnership and three of the other co-owners of the property (the "Plaintiffs") commenced legal action against a fourth co‑owner ("Defendant") for breach of contract related to a prior attempt to sell the property. The Plaintiffs are suing to recover damages and attorney's fees. In July 2015, the judge ruled that the Defendant had breached the contract. On March 24, 2016, the judge heard the Plaintiffs' motion for summary judgment as to damages. The judge ruled that the Plaintiffs are entitled to attorney's fees, but declined to award damages until additional proof of damages could be provided. On March 22, 2017, the Plaintiffs signed a settlement agreement with the Defendant for damages related to the breach of contract. The Partnership's share of the settlement is $35,705. This amount was recognized as Miscellaneous Income in the first quarter of 2017. In addition, on April 30, 2017, the Plaintiffs filed a motion with the court that details the Plaintiffs' legal and other costs related to the legal action and why the Plaintiffs believe the costs should be recovered from the Defendant. On July 7, 2017, the judge issued a ruling that set the amount that the Plaintiffs can recover from the Defendant. The Partnership's share of this amount is $50,689. The Defendant subsequently filed a motion requesting that the judge reconsider the amount awarded. The Plaintiffs filed a response to the Defendant's motion. On September 6, 2017, the judge denied the Defendant's motion to reconsider. Subsequently, the Defendant filed an appeal with the Court of Appeals. The Plaintiffs are waiting to find out if the Court will hear the appeal. Due to the uncertainty of this situation, the Partnership did not accrue a receivable for the recovery of any legal costs. Through September 30, 2017, the Partnership's share of the legal and other costs incurred related to the legal action was $137,396. For the nine months ended September 30, 2017 and 2016, the legal and other costs were $27,941 and $11,202, respectively. Page 9 of 18 AEI NET LEASE INCOME & GROWTH FUND XX LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS (Continued) (4) Payable to AEI Fund Management, Inc. – AEI Fund Management, Inc. performs the administrative and operating functions for the Partnership. The payable to AEI Fund Management represents the balance due for those services. This balance is non-interest bearing and unsecured and is to be paid in the normal course of business. (5) Partners' Capital – For the nine months ended September 30, 2017 and 2016, the Partnership declared distributions of $839,402 and $846,354, respectively. The Limited Partners received distributions of $831,008 and $837,890 and the General Partners received distributions of $8,394 and $8,464 for the periods, respectively. The Limited Partners' distributions represented $41.25 and $41.27 per Limited Partnership Unit outstanding using 20,144 and 20,303 weighted average Units in 2017 and 2016, respectively. The distributions represented $26.16 and $19.33 per Unit of Net Income and $15.09 and $21.94 per Unit of return of contributed capital in 2017 and 2016, respectively. As part of the distributions discussed above, the Partnership distributed net sale proceeds (from property sales completed in 2015) of $107,756 in 2016. The Limited Partners received distributions of $106,678 and the General Partners received distributions of $1,078. The Limited Partners' distributions represented $5.26 per Unit. On April 1, 2017, the Partnership repurchased a total of 28.72 Units for $25,738 from three Limited Partners in accordance with the Partnership Agreement. On April 1, 2016, the Partnership repurchased a total of 115.00 Units for $98,301 from three Limited Partners. The Partnership acquired these Units using Net Cash Flow from operations. The repurchases increase the remaining Limited Partners' ownership interest in the Partnership. As a result of these repurchases and pursuant to the Partnership Agreement, the General Partners received distributions of $260 and $993 in 2017 and 2016, respectively. (6) Fair Value Measurements – As of September 30, 2017 and December 31, 2016, the Partnership had no assets or liabilities measured at fair value on a recurring basis or nonrecurring basis. Page 10 of 18 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. This section contains "forward-looking statements" which represent management's expectations or beliefs concerning future events, including statements regarding anticipated application of cash, expected returns from rental income, growth in revenue, the sufficiency of cash to meet operating expenses, rates of distribution, and other matters. These, and other forward-looking statements, should be evaluated in the context of a number of factors that may affect the Partnership's financial condition and results of operations, including the following: — | Market and economic conditions which affect the value of the properties the Partnership owns and the cash from rental income such properties generate; --+------------------------------------------------------------------------------------------------------------------------------------------------------- — | the federal income tax consequences of rental income, deductions, gain on sales and other items and the effects of these consequences for the Partners; --+-------------------------------------------------------------------------------------------------------------------------------------------------------- — | resolution by the General Partners of conflicts with which they may be confronted; --+----------------------------------------------------------------------------------- — | the success of the General Partners of locating properties with favorable risk return characteristics; --+------------------------------------------------------------------------------------------------------- — | the effect of tenant defaults; and --+----------------------------------- — | the condition of the industries in which the tenants of properties owned by the Partnership operate. --+----------------------------------------------------------------------------------------------------- Application of Critical Accounting Policies The Partnership's financial statements have been prepared in accordance with US GAAP. Preparing the financial statements requires management to use judgment in the application of these accounting policies, including making estimates and assumptions. These judgments will affect the reported amounts of the Partnership's assets and liabilities and the disclosure of contingent assets and liabilities as of the dates of the financial statements and will affect the reported amounts of revenue and expenses during the reporting periods. It is possible that the carrying amount of the Partnership's assets and liabilities, or the results of reported operations, will be affected if management's estimates or assumptions prove inaccurate. Management of the Partnership evaluates the following accounting estimates on an ongoing basis, and has discussed the development and selection of these estimates and the management discussion and analysis disclosures regarding them with the managing partner of the Partnership. Allocation of Purchase Price of Acquired Properties Upon acquisition of real properties, the Partnership records them in the financial statements at cost. The purchase price is allocated to tangible assets, consisting of land and building, and to identified intangible assets and liabilities, which may include the value of above market and below market leases and the value of in-place leases. The allocation of the purchase price is based upon the fair value of each component of the property. Although independent appraisals may be used to assist in the determination of fair value, in many cases these values will be based upon management's assessment of each property, the selling prices of comparable properties and the discounted value of cash flows from the asset. Page 11 of 18 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS. (Continued) The fair values of above market and below market in-place leases will be recorded based on the present value (using an interest rate which reflects the risks associated with the leases acquired) of the difference between (i) the contractual amounts to be paid pursuant to the in-place leases and (ii) an estimate of fair market lease rates for the corresponding in-place leases measured over a period equal to the non-cancelable term of the lease including any bargain renewal periods. The above market and below market lease values will be capitalized as intangible lease assets or liabilities. Above market lease values will be amortized as an adjustment of rental income over the remaining term of the respective leases. Below market lease values will be amortized as an adjustment of rental income over the remaining term of the respective leases, including any bargain renewal periods. If a lease were to be terminated prior to its stated expiration, all unamortized amounts of above market and below market in-place lease values relating to that lease would be recorded as an adjustment to rental income. The fair values of in-place leases will include estimated direct costs associated with obtaining a new tenant, and opportunity costs associated with lost rentals which are avoided by acquiring an in-place lease. Direct costs associated with obtaining a new tenant may include commissions, tenant improvements, and other direct costs and are estimated, in part, by management's consideration of current market costs to execute a similar lease. These direct costs will be included in intangible lease assets on the balance sheet and will be amortized to expense over the remaining term of the respective leases. The value of opportunity costs will be calculated using the contractual amounts to be paid pursuant to the in-place leases over a market absorption period for a similar lease. These intangibles will be included in intangible lease assets on the balance sheet and will be amortized to expense over the remaining term of the respective leases. If a lease were to be terminated prior to its stated expiration, all unamortized amounts of in-place lease assets relating to that lease would be expensed. The determination of the fair values of the assets and liabilities acquired will require the use of significant assumptions with regard to the current market rental rates, rental growth rates, discount and capitalization rates, interest rates and other variables. If management's estimates or assumptions prove inaccurate, the result would be an inaccurate allocation of purchase price, which could impact the amount of reported net income. Carrying Value of Properties Properties are carried at original cost, less accumulated depreciation and amortization. The Partnership tests long-lived assets for recoverability when events or changes in circumstances indicate that the carrying value may not be recoverable. For properties the Partnership will hold and operate, management determines whether impairment has occurred by comparing the property's probability-weighted future undiscounted cash flows to its current carrying value. For properties held for sale, management determines whether impairment has occurred by comparing the property's estimated fair value less cost to sell to its current carrying value. If the carrying value is greater than the net realizable value, an impairment loss is recorded to reduce the carrying value of the property to its net realizable value. Changes in these assumptions or analysis may cause material changes in the carrying value of the properties. Page 12 of 18 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS. (Continued) Allocation of Expenses AEI Fund Management, Inc. allocates expenses to each of the funds they manage primarily on the basis of the number of hours devoted by their employees to each fund's affairs. They also allocate expenses at the end of each month that are not directly related to a fund's operations based upon the number of investors in the fund and the fund's capitalization relative to other funds they manage. The Partnership reimburses these expenses subject to detailed limitations contained in the Partnership Agreement. Results of Operations For the nine months ended September 30, 2017 and 2016, the Partnership recognized rental income of $1,004,134 and $1,028,149, respectively. In 2017, rental income decreased due to the tenant of the KinderCare daycare center receiving free rent, as discussed below. This decrease was partially offset by additional rent received from one property acquisition in 2016 and rent increases on two properties. Based on the scheduled rent for the properties as of October 31, 2017, the Partnership expects to recognize rental income from continuing operations of approximately $1,352,000 and $1,361,000 in 2017 and 2018, respectively. For the nine months ended September 30, 2017 and 2016, the Partnership incurred Partnership administration expenses from affiliated parties of $131,892 and $134,476, respectively. These administration expenses include costs associated with the management of the properties, processing distributions, reporting requirements and communicating with the Limited Partners. During the same periods, the Partnership incurred Partnership administration and property management expenses from unrelated parties of $73,312 and $58,983, respectively. These expenses represent direct payments to third parties for legal and filing fees, direct administrative costs, outside audit costs, taxes, insurance and other property costs. These expenses were higher in 2017, when compared to 2016, due to expenses related to the legal action involving the owners of the HomeTown Buffet restaurant, as discussed below. For the nine months ended September 30, 2016, the Partnership incurred property acquisition expenses of $47,902 related to the purchase of the Dollar Tree store in Indianapolis, Indiana. The Partnership owned a 40.1354% interest in a HomeTown Buffet restaurant in Albuquerque, New Mexico. The remaining interests in this property were owned by unrelated third parties, who owned the property with the Partnership as tenants-in-common. On November 10, 2015, the Partnership sold the property to an unrelated third party. In December 2014, the Partnership and three of the other co-owners of the property (the "Plaintiffs") commenced legal action against a fourth co‑owner ("Defendant") for breach of contract related to a prior attempt to sell the property. The Plaintiffs are suing to recover damages and attorney's fees. In July 2015, the judge ruled that the Defendant had breached the contract. On March 24, 2016, the judge heard the Plaintiffs' motion for summary judgment as to damages. The judge ruled that the Plaintiffs are entitled to attorney's fees, but declined to award damages until additional proof of damages could be provided. On March 22, 2017, the Plaintiffs signed a settlement agreement with the Defendant for damages related to the breach of contract. The Partnership's share of the settlement is $35,705. This amount was recognized as Miscellaneous Income in the first quarter of 2017. Page 13 of 18 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS. (Continued) In addition, on April 30, 2017, the Plaintiffs filed a motion with the court that details the Plaintiffs' legal and other costs related to the legal action and why the Plaintiffs believe the costs should be recovered from the Defendant. On July 7, 2017, the judge issued a ruling that set the amount that the Plaintiffs can recover from the Defendant. The Partnership's share of this amount is $50,689. The Defendant subsequently filed a motion requesting that the judge reconsider the amount awarded. The Plaintiffs filed a response to the Defendant's motion. On September 6, 2017, the judge denied the Defendant's motion to reconsider. Subsequently, the Defendant filed an appeal with the Court of Appeals. The Plaintiffs are waiting to find out if the Court will hear the appeal. Due to the uncertainty of this situation, the Partnership did not accrue a receivable for the recovery of any legal costs. Through September 30, 2017, the Partnership's share of the legal and other costs incurred related to the legal action was $137,396. For the nine months ended September 30, 2017 and 2016, the legal and other costs were $27,941 and $11,202, respectively. In March 2017, the Partnership entered into an agreement with the tenant of the KinderCare daycare center in Mayfield Heights, Ohio to extend the lease term five years to expire on June 30, 2022. The annual rent will remain the same throughout the remainder of the extended lease term. As part of the agreement, the Partnership paid a tenant improvement allowance of $43,350 that was capitalized. In addition, beginning on July 1, 2017, the tenant received free rent for three months that equaled $40,421. In the first quarter of 2017, the Partnership decided to sell the property. At September 30, 2017, the property was classified as Real Estate Held for Sale with a carrying value of $899,271. For the nine months ended September 30, 2017 and 2016, the Partnership recognized interest income of $2,293 and $2,641, respectively. Management believes inflation has not significantly affected income from operations. Leases may contain rent increases, based on the increase in the Consumer Price Index over a specified period, which will result in an increase in rental income over the term of the leases. Inflation also may cause the real estate to appreciate in value. However, inflation and changing prices may have an adverse impact on the operating margins of the properties' tenants, which could impair their ability to pay rent and subsequently reduce the Net Cash Flow available for distributions. Liquidity and Capital Resources During the nine months ended September 30, 2017, the Partnership's cash balances increased $34,813 as a result of cash generated from operating activities in excess of distributions paid to the Partners and cash used to repurchase Units, which was partially offset by cash paid for a tenant improvement allowance. During the nine months ended September 30, 2016, the Partnership's cash balances decreased $1,820,613 as a result of cash used to purchase property, and distributions paid to the Partners and cash used to repurchase Units in excess of cash generated from operating activities. Page 14 of 18 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS. (Continued) Net cash provided by operating activities increased from $867,848 in 2016 to $945,881 in 2017 as a result of an increase in total rental and interest income in 2017, a decrease in acquisition expenses in 2016, and net timing differences in the collection of payments from the tenants and the payment of expenses, which were partially offset by an increase in Partnership administration and property management expenses in 2017. During 2016, cash from operations was reduced by $47,902 of acquisition expenses related to the purchase of real estate. Pursuant to accounting guidance, these expenses were reflected as operating cash outflows. However, pursuant to the Partnership Agreement, acquisition expenses were funded with proceeds from property sales. The major components of the Partnership's cash flow from investing activities are investments in real estate and proceeds from the sale of real estate. During the nine months ended September 30, 2017 and 2016, the Partnership expended $43,350 and $1,739,074, respectively, to invest in real properties as the Partnership reinvested cash generated from property sales completed in 2015. On January 8, 2016, the Partnership purchased a Dollar Tree store in Indianapolis, Indiana for $1,739,074. The property is leased to Dollar Tree Stores, Inc. under a lease agreement with a remaining primary term of 9.7 years (as of the date of purchase) and annual rent of $117,387. The Partnership's primary use of cash flow, other than investment in real estate, is distribution payments to Partners and cash used to repurchase Units. The Partnership declares its regular quarterly distributions before the end of each quarter and pays the distribution in the first week after the end of each quarter. The Partnership attempts to maintain a stable distribution rate from quarter to quarter. The Partnership may repurchase tendered Units on April 1st and October 1st of each year subject to limitations. For the nine months ended September 30, 2017 and 2016, the Partnership declared distributions of $839,402 and $846,354, respectively, which were distributed 99% to the Limited Partners and 1% to the General Partners. The Limited Partners received distributions of $831,008 and $837,890 and the General Partners received distributions of $8,394 and $8,464 for the periods, respectively. As part of the distributions discussed above, the Partnership distributed net sale proceeds (from property sales completed in 2015) of $107,756 in 2016. The Limited Partners received distributions of $106,678 and the General Partners received distributions of $1,078. The Limited Partners' distributions represented $5.26 per Unit. The Partnership may repurchase Units from Limited Partners who have tendered their Units to the Partnership. Such Units may be acquired at a discount. The Partnership will not be obligated to purchase in any year any number of Units that, when aggregated with all other transfers of Units that have occurred since the beginning of the same calendar year (excluding Permitted Transfers as defined in the Partnership Agreement), would exceed 5% of the total number of Units outstanding on January 1 of such year. In no event shall the Partnership be obligated to purchase Units if, in the sole discretion of the Managing General Partner, such purchase would impair the capital or operation of the Partnership. Page 15 of 18 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS. (Continued) On April 1, 2017, the Partnership repurchased a total of 28.72 Units for $25,738 from three Limited Partners in accordance with the Partnership Agreement. On April 1, 2016, the Partnership repurchased a total of 115.00 Units for $98,301 from three Limited Partners. The Partnership acquired these Units using Net Cash Flow from operations. The repurchases increase the remaining Limited Partners' ownership interest in the Partnership. As a result of these repurchases and pursuant to the Partnership Agreement, the General Partners received distributions of $260 and $993 in 2017 and 2016, respectively. The continuing rent payments from the properties, together with cash generated from property sales, should be adequate to fund continuing distributions and meet other Partnership obligations on both a short-term and long-term basis. Off-Balance Sheet Arrangements As of September 30, 2017 and December 31, 2016, the Partnership had no material off-balance sheet arrangements that had or are reasonably likely to have current or future effects on its financial condition, results of operations, liquidity or capital resources. ITEM 3. QUANTITATIVE & QUALITATIVE DISCLOSURES ABOUT MARKET RISK. Not required for a smaller reporting company. ITEM 4. CONTROLS AND PROCEDURES. (a) Disclosure Controls and Procedures. Under the supervision and with the participation of management, including its President and Chief Financial Officer, the Managing General Partner of the Partnership evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the "Exchange Act")). Based upon that evaluation, the President and Chief Financial Officer of the Managing General Partner concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective in ensuring that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in applicable rules and forms and that such information is accumulated and communicated to management, including the President and Chief Financial Officer of the Managing General Partner, in a manner that allows timely decisions regarding required disclosure. (b) Changes in Internal Control Over Financial Reporting. During the most recent period covered by this report, there has been no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. Page 16 of 18 PART II – OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS. There are no material pending legal proceedings to which the Partnership is a party or of which the Partnership's property is subject. ITEM 1A. RISK FACTORS. Not required for a smaller reporting company. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES & USE OF PROCEEDS. (a) None. (b) Not applicable. (c) Pursuant to Section 7.7 of the Partnership Agreement, as amended, each Limited Partner has the right to present Units to the Partnership for purchase by submitting notice to the Managing General Partner during January or July of each year. The purchase price of the Units is equal to 90% of the net asset value per Unit, as of the first business day of January or July of each year, as determined by the Managing General Partner in accordance with the provisions of the Partnership Agreement. Units tendered to the Partnership during January and July may be repurchased on April 1st and October 1st, respectively, of each year subject to the following limitations. The Partnership will not be obligated to purchase in any year any number of Units that, when aggregated with all other transfers of Units that have occurred since the beginning of the same calendar year (excluding Permitted Transfers as defined in the Partnership Agreement), would exceed 5% of the total number of Units outstanding on January 1 of such year. In no event shall the Partnership be obligated to purchase Units if, in the sole discretion of the Managing General Partner, such purchase would impair the capital or operation of the Partnership. During the period covered by this report, the Partnership did not purchase any Units. ITEM 3. DEFAULTS UPON SENIOR SECURITIES. None. ITEM 4. MINE SAFETY DISCLOSURES. Not Applicable. ITEM 5. OTHER INFORMATION. None. Page 17 of 18 ITEM 6. EXHIBITS. 31.1 | Certification of Chief Executive Officer of General Partner pursuant to Rule 15d-14(a)(17 CFR 240.15d-14(a)) and Section 302 of the Sarbanes-Oxley Act of 2002. -----+---------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.2 | Certification of Chief Financial Officer of General Partner pursuant to Rule 15d-14(a)(17 CFR 240.15d-14(a)) and Section 302 of the Sarbanes-Oxley Act of 2002. -----+---------------------------------------------------------------------------------------------------------------------------------------------------------------- 32 | Certification of Chief Executive Officer and Chief Financial Officer of General Partner pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. ---+--------------------------------------------------------------------------------------------------------------------------------------------------- SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Dated: November 13, 2017 | AEI Net Lease Income & Growth Fund XX --------------------------+-------------------------------------- | Limited Partnership --------------------------+-------------------------------------- | By: | AEI Fund Management XX, Inc. --------------------------+---------------------------------------+------------------------------- | Its: | Managing General Partner --------------------------+---------------------------------------+------------------------------- | By: | /s/ ROBERT P JOHNSON --------------------------+---------------------------------------+------------------------------- | | Robert P. Johnson --------------------------+---------------------------------------+------------------------------- | | President --------------------------+---------------------------------------+------------------------------- | | (Principal Executive Officer) --------------------------+---------------------------------------+------------------------------- | By: | /s/ PATRICK W KEENE --------------------------+---------------------------------------+------------------------------- | | Patrick W. Keene --------------------------+---------------------------------------+------------------------------- | | Chief Financial Officer --------------------------+---------------------------------------+------------------------------- | | (Principal Accounting Officer) --------------------------+---------------------------------------+------------------------------- Page 18 of 18

ALLIED HEALTHCARE PRODUCTS INC

874710

10-Q

0001144204-17-058136

UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 FORM 10-Q x | Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. --+---------------------------------------------------------------------------------------------------------------------------------- For the quarterly period ended September 30, 2017 ¨ | Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. --+----------------------------------------------------------------------------------------------------------------------------------- For the transition period from________ to ________ Commission File Number: 0-19266 ALLIED HEALTHCARE PRODUCTS, INC. (Exact name of registrant as specified in its charter) Delaware | 25-1370721 --------------------------------+-------------------- (State or other jurisdiction of | (I.R.S. Employer --------------------------------+-------------------- Incorporation or organization) | Identification No.) --------------------------------+-------------------- 1720 Sublette Avenue, St. Louis, Missouri 63110 (Address of principal executive offices, including zip code) (314) 771-2400 (Registrant’s telephone number, including area code) N/A (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve months (or for such shorter periods that the registrant was required to file such reports, and (2) has been subject to such filing requirements for the past ninety days. Yes x No ¨ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large accelerated filer ¨ | Accelerated filer ¨ ---------------------------------------------------------------------------+----------------------------- Non-accelerated filer ¨ (Do not check if a smaller reporting company) | Smaller reporting company x ---------------------------------------------------------------------------+----------------------------- Emerging growth company ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x The number of shares of common stock outstanding at November 1, 2017 is 4,013,537 shares. INDEX | | | Page Number ----------+-----------------------+---------------------------------------------------------------------------------------+------------ Part I – | Financial Information | ----------+-----------------------+-------------------------------------------------------------------------------------- | Item 1. | Financial Statements | ----------+-----------------------+---------------------------------------------------------------------------------------+------------ | | Statement of Operations - Three months ended September 30, 2017 and 2016 (Unaudited) | 3 ----------+-----------------------+---------------------------------------------------------------------------------------+------------ | | Balance Sheet - September 30, 2017 (Unaudited) and June 30, 2017 | 4 - 5 ----------+-----------------------+---------------------------------------------------------------------------------------+------------ | | Statement of Cash Flows - Three months ended September 30, 2017 and 2016 (Unaudited) | 6 ----------+-----------------------+---------------------------------------------------------------------------------------+------------ | | Notes to Financial Statements | 7 – 11 ----------+-----------------------+---------------------------------------------------------------------------------------+------------ | Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations | 11-14 ----------+-----------------------+---------------------------------------------------------------------------------------+------------ | Item 3. | Quantitative and Qualitative Disclosure about Market Risk | 15 ----------+-----------------------+---------------------------------------------------------------------------------------+------------ | Item 4. | Controls and Procedures | 15 ----------+-----------------------+---------------------------------------------------------------------------------------+------------ Part II - | Other Information | ----------+-----------------------+-------------------------------------------------------------------------------------- | Item 1. | Legal Proceedings | 15 ----------+-----------------------+---------------------------------------------------------------------------------------+------------ | Item 6. | Exhibits | 16 ----------+-----------------------+---------------------------------------------------------------------------------------+------------ | | Signature | 17 ----------+-----------------------+---------------------------------------------------------------------------------------+------------ “SAFE HARBOR” STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 Statements contained in this Report, which are not historical facts or information, are “forward-looking statements.” Words such as “believe,” “expect,” “intend,” “will,” “should,” and other expressions that indicate future events and trends identify such forward-looking statements. These forward-looking statements involve risks and uncertainties, which could cause the outcome and future results of operations, and financial condition to be materially different than stated or anticipated based on the forward-looking statements. Such risks and uncertainties include both general economic risks and uncertainties, risks and uncertainties affecting the demand for and economic factors affecting the delivery of health care services, both in the United States and in our overseas markets, impacts of the U.S. Affordable Care Act, the outcome of litigation proceedings and specific matters which relate directly to the Company’s operations and properties as discussed in the Company’s annual report on Form 10-K for the year ended June 30, 2017. The Company cautions that any forward-looking statements contained in this report reflect only the belief of the Company or its management at the time the statement was made. Although the Company believes such forward-looking statements are based upon reasonable assumptions, such assumptions may ultimately prove inaccurate or incomplete. The Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the statement was made. 2 - PART I. FINANCIAL INFORMATION Item 1. Financial Statements ALLIED HEALTHCARE PRODUCTS, INC. STATEMENT OF OPERATIONS (UNAUDITED) | Three months ended | --------------------------------------------------------+--------------------+---------- | September 30, | --------------------------------------------------------+--------------------+---------- | 2017 | | | 2016 | --------------------------------------------------------+--------------------+-----------+---+------+-- Net sales | $ | 7,896,853 | | | $ | 8,440,413 | --------------------------------------------------------+--------------------+-----------+---+------+---+-----------+-- Cost of sales | | 6,539,784 | | | | 6,883,243 | --------------------------------------------------------+--------------------+-----------+---+------+---+-----------+-- Gross profit | | 1,357,069 | | | | 1,557,170 | --------------------------------------------------------+--------------------+-----------+---+------+---+-----------+-- Selling, general and | | | | | | | --------------------------------------------------------+--------------------+-----------+---+------+---+-----------+-- administrative expenses | | 2,124,468 | | | | 2,374,120 | --------------------------------------------------------+--------------------+-----------+---+------+---+-----------+-- Loss from operations | | (767,399 | ) | | | (816,950 | ) --------------------------------------------------------+--------------------+-----------+---+------+---+-----------+-- Other (income) expenses: | | | | | | | --------------------------------------------------------+--------------------+-----------+---+------+---+-----------+-- Interest income | | (215 | ) | | | (653 | ) --------------------------------------------------------+--------------------+-----------+---+------+---+-----------+-- Other, net | | 52 | | | | 39 | --------------------------------------------------------+--------------------+-----------+---+------+---+-----------+-- | | (163 | ) | | | (614 | ) --------------------------------------------------------+--------------------+-----------+---+------+---+-----------+-- Loss before benefit from income taxes | | (767,236 | ) | | | (816,336 | ) --------------------------------------------------------+--------------------+-----------+---+------+---+-----------+-- Benefit from income taxes | | - | | | | - | --------------------------------------------------------+--------------------+-----------+---+------+---+-----------+-- Net loss | $ | (767,236 | ) | | $ | (816,336 | ) --------------------------------------------------------+--------------------+-----------+---+------+---+-----------+-- Basic and diluted loss per share | $ | (0.19 | ) | | $ | (0.20 | ) --------------------------------------------------------+--------------------+-----------+---+------+---+-----------+-- Weighted average shares outstanding - basic and diluted | | 4,013,537 | | | | 4,013,537 | --------------------------------------------------------+--------------------+-----------+---+------+---+-----------+-- See accompanying Notes to Financial Statements. 3 - ALLIED HEALTHCARE PRODUCTS, INC. BALANCE SHEET ASSETS | (Unaudited) | | | ---------------------------------------------------+---------------+------------+----------+-- | September 30, | | June 30, | ---------------------------------------------------+---------------+------------+----------+-- | 2017 | | 2017 | ---------------------------------------------------+---------------+------------+----------+-- Current assets: | | | | | ---------------------------------------------------+---------------+------------+----------+---+----------- Cash and cash equivalents | $ | 244,250 | | $ | 995,704 ---------------------------------------------------+---------------+------------+----------+---+----------- Accounts receivable, net of allowances of $170,000 | | 3,434,382 | | | 3,362,438 ---------------------------------------------------+---------------+------------+----------+---+----------- Inventories, net | | 9,133,913 | | | 8,511,954 ---------------------------------------------------+---------------+------------+----------+---+----------- Income tax receivable | | 13,455 | | | 12,555 ---------------------------------------------------+---------------+------------+----------+---+----------- Other current assets | | 332,009 | | | 315,678 ---------------------------------------------------+---------------+------------+----------+---+----------- Total current assets | | 13,158,009 | | | 13,198,329 ---------------------------------------------------+---------------+------------+----------+---+----------- Property, plant and equipment, net | | 5,506,318 | | | 5,734,041 ---------------------------------------------------+---------------+------------+----------+---+----------- Deferred income taxes | | 683,763 | | | 683,763 ---------------------------------------------------+---------------+------------+----------+---+----------- Other assets, net | | 7,686 | | | 20,516 ---------------------------------------------------+---------------+------------+----------+---+----------- Total assets | $ | 19,355,776 | | $ | 19,636,649 ---------------------------------------------------+---------------+------------+----------+---+----------- See accompanying Notes to Financial Statements. (CONTINUED) 4 - ALLIED HEALTHCARE PRODUCTS, INC. BALANCE SHEET (CONTINUED) LIABILITIES AND STOCKHOLDERS’ EQUITY | (Unaudited) | | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+-------------+---+----------+-- | September 30, | | | June 30, | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+-------------+---+----------+-- | 2017 | | | 2017 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+-------------+---+----------+-- Current liabilities: | | | | | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+-------------+---+----------+---+-------------+-- Accounts payable | $ | 1,568,807 | | | $ | 1,440,403 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+-------------+---+----------+---+-------------+-- Other accrued liabilities | | 2,367,280 | | | | 2,009,966 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+-------------+---+----------+---+-------------+-- Total current liabilities | | 3,936,087 | | | | 3,450,369 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+-------------+---+----------+---+-------------+-- Commitments and contingencies | | | | | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+-------------+---+----------+---+-------------+-- Stockholders’ equity: | | | | | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+-------------+---+----------+---+-------------+-- Preferred stock; $0.01 par value; 1,500,000 shares authorized; no shares issued and outstanding | | - | | | | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+-------------+---+----------+---+-------------+-- Series A preferred stock; $0.01 par value; 200,000 shares authorized; no shares issued and outstanding | | - | | | | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+-------------+---+----------+---+-------------+-- Common stock; $0.01 par value; 30,000,000 shares authorized; 5,213,902 shares issued at September 30, 2017 and June 30, 2017; 4,013,537 shares outstanding at September 30, 2017 and June 30, 2017 | | 52,139 | | | | 52,139 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+-------------+---+----------+---+-------------+-- Additional paid-in capital | | 48,486,035 | | | | 48,485,390 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+-------------+---+----------+---+-------------+-- Accumulated deficit | | (12,137,697 | ) | | | (11,370,461 | ) ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+-------------+---+----------+---+-------------+-- Less treasury stock, at cost; 1,200,365 shares at September 30, 2017 and June 30, 2017 | | (20,980,788 | ) | | | (20,980,788 | ) ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+-------------+---+----------+---+-------------+-- Total stockholders’ equity | | 15,419,689 | | | | 16,186,280 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+-------------+---+----------+---+-------------+-- Total liabilities and stockholders’ equity | $ | 19,355,776 | | | $ | 19,636,649 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+-------------+---+----------+---+-------------+-- See accompanying Notes to Financial Statements. 5 - ALLIED HEALTHCARE PRODUCTS, INC. STATEMENT OF CASH FLOWS (UNAUDITED) | Three months ended | --------------------------------------------------------------------------------+--------------------+--------- | September 30, | --------------------------------------------------------------------------------+--------------------+--------- | 2017 | | | 2016 | --------------------------------------------------------------------------------+--------------------+----------+---+------+--- Cash flows from operating activities: | | | | | | | --------------------------------------------------------------------------------+--------------------+----------+---+------+----+-----------+-- Net loss | ($ | 767,236 | ) | | ($ | 816,336 | ) --------------------------------------------------------------------------------+--------------------+----------+---+------+----+-----------+-- Adjustments to reconcile net loss to net cash used in operating activities: | | | | | | | --------------------------------------------------------------------------------+--------------------+----------+---+------+----+-----------+-- Depreciation and amortization | | 240,553 | | | | 282,745 | --------------------------------------------------------------------------------+--------------------+----------+---+------+----+-----------+-- Stock based compensation | | 645 | | | | 579 | --------------------------------------------------------------------------------+--------------------+----------+---+------+----+-----------+-- Provision for doubtful accounts and sales returns and allowances | | 1,090 | | | | 11,015 | --------------------------------------------------------------------------------+--------------------+----------+---+------+----+-----------+-- Changes in operating assets and liabilities: | | | | | | | --------------------------------------------------------------------------------+--------------------+----------+---+------+----+-----------+-- Accounts receivable | | (73,034 | ) | | | 871,411 | --------------------------------------------------------------------------------+--------------------+----------+---+------+----+-----------+-- Inventories | | (621,959 | ) | | | (184,016 | ) --------------------------------------------------------------------------------+--------------------+----------+---+------+----+-----------+-- Income tax receivable | | (900 | ) | | | (5,403 | ) --------------------------------------------------------------------------------+--------------------+----------+---+------+----+-----------+-- Other current assets | | (16,331 | ) | | | (152,911 | ) --------------------------------------------------------------------------------+--------------------+----------+---+------+----+-----------+-- Accounts payable | | 128,404 | | | | (63,871 | ) --------------------------------------------------------------------------------+--------------------+----------+---+------+----+-----------+-- Other accrued liabilities | | 357,314 | | | | (273,851 | ) --------------------------------------------------------------------------------+--------------------+----------+---+------+----+-----------+-- Net cash used in operating activities | | (751,454 | ) | | | (330,638 | ) --------------------------------------------------------------------------------+--------------------+----------+---+------+----+-----------+-- Cash flows from investing activities: | | | | | | | --------------------------------------------------------------------------------+--------------------+----------+---+------+----+-----------+-- Capital expenditures | | - | | | | (8,602 | ) --------------------------------------------------------------------------------+--------------------+----------+---+------+----+-----------+-- Net cash used in investing activities | | - | | | | (8,602 | ) --------------------------------------------------------------------------------+--------------------+----------+---+------+----+-----------+-- Net decrease in cash and cash equivalents | | (751,454 | ) | | | (339,240 | ) --------------------------------------------------------------------------------+--------------------+----------+---+------+----+-----------+-- Cash and cash equivalents at beginning of period | | 995,704 | | | | 1,703,663 | --------------------------------------------------------------------------------+--------------------+----------+---+------+----+-----------+-- Cash and cash equivalents at end of period | $ | 244,250 | | | $ | 1,364,423 | --------------------------------------------------------------------------------+--------------------+----------+---+------+----+-----------+-- See accompanying Notes to Financial Statements. 6 - ALLIED HEALTHCARE PRODUCTS, INC. NOTES TO FINANCIAL STATEMENTS (UNAUDITED) 1. Summary of Significant Accounting and Reporting Policies Basis of Presentation The accompanying unaudited financial statements of Allied Healthcare Products, Inc. (the “Company”) have been prepared in accordance with the instructions for Form 10-Q and do not include all of the information and disclosures required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments, consisting only of normal recurring adjustments considered necessary for a fair presentation, have been included. Operating results for any quarter are not necessarily indicative of the results for any other quarter or for the full year. These statements should be read in conjunction with the financial statements and notes to the financial statements thereto included in the Company’s Annual Report on Form 10-K for the year ended June 30, 2017. Recently Issued Accounting Guidance In May 2014, the FASB and International Accounting Standards Board jointly issued new principles-based accounting guidance for revenue recognition that will supersede virtually all existing revenue guidance. The core principle of this guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services. To achieve the core principle, the guidance establishes the following five steps: 1) identify the contract(s) with a customer, 2) identify the performance obligation in the contract, 3) determine the transaction price, 4) allocate the transaction price to the performance obligations in the contract, and 5) recognize revenue when (or as) the entity satisfies a performance obligation. The guidance also details the accounting treatment for costs to obtain or fulfill a contract. Lastly, disclosure requirements have been enhanced to provide sufficient information to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. This guidance is effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. In July 2015, the FASB affirmed its proposal to defer the effective date by one year. In May 2016, the FASB issued improvements and practical expedients to the standard that included clarification of the collectability criterion, noncash considerations as well as clarification of options at transition. In December 2016, the FASB issued additional corrections and improvements. The Company is in the process of evaluating the impact of this guidance. This new guidance, will likely result in a change in the nature and extent of the related footnote disclosures. The Company plans to adopt the new guidance when effective and presently anticipates adopting on a modified retrospective basis to each prior reporting period presented with the election of applicable practical expedients. In February 2016, the FASB issued ASU 2016-02, “Leases (Topic 842)” (“ASU 2016-02”), which requires lessees to recognize assets and liabilities for leases with lease terms of more than 12 months and disclose key information about leasing arrangements. Consistent with current U.S. GAAP, the recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee primarily will depend on its classification as a finance or operating lease. The update is effective for reporting periods beginning after December 15, 2018. Early adoption is permitted. The Company is in the process of evaluating the impact of this update on its financial statements. 7 - Fair Value of Financial Instruments The Company’s financial instruments consist of cash and cash equivalents, accounts receivable and accounts payable. The carrying amounts for cash and cash equivalents, accounts receivable and accounts payable approximate their fair value due to the short maturity of these instruments. 2. Inventories Inventories are comprised as follows: | September 30, 2017 | | | June 30, 2017 | --------------------------------------------+--------------------+------------+---+---------------+-- Work-in progress | $ | 632,306 | | | $ | 468,839 | --------------------------------------------+--------------------+------------+---+---------------+---+------------+-- Component parts | | 7,527,693 | | | | 7,271,908 | --------------------------------------------+--------------------+------------+---+---------------+---+------------+-- Finished goods | | 2,570,120 | | | | 2,368,855 | --------------------------------------------+--------------------+------------+---+---------------+---+------------+-- Reserve for obsolete and excess inventories | | (1,596,206 | ) | | | (1,597,648 | ) --------------------------------------------+--------------------+------------+---+---------------+---+------------+-- | $ | 9,133,913 | | | $ | 8,511,954 | --------------------------------------------+--------------------+------------+---+---------------+---+------------+-- 3. Earnings per share Basic earnings per share are based on the weighted average number of shares of all common stock outstanding during the period. Diluted earnings per share are based on the sum of the weighted average number of shares of common stock and common stock equivalents outstanding during the period. The number of basic and diluted shares outstanding for the three months ended September 30, 2017 and 2016 were 4,013,537. 4. Commitments and Contingencies Legal Claims The Company is subject to various investigations, claims and legal proceedings covering a wide range of matters that arise in the ordinary course of its business activities. The Company intends to continue to conduct business in such a manner as to avert any FDA action seeking to interrupt or suspend manufacturing or require any recall or modification of products. The Company has recognized the costs and associated liabilities only for those investigations, claims and legal proceedings for which, in its view, it is probable that liabilities have been incurred and the related amounts are estimable. Based upon information currently available, management believes that existing accrued liabilities are sufficient. Stuyvesant Falls Power Litigation. The Company is currently involved in litigation with Niagara Mohawk Power Corporation d/b/a National Grid (“Niagara”), which provides electrical power to the Company’s facility in Stuyvesant Falls, New York, and one other party. The Company maintains in its defense of the lawsuit that it is entitled to a certain amount of free electricity based on covenants running with the land which have been honored for more than a century. After the commencement of the litigation, Niagara began sending invoices to the Company for electricity used at the Company’s Stuyvesant Falls plant. Niagara’s attempts to collect such invoices were stopped in December 2010 by a temporary restraining order. Among other things, Niagara seeks as damages the value of electricity received by the Company without charge. The total value of electricity at issue in the litigation is not known with certainty and Niagara has alleged different amounts of damages. Niagara alleged in its Second Amended Verified Complaint, dated February 6, 2012, damages of approximately $469,000 in free electricity from May 2003 through May 2010. Niagara also alleged in its Motion For Summary Judgment, filed on March 14, 2014, damages of approximately $492,000 in free electricity from May 2010 through the date of the filing. In April 2015, Allied received an invoice for electrical power at the Stuyvesant Falls plant with an “Amount Due” balance of $696,000 as of March 31, 2015 without any description as to the period of time covered by the invoice. 8 - The Company filed a Motion for Summary Judgment on March 14, 2014, seeking dismissal of Niagara’s claims and oral arguments on the motions were held on June 13, 2014. On October 1, 2014, the Court granted the Company’s motion, denied Niagara’s motion and ruled that the Company is entitled to receive electrical power pursuant to the power covenants. On October 26 and October 30, 2014, Niagara and the other party filed separate notices of appeal of the Court’s decision. On March 31, 2016 the Supreme Court of New York, Appellate Division, Third Department reversed the trial court decision and held that the free power covenants are no longer enforceable. The Company’s application for leave to appeal this ruling was dismissed as premature by the New York Court of Appeals on September 20, 2016. On May 26, 2017 the Company again moved for leave to appeal the March 31, 2016 decision. That motion was granted on October 7, 2017 by the New York State Court of Appeals. The appellate decision terminated the enforceability of the free power covenants as of March 31, 2016. The appellate decision did not order the Company to pay any amounts for power consumed prior to such date and the Company believes that it is not liable for any such damages as a result of the appellate decision. On December 21, 2016, Niagara filed a motion to the trial court asking that it hold additional proceedings to establish what damages, if any, are owed to Niagara as the result of the appellate decision. The Company filed its response on January 23, 2017. On April 25, 2017, the court denied Niagara’s motion in its entirety finding that no damages could be awarded based on the Appellate Division’s decision. Niagara has filed a Notice of Appeal from that decision, but to date, has not filed the appeal. As of September 30, 2017, the Company has not recorded a provision for this matter. The Company commenced paying for power at the Stuyvesant Falls facility in April 2016. Employment Contract The Company has entered into an employment contract with its chief executive officer with annual renewals. The contract includes termination without cause and change of control provisions, under which the chief executive officer is entitled to receive specified severance payments generally equal to two times ending annual salary if the Company terminates his employment without cause or he voluntarily terminates his employment with “good reason.” “Good Reason” generally includes changes in the scope of his duties or location of employment but also includes (i) the Company’s written election not to renew the Employment Agreement and (ii) certain voluntary resignations by the chief executive officer following a “Change of Control” as defined in the Agreement. 9 - 5. Financing On February 27, 2017, Allied Healthcare Products, Inc. (the “Company”) entered into a Loan and Security Agreement (the “Credit Agreement”) with Summit Financial Resources, L.P. (“Summit”) pursuant to which the Company obtained a secured revolving credit facility (the “Credit Facility”). The Company’s obligations under the Credit Facility are secured by all of the Company’s personal property, both tangible and intangible, pursuant to the terms and subject to the conditions set forth in the Credit Agreement. Availability of funds under the Credit Agreement is based on the Company’s accounts receivable and inventory but will not exceed $2,000,000. At September 30, 2017 availability under the agreement was $2,000,000. The Credit Facility will be available, subject to its terms, on a revolving basis until it expires on February 27, 2019, at which time all amounts outstanding under the Credit Facility will be due and payable. Advances will bear interest at a rate equal to 2.00% in excess of the prime rate as reported in the Wall Street Journal. Interest is computed based on the actual number of days elapsed over a year of 360 days. In addition to interest, the Credit facility requires that the Company pay the lender a monthly administration fee in an amount equal to forty-seven hundredths percent (0.47%) of the average outstanding daily principal amount of loan advances for the each calendar month, or portion thereof. Regardless of the amount borrowed under the Credit Facility, the Company will pay a minimum amount of .25% (25 basis points) per month on the maximum availability ($5,000 per month). In the event the Company prepays or terminates the Credit Facility, the Company will be obligated to pay an amount equal to twelve months of minimum monthly payments, minus the number of months elapsed since the effective date of the Credit Agreement. Under the Credit Agreement, advances are generally subject to customary borrowing conditions and to Summit’s sole discretion to fund the advances. The Credit Agreement also contains covenants with which the Company must comply during the term of the Credit Facility. Among other things, such covenants require the Company to maintain insurance on the collateral, operate in the ordinary course and not engage in a change of control, dissolve or wind up the Company. The Credit Agreement also contains certain events of default including, without limitation: the failure to make payments when due; the material breach of representations or warranties contained in the Credit Agreement or other loan documents; cross-default with other indebtedness of the Company; the entry of judgments or fines that may have a material adverse effect on the Company; failure to comply with the observance or performance of covenants contained in the Credit Agreement or other loan documents; insolvency of the Company, appointment of a receiver, commencement of bankruptcy or other insolvency proceedings; dissolution of the Company; the attachment of any state or federal tax lien; attachment or levy upon or seizure of the Company’s property; or any change in the Company’s condition that may have a material adverse effect. After an event of default, and upon the continuation thereof, the principal amount of all loans made under the Credit Facility would bear interest at a rate per annum equal to 20.00% above the otherwise applicable interest rate (provided, that the interest rate may not exceed the highest rate permissible under law), and Summit would have the option to accelerate maturity and payment of the Company’s obligations under the Credit Facility. 10 -- At September 30, 2017, the Company had no aggregate indebtedness, including capital lease obligations, short-term debt and long term debt. The prime rate as reported in the Wall Street Journal was 4.25% on September 30, 2017. The Company was in compliance with all of the covenants associated with the Credit Facility at September 30, 2017. 6. Income Taxes The Company accounts for income taxes under ASC Topic 740: “Income Taxes.” Under ASC 740, the deferred tax provision is determined using the liability method, whereby deferred tax assets and liabilities are recognized based upon temporary differences between the financial statement and income tax bases of assets and liabilities using presently enacted tax rates. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized. In the quarter ended September 30, 2017 the Company recorded the tax benefit of losses incurred during the current quarter in the amount of approximately $292,000. As the realization of the tax benefit of the net operating loss is not assured an additional valuation allowance of approximately $292,000 was recorded. In the quarter ended September 30, 2016 the Company recorded the tax benefit of losses incurred in the amount of approximately $306,000. As the realization of the tax benefit of the net operating loss is not assured an additional valuation allowance of approximately $306,000 was recorded. The total valuation allowance recorded by the Company as of September 30, 2017 and 2016 was approximately $2,845,000 and $2,119,000, respectively. To the extent that the Company’s losses continue in future quarters, the tax benefit of those losses will be subject to a valuation allowance. Item 2. Management’s Discussion and Analysis of Financial Conditions and Results of Operations Results of Operations Three months ended September 30, 2017 compared to three months ended September 30, 2016 Allied had net sales of $7.9 million for the three months ended September 30, 2017, down $0.5 million from net sales of $8.4 million in the prior year same quarter. Domestic sales were down 6.9% while international sales, which represented 24.5% of first quarter sales, were down 5.1% from the prior year same quarter. Orders for the Company’s products for the three months ended September 30, 2017 of $7.8 million were $0.4 million or 4.9% lower than orders for the prior year same quarter of $8.2 million. Domestic orders are down 9.8% over the prior year same quarter, while international orders, which represented 26.5% of first quarter orders, were 11.2% higher than orders for the prior year same quarter. Domestically, the decrease in orders and sales is partially due to decreases in sales of carbon dioxide absorbents and of products to the hospital construction market. Improvements in International orders include the impact the Company has seen as the AHP 300 product line begins to be recognized for service in areas wiht limited medical resources. International sales and orders are subject to fluctuation in international demand. These fluctuations are at times due to political and economic uncertainty internationally. International sales continue to be impacted by political and economic uncertainty in regions and countries such as Russia, Ukraine, and South America, including Venezuela. 11 -- Gross profit for the three months ended September 30, 2017 was $1.4 million, or 17.7% of net sales, compared to $1.6 million, or 19.0% of net sales, for the three months ended September 30, 2016. Gross profit for the quarter was unfavorably impacted by the decrease in sales volume. Manufacturing Overhead spending was unchanged from the prior year. The lower level of sales results in less utilization of fixed overhead expenses, resulting in lower gross profit. Selling, general and administrative expenses for the three months ended September 30, 2017 were $2.1 million compared to selling, general and administrative expenses of $2.4 million for the three months ended September 30, 2016. Personnel cost, primarily salaries and fringe benefits, decreased by approximately $118,000. Non-personnel cost decreased by approximately $132,000 which included a reduction of approximately $95,000 in legal expense. Loss from operations was $767,399 for the three months ended September 30, 2017 compared to loss from operations of $816,950 for the three months ended September 30, 2016. Allied had a loss before benefit from income taxes in the first quarter of fiscal 2018 of $767,236 compared to a loss before benefit from income taxes in the first quarter of fiscal 2017 of $816,336. The Company’s tax provision net of valuation allowance reflects a tax benefit of $0 for the three months ended September 30, 2017 and 2016. In the quarter ended September 30, 2017 the tax benefit of losses in the amount of approximately $292,000 was fully offset by a valuation allowance of equivalent amount. In the quarter ended September 30, 2016 the Company recorded the tax benefit of losses incurred in the amount of approximately $306,000 net of additions to the valuation allowance of like amount. To the extent that the Company’s losses continue in future quarters, the tax benefit of those losses will be fully offset by a valuation allowance. Net loss for the first quarter of fiscal 2018 was $767,236 or $0.19 per basic and diluted share compared to net loss of $816,336 or $0.20 per basic and diluted share for the first quarter of fiscal 2017. The weighted average number of common shares outstanding, used in the calculation of basic and diluted earnings per share for the first quarters of fiscal 2018 and 2017 were 4,013,537. Liquidity and Capital Resources The Company believes that available resources, including available borrowing under the Credit Facility discussed below, are sufficient to meet operating requirements in the next twelve months. 12 -- The Company’s working capital was $9.2 million at September 30, 2017 compared to $9.7 million at June 30, 2017. Cash and cash equivalents decreased by $0.8 million and Other Accrued Liabilities increased by $0.4 million. During fiscal 2018, these decreases in working capital were offset by an increase in Inventory and Accounts Receivable by $0.6 million and $0.1 million, respectively. Accounts Receivable was $3.4 million at September 30, 2017 and as measured in days sales outstanding (“DSO”) was 42 DSO; up from 39 DSO at June 30, 2017. The Company does adjust product forecast, order quantities and safety stock based on changes in demand patterns in order to manage inventory levels. As of September 30, 2017, the Company was party to a Loan and Security Agreement, dated February 27, 2017, with Summit Financial Resources, L.P. (the “Credit Agreement”), under which the Company had $2,000,000 available for borrowing (the “Credit Facility”). The Company’s obligations under the Credit Facility are secured by all of the Company’s personal property, both tangible and intangible, pursuant to the terms and subject to the conditions set forth in the Credit Agreement. Availability of funds under the Credit Agreement is based on the Company’s accounts receivable and inventory but will not exceed $2,000,000.00. At September 30, 2017 availability under the Credit Agreement was $2,000,000. 13 -- The Credit Facility will be available, subject to its terms, on a revolving basis until it expires on February 27, 2019. Advances will bear interest at a rate equal to 2.00% in excess of the prime rate as reported in the Wall Street Journal and subject to a minimum availability fee of 0.25% (25 basis points) per month on the maximum availability ($5,000 per month). In addition to interest, the Credit facility requires that the Company pay the lender a monthly administration fee in an amount equal to forty-seven hundredths percent (0.47%) of the average outstanding daily principal amount of loan advances for the each calendar month, or portion thereof. Under the Credit Agreement, advances are generally subject to customary borrowing conditions and to Summit’s sole discretion to fund the advances. The Credit Agreement also contains covenants with which the Company must comply during the term of the Credit Facility. Among other things, such covenants require the Company to maintain insurance on the collateral, operate in the ordinary course and not engage in a change of control, dissolve or wind up the Company. In the event of default, interest is calculated on a variable interest rate equal to 20.00% above the prime rate, adjusted as of the date of any change in the prime rate. At September 30, 2017, the Company had no aggregate indebtedness, including capital lease obligations, short-term debt, and long term debt. The Company was in compliance with all of the covenants associated with the Credit Facility at September 30, 2017. Litigation and Contingencies The Company becomes, from time to time, a party to personal injury litigation arising out of incidents involving the use of its products. The Company believes that any potential judgments resulting from these claims over its self-insured retention will be covered by the Company’s product liability insurance. See Part II, Item 1 – Legal Proceedings, below, for more information concerning litigation. Critical Accounting Policies The impact and any associated risks related to the Company’s critical accounting policies on business operations are discussed throughout “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” where such policies affect the Company’s reported and expected financial results. For a detailed discussion on the application of these and other accounting policies, see the Company’s Annual Report on Form 10-K for the year ended June 30, 2017. Recently Issued Accounting Guidance See Note 1 – Summary of Significant Accounting and Reporting Policies for more information on recent accounting pronouncements and their impact, if any, on the Company’s financial statements. Management believes there have been no material changes to our critical accounting policies. 14 -- Item 3. | Quantitative and Qualitative Disclosure about Market Risk --------+--------------------------------------------------------------------------------------------------- At September 30, 2017, the Company did not have any debt outstanding. The Credit Facility bears interest at a rate using the Prime Rate, as reported in the Wall Street Journal, as the basis, and therefore is subject to additional expense should there be an increase in market interest rates while borrowing on the revolving credit facility. The Company had no holdings of derivative financial or commodity instruments at September 30, 2017. The Company has international sales; however these sales are denominated in U.S. dollars, mitigating foreign exchange rate fluctuation risk. Item 4. | Controls and Procedures --------+----------------------------------------------------------------- Evaluation of Disclosure Controls and Procedures The Company maintains controls and procedures designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Based upon their evaluation of those controls and procedures performed as of September 30, 2017, the Chief Executive Officer and Chief Financial Officer of the Company concluded that its disclosure controls and procedures were effective. Changes in internal control over financial reporting There were no changes in the Company’s internal control over financial reporting during the quarter ended September 30, 2017 that have materially affected, or are reasonably likely to materially affect, the registrant’s internal control over financial reporting. Part II. | OTHER INFORMATION ---------+------------------ Item 1. | Legal Proceedings --------+----------------------------------------------------------- Stuyvesant Falls Power Litigation. The Company is currently involved in litigation with Niagara Mohawk Power Corporation d/b/a National Grid (“Niagara”), which provides electrical power to the Company’s facility in Stuyvesant Falls, New York, and one other party. The Company maintains in its defense of the lawsuit that it is entitled to a certain amount of free electricity based on covenants running with the land which have been honored for more than a century. After the commencement of the litigation, Niagara began sending invoices to the Company for electricity used at the Company’s Stuyvesant Falls plant. Niagara’s attempts to collect such invoices were stopped in December 2010 by a temporary restraining order. Among other things, Niagara seeks as damages the value of electricity received by the Company without charge. The total value of electricity at issue in the litigation is not known with certainty and Niagara has alleged different amounts of damages. Niagara alleged in its Second Amended Verified Complaint, dated February 6, 2012, damages of approximately $469,000 in free electricity from May 2003 through May 2010. Niagara also alleged in its Motion For Summary Judgment, filed on March 14, 2014, damages of approximately $492,000 in free electricity from May 2010 through the date of the filing. In April 2015, Allied received an invoice for electrical power at the Stuyvesant Falls plant with an “Amount Due” balance of $696,000 as of March 31, 2015 without any description as to the period of time covered by the invoice. 15 -- The Company filed a Motion for Summary Judgment on March 14, 2014, seeking dismissal of Niagara’s claims and oral arguments on the motions were held on June 13, 2014. On October 1, 2014, the Court granted the Company’s motion, denied Niagara’s motion and ruled that the Company is entitled to receive electrical power pursuant to the power covenants. On October 26 and October 30, 2014, Niagara and the other party filed separate notices of appeal of the Court’s decision. On March 31, 2016 the Supreme Court of New York, Appellate Division, Third Department reversed the trial court decision and held that the free power covenants are no longer enforceable. The Company’s application for leave to appeal this ruling was dismissed as premature by the New York Court of Appeals on September 20, 2016. On May 26, 2017 the Company again moved for leave to appeal the March 31, 2016 decision. That motion was granted on October 7, 2017 by the New York State Court of Appeals. The appellate decision terminated the enforceability of the free power covenants as of March 31, 2016. The appellate decision did not order the Company to pay any amounts for power consumed prior to such date and the Company believes that it is not liable for any such damages as a result of the appellate decision. On December 21, 2016, Niagara filed a motion to the trial court asking that it hold additional proceedings to establish what damages, if any, are owed to Niagara as the result of the appellate decision. The Company filed its response on January 23, 2017. On April 25, 2017, the court denied Niagara’s motion in its entirety finding that no damages could be awarded based on the Appellate Division’s decision. Niagara has filed a Notice of Appeal from that decision, but to date, has not filed the appeal. As of September 30, 2017, the Company has not recorded a provision for this matter. The Company commenced paying for power at the Stuyvesant Falls facility in April 2016. Item 6. | Exhibits --------+--------- (a) | Exhibits: ----+----------------------------------------------------------------------------------- | 31.1 Certification of Chief Executive Officer (filed herewith) ----+----------------------------------------------------------------------------------- | 31.2 Certification of Chief Financial Officer (filed herewith) ----+----------------------------------------------------------------------------------- | 32.1 Sarbanes-Oxley Certification of Chief Executive Officer (furnished herewith)* ----+----------------------------------------------------------------------------------- | 32.2 Sarbanes-Oxley Certification of Chief Financial Officer (furnished herewith)* ----+----------------------------------------------------------------------------------- | 101.INS XBRL Instance Document** ----+----------------------------------------------------------------------------------- | 101.SCH XBRL Taxonomy Extension Schema Document** ----+----------------------------------------------------------------------------------- | 101.CAL XBRL Taxonomy Extension Calculation Linkbase Document** ----+----------------------------------------------------------------------------------- | 101.DEF XBRL Taxonomy Extension Definition Linkbase Document** ----+----------------------------------------------------------------------------------- | 101.LAB XBRL Taxonomy Extension Label Linkbase Document** ----+----------------------------------------------------------------------------------- | 101.PRE XBRL Taxonomy Extension Presentation Linkbase Document** ----+----------------------------------------------------------------------------------- *Notwithstanding any incorporation of this Quarterly Report on Form 10-Q in any other filing by the Registrant, Exhibits furnished herewith and designated with an asterisk (*) shall not be deemed incorporated by reference to any other filing under the Securities Act of 1933 or the Securities Exchange Act of 1934 unless specifically otherwise set forth therein. **Filed herewith as Exhibit 101 are the following materials formatted in XBRL: (i) Statement of Operations, (ii) Balance Sheet, (iii) Statement of Cash Flows and (iv) Notes to Financial Statements. 16 -- SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. ALLIED HEALTHCARE PRODUCTS, INC. -------------------------------- /s/ Daniel C. Dunn -------------------------------------- Daniel C. Dunn Chief Financial Officer -------------------------------------- Date: November 13, 2017 ----------------------- 17 --

ALPHA ENERGY INC

855787

10-Q

0001078782-17-001546

Form 10-Q Quarterly Report U.S. SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) [X] Quarterly Report under Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended September 30, 2017 [ ] Transition Report under Section 13 or 15(d) of the Exchange Act For the Transition Period from ________to __________ Commission File Number: 333-197642 Alpha Energy, Inc. (Exact Name of Registrant as Specified in its Charter) Colorado | 90-1020566 --------------------------------+----------------------- (State of other jurisdiction of | (I.R.S. Employer --------------------------------+----------------------- incorporation or organization) | Identification Number) --------------------------------+----------------------- 600 17th Street, 2800 South | -----------------------------------------+----------- Denver, CO | 80202 -----------------------------------------+----------- (Address of principal executive offices) | (Zip Code) -----------------------------------------+----------- Registrant's Phone: 970-568-6862 Indicate by check mark whether the issuer (1) filed all reports required to be filed by Section13 or 15(d) of the Exchange Act of 1934 during the past 12 months (or such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [ ] No [X] Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. Large accelerated filer | [ ] | Accelerated filer | [ ] ------------------------+-------+---------------------------+------ Non-accelerated filer | [ ] | Smaller reporting company | [X] ------------------------+-------+---------------------------+------ | | Emerging Growth company | [ ] ------------------------+-------+---------------------------+------ If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. [ ] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X] As of November 10, 2017, the issuer had 17,016,428 shares of common stock issued and outstanding. 1 | TABLE OF CONTENTS | Page -------------------------------+--------------------------------------------------------------------------------------+----- PART I – FINANCIAL INFORMATION ------------------------------ Item 1. | Financial Statements | 3 -------------------------------+--------------------------------------------------------------------------------------+----- Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operation | 12 -------------------------------+--------------------------------------------------------------------------------------+----- Item 3. | Quantitative and Qualitative Disclosures about Market Risk | 14 -------------------------------+--------------------------------------------------------------------------------------+----- Item 4. | Controls and Procedures | 14 -------------------------------+--------------------------------------------------------------------------------------+----- PART II – OTHER INFORMATION ------------------------------ Item 1. | Legal Proceedings | 15 -------------------------------+--------------------------------------------------------------------------------------+----- Item 1A. | Risk Factors | 15 -------------------------------+--------------------------------------------------------------------------------------+----- Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | 15 -------------------------------+--------------------------------------------------------------------------------------+----- Item 3. | Defaults Upon Senior Securities | 15 -------------------------------+--------------------------------------------------------------------------------------+----- Item 4. | Submission of Matters to a Vote of Security Holders | 15 -------------------------------+--------------------------------------------------------------------------------------+----- Item 5. | Other Information | 15 -------------------------------+--------------------------------------------------------------------------------------+----- Item 6. | Exhibits | 16 -------------------------------+--------------------------------------------------------------------------------------+----- 2 ITEM 1. FINANCIAL STATEMENTS ALPHA ENERGY, INC. Unaudited Financial Statements September 30, 2017 3 ALPHA ENERGY, INC. Unaudited Financial Statements September 30, 2017 | Page(s) ---------------------------------------------------------------------------------------------------+-------- Unaudited Balance Sheets as of September 30, 2017 and December 31, 2016 | 5 ---------------------------------------------------------------------------------------------------+-------- Unaudited Statements of Operations for the three and nine months ended September 30, 2017 and 2016 | 6 ---------------------------------------------------------------------------------------------------+-------- Unaudited Statements of Cash Flows for the nine months ended September 30, 2017 and 2016 | 7 ---------------------------------------------------------------------------------------------------+-------- Notes to the Unaudited Financial Statements | 8 ---------------------------------------------------------------------------------------------------+-------- 4 ALPHA ENERGY, INC. --------------------------------------------------------- BALANCE SHEETS --------------------------------------------------------- (UNAUDITED) --------------------------------------------------------- | | September 30, 2017 | | December 31, 2016 ----------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+------------------ ASSETS --------------------------------------------------------- Current assets | | | | | ----------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+--------- | Cash | $ | 17,117 | | $ | 453 ----------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+----------+---------- | Other current asset | | 943 | | | - ----------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+----------+---------- Total current assets | | 18,060 | | | 453 ----------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+--------- | Oil and gas lease, unproved, full cost | | - | | | 2,924 ----------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+----------+---------- | Oil and gas lease, proved | | - | | | 8,326 ----------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+----------+---------- Total assets | $ | 18,060 | | $ | 11,703 ----------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+--------- LIABILITIES AND STOCKHOLDER'S DEFICIT --------------------------------------------------------- Current liabilities | | | | | ----------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+--------- | Accounts payable | $ | 16,119 | | $ | 17,571 ----------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+----------+---------- | Interest payable | | 1,686 | | | - ----------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+----------+---------- | Derivative liability | | 156,504 | | | - ----------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+----------+---------- | Notes payable, related party | | 9,780 | | | 17,855 ----------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+----------+---------- Total current liabilities | | 184,089 | | | 35,426 ----------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+--------- | Convertible credit line payable – related party, net of discount of $82,726 and $0, respectively | | 2,640 | | | - ----------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+----------+---------- | Asset retirement obligation | | 617 | | | 567 ----------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+----------+---------- Total liabilities | | 187,346 | | | 35,993 ----------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+--------- Stockholders' deficit | | | | | ----------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+--------- | Preferred stock, $0.0001 par value; 10,000,000 shares authorized; none issued or outstanding | | - | | | - ----------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+----------+---------- | Common stock, $0.0001 par value; 65,000,000 shares authorized; 17,016,428 issued and outstanding at September 30, 2017 and December 31, 2016, respectively | | 1,702 | | | 1,702 ----------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+----------+---------- | Additional paid in capital | | 92,278 | | | 92,278 ----------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+----------+---------- | Accumulated deficit | | (263,266) | | | (118,270) ----------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+----------+---------- Total stockholders' deficit | | (169,286) | | | (24,290) ----------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+--------- Total liabilities and stockholders' deficit | $ | 18,060 | | $ | 11,703 ----------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+--------- See accompanying notes to unaudited financial statements. --------------------------------------------------------- 5 ALPHA ENERGY, INC. ------------------------------------------------------------- STATEMENTS OF OPERATIONS ------------------------------------------------------------- (UNAUDITED) ------------------------------------------------------------- | | Three months ended September 30, | | Nine months ended September 30, --------------------------------------------------------------+-----------------------------------------------------+----------------------------------+---------+-------------------------------- | | 2017 | | 2016 | | 2017 | | 2016 --------------------------------------------------------------+-----------------------------------------------------+----------------------------------+---------+---------------------------------+------------+-------+---+----------- Revenues | $ | 955 | | $ | - | | $ | 2,383 | | $ | - --------------------------------------------------------------+-----------------------------------------------------+----------------------------------+---------+---------------------------------+------------+-------+---+------------+---------+---+----------- Lease operating expenses | | 1,034 | | | - | | | 2,480 | | | - --------------------------------------------------------------+-----------------------------------------------------+----------------------------------+---------+---------------------------------+------------+-------+---+------------+---------+---+----------- Gross margin | | (79) | | | - | | | (97) | | | - --------------------------------------------------------------+-----------------------------------------------------+----------------------------------+---------+---------------------------------+------------+-------+---+------------+---------+---+----------- Operating expenses | | | | | | | | | | | --------------------------------------------------------------+-----------------------------------------------------+----------------------------------+---------+---------------------------------+------------+-------+---+------------+---------+---+----------- | Professional services | | 20,910 | | | 7,465 | | | 53,320 | | | 15,915 --------------------------------------------------------------+-----------------------------------------------------+----------------------------------+---------+---------------------------------+------------+-------+---+------------+---------+---+------------+------- | General and administrative | | 550 | | | 2,200 | | | 4,225 | | | 2,315 --------------------------------------------------------------+-----------------------------------------------------+----------------------------------+---------+---------------------------------+------------+-------+---+------------+---------+---+------------+------- | Impairment loss | | - | | | - | | | 11,250 | | | - --------------------------------------------------------------+-----------------------------------------------------+----------------------------------+---------+---------------------------------+------------+-------+---+------------+---------+---+------------+------- Total operating expenses | | 21,460 | | | 9,665 | | | 68,795 | | | 18,230 --------------------------------------------------------------+-----------------------------------------------------+----------------------------------+---------+---------------------------------+------------+-------+---+------------+---------+---+----------- Loss from operations | | (21,539) | | | (9,665) | | | (68,892) | | | (18,230) --------------------------------------------------------------+-----------------------------------------------------+----------------------------------+---------+---------------------------------+------------+-------+---+------------+---------+---+----------- Other expense | | | | | | | | | | | --------------------------------------------------------------+-----------------------------------------------------+----------------------------------+---------+---------------------------------+------------+-------+---+------------+---------+---+----------- | Interest expense | | (5,727) | | | (300) | | | (6,966) | | | (921) --------------------------------------------------------------+-----------------------------------------------------+----------------------------------+---------+---------------------------------+------------+-------+---+------------+---------+---+------------+------- | Loss on initial measurement of derivative liability | | (2,912) | | | - | | | (2,912) | | | - --------------------------------------------------------------+-----------------------------------------------------+----------------------------------+---------+---------------------------------+------------+-------+---+------------+---------+---+------------+------- | Loss on fair market value of derivative liability | (66,226) | | | - | | | (66,226) | | | - --------------------------------------------------------------+-----------------------------------------------------+----------------------------------+---------+---------------------------------+------------+-------+---+------------+---------+---+----------- Total other expense | | (74,865) | | | (300) | | | (76,104) | | | (921) --------------------------------------------------------------+-----------------------------------------------------+----------------------------------+---------+---------------------------------+------------+-------+---+------------+---------+---+----------- | Provision for income taxes | | - | | | - | | | - | | | - --------------------------------------------------------------+-----------------------------------------------------+----------------------------------+---------+---------------------------------+------------+-------+---+------------+---------+---+------------+------- Net loss | $ | (96,404) | | $ | (9,965) | | $ | (144,996) | | $ | (19,151) --------------------------------------------------------------+-----------------------------------------------------+----------------------------------+---------+---------------------------------+------------+-------+---+------------+---------+---+----------- Net loss per common share, basic and diluted | $ | (0.01) | | $ | (0.00) | | $ | (0.01) | | $ | (0.00) --------------------------------------------------------------+-----------------------------------------------------+----------------------------------+---------+---------------------------------+------------+-------+---+------------+---------+---+----------- Weighted average common shares outstanding, basic and diluted | | 17,016,428 | | | 16,866,428 | | | 17,016,428 | | | 16,866,428 --------------------------------------------------------------+-----------------------------------------------------+----------------------------------+---------+---------------------------------+------------+-------+---+------------+---------+---+----------- See accompanying notes to unaudited financial statements. ------------------------------------------------------------- 6 ALPHA ENERGY, INC. --------------------------------------------------------- STATEMENTS OF CASH FLOWS --------------------------------------------------------- (UNAUDITED) --------------------------------------------------------- | | | Nine months ended September 30, ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+-------------------------------- | | | 2017 | | 2016 ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+--------- Cash flows from operating activities | | | | | ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+--------- | | Net loss | $ | (144,996) | | $ | (19,151) ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+----------+---+--------- | Adjustments to reconcile net loss to net cash used in operating activities: | | | | ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+--------- | | Debt discount amortization | | 4,640 | | | - ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+----------+---+--------- | | Excess fair market value of initial measurement of derivative liability | | 2,912 | | | - ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+----------+---+--------- | | Loss on fair market value of derivative liability | | 66,226 | | | - ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+----------+---+--------- | | Impairment loss | | 11,250 | | | - ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+----------+---+--------- | | Asset retirement obligation expense | | 50 | | | - ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+----------+---+--------- | Changes in operating assets and liabilities: | | | | | ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+----------+-- | | Prepaid expenses and other current assets | | (943) | | | - ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+----------+---+--------- | | Accounts payable | | 1,178 | | | 4,962 ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+----------+---+--------- | | Interest payable | | 1,686 | | | - ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+----------+---+--------- Net cash used in operating activities | | (57,997) | | | (14,189) ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+--------- Cash flows from investing activities | | | | | ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+--------- Advance to related party | | (445) | | | - ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+--------- Repayment from related party | | 445 | | | - ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+--------- Net cash used in investing activities | | - | | | - ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+--------- Cash flows from financing activities | | | | | ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+--------- | | Proceeds from notes payable | | 87,366 | | | - ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+----------+---+--------- | | Payments on convertible credit line payable – related party | | (2,000) | | | - ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+----------+---+--------- | | Proceeds from related party loans | | 8,031 | | | 14,300 ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+----------+---+--------- | | Repayments of related party loans | | (18,736) | | | - ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+----------+---+--------- Net cash provided by financing activities | | 74,661 | | | 14,300 ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+--------- | | Net change in cash | | 16,664 | | | 111 ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+----------+---+--------- | | Cash, beginning of period | | 453 | | | 116 ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+----------+---+--------- | | Cash, end of period | $ | 17,117 | | $ | 227 ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+----------+---+--------- Supplemental cash flow information | | | | | ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+--------- | Cash paid for interest | $ | - | | $ | - ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+----------+-- | Cash paid for income taxes | $ | - | | $ | - ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+----------+-- Supplemental disclosure of non-cash financing activities | | | | | ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+--------- | Payment of expenses by related party on behalf of the Company | $ | 2,630 | | $ | - ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+----------+-- | Debt discount on convertible credit line payable – related party | $ | 87,366 | | $ | - ----------------------------------------------------------+-----------------------------------------------------------------------------+-------------------------------------------------------------------------+---------------------------------+-----------+----------+-- See accompanying notes to unaudited financial statements. --------------------------------------------------------- 7 ALPHA ENERGY, INC. Notes to Unaudited Financial Statements September 30, 2017 NOTE 1 – BASIS OF PRESENTATION The accompanying unaudited interim financial statements have been prepared by the Company without audit. In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position, results of operations, and cash flows as of September 30, 2017, and for all periods presented herein, have been made. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted. Notes to the financial statements which would substantially duplicate the disclosures contained in the audited financial statements for the most recent fiscal period, as reported in the Form 10-K, have been omitted. It is suggested that these unaudited interim financial statements be read in conjunction with the financial statements and notes thereto included in the Company’s December 31, 2016 audited financial statements. The results of operations for the three and nine months ended September 30, 2017 are not necessarily indicative of the operating results for the full year. Related party policy In accordance with ASC 850, the Company discloses: the nature of the related party relationship(s) involved; a description of the transactions, including transactions to which no amounts or nominal amounts were ascribed, for each of the periods for which income statements are presented, and such other information deemed necessary to an understanding of the effects of the transactions on the financial statements; the dollar amounts of transactions for each of the periods for which income statements are presented and the effects of any change in the method of establishing the terms from that used in the preceding period; and amounts due from or to related parties as of the date of each balance sheet presented and, if not otherwise apparent, the terms and manner of settlement. Revenue recognition The Company records revenues from the sales of natural gas and crude oil when the production is produced and sold, and also when collectability is ensured. The Company may in the future have an interest with other producers in certain properties, in which case the Company will use the sales method to account for gas imbalances. Under this method, revenue will be recorded on the basis of natural gas actually sold by the Company. The Company also reduces revenue for other owners’ natural gas sold by the Company that cannot be volumetrically balanced in the future due to insufficient remaining reserves. The Company’s remaining over- and under-produced gas balancing positions are considered in the Company’s proved oil and natural gas reserves. The Company had no gas imbalances at September 30, 2017 or December 31, 2016. Impairment The net book value of all capitalized oil and natural gas properties within a cost center, less related deferred income taxes, is subject to a full cost ceiling limitation which is calculated quarterly. Under the ceiling limitation, costs may not exceed an aggregate of the present value of future net revenues attributable to proved oil and natural gas reserves discounted at 10 percent using current prices, plus the lower of cost or market value of unproved properties included in the amortization base, plus the cost of unevaluated properties, less any associated tax effects. Any excess of the net book value, less related deferred tax benefits, over the ceiling is written off as expense. Impairment expense recorded in one period may not be reversed in a subsequent period even though higher oil and gas prices may have increased the ceiling applicable to the subsequent period. During the year ended December 31, 2016, the Company evaluated the future production of its leases through the termination of each lease. Through its analysis, the Company determined the present value of future production was less than the carrying value of the leases on the balance sheet. The Company recorded an impairment loss of $35,432 during the years ended December 31, 2016. The Company performed an additional analysis during the nine months ended September 30, 2017 and determined its proved and unproved properties were fully impaired and recorded an impairment loss of $11,250 during the nine months ended September 30, 2017. Derivative Liabilities The Company records a debt discount related to the issuance of convertible debts that have conversion features at adjustable rates. The debt discount for the convertible instruments is recognized and measured by allocating a portion of the proceeds as an increase in additional paid-in capital and as a reduction to the carrying amount of the convertible instrument equal to the intrinsic value of the conversion features. The debt discount will be accreted by recording additional non-cash gains and losses related to the change in fair market values of derivative liabilities over the life of the convertible notes. 8 NOTE 2 – GOING CONCERN The Company’s interim unaudited financial statements are prepared using generally accepted accounting principles in the United States of America applicable to a going concern which contemplates the realization of assets and liquidation of liabilities in the normal course of business. The Company has not yet established an ongoing source of revenues sufficient to cover its operating costs and allow it to continue as a going concern. These conditions raise substantial doubt about the Company’s ability to continue as a going concern for a period of twelve months from the date of issuance of this report. The ability of the Company to continue as a going concern is dependent on the Company obtaining adequate capital to fund operating losses until it becomes profitable. If the Company is unable to obtain adequate capital, it could be forced to cease operations. In order to continue as a going concern, the Company will need, among other things, additional capital resources. Management’s plan is to obtain such resources for the Company by obtaining capital from management and significant shareholders sufficient to meet its minimal operating expenses and seeking equity and/or debt financing. However management cannot provide any assurances that the Company will be successful in accomplishing any of its plans. The ability of the Company to continue as a going concern is dependent upon its ability to successfully accomplish the plans described in the preceding paragraph and eventually secure other sources of financing and attain profitable operations. The accompanying financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern. NOTE 3 – COMMON STOCK WARRANTS Through the year ended December 31, 2014, the Company issued warrants in connection with common stock issued for cash. The following table summarizes all stock warrant activity for the nine months ended September 30, 2017: | Shares | | Weighted- Average Exercise Price Per Share --------------------------------+--------+-----------+------------------------------------------- Outstanding, December 31, 2016 | | 240,000 | | $ | 0.125 --------------------------------+--------+-----------+--------------------------------------------+---+------ Granted | | - | | | - --------------------------------+--------+-----------+--------------------------------------------+---+------ Exercised | | - | | | - --------------------------------+--------+-----------+--------------------------------------------+---+------ Forfeited | | - | | | - --------------------------------+--------+-----------+--------------------------------------------+---+------ Expired | | (240,000) | | | 0.125 --------------------------------+--------+-----------+--------------------------------------------+---+------ Outstanding, September 30, 2017 | | - | | $ | - --------------------------------+--------+-----------+--------------------------------------------+---+------ The weighted average remaining contractual life of options outstanding as of September 30, 2017 and December 31, 2016, was approximately 0.00 and 0.20 years, respectively. The exercise price of these options was $0.125 and the intrinsic value of the options as of September 30, 2017 and December 31, 2016 is $0.00, respectively. NOTE 4 – RELATED PARTY TRANSACTIONS During the nine months ended September 30, 2017, the Company borrowed $8,031 and made repayments on short term related party loans payable of $18,736. During the nine months ended September 30, 2017, a significant shareholder made payment of $2,630 for expenses on behalf of the Company. The advances are non-interest bearing and due on demand. There was $9,780 and $17,855 due to related parties as of September 30, 2017 and December 31, 2016, respectively. During the nine months ended September 30, 2017, the Company made advances to related parties of $445 which were repaid during the same period. The advances are non-interest bearing and due on demand. There was $0 due from related parties as of September 30, 2017 and December 31, 2016, respectively. Fred Ziegler, who is the spouse of our President, Karen Ziegler, is an unpaid consultant for the Company. Although uncompensated and not having direct ownership of stock, he has the ability to exercise significant influence over the Company given the personal relationship with one of our officers. 9 During the nine months ended September 30, 2017, the majority owners of the Company sold their stock in a private transaction to AEI Acquisition Company, LLC. Immediately after the close of the transaction, AEI Acquisition Company owned 85% of the issued and outstanding shares of the Company. During the nine months ended September 30, 2017, the Company converted existing notes payable due to AEI Acquisition Company of $87,366 to a convertible credit line. See Note 6 – Convertible Credit Line Payable – Related Party. NOTE 5 – NOTES PAYABLE On February 1, 2017, the Company executed a promissory note for $56,216. The note bears simple interest at a rate of 3.75%, is not convertible to equity of the Company and is due on February 1, 2018. During the three months ended June 30, 2017, the Company received additional advances of $7,600. During the three months ended September 30, 2017, the Company made repayments of $2,000 and received additional advances of $23,550. On September 1, 2017, the outstanding balance of $87,366 on the note payable was converted to a convertible credit line payable as discussed in Note 6 – Convertible Credit Line Payable – Related Party. NOTE 6 – CONVERTIBLE CREDIT LINE PAYABLE – RELATED PARTY On September 1, 2017, the Company entered into a convertible credit line agreement to borrow up to $500,000. On the same date, the outstanding balance on a note payable of $87,366 was exchanged as a draw on the credit line. The loan modification is considered substantial under ASC 470-50. The outstanding balance accrues interest at a rate of 7% per annum and the outstanding balance is convertible to common stock of the Company at the lesser of the close price of the common stock as quoted on the OTCBB on the day interest is due and payable immediately preceding the conversion or $1.50. The Company analyzed the conversion options in the convertible line of credit for derivative accounting consideration under ASC 815, Derivative and Hedging, and determined that the transaction does qualify for derivative treatment. The Company measured the derivative liability and recorded a debt discount of $87,366 upon initial measurement. During the nine months ended September 30, 2017, the Company amortized $4,640 of the discount as interest expense leaving an unamortized discount of $82,726 as of September 30, 2017. See discussion of derivative liability in Note 7 – Derivative Liability The Company made payments of $2,000 on the credit line at September 30, 2017. There was $85,366 of principal and $1,686 of accrued interest outstanding as of September 30, 2017. As of September 30, 2017 there was an unamortized debt discount of $82,726 resulting in a net balance represented on the balance sheet of $2,640. NOTE 7 – DERIVATIVE LIABILITY As discussed in Note 1, on a recurring basis, we measure certain financial assets and liabilities based upon the fair value hierarchy. The following table presents information about the Company’s liabilities measured at fair value as of September 30, 2017 and December 31, 2016: | Level 1 | | Level 2 | | Level 3 | Fair Value at September 30, 2017 ---------------------+---------+---+---------+---+---------+--------------------------------- Liabilities | | | | | | | | | ---------------------+---------+---+---------+---+---------+----------------------------------+---------+---+-------- Derivative Liability | $ | - | | $ | - | $ | 156,504 | $ | 156,504 ---------------------+---------+---+---------+---+---------+----------------------------------+---------+---+-------- | Level 1 | | Level 2 | | Level 3 | Fair Value at December 31, 2016 ---------------------+---------+---+---------+---+---------+-------------------------------- Liabilities | | | | | | | | | ---------------------+---------+---+---------+---+---------+---------------------------------+---+---+-- Derivative Liability | $ | - | | $ | - | $ | - | $ | - ---------------------+---------+---+---------+---+---------+---------------------------------+---+---+-- As of September 30, 2017, the Company had a $156,504 derivative liability balance on the balance sheet and recorded a loss from derivative liability fair value adjustment of $66,226 during the three and nine months, respectively ended September 30, 2017. The Company assessed its outstanding convertible credit line payable as summarized in Note 6 – Convertible Credit Line Payable- Related Party and determined certain convertible credit lines payable with variable conversion features contain embedded derivatives and are therefore accounted for at fair value under ASC 920, Fair Value Measurements and Disclosures and ASC 825, Financial Instruments. 10 Utilizing Level 3 Inputs, the Company recorded fair market value adjustments related to convertible notes payable for the three months ended September 30, 2017 of $66,226 and fair value adjustments related to the convertible notes payable for the nine months ended September 30, 2017 of $66,226, respectively. The derivative liability was initially measured at $90,278, resulting in a loss on initial measurement of $2,912, on September 1, 2017 using the following assumptions: exercise price of $1.50, 58,244 common shares the balance can be converted into shares and a stock price at measurement date of $1.55. The fair market value adjustments as of September 30, 2017 were calculated utilizing a max valuation method using the following assumptions: exercise price of $1.50, 56,911 common shares the balance can be converted into and a stock price at measurement date of $2.75. A summary of the activity of the derivative liability is shown below: Balance at December 31, 2016 | $ | - ---------------------------------------------------+---+-------- Derivative liabilities recorded | | 87,366 ---------------------------------------------------+---+-------- Day one loss | | 2,912 ---------------------------------------------------+---+-------- Change due to note conversion | | - ---------------------------------------------------+---+-------- Loss on change in derivative fair value adjustment | | 66,226 ---------------------------------------------------+---+-------- Balance at September 30, 2017 | $ | 156,504 ---------------------------------------------------+---+-------- 11 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORWARD-LOOKING STATEMENTS This Form 10-Q includes "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements, other than statements of historical facts, included or incorporated by reference in this Form 10-Q which address activities, events or developments which the Company expects or anticipates will or may occur in the future, including such things as future capital expenditures (including the amount and nature thereof); finding suitable merger or acquisition candidates; expansion and growth of the Company's business and operations; and other such matters are forward-looking statements. These statements are based on certain assumptions and analyses made by the Company in light of its experience and its perception of historical trends, current conditions and expected future developments, as well as other factors it believes are appropriate under the circumstances. However, whether actual results or developments will conform with the Company's expectations and predictions is subject to a number of risks and uncertainties, including general economic, market and business conditions; the business opportunities (or lack thereof) that may be presented to and pursued by the Company; changes in laws or regulation; and other factors, most of which are beyond the control of the Company. These forward-looking statements can be identified by the use of predictive, future-tense or forward-looking terminology, such as "believes," "anticipates," "expects," "estimates," "plans," "may," "will," or similar terms. These statements appear in a number of places in this Filing and include statements regarding the intent, belief or current expectations of the Company, and its directors or its officers with respect to, among other things: (i) trends affecting the Company's financial condition or results of operations for its limited history; (ii) the Company's business and growth strategies; and, (iii) the Company's financing plans. Investors are cautioned that any such forward-looking statements are not guarantees of future performance and involve significant risks and uncertainties, and that actual results may differ materially from those projected in the forward-looking statements as a result of various factors. Such factors that could adversely affect actual results and performance include, but are not limited to, the Company's limited operating history, potential fluctuations in quarterly operating results and expenses, government regulation, technological change and competition. Consequently, all of the forward-looking statements made in this Form 10-Q are qualified by these cautionary statements and there can be no assurance that the actual results or developments anticipated by the Company will be realized or, even if substantially realized, that they will have the expected consequence to or effects on the Company or its business or operations. The Company assumes no obligations to update any such forward-looking statements. General Business Development The Company was formed on September 26, 2013 in the State of Colorado. Business Strategy The Company was incorporated in September 2013. Our business model is to purchase or trade stock for oil and gas properties to be held as long term assets. Oil and gas commodity pricing has stabilized under the current economic market conditions bringing the U.S. to become the number one producer in the world. The momentum to drill using enhanced drilling technology in previously undeveloped areas assures the continued value of these properties. Our lean operating structure positions us well to compete in this very competitive market. Our strategy is to acquire producing properties that the Company can operate which have proven un-drilled locations available for further development. At this time the Company is reviewing several properties but have no contractual commitments to date. Our management’s years of experience and knowledge of the oil and gas industry leads us to believe that there are an abundance of good drilling prospects available that have either been overlooked or are not big enough for the larger companies. In the process of identifying these drilling prospects, the Company will utilize the expertise of existing management and employ the highest caliber contract engineering firms available to further evaluate the properties. To qualify for acquisition, the calculated cash flow after taxes and operating expenses, including ten percent (10%) interest per year, will recover the acquisition cost in 22 to 30 months. The cash flow calculation will be based conservatively on $51 per barrel of oil and $2.89 per MCF of gas. In addition, the selection criteria will require the life of current producing wells to be 7 years or longer and the field must have a minimum total life of 15 years. 12 In the first phase we intend on concentrating on prospects in eastern Colorado, western Kansas and southern Wyoming. The depth of the wells in the target areas average from 1500 ft. for the Niobrara formation to a total depth of 5800 ft. for the Topeka, Heebner, Lansing-Kansas City, Marmaton, Cherokee, Atoka, Morrow, Mississippian, Spergen, and Osage formations. By concentrating our initial efforts on shallower prospects we minimize drilling and operating costs. As we grow we plan to expand into the Front Range (Northern Front Range Outcrop) and Denver Basin Province (D-J Basin, Wattenberg) of Colorado and into western Kansas (Hugoton Embayment Anadarko Basin – Central Kansas Uplift). The wells in these areas range from 4,000 ft. to 10,000 ft. Such wells are more expensive to drill and operate, but also offer bigger returns. Some of the formations in these areas are the Sussex, Niobrara, Codell, J Sand and the D Sand formations. The Company intends to develop prospects and intends to obtain partners to participate in the costs of drilling or acquisitions with the Company serving as the designated Operator. The Company intends to also retain a royalty or working interest in the wells drilled or acquired. The Company has engaged in verbal negotiations for acquisition of oil and gas leases located in Northern and eastern Colorado basin and intends to engage in additional negotiations in the future. In the second phase of operations, we intend to expand into Oklahoma, Texas, and eastern Kansas. We intend to place a great deal of emphasis on natural gas production and the transportation of natural gas. We believe natural gas will be the fuel of the future for automobiles, trucks and buses because of the clean-air standards that are proposed and will soon be going into effect, and now is an ideal time to acquire natural gas assets due to the current pricing matrix. The Company also plans on acquiring field transportation and short haul lines as part of our future business plan expansion. Acquiring these types of company lines, specifically in the areas where the company will have production located, will be advantageous due to savings in internal transportation costs, and the profitability margins of operating the lines and marketing natural gas. Managing the transportation system, in conjunction with field operations, will enhance cash flow. After obtaining the transportation lines, we hope to then develop our own end-users for natural gas. This will further enhance the profit margin of the company. In December of 2016 alpha energy purchased the following lease from McCartney engineering: The lease is located in Yuma county Colorado and consists of 480 acres, we have a 100% WI and 80% NRI the formation which the wells are in is the Niabrara formation at a depth of 2800 ft. There is one producing well and one cased well. The producing well will need to have some smaller tubing ran in and possibly a small pump to increase the gas production. This well has produced for over 15 years. The cased well will need to be fracked and tubing run in it and put on line. With the lease we also obtained the seismic work that has been done which indicates that there should be 3 possibly four new sites that we intend to produce at about the rate between 40 and 50 mcfpd. These wells have a life expectancycy of over 30 years. All these wells would be at about the 2800 ft in depth range and all will have to be fracked. The cost of the wells should be less than $90,000 per well. On April 20, 2016, the Company entered into a lease extension agreement with a related party to extend the term of the lease for a period of three years for consideration of $10 cash. The original lease was entered into on October 1, 2013 and set to expire on October 1, 2016. The extension is under the same terms as the original lease agreement and will expire on October 1, 2019. Liquidity and Capital Resources As of September 30, 2017, we had $17,117 in cash, total current assets of $18,060 and total current liabilities of $184,089 creating a working capital deficit of $166,029. Current liabilities consisted primarily of $16,119 of accounts payable and $156,504 of current derivative liability. Going Concern The future of our company is dependent upon its ability to obtain financing and upon future profitable operations. Management has plans to seek additional capital through a private placement and public offering of its common stock, if necessary. See note 2 to the financial statements for additional information. 13 Results of Operations We did not generate revenues during the three or nine months ended September 30, 2016. Revenue for the three and nine months ended September 30, 2017 were $955 and $2,383. Total operating expenses were $9,665 during the three months ended September 30, 2016 compared to $21,460 during the same period in 2017. The increase is the result of fees associated with the acquisition and upkeep of our leases. Total operating expenses were $18,230 during the nine months ended September 30, 2016 compared to $68,795 for the same period in 2017. The increase is the result of incurring of fees associated with the acquisition and upkeep of our leases that did not exist during the nine months ended September 30, 2016 and due to impairment of our oil and gas properties. CRITICAL ACCOUNTING POLICIES In Financial Reporting release No. 60, "CAUTIONARY ADVICE REGARDING DISCLOSURE ABOUT CRITICAL ACCOUNTING POLICIES" ("FRR 60"), the Securities and Exchange Commission suggested that companies provide additional disclosure and commentary on their most critical accounting policies. In FRR 60, the SEC defined the most critical accounting policies as the ones that are most important to the portrayal of a company's financial condition and operating results, and require management to make its most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Based on this definition, our most critical accounting policies include: non-cash compensation valuation that affects the total expenses reported in the current period and the valuation of shares and underlying mineral rights acquired with shares. The methods, estimates and judgments we use in applying these most critical accounting policies have a significant impact on the results we report in our financial statements. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company is not exposed to market risk related to interest rates or foreign currencies. CONTROLS AND PROCEDURES ITEM 4. CONTROLS AND PROCEDURES Evaluation of Disclosure Controls and Procedures As required by Rule 13a-15 under the Securities Exchange Act of 1934 (the “1934 Act”), as of March 31, 2015, we carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures. This evaluation was carried out under the supervision and with the participation of our Chief Executive Officer (our principal executive officer) and our Chief Financial Officer (our principal financial officer), who concluded, that because of the material weakness in our internal control over financial reporting (“ICFR”) described below, our disclosure controls and procedures were not effective as of September 30, 2017. Disclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Securities Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and our principal financial officer, as appropriate, to allow timely decisions regarding required disclosure. Changes in Internal Control over Financial Reporting There have been no changes in our internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Exchange Act Rules 13a-15 or 15d-15 that occurred during our third quarter that have materially affected, or are reasonable likely to materially affect, our internal control over financial reporting. 14 PART II OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The Company is not a party to any legal proceedings. ITEM 1A. RISK FACTORS There has been no material changes in the risk factors set forth in the Company’s Form 10K for the period ended December 31, 2016. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS There were no sales of unregistered equity securities during the covered time period. ITEM 3. DEFAULTS UPON SENIOR SECURITIES None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. ITEM 5. OTHER INFORMATION None. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K The following documents are included or incorporated by reference as exhibits to this report: Exhibit Number | Description ---------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.1 | Certification of Chief Executive Officer pursuant to Securities Exchange Act Rule 13a-14(a)/15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. ---------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.2 | Certification of Chief Financial Officer pursuant to Securities Exchange Act Rule 13a-14(a)/15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. ---------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 32.1 | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. ---------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 32.1 | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. ---------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (b) REPORTS ON FORM 8-K None. 15 SIGNATURES In accordance with Section 13 or 15 (d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Date: November 13, 2017. Alpha Energy, Inc. ------------------------------------- Registrant ------------------------------------- By: Karen Zeigler ------------------------------------- Karen Ziegler Chief Executive Officer ------------------------------------- 16

AMERI Holdings, Inc.

890821

10-Q

0001140361-17-042135

UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2017 | Commission file number 000-26460 --------------------------------------------------+--------------------------------- AMERI Holdings, Inc. (Exact name of registrant as specified in its charter) Delaware | 95-4484725 ---------------------------------------------------------------+------------------------------------- (State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) ---------------------------------------------------------------+------------------------------------- 100 Canal Pointe Boulevard, Suite 108, Princeton, New Jersey | 08540 -------------------------------------------------------------+----------- (Address of principal executive offices) | (Zip Code) -------------------------------------------------------------+----------- Registrant’s telephone number, including area code:732-243-9250 Securities registered pursuant to Section 12(b) of the Act: Title of Each Class | Name of Each Exchange on Which Registered --------------------+------------------------------------------ N/A | N/A --------------------+------------------------------------------ Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.01 par value per share (Title of class) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☑ No ☐ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☑ No ☐ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer”, “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large accelerated filer ☐ | Accelerated filer ☐ --------------------------+---------------------------- Non-accelerated filer ☐ | Smaller reporting company ☑ --------------------------+---------------------------- Emerging growth company ☑ | --------------------------+---------------------------- If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 7(a)(2)(B) of the Securities Act. ☐ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☑ As of October 30, 2017, 15,856,249 shares of the registrant’s common stock were issued and outstanding. AMERI Holdings, Inc. QUARTERLY REPORT ON FORM 10-Q FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2017 TABLE OF CONTENTS | Page -----------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ PART I - FINANCIAL INFORMATION | -----------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ Item 1 - Financial Statements | 3 -----------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | Unaudited Condensed Consolidated Balance Sheets as of September 30, 2017 and December 31, 2016 | 3 -----------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-- | Unaudited Condensed Consolidated Statements of Operations and Comprehensive Income (Loss) for the Three Months Ended September 30, 2017 and 2016 and for the Nine Months Ended September 30, 2017 and 2016. | 4 -----------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-- | Unaudited Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2017 | 5 -----------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-- | Notes to Unaudited Condensed Consolidated Financial Statements | 6 -----------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-- Item 2 - Management’s Discussion and Analysis of Financial Condition and Results of Operations | 17 -----------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ Item 3 - Quantitative and Qualitative Disclosures About Market Risk | 25 -----------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ Item 4 - Controls and Procedures | 25 -----------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ PART II - OTHER INFORMATION | 26 -----------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ Item 1 - Legal Proceedings | 26 -----------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ Item 1A - Risk Factors | 26 -----------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ Item 2 - Unregistered Sales of Equity Securities and Use of Proceeds | 26 -----------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ Item 3 - Defaults upon Senior Securities | 26 -----------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ Item 4 - Mine Safety Disclosures | 27 -----------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ Item 5 – Other Information | 27 -----------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ Item 6 – Exhibits | 27 -----------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ Signatures | 29 -----------------------------------------------------------------------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 2 PART I ITEM 1. | FINANCIAL STATEMENTS --------+--------------------- AMERI HOLDINGS, INC. UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS | September 30, 2017 | | December 31, 2016 ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+------------------ Assets | | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------ Current assets: | | | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+------------------ Cash and cash equivalents | $ | 844,104 | | $ | 1,379,887 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Accounts receivable | | 9,167,088 | | | 8,059,910 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Investments | | 82,908 | | | 82,908 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Other current assets | | 1,321,334 | | | 542,237 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Total current assets | | 11,415,434 | | | 10,064,942 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Other assets: | | | | | | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Property and equipment, net | | 92,870 | | | 100,241 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Intangible assets, net | | 10,253,381 | | | 8,764,704 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Acquired goodwill | | 21,886,567 | | | 17,089,076 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Deferred income tax assets, net | | 3,488,960 | | | 3,488,960 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Total other assets | | 35,721,778 | | | 29,442,981 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Total assets | $ | 47,137,212 | | $ | 39,507,923 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Current liabilities: | | | | | | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Line of credit | $ | 3,765,391 | | | 3,088,890 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Accounts payable | | 4,126,323 | | | 5,130,817 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Other accrued expenses | | 3,947,293 | | | 2,165,088 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Bank term loan | | 406,156 | | | 405,376 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Consideration payable – cash | | 7,129,238 | | | 1,854,397 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Consideration payable – equity | | 11,589,973 | | | 64,384 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Dividend payable | | 527,979 | | | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Total current liabilities | | 31,492,353 | | | 12,708,952 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Long- term Liabilities: | | | | | | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Convertible notes | | 1,250,000 | | | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Bank term loan | | 1,575,206 | | | 1,536,191 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Consideration payable – cash | | - | | | 2,711,717 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Consideration payable – equity | | 600,000 | | | 10,887,360 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Total long-term liabilities | | 3,425,206 | | | 15,135,268 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Total liabilities | | 34,917,559 | | | 27,844,220 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Stockholders’ equity: | | | | | | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Preferred stock, $0.01 par value; 1,000,000 authorized, 383,985 issued and outstanding as of September 30, 2017 and 363,611 as of December 31, 2016 | | 3,840 | | | 3,636 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Common stock, $0.01 par value; 100,000,000 shares authorized, 15,856,249 and 13,885,972 issued and outstanding as of September 30, 2017 and December 31, 2016, respectively | | 158,561 | | | 138,860 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Additional paid-in capital | | 25,487,970 | | | 15,358,839 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Accumulated deficit | | (13,430,711 | ) | | (3,833,588 | ) ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Accumulated other comprehensive income (loss) | | (18,511 | ) | | (7,426 | ) ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Non-controlling interest | | 18,504 | | | 3,382 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Total stockholders’ equity | | 12,219,653 | | | 11,663,703 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- Total liabilities and stockholders’ equity | $ | 47,137,212 | | $ | 39,507,923 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+-------------------+---+------------+-- See accompanying notes to the unaudited condensed consolidated financial statements. 3 AMERI HOLDINGS, INC. UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS) | Three Months Ended September 30, 2017 | | | Three Months Ended September 30, 2016 | | | Nine Months Ended September 30, 2017 | | Nine Months Ended September 30, 2016 | -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+-- Revenue | $ | 12,529,928 | | | $ | 10,058,558 | | $ | 37,139,114 | | $ | 23,758,460 | -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- Cost of revenue | | 9,966,490 | | | | 8,361,960 | | | 28,941,535 | | | 18,897,059 | -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- Gross profit | | 2,563,438 | | | | 1,696,598 | | | 8,197,579 | | | 4,861,401 | -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- Operating expenses | | | | | | | | | | | | | -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- Selling and marketing | | 402,846 | | | | 137,024 | | | 1,170,051 | | | 401,487 | -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- General and administration | | 5,283,059 | | | | 1,326,327 | | | 12,389,581 | | | 5,316,390 | -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- Acquisition related expenses | | 5,694 | | | | 1,015,558 | | | 390,174 | | | 1,630,778 | -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- Depreciation and amortization | | 817,284 | | | | 509,377 | | | 2,332,041 | | | 722,390 | -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- Operating expenses | | 6,508,883 | | | | 2,988,286 | | | 16,281,847 | | | 8,071,045 | -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- Operating income (loss) | | (3,945,445 | ) | | | (1,291,688 | ) | | (8,084,268 | ) | | (3,209,644 | ) -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- Interest expenses | | (132,973 | ) | | | (290,423 | ) | | (388,122 | ) | | (674,683 | ) -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- Changes in estimates | | - | | | | - | | | 400,000 | | | - | -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- Others, net | | 17,446 | | | | (195,518 | ) | | 21,921 | | | (197,679 | ) -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- Income (loss) before income taxes | | (4,060,972 | ) | | | (1,777,629 | ) | | (8,050,469 | ) | | (4,082,006 | ) -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- Tax benefit / (provision) | | - | | | | - | | | - | | | - | -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- Income after income taxes | | (4,060,972 | ) | | | (1,777,629 | ) | | (8,050,469 | ) | | (4,082,006 | ) -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- Net income attributable to non-controlling interest | | (6,632 | ) | | | - | | | (18,504 | ) | | - | -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- Net income (loss) attributable to the Company | | (4,067,604 | ) | | | (1,777,629 | ) | | (8,068,973 | ) | | (4,082,006 | ) -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- Dividend on preferred stock | | (541,864 | ) | | | - | | | (1,546,655 | ) | | - | -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- Net loss attributable to common stock holders | | (4,609,468 | ) | | | (1,777,629 | ) | | (9,615,628 | ) | | (4,082,006 | ) -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- Other comprehensive income (loss), net of tax | | - | | | | - | | | - | | | - | -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- Foreign exchange translation | | (14,234 | ) | | | 59,079 | | | (11,084 | ) | | (6,619 | ) -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- Comprehensive income/(loss) | $ | (4,623,702 | ) | | $ | (1,718,550 | ) | $ | (9,626,712 | ) | $ | (4,088,625 | ) -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- Comprehensive income/(loss) attributable to the Company | | (4,617,070 | ) | | | (1,718,550 | ) | | (9,608,208 | ) | | (4,088,625 | ) -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- Comprehensive income/(loss) attributable to the non-controlling interest | | (6,632 | ) | | | - | | | (18,504 | ) | | - | -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- | $ | (4,623,702 | ) | | $ | (1,718,550 | ) | $ | (9,626,712 | ) | $ | (4,088,625 | ) -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- Basic income (loss) per share | $ | (0.31 | ) | | $ | (0.13 | ) | $ | (0.66 | ) | $ | (0.32 | ) -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- Diluted income (loss) per share | $ | (0.31 | ) | | $ | (0.13 | ) | $ | (0.66 | ) | $ | (0.32 | ) -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- Basic weighted average number of common shares outstanding | | 14,715,947 | | | | 13,653,586 | | | 14,472,322 | | | 12,794,149 | -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- Diluted weighted average number of common shares outstanding | | 14,715,947 | | | | 13,653,586 | | | 14,472,322 | | | 12,794,149 | -------------------------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+--------------------------------------+---+--------------------------------------+---+---+------------+-- See accompanying notes to the unaudited condensed consolidated financial statements. 4 AMERI HOLDINGS, INC. UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS | Nine Months Ended September 30, | ---------------------------------------------------------------------------------------------+---------------------------------+----------- | 2017 | | | 2016 | ---------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+-- Cash flow from operating activities | | | | | ---------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+-- Comprehensive income/(loss) | $ | (9,626,712 | ) | | $ | (4,088,625 | ) ---------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Adjustment to reconcile comprehensive income/(loss) to net cash used in operating activities | | | | | | | ---------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Depreciation and amortization | | 2,332,041 | | | | 722,390 | ---------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Provision for Preference dividend | | 1,546,655 | | | | - | ---------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Changes in estimate of contingent consideration | | (400,000 | ) | | | - | ---------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Stock, option, restricted stock unit and warrant expense | | 5,167,358 | | | | 945,959 | ---------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Foreign exchange translation adjustment | | 11,085 | | | | - | ---------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Changes in assets and liabilities: | | | | | | | ---------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Increase (decrease) in: | | | | | | | ---------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Accounts receivable | | (1,107,178 | ) | | | (2,852,778 | ) ---------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Other current assets | | (779,097 | ) | | | (285,831 | ) ---------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Increase (decrease) in: | | | | | | | ---------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Accounts payable and accrued expenses | | 1,056,277 | | | | 2,561,321 | ---------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Net cash provided by (used in) operating activities | | (1,799,571 | ) | | | (2,997,564 | ) ---------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Cash flow from investing activities | | | | | | | ---------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Purchase of fixed assets | | (7,797 | ) | | | 3,261,617 | ---------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Acquisition consideration | | (694,711 | ) | | | (8,779,040 | ) ---------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Investments | | - | | | | 82,908 | ---------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Net cash used in investing activities | | (702,508 | ) | | | (5,434,515 | ) ---------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Cash flow from financing activities | | | | | | | ---------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Proceeds from bank loan and convertible notes, net | | 1,966,296 | | | | 4,467,879 | ---------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Additional stock issued | | - | | | | 5,000,000 | ---------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Net cash provided by financing activities | | 1,966,296 | | | | 9,467,879 | ---------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Net increase (decrease) in cash and cash equivalents | | (535,783 | ) | | | 1,035,800 | ---------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Cash and cash equivalents as at beginning of the period | | 1,379,887 | | | | 1,878,034 | ---------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Cash at the end of the period | $ | 844,104 | | | $ | 2,913,834 | ---------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- See accompanying notes to the unaudited condensed consolidated financial statements. 5 AMERI HOLDINGS, INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 2017 NOTE 1. | ORGANIZATION: --------+-------------- AMERI Holdings, Inc. is a fast-growing technology services company which provides SAP cloud, digital and enterprise services to clients worldwide. Headquartered in Princeton, New Jersey Ameri100 has offices in the U.S. and Canada. The Company additionally has global delivery centers in India. With its bespoke engagement model, Ameri100 delivers transformational value to its clients across industry verticals. NOTE 2. | BASIS OF PRESENTATION: --------+----------------------- The accompanying unaudited condensed consolidated financial statements have been prepared by the Company in accordance with generally accepted accounting principles in the United States of America, or U.S. GAAP, and Article 10 of Regulation S-X under the Securities Exchange Act of 1934, as amended. Certain information and disclosure notes normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted pursuant to those rules and regulations, although we believe that the disclosures made are adequate to ensure the information presented is not misleading. The accompanying unaudited condensed consolidated financial statements reflect all adjustments (which were of a normal, recurring nature) that, in the opinion of management, are necessary to present fairly our financial position, results of operations and cash flows as of and for the interim periods presented. All intercompany transactions have been eliminated in the accompanying unaudited condensed consolidated financial statements. Our comprehensive income (loss) consists of net income (loss) plus or minus any periodic currency translation adjustments. The Company’s year-end is December 31. Ameri and Partners Inc, the Company’s wholly-owned operating subsidiary that was the accounting acquirer in connection with the Company’s May 2015 reverse merger, changed its fiscal year end from March 31 to December 31 pursuant to the merger, so that all of the Company’s subsidiaries’ year-ends are consistent with the year-end of the Company. During the first quarter of 2016, the Company erroneously classified approximately $1.9 million of expenses as general and administrative expenses which should have been classified as cost of revenue. The Company has corrected this error in its Quarterly Report on Form 10-Q for the quarter ended March 31, 2017. The reclassification did not change the Company’s net income or loss for the period reported. The results for the interim periods presented are not necessarily indicative of the results expected for any future period. The following information should be read in conjunction with the audited financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2016. Recent Accounting Pronouncements New Standards to Be Implemented In May 2014, the Financial Accounting Standards Board (the “FASB”) issued Accounting Standards Update (“ASU”) 2014-09, “Revenue from Contracts with Customers (Topic 606),” which supersedes the revenue recognition requirements in “Revenue Recognition (Topic 605).” This ASU requires an entity to recognize revenue when goods are transferred or services are provided to customers in an amount that reflects the consideration to which the entity expects to be entitled to in exchange for those goods or services. This ASU also requires disclosures enabling users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. In August 2015, the FASB issued ASU 2015-14, “Revenue from Contracts with Customers (Topic 606), deferral of the Effective Date.” With the issuance of ASU 2015-14, the new revenue guidance ASU 2014-09 will be effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2018, using one of two prescribed retrospective methods. In April 2016, the FASB issued ASU 2016-10, “Revenue from Contracts with Customer (Topic 606), Identifying Performance Obligations and Licensing.” The guidance is applicable from the date of applicability of ASU 2014-09. This ASU finalizes the amendments to the guidance on the new revenue standard on the identification of performance obligations and accounting for licenses of intellectual property. In December 2016, the FASB issued ASU 2016-20, “Technical Corrections and Improvements (Topic 606)” which is applicable from the date of applicability of ASU 2014-09. This guidance provides optional exemptions from the disclosure requirement for remaining performance obligations for specific situations in which an entity need not estimate variable consideration to recognize revenue. In May 2016, FASB issued ASU No. 2016-12, “Narrow-Scope Improvements and Practical Expedients”. This amendment clarified certain aspects of Topic 606 and will be applicable from the date of applicability of ASU 2014-09. The Company is in process of evaluating the impact of the foregoing updates. 6 In February 2016, the FASB issued ASU No. 2016-02, “Leases (Topic 842)”. This new standard replaces the existing guidance on leases and requires the lessee to recognize a right-of-use asset and a lease liability for all leases with lease terms equal to or greater than twelve months. For finance leases, the lessee would recognize interest expense and amortization of the right-of-use asset, and for operating leases, the lessee would recognize total lease expense on a straight-line basis. This standard is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2018. Upon adoption, entities will be required to use a modified retrospective transition which provides for certain practical expedients. Entities are required to apply the new standard at the beginning of the earliest comparative period presented. Early adoption of this new standard is permitted. The Company is currently evaluating the effect this new standard will have on its consolidated financial statements and related disclosures. The Company does not expect the requirement to recognize a right-of-use asset and a lease liability for operating leases to have a material impact on the presentation of its consolidated statements of financial position. In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (ASU 2016-15), which clarifies how companies present and classify certain cash receipts and cash payments in the statement of cash flows. The guidance is effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Based on its current assessment, the Company does not expect the adoption of this update to have a material impact on its consolidated financial statements. On November 17, 2016, the FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash, which is intended to reduce diversity in the presentation of restricted cash and restricted cash equivalents in the statement of cash flows. This new standard requires that restricted cash and restricted cash equivalents be included as components of total cash and cash equivalents as presented on the statement of cash flows. As a result, entities will no longer present transfers between cash and cash equivalents and restricted cash and restricted cash equivalents in the statement of cash flows. ASU 2016-18 is effective for annual periods beginning after December 15, 2017 including interim periods within those fiscal years, but earlier adoption is permitted. The Company does not believe the adoption of this new standard will have a material impact on its consolidated financial statements. In January 2017, the FASB issued ASU No. 2017-04, simplifying the Test for Goodwill Impairment. Under this new standard, goodwill impairment would be measured as the amount by which a reporting unit’s carrying value exceeds its fair value, not to exceed the carrying value of goodwill. This ASU eliminates existing guidance that requires an entity to determine goodwill impairment by calculating the implied fair value of goodwill by hypothetically assigning the fair value of a reporting unit to all of its assets and liabilities as if that reporting unit had been acquired in a business combination. This update is effective for annual periods beginning after December 15, 2019, and interim periods within those periods. Early adoption is permitted for interim or annual goodwill impairment test performed on testing dates after January 1, 2017. The Company is in process of evaluating the impact of these updates. In January 2017, the FASB issued ASU No. 2017-01, clarifying the Definition of a Business, which clarifies and provides a more robust framework to use in determining when a set of assets and activities is a business. The amendments in this update should be applied prospectively on or after the effective date. This update is effective for annual periods beginning after December 15, 2017 and interim periods within those periods. Early adoption is permitted for acquisition or deconsolidation transactions occurring before the issuance date or effective date and only when the transactions have not been reported in issued or made available for issuance financial statements. The Company does not believe the adoption of this new standard will have a material impact on its consolidated financial statements. Standards Implemented In September 2015, the FASB issued ASU No. 2015-16, “Simplifying the Accounting for Measurement-Period Adjustments”. The guidance eliminates the requirement that an acquirer in a business combination account for a measurement period adjustment retrospectively. Instead, an acquirer will recognize a measurement period adjustment during the period in which the amount of the adjustment is determined. In addition, the portion of the amount recorded in current period earnings by line item that would have been recorded in previous reporting periods if the adjustment to the provisional amounts had been recognized as of the acquisition date should be presented separately on the face of the income statement or disclosed in the notes. This guidance was effective for fiscal years beginning after December 15, 2015, including interim periods within those fiscal years. This guidance did not have a material impact on the Company’s consolidated financial results. In March 2016, the FASB issued ASU No. 2016-09, “Compensation – Stock Compensation”. The new guidance changes the accounting for share based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities and classification in the Consolidated Statement of Cash Flows. The guidance is effective for annual periods beginning after December 15, 2016, and interim periods within those annual periods. This guidance did not have a material impact on the Company’s consolidated financial results. 7 NOTE 3. | BUSINESS COMBINATIONS: --------+----------------------- Acquisition of Ameri Georgia On November 20, 2015, we completed the acquisition of Bellsoft, Inc., a consulting company based in Lawrenceville, Georgia with over 175 consultants specialized in the areas of SAP software, business intelligence, data warehousing and other enterprise resource planning services. Following the acquisition, the name of Bellsoft, Inc. was changed to Ameri100 Georgia Inc. (“Ameri Georgia”). Ameri Georgia has operations in the United States, Canada and India. For financial accounting purposes, we recognized September 1, 2015 as the effective date of the acquisition. The total consideration for the acquisition of Ameri Georgia was $9,910,817, consisting of: (a) | A cash payment in the amount of $3,000,000, which was paid at closing; ----+----------------------------------------------------------------------- (b) | 235,295 shares of our common stock issued at closing; ----+------------------------------------------------------ (c) | $250,000 quarterly cash payments paid on the last day of each calendar quarter of 2016; ----+---------------------------------------------------------------------------------------- (d) | A $1,000,000 cash reimbursement paid 5 days following closing to compensate Ameri Georgia for a portion of its approximate cash balance as of September 1, 2015; ----+----------------------------------------------------------------------------------------------------------------------------------------------------------------- (e) | Approximately $2,910,817 paid within 30 days of closing in connection with the excess of Ameri Georgia’s accounts receivable over its accounts payable as of September 1, 2015; and ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ (f) | Earn-out payments of approximately $500,000 a year for 2016 and 2017, if earned through the achievement of annual revenue and earnings before interest taxes, depreciation and amortization (“EBITDA”) targets specified in the purchase agreement, subject to downward or upward adjustment depending on actual results. ----+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- The earn-out for 2016 was 30% higher than the previously agreed targets, resulting in a higher than anticipated earn-out payment, and the excess of the 2016 earn-out payment over what was planned was made as an adjustment to our income statement. The valuation of Ameri Georgia was made on the basis of its projected revenues. The accounting acquisition date for Ameri Georgia was determined on the basis of the date when the Company acquired control of Ameri Georgia, in accordance with FASB codification ASU 805-10-25-6 for business combinations. That ASU provides that the date on which the acquirer obtains control of the acquiree generally is the date on which the acquirer legally transfers the consideration, acquires the assets, and assumes the liabilities of the acquiree—the closing date. However, the acquirer might obtain control on a date that is either earlier or later than the closing date. For example, the acquisition date precedes the closing date if a written agreement provides that the acquirer obtains control of the acquiree on a date before the closing date. An acquirer shall consider all pertinent facts and circumstances in identifying the acquisition date. The term sheet and the Share Purchase Agreement that were entered into by the Company and Ameri Georgia contained agreements by the parties that the Company acquired control of Ameri Georgia’s accounts payable, accounts receivable and business decisions as of September 1, 2015. In addition, on that date, the Company became responsible for performance of Ameri Georgia’s existing contracts. Accordingly, the Company has recognized September 1, 2015 as the accounting acquisition date. The total purchase price of $9,910,817 was allocated to net working capital of $4.6 million, intangibles of $1.8 million, taking into consideration projected revenue from the acquired list of Ameri Georgia customers over a period of three years, and goodwill. The excess of total purchase price over the net working capital and intangibles allocations has been allocated to goodwill. The Company paid $261,876 in cash to the former shareholders of Ameri Georgia as earn-out payments during the nine months ended September 30, 2017. Acquisition of Bigtech Software Private Limited On June 23, 2016, we entered into a definitive agreement to acquire Bigtech Software Private Limited (“Bigtech”), a pure-play SAP services company providing a complete range of SAP services including turnkey implementations, application management, training and basis ABAP support. Based in Bangalore, India, Bigtech offers SAP services to improve business operations at companies of all sizes and verticals. The acquisition of Bigtech was effective as of July 1, 2016, and the total consideration for the acquisition of Bigtech was $850,000, consisting of: (a) | A cash payment in the amount of $340,000, which was due within 90 days of closing and was paid on September 22, 2016; ----+---------------------------------------------------------------------------------------------------------------------- (b) | Warrants for the purchase of 51,000 shares of our common stock (valued at approximately $250,000 based on the $6.51 closing price of our common stock on the closing date of the acquisition), with such warrants exercisable for two years; and ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 8 (c) | $255,000, which may become payable in cash earn-outs to the sellers of Bigtech, if Bigtech achieves certain pre-determined revenue and EBITDA targets in 2017 and 2018. We estimate the earn-out payments to be earned at 100% of the targets set forth in the purchase agreement. ----+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Bigtech’s financial results are included in our condensed consolidated financial results starting July 1, 2016. The Bigtech acquisition did not constitute a significant acquisition for the Company. The valuation of Bigtech was made on the basis of its projected revenues. The total purchase price of $850,000 was allocated to intangibles of $595,000, taking into consideration projected revenue from the acquired list of Bigtech customers over a period of three years, and goodwill. The excess of total purchase price over the intangibles allocation has been allocated to goodwill. The Bigtech acquisition did not constitute a significant acquisition for the Company. Acquisition of Virtuoso On July 22, 2016, we, through wholly-owned acquisition subsidiaries, acquired all of the outstanding membership interests of Virtuoso, L.L.C. (“Virtuoso”), a Kansas limited liability company, pursuant to the terms of an Agreement of Merger and Plan of Reorganization, by and among us, Virtuoso Acquisition Inc., Ameri100 Virtuoso Inc., Virtuoso and the sole member of Virtuoso (the “Sole Member”). Virtuoso is a SAP consulting firm specialized in providing services on SAP S/4 HANA finance, enterprise mobility and cloud migration and is based in Leawood, Kansas. In connection with the merger, Virtuoso’s name was changed to Ameri100 Virtuoso Inc. The Virtuoso acquisition did not constitute a significant acquisition for the Company. The total purchase price paid to the Sole Member for the acquisition of Virtuoso was $1,831,881 consisting of: (a) | A cash payment in the amount of $675,000, which was due within 90 days of closing and was paid on October 21, 2016; ----+-------------------------------------------------------------------------------------------------------------------- (b) | 101,250 shares of our common stock at closing, valued at approximately $700,000 based on the $6.51 closing price of our common stock on the closing date of the acquisition; and ----+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (c) | Earn-out payments in cash and stock of $450,000 and approximately $560,807, respectively, to be paid, if earned, through the achievement of annual revenue and gross margin targets in 2017, 2018 and 2019. Out of the total contingent consideration of approximately $1,000,000, we only considered 50% of the earn-out in the purchase price, mainly due to the reorganization of Virtuoso. ----+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- The total purchase price of $1,831,881 was allocated to intangibles of $0.9 million, taking into consideration projected revenue from the acquired list of Virtuoso customers over a period of three years, and the balance was allocated to goodwill. The Virtuoso earn-out payments for 2016 amounted to $64,736 in cash and 12,408 shares of common stock, which were delivered to the Sole Member during the nine months ended September 30, 2017. Acquisition of Ameri Arizona On July 29, 2016, we acquired 100% of the membership interests of DC&M Partners, L.L.C. (“Ameri Arizona”), an Arizona limited liability company, pursuant to the terms of a Membership Interest Purchase Agreement by and among us, Ameri Arizona, all of the members of Ameri Arizona, Giri Devanur and Srinidhi “Dev” Devanur, our President and Chief Executive Officer and Executive Vice Chairman, respectively. In July 2017, the name of DC&M Partners, L.L.C. was changed to Ameri100 Arizona LLC. Ameri Arizona is a SAP consulting company headquartered in Chandler, Arizona. Ameri Arizona provides its clients with a wide range of information technology development, consultancy and management services with an emphasis on the design, build and rollout of SAP implementations and related products. Ameri Arizona is also a SAP-certified software partner, having launched its SAP reporting, extraction and distribution tool called “IRIS”. Ameri Arizona services clients in diverse industries, including retail, apparel/footwear, third-party logistics providers, chemicals, consumer goods, energy, high-tech electronics, media/entertainment and aerospace. The aggregate purchase price for the acquisition of Ameri Arizona was $15,816,000 consisting of: (a) | A cash payment in the amount of $3,000,000 at closing; ----+------------------------------------------------------- (b) | 1,600,000 shares of our common stock (valued at approximately $10.4 million based on the $6.51 closing price of our common stock on the closing date of the acquisition), which are to be issued on July 29, 2018 or upon a change of control of our company (whichever occurs earlier); and ----+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (c) | Earn-out payments of $1,500,000 payable in cash each year to be paid, if earned, through the achievement of annual revenue and gross margin in 2017 and 2018. ----+-------------------------------------------------------------------------------------------------------------------------------------------------------------- 9 The total purchase price of $15,816,000 was allocated to intangibles of $5.4 million, taking into consideration projected revenue from the acquired list of Ameri Arizona customers over a period of three years, and the balance was allocated to goodwill. Based on the Company’s current estimates of the consideration payable under the purchase agreement, the Company does not believe the Ameri Arizona will achieve its earn-out for 2017 and reduced the consideration payable estimates by $400,000 in its income statement for the quarter ended June 30, 2017. The Company is also currently negotiating with the former members of Ameri Arizona regarding the Company’s earn-out payment obligations. The Company paid $300,000 in earn-out payments during the nine months ended September 30, 2017 for earn-out amounts earned prior to such date. Acquisition of Ameri California On March 10, 2017, we acquired 100% of the shares of ATCG Technology Solutions, Inc. (“Ameri California”), a Delaware corporation, pursuant to the terms of a Share Purchase Agreement among the Company, ATCG, all of the stockholders of Ameri California (the “Stockholders”), and the Stockholders’ representative. In July 2017, the name of ATCG Technology Solutions, Inc. was changed to Ameri100 California Inc. Ameri California provides U.S. domestic, offshore and onsite SAP consulting services and has its main office in Folsom, California. Ameri California specializes in providing SAP Hybris, SAP Success Factors and business intelligence services. The aggregate purchase price for the acquisition of Ameri California was $8,784,533, consisting of: (a) | 576,923 shares of our common stock, valued at approximately $3.8 million based on the closing price of our Common Stock on the closing date of the acquisition; ----+---------------------------------------------------------------------------------------------------------------------------------------------------------------- (b) | Unsecured promissory notes issued to certain of Ameri California’s selling Stockholders for the aggregate amount of $3,750,000 (which notes bear interest at a rate of 6% per annum and mature on June 30, 2018); ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ (c) | Earn-out payments in shares of our common stock (up to an aggregate value of $1,200,000 worth of shares) to be paid, if earned, in each of 2018 and 2019 based on certain revenue and EBITDA targets as specified in the purchase agreement. We estimate those targets will be fully achieved; and ----+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (d) | An additional cash payment of $55,687 for cash that was left in Ameri California at closing. ----+--------------------------------------------------------------------------------------------- The total purchase price of $8,784,533 was allocated to intangibles of $3.75 million, taking into consideration projected revenue from the acquired list of Ameri California customers over a period of three years, and goodwill. The excess of total purchase price over the intangibles allocation has been allocated to goodwill. For this acquisition, the net cash outflow in 2017 was $ 55,687. Presented below is the summary of the foregoing acquisitions: Allocation of purchase price in millions of U.S. dollars Asset Component | Ameri Georgia | | Bigtech | | Virtuoso | Ameri Arizona | Ameri California | ---------------------------------------------+---------------+-----+---------+-----+----------+---------------+------------------+----- Intangible Assets | | 1.8 | | 0.6 | | 0.9 | | 5.4 | 3.8 ---------------------------------------------+---------------+-----+---------+-----+----------+---------------+------------------+------+---- Goodwill | | 3.5 | | 0.3 | | 0.9 | | 10.4 | 5.0 ---------------------------------------------+---------------+-----+---------+-----+----------+---------------+------------------+------+---- Working Capital | | | | | | | | | ---------------------------------------------+---------------+-----+---------+-----+----------+---------------+------------------+------+---- Current Assets | | | | | | | | | ---------------------------------------------+---------------+-----+---------+-----+----------+---------------+------------------+------+---- Cash | | 1.4 | | - | | - | | - | - ---------------------------------------------+---------------+-----+---------+-----+----------+---------------+------------------+------+---- Accounts Receivable | | 5.6 | | - | | - | | - | - ---------------------------------------------+---------------+-----+---------+-----+----------+---------------+------------------+------+---- Other Assets | | 0.2 | | - | | - | | - | - ---------------------------------------------+---------------+-----+---------+-----+----------+---------------+------------------+------+---- | | 7.3 | | - | | - | | - | - ---------------------------------------------+---------------+-----+---------+-----+----------+---------------+------------------+------+---- Current Liabilities | | | | | | | | | ---------------------------------------------+---------------+-----+---------+-----+----------+---------------+------------------+------+---- Accounts Payable | | 1.3 | | - | | - | | - | - ---------------------------------------------+---------------+-----+---------+-----+----------+---------------+------------------+------+---- Accrued Expenses & Other Current Liabilities | | 1.3 | | - | | - | | - | - ---------------------------------------------+---------------+-----+---------+-----+----------+---------------+------------------+------+---- | | 2.7 | | - | | - | | - | - ---------------------------------------------+---------------+-----+---------+-----+----------+---------------+------------------+------+---- Net Working Capital Acquired | | 4.6 | | - | | - | | - | - ---------------------------------------------+---------------+-----+---------+-----+----------+---------------+------------------+------+---- Total Purchase Price | | 9.9 | | 0.9 | | 1.8 | | 15.8 | 8.8 ---------------------------------------------+---------------+-----+---------+-----+----------+---------------+------------------+------+---- 10 The Company has $19,319,211, in total towards consideration payable including contingent consideration payable for its acquisitions, consisting of $7,129,238 in cash obligations and $12,189,973 worth of common stock to be issued (assuming a per share price of $6.51). Out of $19,319,211, $5,346,688 is towards contingent consideration payable on earn-outs. NOTE 4. | REVENUE RECOGNITION: --------+--------------------- The Company recognizes revenue primarily through the provision of consulting services. We generate revenue by providing consulting services under written service contracts with our customers. The service contracts we enter generally fall into two categories: (1) time-and-materials contracts and (2) fixed-price contracts. We consider amounts to be earned once evidence of an arrangement has been obtained, services are delivered, fees are fixed or determinable and collectability is reasonably assured. We establish billing terms at the time at which the project deliverables and milestones are agreed. Our standard payment terms are 60 days from invoice date. When a customer enters into a time-and-materials or fixed-price (or a periodic retainer-based) contract, the Company recognizes revenue in accordance with its evaluation of the deliverables in each contract. If the deliverables represent separate units of accounting, the Company then measures and allocates the consideration from the arrangement to the separate units, based on vendor specific objective evidence of the value for each deliverable. The revenue under time and materials contracts is recognized as services are rendered and performed at contractually agreed upon rates. Revenue pursuant to fixed-price contracts is recognized under the proportional performance method of accounting. We routinely evaluate whether revenue and profitability should be recognized in the current period. We estimate the proportional performance on our fixed-price contracts on a monthly basis utilizing hours incurred to date as a percentage of total estimated hours to complete the project. This method is used because reasonably dependable estimates of costs and revenue earned can be made, based on historical experience and milestones identified in any particular contract. If we do not have a sufficient basis to measure progress toward completion, revenue is recognized upon completion of performance, subject to any warranty provisions or other project management assessments as to the status of work performed. Estimates of total project costs are continuously monitored during the term of an engagement. There are situations where the number of hours to complete projects may exceed our original estimate, as a result of an increase in project scope, unforeseen events that arise, or the inability of the client or the delivery team to fulfill their responsibilities. Accordingly, recorded revenues and costs are subject to revision throughout the life of a project based on current information and historical trends. Such revisions may result in increases or decreases to revenue and income and are reflected in the consolidated financial statements in the periods in which they are first identified. If our initial estimates of the resources required or the scope of work to be performed on a contract are inaccurate, or we do not manage the project properly within the planned time period, a provision for estimated losses on incomplete projects may be made. Any known or probable losses on projects are charged to operations in the period in which such losses are determined. A formal project review process takes place quarterly, although projects are continuously evaluated throughout the period. Management reviews the estimated total direct costs on each contract to determine if the estimated amounts are accurate, and estimates are adjusted as needed in the period identified. No losses were recognized on contracts during the quarter ended September 30, 2017. 11 NOTE 5. | SHARE-BASED COMPENSATION: --------+-------------------------- On April 20, 2015, our Board of Directors and the holder of a majority of our outstanding shares of common stock approved the adoption of our 2015 Equity Incentive Award Plan (the "Plan"). The Plan allows for the issuance of up to 2,000,000 shares of our common stock for award grants. The Plan provides equity-based compensation through the grant of cash-based awards, nonqualified stock options, incentive stock options, stock appreciation rights, restricted stock, restricted stock units, performance shares, performance units and other stock-based awards. We believe that an adequate reserve of shares available for issuance under the Plan is necessary to enable us to attract, motivate and retain key employees and directors and to provide an additional incentive for such individuals through stock ownership and other rights that promote and recognize the financial success and growth of our Company. We granted options to purchase 185,000 shares of our common stock and 98,669 restricted stock units pursuant to the Plan during the nine months ended September 30, 2017. Share based compensation expense for nine months ended September 30, 2017 was $5,167,354. During the quarter ended September 30, 2017, Lone Star Value Investors, LP exercised on a cashless basis a warrant which resulted in the issuance of 1,205,837 shares of our common stock and we recorded a corresponding charge to stock based compensation expense of $2,170,506. During quarter ended June 30, 2017, 174,680 restricted stock units were cancelled and an accelerated cost of $792,764 due to such cancellation has been accounted for as stock based compensation expense. As of September 30, 2017, out of the 2,000,000 shares available under the Plan, aggregate grants of 1,607,758 shares of our common stock had been granted as options and restricted stock units. NOTE 6. | INTANGIBLE ASSETS: --------+------------------- We amortize our intangible assets that have finite lives using the straight-line method. Amortization expense was $2,264,247 during the nine months ended September 30, 2017. This amortization expense relates to customer lists and products capitalized on our balance sheet, which expire through 2020. As of September 30, 2017, and December 31, 2016, capitalized intangible assets were as follows: | September 30, 2017 | | December 31, 2016 ------------------------------+--------------------+---+------------------ Capitalized intangible assets | | $ | 12,517,628 | $ | 10,074,546 ------------------------------+--------------------+---+-------------------+---+----------- Accumulated amortization | | | 2,264,247 | | 1,309,842 ------------------------------+--------------------+---+-------------------+---+----------- Total intangible assets | | $ | 10,253,381 | $ | 8,764,704 ------------------------------+--------------------+---+-------------------+---+----------- Our amortization schedule is as follows: Years ending December 31, | Amount | --------------------------+--------+----------- 2017 | $ | 665,859 --------------------------+--------+----------- 2018 | | 2,955,873 --------------------------+--------+----------- 2019 | | 2,727,968 --------------------------+--------+----------- 2020 | | 2,652,000 --------------------------+--------+----------- 2021 | | 1,251,681 --------------------------+--------+----------- Total | $ | 10,253,381 --------------------------+--------+----------- The Company’s intangible assets consist of the customer lists acquired from the Company’s acquisition of WinHire Inc, Ameri Georgia, Ameri Arizona, Virtuoso, Bigtech and Ameri California. The products acquired from the acquisition of Linear Logics. Corp. and the amount spent on improving those products are also categorized as intangible assets and are being amortized over the useful life of those products. NOTE 7. | GOODWILL: --------+---------- Goodwill represents the excess of the aggregate purchase price over the fair value of the net assets acquired in business combinations. Goodwill was comprised of the following amounts: | September 30, 2017 | | December 31, 2016 | -----------------------------------+--------------------+------------+-------------------+-- Virtuoso | $ | 939,881 | | $ | 939,881 -----------------------------------+--------------------+------------+-------------------+---+----------- Ameri Arizona | | 10,416,000 | | | 10,416,000 -----------------------------------+--------------------+------------+-------------------+---+----------- Bigtech | | 299,803 | | | 314,555 -----------------------------------+--------------------+------------+-------------------+---+----------- Ameri Consulting Service Pvt. Ltd. | | 1,948,118 | | | 1,948,118 -----------------------------------+--------------------+------------+-------------------+---+----------- Ameri Georgia | | 3,470,522 | | | 3,470,522 -----------------------------------+--------------------+------------+-------------------+---+----------- Ameri California | | 4,812,243 | | | - -----------------------------------+--------------------+------------+-------------------+---+----------- Total | $ | 21,886,567 | | $ | 17,089,076 -----------------------------------+--------------------+------------+-------------------+---+----------- 12 As per Company policy, goodwill impairment tests will be conducted on an annual basis and any impairment will be reflected in the Company’s statements of operations. NOTE 8. | EARNINGS (LOSS) PER SHARE: --------+--------------------------- A reconciliation of net income and weighted average shares used in computing basic and diluted net income per share is as follows: | Nine Months Ended September 30, 2017 | | | Nine Months Ended September 30, 2016 | -------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+-- Net income (loss) attributable to common stock holders | $ | (9,615,628 | ) | | $ | (4,082,006 | ) -------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+-- Weighted average common shares outstanding | | 14,472,322 | | | | 12,794,149 | -------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+-- Basic net income (loss) per share of common stock | $ | (0.66 | ) | | $ | (0.32 | ) -------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+-- Diluted net income (loss) per share of common stock | $ | (0.66 | ) | | $ | (0.32 | ) -------------------------------------------------------+---------------------------------------+------------+---+---------------------------------------+---+------------+-- Share based awards, inclusive of all grants made under the Plan, for which either the stock option exercise price or the fair value of the restricted share award exceeds the average market price over the period, have an anti- dilutive effect on earnings per share, and accordingly, are excluded from the diluted computations for all periods presented. NOTE 9. | OTHER ITEMS: --------+------------- The Company paid an in-kind dividend on its Series A Preferred Stock for the quarter ended September 30, 2017 by issuing 10,277 shares of Series A Preferred Stock to the sole holder of the Company’s Series A Preferred Stock. The Company has yet to make the dividend payment on its Series A Preferred Stock which was payable on September 30, 2017. The Company will pay the sole holder of the Series A Preferred Stock the accrued dividend in-kind pursuant to the terms of the Certificate of Designation contemporaneously with the filing of this Quarterly Report on Form 10-Q for the quarter ended September 30, 2017. NOTE 10. | BANK DEBT: ---------+----------- On July 1, 2016, the Company entered into a Loan and Security Agreement (the “Loan Agreement”), with its wholly-owned subsidiaries Ameri and Partners Inc and Ameri Georgia, as borrowers (the “Borrowers”), the Company and its wholly-owned subsidiary Linear Logics, Corp. serving as guarantors, the Company’s Chief Executive Officer, Giri Devanur, serving as a validity guarantor, and Sterling National Bank, N.A. (as lender and as agent, “Sterling”). The Company joined Ameri Arizona, Virtuoso and Ameri California as borrowers under the Loan Agreement following their respective acquisition. Under the Loan Agreement, the Borrowers can borrow up to an aggregate of $10 million, which includes up to $8 million in principal for revolving loans (the “Revolving Loans”) for general working capital purposes, up to $2 million in principal pursuant to a term loan (the “Term Loan”) for the purpose of a permitted business acquisition and up to $200,000 for letters of credit. A portion of the proceeds of the Loan Agreement were also used to repay the November 20, 2015 credit facility that was entered into between the Company, its wholly-owned subsidiary Ameri Georgia and Federal National Payables, Inc. The maturity of the loans under the Loan Agreement are as follows: Revolving Loan Maturity Date: July 1, 2019; provided, however, that the Revolving Loan Maturity Date will extend and renew automatically for successive one-year terms on each anniversary of the initial Revolving Loan Maturity Date (each an “Anniversary Date”) thereafter, unless not less than sixty (60) days prior to any such Anniversary Date, written notice of non-renewal is given by either party to the other, in which case the Revolving Loan Maturity Date will be such next Anniversary Date. Term Loan Maturity Date: The earliest of (a) the date following acceleration of the Term Loan and/or the Revolving Loans; (b) the Revolving Loan Maturity Date; or (c) July 1, 2019. Interest under the Loan Agreement is payable monthly in arrears and accrues as follows: (a) | in the case of Revolving Loans, a rate per annum equal to the sum of (i) the Wall Street Journal Prime Rate plus (ii) 2.00%; ----+----------------------------------------------------------------------------------------------------------------------------- 13 (b) | in the case of the Term Loan, a rate per annum equal to the sum of (i) the Wall Street Journal Prime Rate plus (ii) 3.75%; and ----+------------------------------------------------------------------------------------------------------------------------------- (c) | in the case of other obligations of the Borrowers, a rate per annum equal to the sum of (i) the greater of (A) 3.25% or (B) Wall Street Journal Prime Rate plus (ii) 3.75%. ----+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------- The Loan Agreement also requires the payment of certain fees, including, but not limited to letter of credit fees and an unused Revolving Loans fee. The Loan Agreement contains financial and other covenant requirements, including, but not limited to, financial covenants that require the Borrowers to not permit capital expenditures above $150,000 in any fiscal year, maintain a fixed charge coverage ratio of not less than 2.00 to 1.00 and maintain certain debt to EBITDA ratios. The Loan Agreement also requires the Company and Borrowers to obtain Sterling’s consent before making any permitted acquisitions. The amounts borrowed by the Borrowers under the Loan Agreement are guaranteed by the guarantors, and the Loan Agreement is secured by substantially all of the Borrowers’ assets. The principal amount of the Term Loan will be repaid as follows: (i) equal consecutive monthly installments in the amount of $33,333.33 each, paid on the first day of each calendar month and (ii) one final payment of the entire remaining principal balance, together with all accrued unpaid interest on the Term Loan maturity date. On August 28, 2017, the Company and certain of its subsidiaries obtained an incremental term loan from Sterling National Bank in the amount of $343,200.58, which amount shall be an addition to and comprise a part of the existing term loan under the existing Loan Agreement. The Company has not been in compliance with the financial covenants contained in its Loan Agreement with Sterling National Bank. The Company received waivers from Sterling National Bank for its non-compliance with the Loan Agreement for the quarters ended March 31, 2017, June 30, 2017 and September 30, 2017 in exchange for the payment of a fee of $5,000 for each quarterly waiver. The Company does not expect to be in compliance with the terms of the Loan Agreement following the conclusion of the terms of the waivers granted by Sterling National Bank. The Company is continuing to work with Sterling National Bank to address its non-compliance. If we are unable to obtain future waivers from Sterling National Bank, the bank could declare our loans with it to be in default and elect to claim all amounts outstanding to be immediately due and payable and terminate all commitments to extend further credit. If we are unable to repay the outstanding amounts, Sterling National Bank could proceed against the collateral granted to it to secure our indebtedness to it. We pledged substantially all of our assets as collateral under the Loan Agreement. The Loan Agreement is also supported by a limited guaranty from Giri Devanur, our President and Chief Executive Officer. If Sterling National Bank accelerates the repayment of our loans, there is no assurance that we will have sufficient assets to repay the loans. A default under the Loan Agreement may also result in an event of default under the Company’s outstanding convertible notes. We are currently looking for additional sources of financing, however there is no guarantee that we will have additional financing available to us. Interest paid on the Term Loan during the nine months ended September 30, 2017 amounted to $108,206. Principal repaid on the Term Loan during the nine months ended September 30, 2017 was $304,144. The short term and long-term outstanding balances on the Term Loan as of September 30, 2017 was $406,156 and $1,575,206, respectively. The outstanding balance of the Revolving Loans as of September 30, 2017 was $3,765,391. Bigtech, which was acquired as of July 1, 2016, had a term loan of $14,695 and a line of credit for $305,282 as of September 30, 2017. The Bigtech line of credit is with an Indian bank, HDFC Bank Limited, and was entered into on September 3, 2015 for Bigtech’s working capital requirements. The line of credit is for up to $416,667 with an interest rate of 11.85% per annum and maturity in June 2020. The Bigtech term loan accrues interest at the rate of 10.30% per annum and matures in 2020. Both the term loan and the line of credit were already in place when the Company acquired Bigtech. Interest paid during the nine months ended September 30, 2017 amounted to $1,486 for the term loan and $28,560 line of credit held by Bigtech. NOTE 11. | CONVERTIBLE NOTES: ---------+------------------- On March 7, 2017, we completed the sale and issuance of 8% Convertible Unsecured Promissory Notes (the “2017 Notes”) for aggregate proceeds to us of $1,250,000 from four accredited investors, including one of the Company’s directors, Dhruwa N. Rai. The 2017 Notes were issued pursuant to Securities Purchase Agreements between the Company and each investor. The 2017 Notes bear interest at 8% per annum until maturity in March 2020, with interest being paid annually on the first, second and third anniversaries of the issuance of the 2017 Notes beginning in March 2018. From and after an event of default and for so long as the event of default is continuing, the 2017 Notes will bear default interest at the rate of 10% per annum. The 2017 Notes can be prepaid by us at any time without penalty. 14 The 2017 Notes are convertible into shares of our common stock at a conversion price of (i) in the event that any registration statement for the public offering of common stock filed by the Company with the Securities and Exchange Commission (the “SEC”) in connection with an uplisting to a national stock exchange is declared effective by the SEC on or prior to December 31, 2017, such price per share that is equal to 68% of the price per share of common stock offered and sold pursuant to such registration statement, or (ii) if no such registration statement is declared effective by December 31, 2017, such price per share that is equal to the weighted average closing price per share of the Company’s common stock for the 20 trading days immediately preceding December 31, 2017, subject to adjustment under certain circumstances. The 2017 Notes rank junior to our secured credit facility with Sterling National Bank. The 2017 Notes also include certain negative covenants including, without the investors’ approval, restrictions on dividends and other restricted payments and reclassification of its stock. NOTE 12. | COMMITMENTS AND CONTINGENCIES: ---------+------------------------------- Operating Leases The Company’s principal facility is located in Princeton, New Jersey. The Company also leases office space in various locations with expiration dates between 2016 and 2020. The lease agreements often include leasehold improvement incentives, escalating lease payments, renewal provisions and other provisions which require the Company to pay taxes, insurance, maintenance costs, or defined rent increases. All of the Company’s leases are accounted for as operating leases. Rent expense is recorded over the lease terms on a straight-line basis. Rent expense was $232,022 and $125,883 for the nine months ended September 30, 2017 and 2016, respectively. The increase during the comparative periods is due to the addition of office space through the acquisition of Ameri Arizona, Virtuoso, Bigtech and Ameri California. The Company has entered into an operating lease for its primary office facility in Princeton, New Jersey, which expires in July 2019. The future minimum rental payments under these lease agreements are as follows: Year ending December 31, | Amount | -------------------------+--------+-------- 2017 | $ | 68,360 -------------------------+--------+-------- 2018 | | 189,428 -------------------------+--------+-------- 2019 | | 123,083 -------------------------+--------+-------- 2020 | | 70,333 -------------------------+--------+-------- 2021 | | 7,371 -------------------------+--------+-------- Total | $ | 458,575 -------------------------+--------+-------- NOTE 13. | FAIR VALUE MEASUREMENT: ---------+------------------------ The group’s financial instruments consist primarily of cash and cash equivalent, accounts receivable, accounts payable, contingent consideration liability and accrued liabilities. The carrying amounts of accounts receivable, accounts payable, cash and cash equivalents and accrued liabilities are considered to be the same as their fair value, due to their short-term nature. Fair value is defined as the exchange price that would be received for an asset or an exit price paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value must maximize the use of observable inputs and minimize the use of unobservable inputs. The current accounting guidance for fair value measurements defines a three-level valuation hierarchy for disclosures as follows: • | Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities; --+----------------------------------------------------------------------------------------------------- • | Level 2 inputs are quoted prices for similar assets and liabilities in active markets or inputs that are observable for the asset or liability, either directly or indirectly through market corroboration, for substantially the full term of the financial instrument; and --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Level 3 inputs are unobservable inputs based on our own assumptions used to measure assets and liabilities at fair value. --+-------------------------------------------------------------------------------------------------------------------------- A financial asset or liability’s classification within the hierarchy is determined based upon the lowest level input that is significant to the fair value measurement. 15 The following table sets forth the financial assets, measured at fair value, by level within the fair value hierarchy as of September 30, 2017 and December 31, 2016: | September 30, 2017 | | December 31, 2016 -------------------------+--------------------+---+------------------ Level 3 | | | | -------------------------+--------------------+---+-------------------+-- Contingent consideration | | $ | 5,346,688 | $ | 5,266,488 -------------------------+--------------------+---+-------------------+---+---------- The following table presents the change in level 3 instruments: | Three Months Ended September 30, 2017 | | Nine Months Ended September 30, 2017 | --------------------------------------------------+----------------------------------------+-----------+---------------------------------------+-- Opening balance | | 5,346,688 | | | 5,266,488 | --------------------------------------------------+----------------------------------------+-----------+---------------------------------------+---+-----------+-- Additions during the period | $ | - | | $ | 1,200,000 | --------------------------------------------------+----------------------------------------+-----------+---------------------------------------+---+-----------+-- Paid/settlements | | - | | | (719,800 | ) --------------------------------------------------+----------------------------------------+-----------+---------------------------------------+---+-----------+-- Total gains recognized in Statement of Operations | | - | | | (400,000 | ) --------------------------------------------------+----------------------------------------+-----------+---------------------------------------+---+-----------+-- Closing balance | | 5,346,688 | | | 5,346,688 | --------------------------------------------------+----------------------------------------+-----------+---------------------------------------+---+-----------+-- Contingent consideration pertaining to the acquisitions referred to in note 3 above as of September 30, 2017 has been classified under level 3 as the fair valuation of such contingent consideration has been done using one or more of the significant inputs which are not based on observable market data. The fair value of the contingent consideration was estimated using a discounted cash flow technique with significant inputs that are not observable in the market. The significant inputs not supported by market activity included our probability assessments of expected future cash flows related to the acquisitions during the earn-out period, appropriately discounted considering the uncertainties associated with the obligation, and calculated in accordance with the respective terms of the share purchase agreements. The amount of total gains/(losses) included in our Statement of Operations and Comprehensive Income/(Loss) is attributable to change in fair value of contingent consideration arising from the acquisition of Ameri Arizona were $400,000 and $0 for the nine months ended September 30, 2017 and the year ended December 31, 2016, respectively. Note 14. | NON-CONTROLLING INTEREST: ---------+-------------------------- The subsidiaries of the Company are all direct or indirect wholly-owned subsidiaries, except for Ameritas Technologies India Private Limited, of which the Company held 76% of the equity of the company, through September 30, 2017. The Company attributes relevant gains and losses to such non-controlling interests for every financial year. During the three months ended September 30, 2017 and 2016 and the nine months ended September 30, 2017 and 2016 the profit/(loss) attributable to the holders of non-controlling interests amounted to $(6,632) and $0 and $(18,504) and $0, respectively. NOTE 15. | RESTRUCTURING AND STREAMLINING COSTS: ---------+-------------------------------------- During the quarter ended September 30, 2017, the Company streamlined its operations by eliminating redundant positions across its acquired entities, which resulted in a restructuring charge of approximately $85,000 affecting approximately 20 employees. The Company anticipates that streamlining of its operations will result in annual savings of approximately $1.5 million, inclusive of payroll, benefits, office consolidations and other ancillary employee related costs. 16 ITEM 2. | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS --------+-------------------------------------------------------------------------------------- The accompanying unaudited condensed consolidated financial statements should be read in conjunction with our audited consolidated financial statements (and notes thereto) included in our Annual Report on Form 10-K for the year ended December 31, 2016. This Quarterly Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. See “Special Note Regarding Forward-Looking Statements” included elsewhere herein. We use the terms “we,” “our,” “us,” “AMERI” and “the Company” in this report to refer to AMERI Holdings, Inc. and its wholly-owned subsidiaries. Company History We were incorporated under the laws of the State of Delaware in February 1994 as Spatializer Audio Laboratories, Inc., which was a shell company immediately prior to our completion of a “reverse merger” transaction on May 26, 2015, in which we caused Ameri100 Acquisition, Inc., a Delaware corporation and our newly created, wholly owned subsidiary, to be merged with and into Ameri and Partners Inc (“Ameri and Partners”), a Delaware corporation (the “Merger”). On May 26, 2015, we completed the Merger, in which we caused Ameri100 Acquisition, Inc., a Delaware corporation and our newly created, wholly owned subsidiary, to be merged with and into Ameri and Partners (doing business as Ameri100), a Delaware corporation. As a result of the Merger, Ameri and Partners became our wholly owned operating subsidiary. The Merger was consummated under Delaware law, pursuant to an Agreement of Merger and Plan of Reorganization, dated as of May 26, 2015 (the “Merger Agreement”), and in connection with the Merger we changed our name to AMERI Holdings, Inc. We are headquartered in Princeton, New Jersey. Overview We specialize in delivering SAPTM cloud, digital and enterprise services to clients worldwide. Our SAP focus allows us to provide technological solutions to a broad and growing base of clients. We are headquartered in Princeton, NJ, and we have offices across the United States, which are supported by offices in India. Our model inverts the conventional global delivery model wherein offshore information technology (“IT”) service providers are based abroad and maintain a minimal presence in the United States. With a strong SAP focus, our client partnerships anchor around SAP cloud services, artificial intelligence, internet of things and robotic process automation. We pursue an acquisition strategy that seeks to disrupt the established business model of offshore IT service providers. We partnered with NEC Corporation of America (NEC), in February 2017, to offer SAP HANA Migration services. Through this partnership, the Company will offer solutions to its clients aspiring to make the transition from SAP ECC (on-premise) applications to SAP HANA applications. NEC is a leading technology integrator providing integrated communications, analytics, security, biometrics and technology solutions. We generate revenue by providing consulting services under written service contracts with our customers. The service contracts we enter into generally fall into two categories: (1) time-and-materials contracts and (2) fixed-price contracts. When a customer enters into a time-and-materials or fixed-price (or a periodic retainer-based) contract, the revenue is recognized in accordance with the deliverables of each contract. If the deliverables involve separate units of accounting, the consideration from the arrangement is measured and allocated to the separate units, based on vendor specific objective evidence of the value for each deliverable. The revenue under time and materials contracts is recognized as services are rendered and performed at contractually agreed upon rates. Revenue pursuant to fixed-price contracts is recognized under the proportional performance method of accounting. We routinely evaluate whether revenue and profitability should be recognized in the current period. We estimate the proportional performance on fixed-price contracts on a monthly basis utilizing hours incurred to date as a percentage of total estimated hours to complete the project. For the three months ended September 30, 2017 and September 30, 2016, sales to five major customers accounted for 43% and 45% of our total revenue, respectively. One of our customers contributed 14% of our revenue for the three months ended September 30, 2017. For the comparable period in 2016, two customers each contributed 15% and 12% of our revenue, respectively. For the nine months ended September 30, 2017 and September 30, 2016, sales to five major customers accounted for 39% and 54% of our total revenue, respectively. One of our customers contributed 11% of our revenue for the nine months ended September 30, 2017. For the comparable period in 2016, two of our customers each contributed 19% and 14% of our revenue, respectively. We continue to explore strategic alternatives to improve the market position and profitability of our product and service offerings in the marketplace, generate additional liquidity for the Company, and enhance our valuation. We expect to pursue our goals during the next twelve months through organic growth and through other strategic alternatives. Some of these alternatives have included, and could continue to include, selective acquisitions. The Company has obtained financing and additional capital from the sale of equity and incurrence of indebtedness in the past, and continues to consider capital raising and financing from the sale of various types of equity and incurrence of indebtedness to provide capital for our business plans and operations in the future. The Company has also provided, and may from time to time in the future provide, information to interested parties. 17 Matters that May or Are Currently Affecting Our Business The main challenges and trends that could affect or are affecting our financial results include: · | Our ability to enter into additional technology-management and consulting agreements, to diversify our client base and to expand the geographic areas we serve; --+---------------------------------------------------------------------------------------------------------------------------------------------------------------- · | Our ability to attract competent, skilled professionals and on-demand technology partners for our operations at acceptable prices to manage our overhead; --+---------------------------------------------------------------------------------------------------------------------------------------------------------- · | Our ability to acquire other technology services companies and integrate them with our existing business; --+---------------------------------------------------------------------------------------------------------- · | Our ability to raise additional capital, if and when needed; and --+------------------------------------------------------------------ · | Our ability to control our costs of operation as we expand our organization and capabilities. --+---------------------------------------------------------------------------------------------- RESULTS OF OPERATIONS Results of Operations for the Three Months Ended September 30, 2017 Compared to the Three Months Ended September 30, 2016 and for the Nine Months Ended September 30, 2017 Compared to the Nine Months Ended September 30, 2016 | Three Months Ended September 30, 2017 | | | Three Months Ended September 30, 2016 | | | Nine Months Ended September 30, 2017 | | Nine Months Ended September 30, 2016 | -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+-- Revenue | $ | 12,529,928 | | | $ | 10,058,558 | | $ | 37,139,114 | | | 23,758,460 | -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- Cost of revenue | | 9,966,490 | | | | 8,361,960 | | | 28,941,535 | | | 18,897,059 | -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- Gross profit | | 2,563,438 | | | | 1,696,598 | | | 8,197,579 | | | 4,861,401 | -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- Operating expenses | | | | | | | | | | | | | -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- Selling and marketing | | 402,846 | | | | 137,024 | | | 1,170,051 | | | 401,487 | -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- General and administration | | 5,283,059 | | | | 1,326,327 | | | 12,389,581 | | | 5,316,390 | -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- Acquisition related expenses | | 5,694 | | | | 1,015,558 | | | 390,174 | | | 1,630,778 | -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- Depreciation and amortization | | 817,284 | | | | 509,377 | | | 2,332,041 | | | 722,390 | -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- Operating expenses | | 6,508,883 | | | | 2,988,286 | | | 16,281,847 | | | 8,071,045 | -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- Operating income (loss) | | (3,945,445 | ) | | | (1,291,688 | ) | | (8,084,268 | ) | | (3,209,644 | ) -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- Interest expenses | | (132,973 | ) | | | (290,423 | ) | | (388,122 | ) | | (674,683 | ) -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- Changes in estimates | | - | | | | - | | | 400,000 | | | - | -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- Others, net | | 17,446 | | | | (195,518 | ) | | 21,921 | | | (197,679 | ) -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- Income (loss) before income taxes | | (4,060,972 | ) | | | (1,777,629 | ) | | (8,050,469 | ) | | (4,082,006 | ) -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- Tax benefit / (provision) | | - | | | | - | | | - | | | - | -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- Income after income taxes | | (4,060,972 | ) | | | (1,777,629 | ) | | (8,050,469 | ) | | (4,082,006 | ) -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- Net income attributable to non-controlling interest | | (6,632 | ) | | | - | | | (18,504 | ) | | - | -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- Net income (loss) attributable to the Company | | (4,067,604 | ) | | | (1,777,629 | ) | | (8,068,973 | ) | | (4,082,006 | ) -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- Dividend on preferred stock | | (541,864 | ) | | | - | | | (1,546,655 | ) | | - | -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- Net loss attributable to common stock holders | | (4,609,468 | ) | | | (1,777,629 | ) | | (9,615,628 | ) | | (4,082,006 | ) -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- Other comprehensive income (loss), net of tax | | - | | | | - | | | - | | | - | -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- Foreign exchange translation | | (14,234 | ) | | | 59,079 | | | (11,084 | ) | | (6,619 | ) -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- Comprehensive income/(loss) | $ | (4,623,702 | ) | | $ | (1,718,550 | ) | $ | (9,626,712 | ) | $ | (4,088,625 | ) -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- Comprehensive income/(loss) attributable to the Company | | (4,617,070 | ) | | | (1,718,550 | ) | | (9,608,208 | ) | | (4,088,625 | ) -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- Comprehensive income/(loss) attributable to the non-controlling interest | | (6,632 | ) | | | - | | | (18,504 | ) | | - | -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- | $ | (4,623,702 | ) | | $ | (1,718,550 | ) | $ | (9,626,712 | ) | $ | (4,088,625 | ) -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- Basic income (loss) per share | $ | (0.31 | ) | | $ | (0.13 | ) | $ | (0.66 | ) | $ | (0.32 | ) -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- Diluted income (loss) per share | $ | (0.31 | ) | | $ | (0.13 | ) | $ | (0.66 | ) | $ | (0.32 | ) -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- Basic weighted average number of common shares outstanding | | 14,715,947 | | | | 13,653,586 | | | 14,472,322 | | | 12,794,149 | -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- Diluted weighted average number of common shares outstanding | | 14,715,947 | | | | 13,653,586 | | | 14,472,322 | | | 12,794,149 | -------------------------------------------------------------------------+-----------------------------------------+------------+---+-----------------------------------------+---+------------+----------------------------------------+---+----------------------------------------+---+---+------------+-- 18 Revenues Revenues for the three months ended September 30, 2017 increased by approximately $2.47 million as compared to the three months ended September 30, 2016. This increase was primarily attributable to our acquisition of Ameri California. For changes in revenue by entity please refer to the table below. Revenues by subsidiary of the Company (in millions of U.S. dollars) | Three Months Ended September 30, 2017 | Three Months Ended September 30, 2016 | Increase (Decrease) -----------------+----------------------------------------+----------------------------------------+-------------------- Ameri & Partners | 1.41 | 2.07 | (0.66) -----------------+----------------------------------------+----------------------------------------+-------------------- Ameri Georgia | 4.64 | 4.38 | 0.26 -----------------+----------------------------------------+----------------------------------------+-------------------- Bigtech | 0.31 | 0.31 | 0.00 -----------------+----------------------------------------+----------------------------------------+-------------------- Ameri Arizona | 3.09 | 3.28 | (0.19) -----------------+----------------------------------------+----------------------------------------+-------------------- Ameri California | 3.07 | - | 3.07 -----------------+----------------------------------------+----------------------------------------+-------------------- Total | 12.53 | 10.06 | 2.47 -----------------+----------------------------------------+----------------------------------------+-------------------- Revenues for the nine months ended September 30, 2017 increased by approximately $13.38 million as compared to the nine months ended September 30, 2016. Of this increase in revenue, $6.60 million was attributable to our acquisition of Ameri California and $7.35 million was attributable to increases of revenue from Ameri Arizona and Bigtech for which we had the benefit of a full nine months of revenue in 2017 while in 2016 each company was not acquired until July of 2016. Changes in revenue by entity were as follows. Revenues by subsidiary of the Company (in millions of U.S. dollars) | Nine Months Ended September 30, 2017 | Nine Months Ended September 30, 2016 | Increase (Decrease) -----------------+--------------------------------------+--------------------------------------+-------------------- Ameri & Partners | 4.77 | 5.53 | (0.76) -----------------+--------------------------------------+--------------------------------------+-------------------- Ameri Georgia | 14.82 | 14.62 | 0.20 -----------------+--------------------------------------+--------------------------------------+-------------------- Bigtech | 0.82 | 0.31 | 0.51 -----------------+--------------------------------------+--------------------------------------+-------------------- Ameri Arizona | 10.12 | 3.28 | 6.84 -----------------+--------------------------------------+--------------------------------------+-------------------- Ameri California | 6.60 | - | 6.60 -----------------+--------------------------------------+--------------------------------------+-------------------- Total | 37.14 | 23.76 | 13.38 -----------------+--------------------------------------+--------------------------------------+-------------------- Gross Margin Our gross margin was 20% for the three months ended September 30, 2017, as compared to 17% for the three months ended September 30, 2016. Gross margin from Ameri California , which was acquired in March 2017, was 28%; without that acquisition our gross margin would have been 18%. Our gross margin was 22% for the nine months ended September 30, 2017, as compared to 20% for the nine months ended September 30, 2016. Gross margin from Ameri California was 29%; without this acquisition our gross margin would have been 21%. Our target gross margins in future periods are anticipated to be in the range of 20% to 25% based on a mix of project revenues and professional service revenues. However, there is no assurance that we will achieve such anticipated gross margins. 19 Selling and Marketing Expenses Selling and marketing expenses were $402,846 for the three months ended September 30, 2017, compared to $137,024 for the three months ended September 30, 2016. Our acquisition of Ameri California and Ameri Arizona added selling and marketing expenditures of $65,557 and $221,810, respectively. Selling and marketing expenses were $1,170,051 for the nine months ended September 30, 2017, compared to $ 401,486 for the nine months ended September 30, 2016. Our acquisition of Ameri California and Ameri Arizona added selling and marketing expenditures of $141,268 and 718,607, respectively. However, selling and marketing expenditures for Ameri Georgia decreased by $85,615 in the nine months ended September 30, 2017. General and Administration Expenses General and Administration (“G&A”) expenses include all costs, including rent costs, which are not directly associated with revenue-generating activities, as well as the non-cash expense for stock based compensation. These include employee costs, corporate costs and facilities costs. Employee costs include administrative salaries and related employee benefits, travel, recruiting and training costs. Corporate costs include reorganization costs, legal, accounting and outside consulting fees. Facility costs primarily include rent and communications costs. G&A expenses for the three months ended September 30, 2017 were $5,283,059 as compared to $1,326,327 for the three months ended September 30, 2016. G&A expenses increased by $3,956,732 of which $2,194,121 was attributable to stock based compensation expenses. our acquisition of Ameri California and Ameri Arizona added an additional $740,198 to our G&A expenses for the three months ended September 30, 2017 as compared to the same period in 2016. G&A expenses for the nine months ended September 30, 2017 were $12,389,581 as compared to $5,316,389 for the nine months ended September 30, 2016. G&A expenses increased by $7,073,192, of which $4,221,395 was attributable to our stock based compensation expense due to grants made to our employees, accelerated expenses upon cancellation of restricted stock units in the second quarter of 2017 and a charge related to a warrant exercised by Lone star Value Investors, LP during the quarter ended September 30, 2017. Our acquisition of Ameri California and Ameri Arizona added an additional $2,477,041 to our G&A expenses for the nine months ended September 30, 2017 as compared to the same period in 2016. Depreciation and Amortization Depreciation and amortization expense amounted to $817,284 for the three months ended September 30, 2017, as compared to $509,377 for the three months ended September 30, 2016. We capitalized the customer lists acquired during various acquisitions, resulting in increased amortization costs. The customer lists from each acquisition are amortized over a period of 60 months. Depreciation and amortization expense amounted to $2,332,041 for the nine months ended September 30, 2017, as compared to $722,390 for the nine months ended September 30, 2016. We capitalized the customer lists acquired during various acquisitions, resulting in increased amortization costs. The customer lists from each acquisition are amortized over a period of 60 months. Operating Income/ (Loss) Our operating income/(loss) was $(3,945,445) for the three months ended September 30, 2017, as compared to $(1,291,688) for the three months ended September 30, 2016. This increase in loss was mainly due to the increase in G&A expenses of our acquired entities. Our operating income (loss) was $(8,084,268) for the nine months ended September 30, 2017, as compared to $(3,209,644) for the nine months ended September 30, 2016. This increase in loss was mainly due to the increase in G&A expenses of our acquired entities. Interest Expense Our interest expense for the three months ended September 30, 2017 was $132,973 as compared to $290,423 for the three months ended September 30, 2016. The decrease is mainly due to changes in interest rates charged by our lenders. Our interest expense for the nine months ended September 30, 2017 was $388,122 as compared to $674,683 for the nine months ended September 30, 2016. The decrease is mainly due to changes in interest rates charged by our lenders. Changes in Estimates Based on our current estimates of consideration payable under the Ameri Arizona purchase agreement, we do not believe Ameri Arizona will achieve its 2017 earn-out and we have adjusted the consideration payable in connection therewith by reducing the estimates by $400,000 and reflecting the adjustment in our income statement for the quarter ended June 30, 2017. 20 Income taxes Our provision for income taxes for the three months ended September 30, 2017 and the three months period ended September 30, 2016 was $0 for each period. Our provision for income taxes for the nine months ended September 30, 2017 and the nine months period ended September 30, 2016 was $0 for each period. Acquisition Related Expenses We had acquisition related expenditures of $390,174 and $1,630,778 during the nine months ended September 30, 2017 and September 30, 2016, respectively. These expenses included acquisition costs and legal, banking and other acquisition related fees incurred in connection with our acquisitions. The decrease is due to the decline in acquisition related activities in the nine months ended September 30, 2017 as compared to the nine months ended September 30, 2016. Liquidity and Capital Resources Our cash position was $844,104 as of September 30, 2017, as compared to $1,379,887 as of December 31, 2016, a decrease of $535,783 primarily due to the use of funds towards working capital and earn-out payments. Cash used for operating activities was $1,799,568 during the nine months ended September 30, 2017 and was primarily a result of net changes in working capital requirements. Cash used in investing activities was $702,508 during the nine months ended September 30, 2017. Cash provided by financing activities was $1,966,296 during the nine months ended September 30, 2017 and was attributable to the increased borrowing under our line of credit with Sterling National Bank and the issuance of convertible notes. Due to our current constraints in working capital, we have been unable to pay a few vendors and as a result some of them have threatened legal action against us. We are currently working with these vendors to negotiate longer payment terms until we are able to raise more capital; the Company is trying to mitigate these efforts by raising more capital and through streamlining its operations which will provide cash savings going forward, however there can be no assurance that the Company will be able to secure additional sources of capital. In case we are unable to pay these vendors, they can take legal action against us or stop doing business with us which may have an impact on our revenue. On July 1, 2016, the Company entered into a Loan and Security Agreement (the “Loan Agreement”), with its wholly-owned subsidiaries Ameri and Partners Inc and Ameri Georgia, as borrowers (the “Borrowers”), the Company and its wholly-owned subsidiary Linear Logics, Corp. serving as guarantors, the Company’s Chief Executive Officer, Giri Devanur, serving as a validity guarantor, and Sterling National Bank, N.A. (as lender and as agent, “Sterling”). The Company joined Ameri Arizona, Virtuoso and Ameri California as borrowers under the Loan Agreement following their respective acquisition. Under the Loan Agreement, the Borrowers can borrow up to an aggregate of $10 million, which includes up to $8 million in principal for revolving loans (the “Revolving Loans”) for general working capital purposes, up to $2 million in principal pursuant to a term loan (the “Term Loan”) for the purpose of a permitted business acquisition and up to $200,000 for letters of credit. A portion of the proceeds of the Loan Agreement were also used to repay the November 20, 2015 credit facility that was entered into between the Company, its wholly-owned subsidiary Ameri Georgia and Federal National Payables, Inc. The maturity of the loans under the Loan Agreement are as follows: Revolving Loan Maturity Date: July 1, 2019; provided, however, that the Revolving Loan Maturity Date will extend and renew automatically for successive one-year terms on each anniversary of the initial Revolving Loan Maturity Date (each an “Anniversary Date”) thereafter, unless not less than sixty (60) days prior to any such Anniversary Date, written notice of non-renewal is given by either party to the other, in which case the Revolving Loan Maturity Date will be such next Anniversary Date. Term Loan Maturity Date: The earliest of (a) the date following acceleration of the Term Loan and/or the Revolving Loans; (b) the Revolving Loan Maturity Date; or (c) July 1, 2019. Interest under the Loan Agreement is payable monthly in arrears and accrues as follows: (a) | in the case of Revolving Loans, a rate per annum equal to the sum of (i) the Wall Street Journal Prime Rate plus (ii) 2.00%; ----+----------------------------------------------------------------------------------------------------------------------------- (b) | in the case of the Term Loan, a rate per annum equal to the sum of (i) the Wall Street Journal Prime Rate plus (ii) 3.75%; and ----+------------------------------------------------------------------------------------------------------------------------------- 21 (c) | in the case of other obligations of the Borrowers, a rate per annum equal to the sum of (i) the greater of (A) 3.25% or (B) Wall Street Journal Prime Rate plus (ii) 3.75%. ----+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------- The Loan Agreement also requires the payment of certain fees, including, but not limited to letter of credit fees and an unused Revolving Loans fee. The Loan Agreement contains financial and other covenant requirements, including, but not limited to, financial covenants that require the Borrowers to not permit capital expenditures above $150,000 in any fiscal year, maintain a fixed charge coverage ratio of not less than 2.00 to 1.00 and maintain certain debt to EBITDA ratios. The Loan Agreement also requires the Company and Borrowers to obtain Sterling’s consent before making any permitted acquisitions. The amounts borrowed by the Borrowers under the Loan Agreement are guaranteed by the guarantors, and the Loan Agreement is secured by substantially all of the Borrowers’ assets. The principal amount of the Term Loan will be repaid as follows: (i) equal consecutive monthly installments in the amount of $33,333.33 each, paid on the first day of each calendar month and (ii) one final payment of the entire remaining principal balance, together with all accrued unpaid interest on the Term Loan maturity date. On August 28, 2017, the Company and certain of its subsidiaries obtained an incremental term loan from Sterling National Bank in the amount of $343,200.58, which amount shall be an addition to and comprise a part of the existing term loan under the existing Loan Agreement. The Company has not been in compliance with the financial covenants contained in its Loan Agreement with Sterling National Bank. The Company received waivers from Sterling National Bank for its non-compliance with the Loan Agreement for the quarters ended March 31, 2017, June 30, 2017 and September 30, 2017 in exchange for the payment of a fee of $5,000 for each quarterly waiver. The Company does not expect to be in compliance with the terms of the Loan Agreement following the conclusion of the terms of the waivers granted by Sterling National Bank. The Company is continuing to work with Sterling National Bank to address its non-compliance. If we are unable to obtain future waivers from Sterling National Bank, the bank could declare our loans with it to be in default and elect to claim all amounts outstanding to be immediately due and payable and terminate all commitments to extend further credit. If we are unable to repay the outstanding amounts, Sterling National Bank could proceed against the collateral granted to it to secure our indebtedness to it. We pledged substantially all of our assets as collateral under the Loan Agreement. The Loan Agreement is also supported by a limited guaranty from Giri Devanur, our President and Chief Executive Officer. If Sterling National Bank accelerates the repayment of our loans, there is no assurance that we will have sufficient assets to repay the loans. A default under the Loan Agreement may also result in an event of default under the Company’s outstanding convertible notes. We are currently looking for additional sources of financing, however there is no guarantee that we will have additional financing available to us. Interest paid on the Term Loan during the nine months ended September 30, 2017 amounted to $108,206. Principal repaid on the Term Loan during the nine months ended September 30, 2017 was $304,144. The short term and long-term outstanding balances on the Term Loan as of September 30, 2017 was $406,156 and $1,575,206, respectively. The outstanding balance of the Revolving Loans as of September 30, 2017 was $3,765,391. Bigtech, which was acquired as of July 1, 2016, had a term loan of $14,695 and a line of credit for $305,282 as of September 30, 2017. The Bigtech line of credit is with an Indian bank, HDFC Bank Limited, and was entered into on September 3, 2015 for Bigtech’s working capital requirements. The line of credit is for up to $416,667 with an interest rate of 11.85% per annum and maturity in June 2020. The Bigtech term loan accrues interest at the rate of 10.30% per annum and matures in 2020. Both the term loan and the line of credit were already in place when the Company acquired Bigtech. Interest paid during the nine months ended September 30, 2017 amounted to $1,486 for the term loan and $28,560 line of credit held by Bigtech. On March 7, 2017, we completed the sale and issuance of 8% Convertible Unsecured Promissory Notes (the “2017 Notes”) for aggregate proceeds to us of $1,250,000 from four accredited investors, including one of the Company’s directors, Dhruwa N. Rai. The 2017 Notes were issued pursuant to Securities Purchase Agreements between the Company and each investor. The 2017 Notes bear interest at 8% per annum until maturity in March 2020, with interest being paid annually on the first, second and third anniversaries of the issuance of the 2017 Notes beginning in March 2018. From and after an event of default and for so long as the event of default is continuing, the 2017 Notes will bear default interest at the rate of 10% per annum. The 2017 Notes can be prepaid by us at any time without penalty. The 2017 Notes are convertible into shares of our common stock at a conversion price of (i) in the event that any registration statement for the public offering of common stock filed by the Company with the SEC in connection with an uplisting to a national stock exchange is declared effective by the SEC on or prior to December 31, 2017, such price per share that is equal to 68% of the price per share of common stock offered and sold pursuant to such registration statement, or (ii) if no such registration statement is declared effective by December 31, 2017, such price per share that is equal to the weighted average closing price per share of the Company’s common stock for the 20 trading days immediately preceding December 31, 2017, subject to adjustment under certain circumstances. The 2017 Notes rank junior to our secured credit facility with Sterling. The 2017 Notes also include certain negative covenants including, without the investors’ approval, restrictions on dividends and other restricted payments and reclassification of its stock. 22 Accounts Receivable Accounts receivable for the period ended September 30, 2017 were $9,167,088 as compared to $8,059,910 as on December 31, 2016. The increase was due to acquisition of Ameri California. Accounts Payable Accounts payable for the period ended September 30, 2017 were $4,126,323 as compared to $5,130,817 as on December 31, 2016. The decrease was primarily due to the payoff of accumulated accounts payable during the nine months ended September 30, 2017. Accrued Expenses Accrued expenses for the period ended September 30, 2017 were $3,947,294 as compared to $2,165,088 as on December 31, 2016. Our acquisition of Ameri California led to an increase of accrued expenses of $754,257 and the balance was attributable to our existing entities. Operating Activities Our largest source of operating cash flows is cash collections from our customers for different information technology services we render under various statements of work. Our primary uses of cash for operating activities are for personnel-related expenditures, leased facilities and taxes. Off- Balance Sheet Arrangements We do not have any off-balance sheet arrangements. Impact of Inflation We do not believe that inflation had a significant impact on our results of operations for the periods presented. On an ongoing basis, we attempt to minimize any effects of inflation on our operating results by controlling operating costs and, whenever possible, seeking to ensure that billing rates reflect increases in costs due to inflation. For all significant foreign operations, the functional currency is the local currency. Assets and liabilities of these operations are translated at the exchange rate in effect at each period end. Statements of Operations accounts are translated at the exchange rate prevailing as of the date of the transaction. The gains or losses resulting from such translation are reported under accumulated other comprehensive income (loss) as a separate component of equity. Realized gains and losses from foreign currency transactions are included in other income, net for the periods presented. Recent Accounting Pronouncements See Note 2 to our unaudited condensed consolidated financial statements for additional information. Critical Accounting Estimates Purchase Price Allocation. We allocate the purchase price of our acquisitions to the assets and liabilities acquired, including identifiable intangible assets, based on their respective fair values at the date of acquisition. Some of the items, including accounts receivable, property and equipment, other intangible assets, certain accrued liabilities and other reserves require a degree of management judgment. Certain estimates may change as additional information becomes available. Goodwill is assigned at the enterprise level and is deductible for tax purposes for certain types of acquisitions. Management finalizes the purchase price allocation within the defined measurement period of the acquisition date as certain initial accounting estimates are resolved. Valuation of Contingent Earn-out Consideration. Acquisitions may include contingent consideration payments based on the achievement of certain future financial performance measures of the acquired company. Contingent consideration is required to be recognized at fair value as of the acquisition date. We estimate the fair value of these liabilities based on financial projections of the acquired companies and estimated probabilities of achievement. We believe our estimates and assumptions are reasonable, however, there is significant judgment involved. We evaluate, on a routine, periodic basis, the estimated fair value of the contingent consideration and changes in estimated fair value, subsequent to the initial fair value estimate at the time of the acquisition, will be reflected in income or expense in the consolidated statements of operations. Changes in the fair value of contingent consideration obligations may result from changes in discount periods and rates, changes in the timing and amount of revenue and/or earnings estimates and changes in probability assumptions with respect to the likelihood of achieving the various earn-out criteria. Any changes in the estimated fair value of contingent consideration may have a material impact on our operating results. 23 Revenue Recognition. We recognize revenue in accordance with the Accounting Standard Codification 605 “Revenue Recognition.” Revenue is recognized when all of the following criteria are met: (1) persuasive evidence of an arrangement exists, (2) delivery has occurred or services have been rendered, (3) the seller’s price to buyer is fixed and determinable, and (4) collectability is reasonably assured. We recognize revenue from information technology services as the services are provided. Service revenues are recognized based on contracted hourly rates, as services are rendered or upon completion of specified contracted services and acceptance by the customer. Accounts Receivable. We extend credit to clients based upon management’s assessment of their credit-worthiness on an unsecured basis. We provide an allowance for uncollectible accounts based on historical experience and management evaluation of trend analysis. We include any balances that are determined to be uncollectible in allowance for doubtful accounts. Property and Equipment. Property and equipment is stated at cost. We provide for depreciation of property and equipment using the straight-line method over the estimated useful lives of the related assets ranging from 3 to 7 years. Leasehold improvements are amortized using the straight-line method over the shorter of the lease terms or the useful lives of the improvements. We charge repairs and maintenance costs that do not extend the lives of the assets to expenses as incurred. Intangible assets. We account for computer software costs developed for internal use in accordance with U.S. GAAP, which requires companies to capitalize certain qualifying costs during the application development stage of the related software development project and to exclude the initial planning phase that determines performance requirements, most data conversion, general and administrative costs related to payroll and training costs incurred. Whenever a software program is considered operational, we consider the project to be completed, place it into service and commence amortization of the development cost in the succeeding month. Goodwill. We capitalize the excess of capitalized intangible assets of an acquisition over the purchase consideration as goodwill in for each of our acquisitions. Impairment of goodwill is analyzed on an annual basis as per Company policy. Special Note Regarding Forward-Looking Information Some of the statements in this Quarterly Report on Form 10-Q and elsewhere constitute forward-looking statements under Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These statements involve known and unknown risks, uncertainties and other factors that may cause results, levels of activity, growth, performance, tax consequences or achievements to be materially different from any future results, levels of activity, growth, performance, tax consequences or achievements expressed or implied by such forward-looking statements. Such factors include, among other things, those listed below. The forward-looking statements included in this Form 10-Q and referred to elsewhere are related to future events or our strategies or future financial performance, including statements concerning our 2017 outlook, future revenue and growth, customer spending outlook, general economic trends, IT service demand, future revenue and revenue mix, utilization, new service offerings, significant customers, competitive and strategic initiatives, growth plans, potential stock repurchases, future results, tax consequences and liquidity needs. In some cases, you can identify forward-looking statements by terminology such as “may,” “should,” “believe,” “anticipate,” “anticipated,” “expectation,” “continued,” “future,” “forward,” “potential,” “estimate,” “estimated,” “forecast,” “project,” “encourage,” “opportunity,” “goal,” “objective,” “could,” “expect,” “expected,” “intend,” “plan,” “planned,” or the negative of such terms or comparable terminology. These forward-looking statements inherently involve certain risks and uncertainties, although they are based on our current plans or assessments which are believed to be reasonable as of the date of this Form 10-Q. Factors that may cause actual results, goals, targets or objectives to differ materially from those contemplated, projected, forecasted, estimated, anticipated, planned or budgeted in such forward-looking statements include, among others, the following possibilities: (1) failure to obtain new customers or retain significant existing customers; (2) the loss of one or more key executives and/or employees; (3) changes in industry trends, such as a decline in the demand for Enterprise Resource Planning and Enterprise Performance Management solutions, custom development and system integration services and/or declines in industry-wide information technology spending, whether on a temporary or permanent basis and/or delays by customers in initiating new projects or existing project milestones; (4) inability to execute upon growth objectives, including new services and growth in entities acquired by our Company; (5) adverse developments and volatility involving geopolitical or technology market conditions; (6) unanticipated events or the occurrence of fluctuations or variability in the matters identified as delays in, or the failure of, our sales pipeline being converted to billable work and recorded as revenue; (8) termination by clients of their contracts with us or inability or unwillingness of clients to pay for our services, which may impact our accounting assumptions; (9) inability to recruit and retain professionals with the high level of information technology skills and experience needed to provide our services; (10) failure to expand outsourcing services to generate additional revenue; (11) any changes in ownership of the Company or otherwise that would result in a limitation of the net operating loss carry forward under applicable tax laws; (12) the failure of the marketplace to embrace advisory and product-based consulting services; (13) changes in our utilization levels; (14) competition in our markets; (15) our ability to grow and manage growth profitably; our ability to access additional capital; (16) changes in applicable laws or regulations; (17) the failure to fully integrate acquired businesses; and (18) poor performance of acquired businesses following the closing of the acquisition. In evaluating these statements, you should specifically consider various factors described above. These factors may cause our actual results to differ materially from those contemplated, projected, anticipated, planned or budgeted in any such forward-looking statements. 24 Although we believe that the expectations in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance, growth, earnings per share or achievements. However, neither we nor any other person assumes responsibility for the accuracy and completeness of such statements. Except as otherwise required, we undertake no obligation to update any of the forward-looking statements after the date of this Form 10-Q to conform such statements to actual results. ITEM 3. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK --------+----------------------------------------------------------- Not applicable. ITEM 4. | CONTROLS AND PROCEDURES --------+------------------------ Management’s Report on Disclosure Controls and Procedures We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934 , as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow for timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, our management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. As required by Rule 13a-15 under the Securities Exchange Act of 1934, as of the end of the period covered by this Quarterly Report on Form 10-Q, we have carried out an evaluation of the effectiveness of the design and operation of our Company's disclosure controls and procedures. This evaluation was carried out under the supervision and with the participation of our Company's management, including our Company's Chief Executive Officer and Chief Financial Officer. Based upon that evaluation, our company's Chief Executive Officer and Chief Financial Officer concluded that our company's disclosure controls and procedures are not yet effective as of the end of the period covered by this report as noted below in management's report on internal control over financial reporting. This is largely due to the fact that we are acquiring privately held companies as part of our growth strategy and our control procedures over all acquired subsidiaries will not be effective until such time as we are able to fully integrate the acquisition with our company and set processes and procedures for the acquired entities. We are working to improve and harmonize our financial reporting controls and procedures across all of our companies. There have been no changes in our internal controls over financial reporting that occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect our internal controls over financial reporting. Disclosure controls and procedures and other procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time period specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934 is accumulated and communicated to management including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure. Our management, including our principal executive officer and principal financial officer, does not expect that our disclosure controls and procedures or our internal controls will prevent all error or fraud. Further, the design of a control system must reflect the fact that there are resource constraints and the benefits of controls must be considered relative to their costs. Due to the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. Management’s Report on Internal Control Over Financial Reporting Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rule 13a-15(f) of the Securities Exchange Act of 1934. Our management has assessed the effectiveness of our internal control over financial reporting as of September 30, 2017, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Our internal control over financial reporting includes maintaining records that in reasonable detail accurately and fairly reflect our transactions and dispositions of our assets; providing reasonable assurance that transactions are recorded as necessary for preparation of our financial statements in accordance with generally accepted accounting principles; providing reasonable assurance that receipts and expenditures are made in accordance with authorizations of management and our directors; and providing reasonable assurance that unauthorized acquisition, use or disposition of our assets that could have a material effect on our financial statements would be prevented or detected on a timely basis. As a result of this assessment, our management concluded that, as of September 30, 2017, our internal control over financial reporting was not yet effective in providing reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. This is largely due to the fact that we are acquiring privately held companies as part of our growth strategy and our control procedures over all acquired subsidiaries will not be effective until such time as we are able to fully integrate the acquisition with our company and set processes and procedures for the acquired entities. We are working to improve and harmonize our financial reporting controls and procedures across all of our companies. 25 This Quarterly Report on Form 10-Q does not include an attestation report of our independent auditors regarding internal control over financial reporting. Management's report was not subject to attestation by our independent auditors pursuant to temporary rules of the SEC that permit our company to provide only management's report in this Quarterly Report on Form 10-Q. Inherent Limitations on Effectiveness of Controls Internal control over financial reporting has inherent limitations which include but is not limited to the use of independent professionals for advice and guidance, interpretation of existing and/or changing rules and principles, segregation of management duties, scale of organization and personnel factors. Internal control over financial reporting is a process, which involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements on a timely basis, however these inherent limitations are known features of the financial reporting process and it is possible to design into the process safeguards to reduce, though not eliminate, this risk. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Changes in Internal Control Over Financial Reporting There were changes to correct certain internal control inadequacies, due to the privately held nature of acquired subsidiaries in our internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act, during the period covered by this report that have not materially affected, or are not reasonably likely to materially affect, our internal control over financial reporting. PART II - OTHER INFORMATION ITEM 1. | LEGAL PROCEEDINGS --------+------------------ None. ITEM 1A. | RISK FACTORS ---------+------------- Not applicable. ITEM 2. | UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS --------+------------------------------------------------------------ None. ITEM 3. | DEFAULTS UPON SENIOR SECURITIES --------+-------------------------------- To date, the Company has not been in conformance with the financial covenants contained in its Loan Agreement with Sterling National Bank. The Company received waivers from Sterling National Bank for its non-compliance with the Loan Agreement for the quarters ended March 31, 2017, June 30, 2017 and September 30, 2017 in exchange for the payment of a fee of $5,000 for each quarterly waiver. The Company does not expect to be in compliance with the terms of the Loan Agreement following the conclusion of the terms of the waivers granted by Sterling National Bank. The Company is continuing to work with Sterling National Bank to address its non-compliance. 26 The Company has yet to make the dividend payment on its Series A Preferred Stock that was payable on September 30, 2017. The Company will pay the sole holder of the Series A Preferred Stock, the accrued dividend in-kind pursuant to the terms of the Certificate of Designation contemporaneously with the filing of this Quarterly Report on Form 10-Q for the quarter ended September 30, 2017. ITEM 4. | MINE SAFETY DISCLOSURES --------+------------------------ Not applicable. ITEM 5. | OTHER INFORMATION --------+------------------ None. ITEM 6. | EXHIBITS --------+--------- Exhibit | Description --------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 2.1 | Agreement of Merger and Plan of Reorganization, dated as of May 26, 2015, among Spatializer Audio Laboratories, Inc., Ameri100 Acquisition, Inc. and Ameri and Partners Inc. (filed as Exhibit 2.1 to AMERI Holdings, Inc.’s Current Report on Form 8-K filed with the SEC on May 26, 2015 and incorporated herein by reference). --------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 2.2 | Stock Purchase Agreement by and between Ameri Holdings, Inc. and the shareholders of Ameri Consulting Service Private Limited. (filed as Exhibit 10.3 to Ameri Holdings, Inc.’s Current Report on Form 8-K filed with the SEC on June 1, 2015 and incorporated herein by reference). --------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 2.3 | Share Purchase Agreement, dated as of November 20, 2015, by and among Ameri Holdings, Inc., Bellsoft, Inc., and all of the shareholders of Bellsoft, Inc. (filed as Exhibit 10.1 to Ameri Holdings, Inc.’s Current Report on Form 8-K filed with the SEC on November 23, 2015 and incorporated herein by reference). --------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 2.4 | Agreement of Merger and Plan of Reorganization, dated as of July 22, 2016, by and among Ameri Holdings, Inc., Virtuoso Acquisition Inc., Ameri100 Virtuoso Inc., Virtuoso, L.L.C. and the sole member of Virtuoso, L.L.C. (filed as Exhibit 2.1 to Ameri Holdings, Inc.’s Current Report on Form 8-K filed with the SEC on July 27, 2016 and incorporated herein by reference). --------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 2.5 | Membership Interest Purchase Agreement, dated as of July 29, 2016, by and among Ameri Holdings, Inc., DC&M Partners, L.L.C., all of the members of DC&M Partners, L.L.C., Giri Devanur and Srinidhi “Dev” Devanur (filed as Exhibit 2.1 to Ameri Holdings, Inc.’s Current Report on Form 8-K filed with the SEC on August 1, 2016 and incorporated herein by reference). --------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 2.6 | Share Purchase Agreement, dated as of March 10, 2017, by and among Ameri Holdings, Inc., ATCG Technology Solutions, Inc., all of the stockholders of ATCG Technology Solutions, Inc., and the Stockholders’ representative (filed as Exhibit 2.1 to Ameri Holdings, Inc.’s Current Report on Form 8-K filed with the SEC on March 13, 2017 and incorporated herein by reference). --------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3.1 | Amended and Restated Certificate of Incorporation of Ameri Holdings, Inc. (filed as Exhibit 3.1 to Ameri Holdings, Inc.’s Current Report on Form 8-K filed with the SEC on June 23, 2016 and incorporated herein by reference). --------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3.2 | Certificate of Designation of Rights and Preferences of 9.00% Series A Cumulative Preferred Stock (filed as Exhibit 3.1 to Ameri Holdings, Inc.’s Current Report on Form 8-K filed with the SEC on January 4, 2017 and incorporated herein by reference). --------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3.3 | Corrected Certificate of Designation of Rights and Preferences of 9.00% Series A Cumulative Preferred Stock (filed as Exhibit 3.3 to Ameri Holdings, Inc.’s Registration Statement on Form S-1, Amendment No. 1, filed with the SEC on April 18, 2017 and incorporated herein by reference). --------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3.4 | Amended and Restated Bylaws of Ameri Holdings, Inc. (filed as Exhibit 3.2 to Ameri Holdings, Inc.’s Current Report on Form 8-K filed with the SEC on June 23, 2016 and incorporated herein by reference). --------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.1 | Form of Certificate Representing Shares of common stock of Registrant (filed as Exhibit 4.1 to Ameri Holdings, Inc.’s Registration Statement on Form S-8 filed with the SEC on December 17, 2015 and incorporated herein by reference). --------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.2 | Form of common stock Purchase Warrant issued by Ameri Holdings, Inc. to Lone Star Value Investors, LP, dated May 26, 2015 (filed as Exhibit 4.1 to Ameri Holdings, Inc.’s Current Report on Form 8-K filed with the SEC on June 1, 2015 and incorporated herein by reference). --------+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 27 4.3 | Common Stock Purchase Warrant, dated May 12, 2016, issued by Ameri Holdings, Inc. to Lone Star Value Investors, LP, dated May 12, 2016 (filed as Exhibit 4.3 to Ameri Holdings, Inc.’s Quarterly Report on Form 10-Q filed with the SEC on May 16, 2016 and incorporated herein by reference). -----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.4 | Amended and Restated Registration Rights Agreement, dated May 12, 2016, by and between Ameri Holdings, Inc. and Lone Star Value Investors, LP (filed as Exhibit 10.3 to Ameri Holdings, Inc.’s Quarterly Report on Form 10-Q filed with the SEC on May 16, 2016 and incorporated herein by reference). -----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.5 | Form of 8% Convertible Unsecured Promissory Note due March 2020 (filed as Exhibit 10.2 to Ameri Holdings, Inc.’s Current Report on Form 8-K filed with the SEC on March 8, 2017 and incorporated herein by reference). -----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.6 | Form of Registration Rights Agreement for 2017 Notes Investors (filed as Exhibit 10.3 to Ameri Holdings, Inc.’s Current Report on Form 8-K filed with the SEC on March 8, 2017 and incorporated herein by reference). -----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.7 | Form of 6% Unsecured Promissory Note (filed as Exhibit 10.1 to Ameri Holdings, Inc.’s Current Report on Form 8-K filed with the SEC on March 13, 2017 and incorporated herein by reference). -----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.1 | Employment Agreement, dated as of May 26, 2015, between Giri Devanur and Ameri Holdings, Inc. (filed as Exhibit 10.4 to Ameri Holdings, Inc.’s Current Report on Form 8-K filed with the SEC on June 1, 2015 and incorporated herein by reference). -----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.2 | Employment Agreement, dated as of May 26, 2015, between Srinidhi “Dev” Devanur and Ameri Holdings, Inc. (filed as Exhibit 10.5 to Ameri Holdings, Inc.’s Current Report on Form 8-K filed with the SEC on June 1, 2015 and incorporated herein by reference). -------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.3 | Employment Letter, dated April 24, 2016, between Ameri and Partners Inc and Viraj Patel (filed as Exhibit 10.1 to Ameri Holdings, Inc.’s Current Report on Form 8-K filed with the SEC on April 25, 2017 and incorporated herein by reference). -------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.4 | Form of Securities Purchase Agreement for 2017 Notes Investors (filed as Exhibit 10.1 to Ameri Holdings, Inc.’s Current Report on Form 8-K filed with the SEC on March 8, 2017 and incorporated herein by reference). -------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.5 | Exchange Agreement, dated as of December 30, 2016, between Ameri Holdings, Inc. and Lone Star Value Investors, LP (filed as Exhibit 10.1 to Ameri Holdings, Inc.’s Current Report on Form 8-K filed with the SEC on January 4, 2017 and incorporated herein by reference). -------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.6 | Loan and Security Agreement, dated as of July 1, 2016, by and among Ameri and Partners Inc, Bellsoft, Inc., Ameri Holdings, Inc., Linear Logics, Corp., Winhire Inc, Giri Devanur, the lenders which become a party to the Loan and Security Agreement, and Sterling National Bank, N.A. (a lender and as agent for the lenders) (filed as Exhibit 10.1 to Ameri Holdings, Inc.’s Current Report on Form 8-K filed with the SEC on July 7, 2016 and incorporated herein by reference). -------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.1* | Section 302 Certification of Principal Executive Officer -------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.2* | Section 302 Certification of Principal Financial and Accounting Officer -------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 32.1** | Section 906 Certification of Principal Executive Officer -------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 32.2** | Section 906 Certification of Principal Financial and Accounting Officer -------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101** | The following materials from Ameri Holdings, Inc.’s Quarterly Report on Form 10-Q for the three months ended September 30, 2017 are formatted in XBRL (eXtensible Business Reporting Language): (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Operations, (iii) the Consolidated Statement of Stockholders’ Equity (Deficit), (iv) the Consolidated Statements of Cash Flow, and (iv) Notes to the Consolidated Financial Statements. -------+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- * | Furnished herewith. --+-------------------- ** | In accordance with Item 601of Regulation S-K, this Exhibit is hereby furnished to the SEC as an accompanying document and is not deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934 or otherwise subject to the liabilities of that Section, nor shall it be deemed incorporated by reference into any filing under the Securities Act of 1933. ---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 28 SIGNATURES Pursuant to the requirements of the Section 13 or 15 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on the 13 th day of November 2017 . AMERI Holdings, Inc. -------------------- By: | /s/ Giri Devanur ---------------------+-------------------------------------------------------------------- | Giri Devanur ---------------------+-------------------------------------------------------------------- | President and Chief Executive Officer (Principal Executive Officer) ---------------------+-------------------------------------------------------------------- By: | /s/ Viraj Patel ----+------------------------------------------------------- | Viraj Patel ----+------------------------------------------------------- | Chief Financial Officer (Principal Accounting Officer) ----+------------------------------------------------------- 29

AMERICAN SHARED HOSPITAL SERVICES

744825

10-Q

0001144204-17-058307

UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 FORM 10-Q (Mark One) x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 --+---------------------------------------------------------------------------------------- For the quarterly period ended September 30, 2017 or ¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 --+----------------------------------------------------------------------------------------- For the transition period from _______________ to _______________. Commission file number 001-08789 American Shared Hospital Services (Exact name of registrant as specified in its charter) California | 94-2918118 --------------------------------+-------------------- (State or other jurisdiction of | (IRS Employer --------------------------------+-------------------- incorporation or organization) | Identification No.) --------------------------------+-------------------- Two Embarcadero Center, Suite 410, San Francisco, California | 94111 -------------------------------------------------------------+----------- (Address of Principal Executive Offices) | (Zip Code) -------------------------------------------------------------+----------- Registrant’s telephone number, including area code: (415) 788-5300 Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer”, “accelerated filer”, “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one): Large Accelerated Filer ¨ | Accelerated Filer ¨ | Non-Accelerated Filer ¨ | Smaller reporting company x --------------------------+---------------------+-------------------------+---------------------------- Emerging Growth Company ¨ | | | --------------------------+---------------------+-------------------------+---------------------------- If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨ Indicate by a check mark whether the registrant is a shell company ( as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x As of November 7, 2017, there are outstanding 5,710,000 shares of the Registrant’s common stock. PART I - FINANCIAL INFORMATION ITEM 1. | FINANCIAL STATEMENTS --------+--------------------- AMERICAN SHARED HOSPITAL SERVICES CONDENSED CONSOLIDATED BALANCE SHEETS | (unaudited) | | | | --------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+-- ASSETS | September 30, 2017 | | | December 31, 2016 | --------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+-- Current assets: | | | | | | | --------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Cash and cash equivalents | $ | 1,315,000 | | | $ | 2,871,000 | --------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Restricted cash | | 350,000 | | | | 250,000 | --------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Accounts receivable, net of allowance for doubtful accounts of $100,000 at September 30, 2017 and $100,000 at December 31, 2016 | | 5,345,000 | | | | 4,085,000 | --------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Other receivables | | 221,000 | | | | 290,000 | --------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Prepaid expenses and other current assets | | 1,859,000 | | | | 892,000 | --------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Total current assets | | 9,090,000 | | | | 8,388,000 | --------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Property and equipment: | | | | | | | --------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Medical equipment and facilities | | 95,865,000 | | | | 96,270,000 | --------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Office equipment | | 566,000 | | | | 537,000 | --------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Deposits and construction in progress | | 3,682,000 | | | | 8,073,000 | --------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- | | 100,113,000 | | | | 104,880,000 | --------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Accumulated depreciation and amortization | | (50,057,000 | ) | | | (53,549,000 | ) --------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Net property and equipment | | 50,056,000 | | | | 51,331,000 | --------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Investment in equity securities | | 579,000 | | | | 579,000 | --------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Other assets | | 251,000 | | | | 300,000 | --------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- Total assets | $ | 59,976,000 | | | $ | 60,598,000 | --------------------------------------------------------------------------------------------------------------------------------+--------------------+-------------+---+-------------------+---+-------------+-- LIABILITIES AND | (unaudited) | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+-------------------+-- SHAREHOLDERS’ EQUITY | September 30, 2017 | | December 31, 2016 | ------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+-------------------+-- Current liabilities: | | | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+-------------------+---+----------- Accounts payable | $ | 261,000 | | $ | 319,000 ------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+-------------------+---+----------- Employee compensation and benefits | | 240,000 | | | 184,000 ------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+-------------------+---+----------- Other accrued liabilities | | 1,289,000 | | | 1,100,000 ------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+-------------------+---+----------- Current portion of long-term debt | | 2,495,000 | | | 2,205,000 ------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+-------------------+---+----------- Current portion of obligations under capital leases | | 4,538,000 | | | 4,873,000 ------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+-------------------+---+----------- Total current liabilities | | 8,823,000 | | | 8,681,000 ------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+-------------------+---+----------- Long-term debt, less current portion | | 4,221,000 | | | 5,106,000 ------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+-------------------+---+----------- Long-term capital leases, less current portion | | 13,538,000 | | | 14,852,000 ------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+-------------------+---+----------- Deferred revenue, less current portion | | 530,000 | | | 610,000 ------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+-------------------+---+----------- Deferred income taxes | | 4,676,000 | | | 4,176,000 ------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+-------------------+---+----------- Shareholders’ equity: | | | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+-------------------+---+----------- Common stock, no par value (10,000,000 authorized; 5,710,000 shares issued and outstanding at September 30, 2017 and 5,468,000 shares at December 31, 2016) | | 10,711,000 | | | 10,596,000 ------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+-------------------+---+----------- Additional paid-in capital | | 6,107,000 | | | 5,949,000 ------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+-------------------+---+----------- Retained earnings | | 5,455,000 | | | 4,950,000 ------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+-------------------+---+----------- Total equity-American Shared Hospital Services | | 22,273,000 | | | 21,495,000 ------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+-------------------+---+----------- Non-controlling interest in subsidiary | | 5,915,000 | | | 5,678,000 ------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+-------------------+---+----------- Total shareholders’ equity | | 28,188,000 | | | 27,173,000 ------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+-------------------+---+----------- Total liabilities and shareholders’ equity | $ | 59,976,000 | | $ | 60,598,000 ------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+-------------------+---+----------- See accompanying notes 2 - AMERICAN SHARED HOSPITAL SERVICES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) | Three months ended September 30, | | | Nine months ended September 30, | -------------------------------------------------------------+----------------------------------+-----------+---+---------------------------------+-- | 2017 | | | 2016 | | | 2017 | | 2016 | -------------------------------------------------------------+----------------------------------+-----------+---+---------------------------------+---+-----------+------+---+------------+-- Rental income from medical services | $ | 4,613,000 | | | $ | 4,884,000 | | $ | 14,472,000 | | $ | 13,640,000 | -------------------------------------------------------------+----------------------------------+-----------+---+---------------------------------+---+-----------+------+---+------------+---+---+------------+-- Costs of revenue: | | | | | | | | | | | | | -------------------------------------------------------------+----------------------------------+-----------+---+---------------------------------+---+-----------+------+---+------------+---+---+------------+-- Maintenance and supplies | | 331,000 | | | | 163,000 | | | 811,000 | | | 657,000 | -------------------------------------------------------------+----------------------------------+-----------+---+---------------------------------+---+-----------+------+---+------------+---+---+------------+-- Depreciation and amortization | | 1,674,000 | | | | 1,687,000 | | | 5,000,000 | | | 4,898,000 | -------------------------------------------------------------+----------------------------------+-----------+---+---------------------------------+---+-----------+------+---+------------+---+---+------------+-- Other direct operating costs | | 726,000 | | | | 638,000 | | | 2,182,000 | | | 2,117,000 | -------------------------------------------------------------+----------------------------------+-----------+---+---------------------------------+---+-----------+------+---+------------+---+---+------------+-- | | 2,731,000 | | | | 2,488,000 | | | 7,993,000 | | | 7,672,000 | -------------------------------------------------------------+----------------------------------+-----------+---+---------------------------------+---+-----------+------+---+------------+---+---+------------+-- Gross Margin | | 1,882,000 | | | | 2,396,000 | | | 6,479,000 | | | 5,968,000 | -------------------------------------------------------------+----------------------------------+-----------+---+---------------------------------+---+-----------+------+---+------------+---+---+------------+-- Selling and administrative expense | | 1,026,000 | | | | 999,000 | | | 3,303,000 | | | 2,911,000 | -------------------------------------------------------------+----------------------------------+-----------+---+---------------------------------+---+-----------+------+---+------------+---+---+------------+-- Interest expense | | 417,000 | | | | 501,000 | | | 1,314,000 | | | 1,219,000 | -------------------------------------------------------------+----------------------------------+-----------+---+---------------------------------+---+-----------+------+---+------------+---+---+------------+-- Operating income | | 439,000 | | | | 896,000 | | | 1,862,000 | | | 1,838,000 | -------------------------------------------------------------+----------------------------------+-----------+---+---------------------------------+---+-----------+------+---+------------+---+---+------------+-- (Loss) on early extinguishment of debt | | - | | | | - | | | - | | | (108,000 | ) -------------------------------------------------------------+----------------------------------+-----------+---+---------------------------------+---+-----------+------+---+------------+---+---+------------+-- Interest and other income (loss) | | - | | | | 3,000 | | | (1,000 | ) | | 11,000 | -------------------------------------------------------------+----------------------------------+-----------+---+---------------------------------+---+-----------+------+---+------------+---+---+------------+-- Income before income taxes | | 439,000 | | | | 899,000 | | | 1,861,000 | | | 1,741,000 | -------------------------------------------------------------+----------------------------------+-----------+---+---------------------------------+---+-----------+------+---+------------+---+---+------------+-- Income tax expense | | 164,000 | | | | 267,000 | | | 600,000 | | | 424,000 | -------------------------------------------------------------+----------------------------------+-----------+---+---------------------------------+---+-----------+------+---+------------+---+---+------------+-- Net income | | 275,000 | | | | 632,000 | | | 1,261,000 | | | 1,317,000 | -------------------------------------------------------------+----------------------------------+-----------+---+---------------------------------+---+-----------+------+---+------------+---+---+------------+-- Less: Net (income) attributable to non-controlling interests | | (176,000 | ) | | | (298,000 | ) | | (756,000 | ) | | (839,000 | ) -------------------------------------------------------------+----------------------------------+-----------+---+---------------------------------+---+-----------+------+---+------------+---+---+------------+-- Net income attributable to American Shared Hospital Services | $ | 99,000 | | | $ | 334,000 | | $ | 505,000 | | $ | 478,000 | -------------------------------------------------------------+----------------------------------+-----------+---+---------------------------------+---+-----------+------+---+------------+---+---+------------+-- Net income per share: | | | | | | | | | | | | | -------------------------------------------------------------+----------------------------------+-----------+---+---------------------------------+---+-----------+------+---+------------+---+---+------------+-- Earnings per common share - basic | $ | 0.02 | | | $ | 0.06 | | $ | 0.09 | | $ | 0.09 | -------------------------------------------------------------+----------------------------------+-----------+---+---------------------------------+---+-----------+------+---+------------+---+---+------------+-- Earnings per common share - diluted | $ | 0.02 | | | $ | 0.06 | | $ | 0.09 | | $ | 0.09 | -------------------------------------------------------------+----------------------------------+-----------+---+---------------------------------+---+-----------+------+---+------------+---+---+------------+-- See accompanying notes 3 - AMERICAN SHARED HOSPITAL SERVICES CONDENSED CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY (Unaudited) | PERIODS ENDED DECEMBER 31, 2016 AND SEPTEMBER 30, 2017 | ----------------------------------------------------+------------------------------------------------------------+---------- | | | | | | Additional | | | | | Non-controlling | | | ----------------------------------------------------+------------------------------------------------------------+-----------+--------+---+------------+------------+---+-----------+-----------+-----------+-----------------+---+------------+------ | Common | | Common | | | Paid-in | | Retained | Sub-Total | | Interests in | | | ----------------------------------------------------+------------------------------------------------------------+-----------+--------+---+------------+------------+---+-----------+-----------+-----------+-----------------+---+------------+------ | Shares | | Stock | | | Capital | | Earnings | ASHS | | Subsidiaries | | | Total ----------------------------------------------------+------------------------------------------------------------+-----------+--------+---+------------+------------+---+-----------+-----------+-----------+-----------------+---+------------+------ Balances at January 1, 2016 | | 5,364,000 | | $ | 10,376,000 | | $ | 5,734,000 | $ | 4,020,000 | | $ | 20,130,000 | | $ | 5,050,000 | | $ | 25,180,000 | ----------------------------------------------------+------------------------------------------------------------+-----------+--------+---+------------+------------+---+-----------+-----------+-----------+-----------------+---+------------+-------+---+-----------+---+---+------------+-- Stock-based compensation expense | | 4,000 | | | - | | | 215,000 | | - | | | 215,000 | | | - | | | 215,000 | ----------------------------------------------------+------------------------------------------------------------+-----------+--------+---+------------+------------+---+-----------+-----------+-----------+-----------------+---+------------+-------+---+-----------+---+---+------------+-- Warrants exercised | | 100,000 | | | 220,000 | | | - | | - | | | 220,000 | | | - | | | 220,000 | ----------------------------------------------------+------------------------------------------------------------+-----------+--------+---+------------+------------+---+-----------+-----------+-----------+-----------------+---+------------+-------+---+-----------+---+---+------------+-- Non-controlling interest investment in subsidiaries | | - | | | - | | | - | | - | | | - | | | 7,000 | | | 7,000 | ----------------------------------------------------+------------------------------------------------------------+-----------+--------+---+------------+------------+---+-----------+-----------+-----------+-----------------+---+------------+-------+---+-----------+---+---+------------+-- Cash distributions to non-controlling interests | | - | | | - | | | - | | - | | | - | | | (699,000 | ) | | (699,000 | ) ----------------------------------------------------+------------------------------------------------------------+-----------+--------+---+------------+------------+---+-----------+-----------+-----------+-----------------+---+------------+-------+---+-----------+---+---+------------+-- Net income | | - | | | - | | | - | | 930,000 | | | 930,000 | | | 1,320,000 | | | 2,250,000 | ----------------------------------------------------+------------------------------------------------------------+-----------+--------+---+------------+------------+---+-----------+-----------+-----------+-----------------+---+------------+-------+---+-----------+---+---+------------+-- Balances at December 31, 2016 | | 5,468,000 | | $ | 10,596,000 | | $ | 5,949,000 | $ | 4,950,000 | | $ | 21,495,000 | | $ | 5,678,000 | | $ | 27,173,000 | ----------------------------------------------------+------------------------------------------------------------+-----------+--------+---+------------+------------+---+-----------+-----------+-----------+-----------------+---+------------+-------+---+-----------+---+---+------------+-- Stock-based compensation expense | | 4,000 | | | - | | | 158,000 | | - | | | 158,000 | | | - | | | 158,000 | ----------------------------------------------------+------------------------------------------------------------+-----------+--------+---+------------+------------+---+-----------+-----------+-----------+-----------------+---+------------+-------+---+-----------+---+---+------------+-- Restricted stock awards | | 162,000 | | | - | | | - | | - | | | - | | | - | | | - | ----------------------------------------------------+------------------------------------------------------------+-----------+--------+---+------------+------------+---+-----------+-----------+-----------+-----------------+---+------------+-------+---+-----------+---+---+------------+-- Warrants and options exercised | | 76,000 | | | 115,000 | | | - | | - | | | 115,000 | | | - | | | 115,000 | ----------------------------------------------------+------------------------------------------------------------+-----------+--------+---+------------+------------+---+-----------+-----------+-----------+-----------------+---+------------+-------+---+-----------+---+---+------------+-- Cash distributions to non-controlling interests | | - | | | - | | | - | | - | | | - | | | (519,000 | ) | | (519,000 | ) ----------------------------------------------------+------------------------------------------------------------+-----------+--------+---+------------+------------+---+-----------+-----------+-----------+-----------------+---+------------+-------+---+-----------+---+---+------------+-- Net income | | - | | | - | | | - | | 505,000 | | | 505,000 | | | 756,000 | | | 1,261,000 | ----------------------------------------------------+------------------------------------------------------------+-----------+--------+---+------------+------------+---+-----------+-----------+-----------+-----------------+---+------------+-------+---+-----------+---+---+------------+-- Balances at September 30, 2017 | | 5,710,000 | | $ | 10,711,000 | | $ | 6,107,000 | $ | 5,455,000 | | $ | 22,273,000 | | $ | 5,915,000 | | $ | 28,188,000 | ----------------------------------------------------+------------------------------------------------------------+-----------+--------+---+------------+------------+---+-----------+-----------+-----------+-----------------+---+------------+-------+---+-----------+---+---+------------+-- See accompanying notes 4 - AMERICAN SHARED HOSPITAL SERVICES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) | Nine Months ended September 30, | -------------------------------------------------------------------------------------------------+---------------------------------+----------- | 2017 | | | 2016 | -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+-- Operating activities: | | | | | | | -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Net income | $ | 1,261,000 | | | $ | 1,317,000 | -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Adjustments to reconcile net income to net cash from operating activities: | | | | | | | -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Depreciation and amortization | | 5,050,000 | | | | 4,929,000 | -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Loss on sale or disposal of assets | | 15,000 | | | | - | -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Loss on early extinguishment of debt | | - | | | | 108,000 | -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Deferred income tax | | 500,000 | | | | 378,000 | -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Stock based compensation expense | | 158,000 | | | | 161,000 | -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Net accrued interest on lease financing | | (79,000 | ) | | | - | -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Other non-cash items | | - | | | | 4,000 | -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Changes in operating assets and liabilities: | | | | | | | -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Accounts receivable and other receivables | | (1,191,000 | ) | | | (1,281,000 | ) -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Prepaid expenses and other assets | | (944,000 | ) | | | (226,000 | ) -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Deferred revenue | | (84,000 | ) | | | (186,000 | ) -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Accounts payable and accrued liabilities | | 290,000 | | | | 490,000 | -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Net cash from operating activities | | 4,976,000 | | | | 5,694,000 | -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Investing activities: | | | | | | | -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Payment for purchase of property and equipment | | (760,000 | ) | | | (1,050,000 | ) -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Proceeds from sale of equipment | | 150,000 | | | | - | -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Net cash (used in) investing activities | | (610,000 | ) | | | (1,050,000 | ) -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Financing activities: | | | | | | | -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Principal payments on long-term debt | | (1,595,000 | ) | | | (2,383,000 | ) -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Principal payments on capital leases | | (3,823,000 | ) | | | (3,054,000 | ) -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Capital contributions from non-controlling interests | | - | | | | 7,000 | -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Distributions to non-controlling interests | | (519,000 | ) | | | (514,000 | ) -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Proceeds from warrants and options exercised | | 115,000 | | | | - | -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Reclassification of restricted cash | | (100,000 | ) | | | (200,000 | ) -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Proceeds from capital lease financing for reimbursement of payments for acquisition of equipment | | - | | | | 1,137,000 | -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Net cash (used in) financing activities | | (5,922,000 | ) | | | (5,007,000 | ) -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Net change in cash and cash equivalents | | (1,556,000 | ) | | | (363,000 | ) -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Cash and cash equivalents at beginning of period | | 2,871,000 | | | | 2,209,000 | -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Cash and cash equivalents at end of period | $ | 1,315,000 | | | $ | 1,846,000 | -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Supplemental cash flow disclosure: | | | | | | | -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Cash paid during the period for: | | | | | | | -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Interest | $ | 1,424,000 | | | $ | 1,614,000 | -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Income taxes paid | $ | 104,000 | | | $ | 219,000 | -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Schedule of non-cash investing and financing activities | | | | | | | -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Acquisition of equipment with capital lease financing | $ | 2,153,000 | | | $ | 8,332,000 | -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- Acquisition of equipment with long-term debt financing | $ | 992,000 | | | $ | - | -------------------------------------------------------------------------------------------------+---------------------------------+------------+---+------+---+------------+-- See accompanying notes 5 - AMERICAN SHARED HOSPITAL SERVICES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) Note 1. Basis of Presentation In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments (consisting of only normal recurring accruals) necessary to present fairly American Shared Hospital Services’ consolidated financial position as of September 30, 2017 and the results of its operations for the three and nine-month periods ended September 30, 2017 and 2016, which results are not necessarily indicative of results on an annualized basis. Consolidated balance sheet amounts as of December 31, 2016 have been derived from audited consolidated financial statements. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2016 included in the Company’s 10-K filed with the Securities and Exchange Commission. These consolidated financial statements include the accounts of American Shared Hospital Services and its subsidiaries (the “Company”) as follows: the Company wholly-owns the subsidiaries American Shared Radiosurgery Services (“ASRS”), PBRT Orlando, LLC (“Orlando”), OR21, Inc. (“OR21”), and MedLeader.com, Inc. (“MedLeader”); the Company is the majority owner of Long Beach Equipment, LLC (“LBE”); ASRS is the majority-owner of GK Financing, LLC (“GKF”) which wholly-owns the subsidiaries Instituto de Gamma Knife del Pacifico S.A.C. (“GKPeru”) and GK Financing U.K., Limited (“GKUK”); GKF is the majority owner of the subsidiaries Albuquerque GK Equipment, LLC (“AGKE”) and Jacksonville GK Equipment, LLC (“JGKE”). The Company (through ASRS) and Elekta AB, the manufacturer of the Gamma Knife (through its wholly-owned United States subsidiary, GKV Investments, Inc.), entered into an operating agreement and formed GKF. As of September 30, 2017, GKF provided Gamma Knife units to sixteen medical centers in the United States in the states of Arkansas, California, Florida, Illinois, Massachusetts, Mississippi, Nebraska, Nevada, New Jersey, New Mexico, New York, Tennessee, Ohio, Oregon, and Texas. GKF also owns and operates a single-unit Gamma Knife facility in Lima, Peru. The Company through its wholly-owned subsidiary, Orlando, provided proton beam radiation therapy (“PBRT”) and related equipment to a customer in the United States. The Company also directly provides radiation therapy and related equipment, including Intensity Modulated Radiation Therapy (“IMRT”), Image Guided Radiation Therapy (“IGRT”) and a CT Simulator to the radiation therapy department at an existing Gamma Knife site in Massachusetts. The Company formed the subsidiaries GKPeru and GKUK for the purposes of expanding its business internationally into Peru and the United Kingdom, respectively; Orlando and LBE to provide proton beam therapy equipment and services in Orlando, Florida and Long Beach, California; and AGKE and JGKE to provide Gamma Knife equipment and services in Albuquerque, New Mexico and Jacksonville, Florida, respectively. AGKE began operations in the second quarter of 2011 and JGKE began operations in the fourth quarter of 2011. Orlando treated its first patient in April 2016. GKPeru treated its first patient in July 2017. GKUK is inactive and LBE is not expected to generate revenue within the next two years. 6 - The Company continues to develop its design and business model for “The Operating Room for the 21st Century” SM (“OR21”), through its 50% owned OR21, LLC (“OR21 LLC”). The remaining 50% is owned by an architectural design company. OR21 is not expected to generate significant revenue within the next two years. MedLeader was formed to provide continuing medical education online and through videos for doctors, nurses, and other healthcare workers. This subsidiary is not operational at this time. All significant intercompany accounts and transactions have been eliminated in consolidation. Based on the guidance provided in accordance with Accounting Standards Codification (“ASC”) 280 Segment Reporting (“ASC 280”), the Company has analyzed its subsidiaries which are all in the business of leasing radiosurgery and radiation therapy equipment to healthcare providers, and concluded there is one reportable segment, Rental Income from Medical Services. The Company provides Gamma Knife, PBRT, and IGRT equipment to seventeen hospitals in the United States as of September 30, 2017. The Company, through GKF, also owns and operates a single-unit Gamma Knife facility in Lima, Peru. These eighteen locations operate under different subsidiaries of the Company, but offer the same service, radiosurgery and radiation therapy. The operating results of the subsidiaries are reviewed by the Company’s Chief Executive Officer and Chief Financial Officer, who are also deemed the Company’s Chief Operating Decision Makers (“CODMs”) and this is done in conjunction with all of the subsidiaries and locations. In February 2016, the Company used proceeds from the lease financing of its MEVION S250 at Orlando Health – UF Health Cancer Center (“Orlando Health”) to pay down $1,000,000 in Promissory Notes (the “Notes”) with four members of the Company’s Board of Directors. Based on the guidance provided in accordance with ASC 405 Extinguishment of Liabilities (“ASC 405”) and ASC 470 Debt Modifications and Extinguishments (“ASC 470”), the pay-down of the Notes is considered an extinguishment of debt and, as such, the difference between the net carrying amount of the Notes and the costs of extinguishment was recognized as a loss on the Company’s condensed consolidated statements of operations. During the year ended December 31, 2016, the Company recorded a loss on early extinguishment of debt of $108,000. The Notes were issued with common stock warrants with an estimated fair value of $145,000. The unamortized balance of the discount on the Notes, of $80,000, and deferred fees incurred from the issuance of the Note of approximately $28,000, were recorded as a loss on early extinguishment. 7 - As of December 31, 2016, the Company had warrants outstanding representing the right to purchase 100,000 shares of the Company’s common stock at $2.20 per share. These warrants were issued with the Notes to four members of the Company’s Board of Directors. During the nine-month period ended September 30, 2017, 100,000 of the warrants were exercised. 50,000 of the 100,000 warrants were exercised via a cashless exercise resulting in the net issuance of approximately 25,000 shares. There are no warrants outstanding as of September 30, 2017. In April 2017, an existing customer exercised their option to purchase the Gamma Knife unit at its hospital at the end of the lease term for a predetermined purchase price, pursuant to the lease agreement. The lease terminated in April 2017, at which time, the unit was depreciated to the purchase price of the sale. Based on the guidance provided in ASC 360 Property, Plant and Equipment (“ASC 360”), the Company did not classify or measure the asset as held for sale prior to the lease termination, because the Gamma Knife unit was not available for immediate sale. On July 21, 2017, the Company entered into a Maintenance and Support Agreement (the “Mevion Service Agreement”) with Mevion Medical Systems, Inc. (“Mevion”), formerly Still River Systems, which provides for maintenance and support of the Company’s PBRT unit at Orlando Health. The Mevion Service Agreement began September 5, 2017 and required an upfront payment of $1,000,000 which was made on August 4, 2017, and further requires payments over the next 11 months. This payment portion was recorded as a prepaid contract and will be amortized over the one-year service period. The Mevion Service Agreement is for a five (5) year period. In May 2014, the Financial Accounting Standards Board “(FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers (Topic 606), (“ASU 2014-09”), which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The ASU will replace most existing revenue recognition guidance in United States Generally Accepted Accounting Principles (“GAAP”) when it becomes effective. In December 2016, FASB issued ASU 2016-20 Technical Corrections and Improvements to Topic 606, (“ASU 2016-20”), which affects some narrow aspects of ASU 2014-09. The new standard is effective for the Company for annual reporting periods beginning after December 15, 2017 and interim reporting periods therein. Early application is permitted for reporting periods beginning after December 15, 2016. The standard permits the use of either the retrospective or cumulative effect transition method. The Company performed an analysis to determine if its revenue agreements with customers fall under the scope of ASU No. 2016-02 Leases (“ASU 2016-02”) or ASU 2014-09 and concluded that, other than with respect to the Company’s stand-alone facility in Lima, Peru, ASU 2014-09 was not applicable. The Company has a project team in place to analyze the impact of ASU 2014-09 to its revenue stream in Peru. The Company believes it is following an appropriate timeline to allow for proper recognition, presentation, and disclosure upon adoption of ASU 2014-09. The Company intends to adopt the standard at the date required for public companies, but has not yet selected a transition method. The Company does not anticipate any change to its IT control environment from the adoption of ASU 2014-09. 8 - In January 2016, the FASB issued ASU No. 2016-01 Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”), which requires equity investments, except those accounted for under the equity method of accounting or those that result in consolidation of the investee, to be measured at fair value with changes in fair value recognized in net income. The new guidance is effective for the Company on January 1, 2018. Early adoption is permitted. The standard permits the use of cumulative-effect transition method. The Company is evaluating the effect that ASU 2016-01 will have on its consolidated financial statements and related disclosures. In February 2016, the FASB issued ASU 2016-02, which requires lessees to recognize, for all leases, at the commencement date, a lease liability, and a right-of-use asset. Under the new guidance, lessor accounting is largely unchanged. The new guidance is effective for the Company on January 1, 2019. Early adoption is permitted. The Company is evaluating the effect that ASU 2016-02 will have on its consolidated financial statements and related disclosures. The Company performed an analysis to determine if its revenue agreements with customers fall under the scope of ASU 2016-02 or ASU 2014-09 and conclude that, other than with respect to the Company’s stand-alone facility in Lima, Peru, ASU 2016-02 applied. The Company believes it is following an appropriate timeline to allow for proper recognition, presentation, and disclosure upon adoption of ASU 2016-02. In March 2016, the FASB issued ASU No. 2016-09 Compensation – Stock Compensation (Topic 718) (“ASU 2016-09”), which changes five aspects of accounting for share-based payment award transactions including 1) accounting for income taxes; 2) classification of excess tax benefits on the statement of cash flows; 3) forfeitures; 4) minimum statutory tax withholding requirements; and 5) classification of employee taxes paid on the statement of cash flows when an employer withholds shares for tax-withholding purposes. The new guidance is effective for the Company for interim and annual periods beginning after December 15, 2016. The Company adopted ASU 2016-09 on January 1, 2017. The Company elected to estimate the impact of forfeitures. There was no material impact on the consolidated financial statements and related disclosures. In June 2016, the FASB issued ASU No. 2016-13 Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”), which requires measurement and recognition of expected credit losses for financial assets held. The new guidance is effective for fiscal periods beginning after December 15, 2019. Early adoption is permitted for fiscal periods beginning after December 15, 2018. The Company is evaluating the effect that ASU 2016-13 will have on its consolidated financial statements and related disclosures. In August 2016, the FASB issued ASU No. 2016-15 Statement of Cash Flows (Topic 230) – Classification of Certain Cash Receipts and Cash Payments (“ASU 2016-15”), which provides guidance on eight specific cash flow issues: debt prepayment or extinguishment costs; settlement of zero-coupon or other debt instruments with coupon interest rates that are insignificant in relation to the effective interest rate of the borrowing; contingent consideration payments made after a business combination; proceeds from the settlement of insurance claims; proceeds from the settlement of corporate-owned life insurance policies; distributions received from equity method investees; beneficial interests in securitization transactions; and separately identifiable cash flows and application of the Predominance Principle. The new guidance is effective for fiscal periods beginning after December 15, 2017 and interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. The Company is evaluating the effect that ASU 2016-15 will have on its consolidated financial statements and related disclosures. 9 - In November 2016, the FASB issued ASU No. 2016-18 Statement of Cash Flows (Topic 230) – Restricted Cash (“ASU 2016-18”), which requires that a statement of cash flows explain the change during the period in total cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. Amounts generally described as restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. The new guidance is effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. The Company is evaluating the effect that ASU 2016-18 will have on its consolidated financial statements and related disclosures. In May 2017, the FASB issued ASU No. 2017-09 Compensation – Stock Compensation (Topic 718): Scope of Modification Accounting (“ASU 2017-09”), which provides guidance on determining which changes to the terms and conditions of share-based payment awards require an entity to apply modification accounting under Topic 718. The new guidance is effective for fiscal years beginning after December 31, 2017. Early adoption is permitted, including adoption in an interim period. The Company is evaluating the effect that ASU 2017-09 will have on its consolidated financial statements and related disclosures. Note 2. Per Share Amounts Per share information has been computed based on the weighted average number of common shares and dilutive common share equivalents outstanding. The computation for the three and nine-month periods ended September 30, 2017 excluded approximately 14,000 stock options, respectively, because the exercise price of the options was higher than the average market price during those periods. The computation for the three-month period ended September 30, 2016 excluded approximately 571,000 stock options and the nine-month period ended September 30, 2016 excluded approximately 600,000 stock options and 200,000 common stock warrants, because the exercise price of the options or warrants was higher than the average market price during those periods. The following table sets forth the computation of basic and diluted earnings per share for the three and nine-month periods ended September 30, 2017 and 2016: | Three Months ended September 30, | | Nine Months ended September 30, | --------------------------------------------------------------+----------------------------------+-----------+---------------------------------+-- | 2017 | | 2016 | | | 2017 | | 2016 --------------------------------------------------------------+----------------------------------+-----------+---------------------------------+---+-----------+------+---+---------- Net income attributable to American Shared Hospital Services | $ | 99,000 | | $ | 334,000 | | $ | 505,000 | $ | 478,000 --------------------------------------------------------------+----------------------------------+-----------+---------------------------------+---+-----------+------+---+-----------+---+---------- Weighted average common shares for basic earnings per share | | 5,947,000 | | | 5,554,000 | | | 5,745,000 | | 5,553,000 --------------------------------------------------------------+----------------------------------+-----------+---------------------------------+---+-----------+------+---+-----------+---+---------- Diluted effect of stock options and restricted stock | | 94,000 | | | 39,000 | | | 167,000 | | 11,000 --------------------------------------------------------------+----------------------------------+-----------+---------------------------------+---+-----------+------+---+-----------+---+---------- Weighted average common shares for diluted earnings per share | | 6,041,000 | | | 5,593,000 | | | 5,912,000 | | 5,564,000 --------------------------------------------------------------+----------------------------------+-----------+---------------------------------+---+-----------+------+---+-----------+---+---------- Basic earnings per share | $ | 0.02 | | $ | 0.06 | | $ | 0.09 | $ | 0.09 --------------------------------------------------------------+----------------------------------+-----------+---------------------------------+---+-----------+------+---+-----------+---+---------- Diluted earnings per share | $ | 0.02 | | $ | 0.06 | | $ | 0.09 | $ | 0.09 --------------------------------------------------------------+----------------------------------+-----------+---------------------------------+---+-----------+------+---+-----------+---+---------- 10 -- Note 3. Stock-based Compensation In June 2010, the Company’s shareholders approved an amendment and restatement of the Company’s stock incentive plan, renaming it the Incentive Compensation Plan (the “Plan”), and among other things, increasing the number of shares of the Company’s common stock reserved for issuance under the Plan to 1,630,000. The Plan provides that the shares reserved under the Plan are available for issuance to officers of the Company, other key employees, non-employee directors, and advisors. The Plan is a successor to the Company’s previous plans, and any shares awarded and outstanding under those plans were transferred to the Plan. No further grants or share issuances will be made under the previous plans. On June 27, 2017, the Company’s shareholders approved an amendment and restatement of the Plan in order to extend the term of the Plan by two years to February 22, 2020. Stock-based compensation expense associated with the Company’s stock options to employees is calculated using the Black-Scholes valuation model. The Company’s stock awards have characteristics significantly different from those of traded options, and changes in the subjective input assumptions can materially affect the fair value estimates. The estimated fair value of the Company’s option grants is estimated using assumptions for expected life, volatility, dividend yield, and risk-free interest rate which are specific to each award. The estimated fair value of the Company’s options is amortized over the period during which an employee is required to provide service in exchange for the award (requisite service period), usually the vesting period. Accordingly, stock-based compensation cost before income tax effect for the Company’s options and restricted stock awards, in the amount of $58,000 and $158,000 is reflected in net income for the three and nine-month periods ended September 30, 2017 compared to $42,000 and $161,000 in the same periods prior year, respectively. At September 30, 2017, there was approximately $330,000 of unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the Plan, excluding the unrecognized compensation cost associated with the Award Agreements, discussed below. This cost is expected to be recognized over a period of approximately three years. On January 4, 2017, the Company entered into a Performance Share Award Agreement with three executive officers of the Company (the “Award Agreements”) for 161,766 restricted stock awards which vest upon the achievement of certain performance metrics. The Award Agreements expire on March 31, 2020. Based on the guidance in ASC 718 Stock Compensation (“ASC 718”), the Company concluded these were performance-based awards with vesting criteria tied to performance metrics and that as of September 30, 2017 it is not probable that any of the required metrics for vesting will be achieved. As a result, the Company has not recognized any stock-based compensation expense associated with these awards for the three and nine-month periods ended September 30, 2017. The unrecognized stock-based compensation expense for these awards was approximately $542,000 as of September 30, 2017. If and when the Company determines that the performance metrics’ achievement becomes probable, the Company will record a cumulative catch-up stock-based compensation amount and the remaining unrecognized amount will be recorded over the remaining requisite service period of the awards. 11 -- The following table summarizes restricted stock awards, consisting primarily of annual automatic grants and deferred compensation to non-employee directors, for the nine-month period ended September 30, 2017: | Restricted Stock Awards | | | Grant Date Weighted- Average Fair Value | | | Intrinsic Value ----------------------------------+-------------------------+---------+---+---------------------------------------------+---+------+---------------- Outstanding at January 1, 2017 | | 4,000 | | | $ | 2.25 | | $ | - ----------------------------------+-------------------------+---------+---+---------------------------------------------+---+------+-----------------+---+-- Granted | | 22,000 | | | $ | 3.47 | | $ | - ----------------------------------+-------------------------+---------+---+---------------------------------------------+---+------+-----------------+---+-- Vested | | (17,000 | ) | | $ | 3.16 | | $ | - ----------------------------------+-------------------------+---------+---+---------------------------------------------+---+------+-----------------+---+-- Forfeited | | - | | | $ | - | | $ | - ----------------------------------+-------------------------+---------+---+---------------------------------------------+---+------+-----------------+---+-- Outstanding at September 30, 2017 | | 9,000 | | | $ | 3.58 | | $ | - ----------------------------------+-------------------------+---------+---+---------------------------------------------+---+------+-----------------+---+-- The following table summarizes stock option activity for the nine-month period ended September 30, 2017: | Stock Options | | | Grant Date Weighted- Average Exercise Price | | | Weighted- Average Remaining Contractual Life (in Years) | Intrinsic Value ----------------------------------+---------------+---------+---+-------------------------------------------------+---+------+-------------------------------------------------------------+---------------- Outstanding at January 1, 2017 | | 625,000 | | | $ | 2.85 | | 4.25 | $ | - ----------------------------------+---------------+---------+---+-------------------------------------------------+---+------+-------------------------------------------------------------+-----------------+---+------ Granted | | 19,000 | | | $ | 3.62 | | 6.80 | $ | - ----------------------------------+---------------+---------+---+-------------------------------------------------+---+------+-------------------------------------------------------------+-----------------+---+------ Exercised | | (4,000 | ) | | $ | 2.81 | | - | $ | - ----------------------------------+---------------+---------+---+-------------------------------------------------+---+------+-------------------------------------------------------------+-----------------+---+------ Forfeited | | (23,000 | ) | | $ | 2.82 | | - | $ | - ----------------------------------+---------------+---------+---+-------------------------------------------------+---+------+-------------------------------------------------------------+-----------------+---+------ Outstanding at September 30, 2017 | | 617,000 | | | $ | 2.87 | | 3.63 | $ | - ----------------------------------+---------------+---------+---+-------------------------------------------------+---+------+-------------------------------------------------------------+-----------------+---+------ Exercisable at September 30, 2017 | | 300,000 | | | $ | 2.82 | | 3.43 | $ | 9,000 ----------------------------------+---------------+---------+---+-------------------------------------------------+---+------+-------------------------------------------------------------+-----------------+---+------ Note 4. Investment in Equity Securities As of September 30, 2017, and December 31, 2016, the Company had a $579,000 investment in the common stock of Mevion, representing an approximate 0.46% interest in Mevion. The Company accounts for this investment under the cost method. The Company carries its investment in Mevion at cost and reviews it for impairment on a quarterly basis, or as events or circumstances might indicate that the carrying value of the investment may not be recoverable. The Company reviewed this investment at September 30, 2017 in light of both current market conditions and the current operations of Mevion as they continue to grow their PBRT business. Based on its analysis, the Company determined no additional impairment needed to be recognized as of September 30, 2017. Note 5. Fair Value of Financial Instruments The Company’s disclosures of the fair value of financial instruments is based on a fair value hierarchy which prioritizes the inputs to the valuation techniques used to measure fair value into three levels. Level 1 inputs are unadjusted quoted market prices in active markets for identical assets and liabilities that the Company has the ability to access at the measurement date. Level 2 inputs are inputs other than quoted prices within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 3 inputs are unobservable inputs for assets or liabilities, and reflect the Company’s own assumptions about the assumptions that market participants would use in pricing the asset or liability. 12 -- The estimated fair value of the Company’s assets and liabilities as of September 30, 2017 and December 31, 2016 were as follows (in thousands): | Level 1 | | Level 2 | | | Level 3 | | Total | Carrying Value | ----------------------------------------+---------+-------+---------+---+---+---------+---+-------+-----------------+------ September 30, 2017 | | | | | | | | | | | | ----------------------------------------+---------+-------+---------+---+---+---------+---+-------+-----------------+-------+---+------ Assets: | | | | | | | | | | | | ----------------------------------------+---------+-------+---------+---+---+---------+---+-------+-----------------+-------+---+------ Cash, cash equivalents, restricted cash | $ | 1,665 | | $ | - | | $ | - | $ | 1,665 | $ | 1,665 ----------------------------------------+---------+-------+---------+---+---+---------+---+-------+-----------------+-------+---+------ Investment in equity securities | | - | | | - | | | 579 | | 579 | | 579 ----------------------------------------+---------+-------+---------+---+---+---------+---+-------+-----------------+-------+---+------ Total | $ | 1,665 | | $ | - | | $ | 579 | $ | 2,244 | $ | 2,244 ----------------------------------------+---------+-------+---------+---+---+---------+---+-------+-----------------+-------+---+------ Liabilities | | | | | | | | | | | | ----------------------------------------+---------+-------+---------+---+---+---------+---+-------+-----------------+-------+---+------ Debt obligations | $ | - | | $ | - | | $ | 6,809 | $ | 6,809 | $ | 6,716 ----------------------------------------+---------+-------+---------+---+---+---------+---+-------+-----------------+-------+---+------ Total | $ | - | | $ | - | | $ | 6,809 | $ | 6,809 | $ | 6,716 ----------------------------------------+---------+-------+---------+---+---+---------+---+-------+-----------------+-------+---+------ December 31, 2016 | | | | | | | | | | | | ----------------------------------------+---------+-------+---------+---+---+---------+---+-------+-----------------+-------+---+------ Assets: | | | | | | | | | | | | ----------------------------------------+---------+-------+---------+---+---+---------+---+-------+-----------------+-------+---+------ Cash, cash equivalents, restricted cash | $ | 3,121 | | $ | - | | $ | - | $ | 3,121 | $ | 3,121 ----------------------------------------+---------+-------+---------+---+---+---------+---+-------+-----------------+-------+---+------ Investment in equity securities | | - | | | - | | | 579 | | 579 | | 579 ----------------------------------------+---------+-------+---------+---+---+---------+---+-------+-----------------+-------+---+------ Total | $ | 3,121 | | $ | - | | $ | 579 | $ | 3,700 | $ | 3,700 ----------------------------------------+---------+-------+---------+---+---+---------+---+-------+-----------------+-------+---+------ Liabilities | | | | | | | | | | | | ----------------------------------------+---------+-------+---------+---+---+---------+---+-------+-----------------+-------+---+------ Debt obligations | $ | - | | $ | - | | $ | 7,354 | $ | 7,354 | $ | 7,311 ----------------------------------------+---------+-------+---------+---+---+---------+---+-------+-----------------+-------+---+------ Total | $ | - | | $ | - | | $ | 7,354 | $ | 7,354 | $ | 7,311 ----------------------------------------+---------+-------+---------+---+---+---------+---+-------+-----------------+-------+---+------ Note 6. Repurchase of Common Stock In 1999 and 2001, the Board of Directors approved resolutions authorizing the Company to repurchase up to a total of 1,000,000 shares of its own stock on the open market, which the Board reaffirmed in 2008. There were no shares repurchased during the three and nine-month periods ended September 30, 2017 or 2016, respectively. There are approximately 72,000 shares remaining under this repurchase authorization as of September 30, 2017. Note 7. Income Taxes The Company generally calculates its effective income tax rate at the end of an interim period using an estimate of the annualized effective income tax rate expected to be applicable for the full fiscal year. However, when a reliable estimate of the annualized effective income tax rate cannot be made, the Company computes its provision for income taxes using the actual effective income tax rate for the results of operations reported within the year-to-date periods. The Company’s effective income tax rate is highly influenced by relative income or losses reported and the amount of the nondeductible stock-based compensation associated with grants of its common stock options and from the results of foreign operations. A small change in estimated annual pretax income (loss) can produce a significant variance in the annualized effective income tax rate given the expected amount of these items. As a result, the Company has computed its provision for income taxes for the three and nine-month periods ended September 30, 2017 and 2016 by applying the actual effective tax rates to income or (loss) reported within the condensed consolidated financial statements through those periods. 13 -- Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations --------+-------------------------------------------------------------------------------------- This quarterly report to the Securities and Exchange Commission may be deemed to contain certain forward-looking statements with respect to the financial condition, results of operations and future plans of the Company, which involve risks and uncertainties including, but not limited to, the risks of the Gamma Knife, proton therapy and radiation therapy businesses, the risks of developing The Operating Room for the 21st CenturySM program, and the risks of investing in Mevion. Further information on potential factors that could affect the financial condition, results of operations and future plans of the Company is included in the filings of the Company with the Securities and Exchange Commission, including the Company’s Annual Report on Form 10-K for the year ended December 31, 2016 and the definitive Proxy Statement for the Annual Meeting of Shareholders held on June 27, 2017. The Company had seventeen Gamma Knife units, one PBRT system and one IGRT unit in operation on September 30, 2017, and on September 30, 2016, respectively. Three of the Company’s customer contracts are through subsidiaries where GKF or its subsidiary is the majority owner and managing partner. Nine of the Company’s sixteen current Gamma Knife customers are under fee-per-use contracts, and seven customers are under retail arrangements. The Company, through GKF, also owns and operates a single-unit Gamma Knife facility in Lima, Peru. This unit economically functions similarly to the Company’s turn-key retail arrangements. The Company’s contracts to provide radiation therapy and related equipment services to an existing Gamma Knife customer and the Company’s PBRT system at Orlando Health, are also considered retail arrangements. Retail arrangements are further classified as either turn-key or revenue sharing. Revenue from fee-per-use contracts is determined by each hospital’s contracted rate. Revenue is recognized at the time procedures are performed, based on each hospital’s contracted rate. Under revenue sharing arrangements, the Company receives a contracted percentage of the reimbursement received by the hospital. The amount the Company expects to receive is recorded as revenue and estimated based on historical experience. Revenue estimates are reviewed periodically and adjusted as necessary. Under turn-key arrangements, the Company receives payment from the hospital in the amount of the hospital’s reimbursement from third party payors, and the Company is responsible for paying all the operating costs of the equipment. Operating costs are determined primarily based on historical treatment protocols and cost schedules with the hospital. The Company records an estimate of operating costs which are reviewed on a regular basis and adjusted as necessary to more accurately reflect the actual operating costs. For turn-key sites, the Company also shares a percentage of net operating profit. The Company records an estimate of net operating profit based on estimated revenues, less estimated operating costs. The operating costs and estimated net operating profit are recorded as other direct operating costs in the condensed consolidated statement of operations. 14 -- Effective January 1, 2017, the Centers for Medicare and Medicaid (“CMS”) established a Comprehensive Ambulatory Payment Classification for single session radiosurgery treatments. CMS has established a 2017 total reimbursement rate of approximately $9,000 ($8,800 in 2016) for a Medicare Gamma Knife treatment. The approximate CMS reimbursement rates for delivery of proton therapy for a simple treatment without compensation will be $494 ($506 in 2016) and $994 ($1,150 in 2016) for simple treatment with compensation, intermediate and complex treatments, respectively. Rental income from medical services decreased by $271,000 and increased by $832,000 to $4,613,000 and $14,472,000 for the three and nine-month periods ended September 30, 2017 from $4,884,000 and $13,640,000 for the three and nine-month periods ended September 30, 2016, respectively. The Company’s PBRT system at Orlando Health treated its first patient in April 2016. For the three and nine-month periods ended September 30, 2017, revenues generated from this system were $935,000 and $2,953,000 compared to $800,000 and $1,246,000 in the same periods prior year, respectively. The number of PBRT fractions increased 71 and 2,038 to 940 and 3,349 for the three and nine-month periods ended September 30, 2017 compared to 869 and 1,311 in the same periods prior year, respectively. The increase is due to the PBRT system ramping up volume in its second year of operations. Gamma Knife revenues decreased $369,000 and $869,000 to $3,564,000 and $11,150,000 for the three and nine-month periods ended September 30, 2017 compared to $3,933,000 and $12,019,000 in the same periods prior year, respectively. Excluding the customer site who purchased their Gamma Knife unit in April 2017 and the customer site whose contract expired August 31, 2017, Gamma Knife revenues increased $142,000 and decreased $51,000 for the three and nine-month periods ended September 30, 2017, compared to the same periods prior year, respectively. For the three-month period ended September 30, 2017, the increase was due to a favorable payor mix at the Company’s Gamma Knife retail sites. For the nine-month period ended September 30, 2017, the decrease was due to lower volumes at the Company’s existing Gamma Knife sites. The Company had two new Gamma Knife sites begin operations during the third quarter 2017. Both sites had minimal volume during the quarter and did not have a significant impact on Gamma Knife revenue for the three and nine-month periods ended September 30, 2017. The number of Gamma Knife procedures decreased by 104 and 193 to 379 and 1,253 for the three and nine-month periods ended September 30, 2017 from 483 and 1,446 in the same periods in the prior year, respectively. Excluding the customer site who purchased their Gamma Knife unit in April 2017 and the customer site whose contract expired August 31, 2017, Gamma Knife procedures increased 5 and decreased 26 for the three and nine-month periods ended September 30, 2017. The decrease for the nine-month period is due to normal, cyclical fluctuations. The Company had two new Gamma Knife sites begin operations during the third quarter 2017. Both sites had minimal volume during the quarter and did not have a significant impact on Gamma Knife volume for the three and nine-month periods ended September 30, 2017. 15 -- IGRT revenues decreased $38,000 and $6,000 to $114,000 and $369,000 for the three and nine-month periods ended September 30, 2017 from $152,000 and $375,000 in the same periods prior year, respectively. The decrease for the three and nine-month periods ended September 30, 2017 is due to lower volumes at the Company’s existing IGRT site. Total costs of revenue increased by $243,000 and $321,000 to $2,731,000 and $7,993,000 for the three and nine-month periods ended September 30, 2017 from $2,488,000 and $7,672,000 in the same periods prior year, respectively. Maintenance and supplies increased by $168,000 and $154,000 for the three and nine-month periods ended September 30, 2017, respectively, primarily due to the Mevion Service Agreement which commenced September 2017. Depreciation and amortization decreased by $13,000 and increased $102,000 for the three and nine-month periods ended September 30, 2017, respectively. The decrease for the three-month period was due to the Company’s contracts which ended in the second and third quarters of 2017, respectively, offset by depreciation expense for the Company’s two new units which began operations in same periods. The increase for the nine-month period ended September 30, 2017 is primarily due to depreciation incurred on the PBRT system and the Company’s two new units which began operations in the second and third quarters of 2017, offset by the expired contracts in the same periods. Other direct operating costs increased by $88,000 and $65,000 for the three and nine-month periods ended September 30, 2017, respectively. The increase for the three and nine-month periods ended September 30, 2017 was due to operating costs at the Company’s Gamma Knife site in Peru and operating costs for the PBRT system. Selling and administrative costs increased by $27,000 and $392,000 for the three and nine-month periods ended September 30, 2017 to $1,026,000 and $3,303,000 from $999,000 and $2,911,000 for the same periods prior year, respectively. For the three-month period ended September 30, 2017, the increase was driven by the Company’s new site in Peru. The increase for the nine-month period ended September 30, 2017 was driven by start-up costs for the Company’s new site in Peru, legal fees, consulting fees, travel costs, severance expense, and building rent. The Company moved offices on August 13, 2016. Prior to the move, the Company subleased a portion of its existing office space. The sublease income offset total rent expense over the term of the sublease, which ended in May 2016. Interest expense decreased by $84,000 and increased $95,000 to $417,000 and $1,314,000 for the three and nine-month periods ended September 30, 2017 from $501,000 and $1,219,000 for the same periods prior year, respectively. For the three-month period ended September 30, 2017 the decrease was due to a lower average principal base on the Gamma Knife debt and leases, compared to prior year, effectively reducing interest expense. The increase for the nine-month period ended September 30, 2017 was due to interest incurred on the PBRT lease financing, offset by a lower average principal base on the Gamma Knife debt and leases, compared to prior year. 16 -- The Company incurred a loss on early extinguishment of debt of $0 for the three and nine-month periods ended September 30, 2017 compared to $0 and $108,000 for the same periods prior year, respectively. In February 2016, the Company used a portion of the proceeds from the lease financing for its first MEVION S250 to pay down the $1,000,000 of Notes that were issued pursuant to the Note agreements between the Company and four members of the Company’s Board of Directors. The Notes and warrant agreements permitted for early payment without penalty to the Company. The Notes were issued with common stock warrants with an estimated fair value of $145,000. The unamortized balance of the discount on the Notes, of $80,000, and deferred fees incurred from the issuance of the Note of approximately $28,000, were recorded as a loss on early extinguishment of debt on the Company’s condensed consolidated Statement of Operations. Interest and other income (loss) decreased by $3,000 and $12,000 to $0 and a loss of $1,000 for the three and nine-month periods ended September 30, 2017 from $3,000 and $11,000 for the same periods prior year, respectively. Interest and other income (loss) is related to exchange rate transactions with the Company’s stand-alone facility in Lima, Peru. Income tax expense decreased $103,000 and increased $176,000 to $164,000 and $600,000 for the three and nine-month periods ended September 30, 2017 from $267,000 and $424,000 for the same periods prior year, respectively. For the three-month period ended September 30, 2017, the decrease was due to lower taxable income attributable to Gamma Knife operations. For the nine-month period ended September 30, 2017, the increase was due to taxable income attributable to Orlando operations. Income tax expense for the nine-month period ended September 30, 2017 was also higher, compared to the same periods prior year, because the Company’s income tax expense computation could not include the losses associated with the Company’s Gamma Knife unit in Peru for financial reporting purposes. Net income attributable to non-controlling interest decreased $122,000 and $83,000 to $176,000 and $756,000 for the three and nine-month periods ended September 30, 2017 from $298,000 and $839,000 for the same periods prior year, respectively. Non-controlling interest primarily represents the 19% interest of GK Financing owned by a third party, as well as non-controlling interests in subsidiaries of GK Financing owned by third parties that began operations in 2011. Variances in net income attributable to non-controlling interest represent the relative increase or decrease in profitability of GKF and these ventures. The Company had net income of $99,000, or $0.02 per diluted share, and net income of $505,000, or $0.09 per diluted share, for the three and nine-month periods ended September 30, 2017 compared to net income of $334,000, or $0.06 per diluted share, and net income of $478,000, or $0.09 per diluted share in the same periods prior year, respectively. Excluding the loss on early extinguishment of debt, net of estimated taxes, net income decreased $37,000 for the nine-month period ended September 30, 2017. For the three and nine-month periods ended September 30, 2017, the decrease in net income was primarily due to lower Gamma Knife volumes, following the expiration of two contracts, PBRT maintenance costs, and increased selling and administrative costs. 17 -- Liquidity and Capital Resources The Company had cash and cash equivalents of $1,665,000 at September 30, 2017 compared to $3,121,000 at December 31, 2016. The Company’s cash position decreased by $1,556,000 due to the upfront payment of $1,000,000 for the Mevion Service Agreement and payments for the purchase of property and equipment of $760,000. These decreases were offset by proceeds from the sale of equipment of $150,000 The Company has scheduled interest and principal payments under its debt obligations of approximately $2,933,000 and scheduled capital lease payments of approximately $5,942,000 during the next 12 months. The Company believes that its cash flow from cash on hand, operations, and other cash resources are adequate to meet its scheduled debt and capital lease obligations during the next 12 months. See additional discussion below related to commitments. The Company as of September 30, 2017 had shareholders’ equity of $28,188,000, working capital of $267,000 and total assets of $59,976,000. Commitments As of September 30, 2017, the Company had commitments to purchase two MEVION S250 PBRT systems for $25,800,000 and the Company had $2,000,000 in non-refundable deposits toward the purchase of these two PBRT systems from Mevion. The non-refundable deposits are recorded in the Condensed Consolidated Balance Sheets as deposits and construction in progress. On July 21, 2017, the Company signed First Amendments to two System Build Agreements (the “Amendments”) for the Company’s second and third Mevion PBRT units. The Company and Mevion have agreed on preliminary construction and delivery timetables for the second and third PBRT units for which the Company has purchase commitments. The Company’s delivery timeframe is triggered by USFDA 510K clearance of Mevion’s recently developed treatment nozzle. The Company is actively seeking sites for these units but, to date, has not entered into agreements with any party for either placement of a PBRT unit or the related financing. The Company projects that it will be required to take delivery of the second and third PBRT units no later than 2019 and 2020, respectively. As of September 30, 2017, the Company had commitments to perform two Cobtalt-60 reloads at existing Gamma Knife customer sites. Total Gamma Knife commitments as of September 30, 2017 were $1,500,000. The Cobalt-60 reloads are scheduled to occur in 2018. It is the Company’s intent to finance these reloads. There are no significant cash requirements, pending financing for the Cobalt-60 reloads in the next 12 months. There can be no assurance that financing will be available for the Company’s current or future projects, or at terms that are acceptable to the Company. 18 -- The Company estimates the following commitments for each of the equipment systems, with expected timing of payments as follows as of September 30, 2017: | 2017 | | Thereafter | | | Total ------------------+------+---+------------+---+------------+------ Proton Beam Units | $ | - | | $ | 25,800,000 | | $ | 25,800,000 ------------------+------+---+------------+---+------------+-------+---+----------- Gamma Knife Units | | - | | | 1,500,000 | | | 1,500,000 ------------------+------+---+------------+---+------------+-------+---+----------- Total Commitments | $ | - | | $ | 27,300,000 | | $ | 27,300,000 ------------------+------+---+------------+---+------------+-------+---+----------- Item 3. | Quantitative and Qualitative Disclosures about Market Risk --------+----------------------------------------------------------- The Company does not hold or issue derivative instruments for trading purposes and is not a party to any instruments with leverage or prepayment features. The Company does not have affiliation with partnerships, trusts or other entities whose purpose is to facilitate off-balance sheet financial transactions or similar arrangements , and therefore has no exposure to the financing, liquidity, market or credit risks associated with such entities. At September 30, 2017, the Company had no significant long-term, market-sensitive investments. Item 4. | Controls and Procedures --------+------------------------ Under the supervision and with the participation of our management, including our chief executive officer and our chief financial officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934. These controls and procedures are designed to ensure that material information relating to the company and its subsidiaries is communicated to the chief executive officer and the chief financial officer. Based on that evaluation, our chief executive officer and our chief financial officer concluded that, as of September 30, 2017, our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934 is accumulated and communicated to the chief executive officer and the chief financial officer, and recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Act is accumulated and communicated to the issuer’s management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. There were no changes in our internal control over financial reporting during the three months ended September 30, 2017 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. PART II - OTHER INFORMATION Item 1. | Legal Proceedings. --------+------------------- | None. --------+------------------- 19 -- Item 1A. | Risk Factors. ---------+------------------------------------------------------------------------------------------------------------------------- | There are no changes from those listed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016. ---------+------------------------------------------------------------------------------------------------------------------------- Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds. ---------+------------------------------------------------------------------------------------------------------------------------- | None. ---------+------------------------------------------------------------------------------------------------------------------------- Item 3. | Defaults Upon Senior Securities. ---------+------------------------------------------------------------------------------------------------------------------------- | None. ---------+------------------------------------------------------------------------------------------------------------------------- Item 4. | Mine Safety Disclosures ---------+------------------------------------------------------------------------------------------------------------------------- | Not applicable. ---------+------------------------------------------------------------------------------------------------------------------------- Item 5. | Other Information. ---------+------------------------------------------------------------------------------------------------------------------------- | None. ---------+------------------------------------------------------------------------------------------------------------------------- 20 -- Item 6. | Exhibit Index --------+-------------- | | | Incorporated by reference herein --------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------- Exhibit | | | | | --------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+---------+----- Number | | Description | Form | Exhibit | Date --------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+---------+----- 10.1 | # | Equipment Lease Agreement (for a Gamma Knife Unit) dated as of February 21, 2017 between Bryan Medical Center and GK Financing, LLC. | | | --------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+---------+----- 10.2 | * | Second Amendment to Lease Agreement for a Gamma Knife Unit dated as of June 30, 2006 between Yale - New Haven Ambulatory Services Corporation, Yale New Haven Hospital, Inc. a/k/a Yale - New Haven Hospital and GK Financing, LLC | | | --------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+---------+----- 31.1 | * | Certification of Chief Executive Officer pursuant to Rule 13a-14a/15d-14a, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | | | --------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+---------+----- 31.2 | * | Certification of Chief Financial Officer pursuant to Rule 13a-14a/15d-14a, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | | | --------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+---------+----- 32.1 | ǂ | Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | | | --------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+---------+----- 101.INS | * | XBRL Instance Document | | | --------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+---------+----- 101.SCH | * | XBRL Taxonomy Extension Schema Document | | | --------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+---------+----- 101.CAL | * | XBRL Taxonomy Calculation Linkbase Document | | | --------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+---------+----- 101.DEF | * | XBRL Taxonomy Definition Linkbase Document | | | --------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+---------+----- 101.LAB | * | XBRL Taxonomy Label Linkbase Document | | | --------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+---------+----- 101.PRE | * | XBRL Taxonomy Extension Presentation Linkbase Document | | | --------+---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+---------+----- * | Filed herewith. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ǂ | Furnished herewith. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- # | Confidential material appearing in this document has been omitted and filed separately with the Securities and Exchange Commission in accordance with Rule 24b-2, promulgated under the Securities and Exchange Act of 1934, as amended. Omitted information has been replaced with asterisks. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 21 -- SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. AMERICAN SHARED HOSPITAL SERVICES Registrant Date: | November 13, 2017 | /s/ Ernest A. Bates, M.D. ------+-------------------+-------------------------------------------------- | | Ernest A. Bates, M.D. ------+-------------------+-------------------------------------------------- | | Chairman of the Board and Chief Executive Officer ------+-------------------+-------------------------------------------------- Date: | November 13, 2017 | /s/ Craig K. Tagawa ------+-------------------+-------------------------------------------------- | | Craig K. Tagawa ------+-------------------+-------------------------------------------------- | | Senior Vice President ------+-------------------+-------------------------------------------------- | | Chief Operating and Financial Officer ------+-------------------+-------------------------------------------------- 22 --

AMERICATOWNE Inc.

1606699

10-Q

0001659173-17-000496

U.S. SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2017 OR [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission file number: 000-55206 AMERICATOWNE, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN CHARTER) Delaware (STATE OR OTHER JURISDICTION OF INCORPORATION OR ORGANIZATION) 000-55206 (COMMISSION FILE NO.) 46-5488722 (IRS EMPLOYEE IDENTIFICATION NO.) 4700 Homewood Court, Suite 100, Raleigh North Carolina 27609 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (888) 406 2713 (ISS-UER TELEPHONE NUMBER) Indicate by check mark whether the registrant (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No ☐ Large accelerated filer ☐ | Accelerated filer ☐ ------------------------------+-------------------------------- Non-accelerated filer ☐ | Smaller reporting company ☒ ------------------------------+-------------------------------- Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒ State the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date: 46,948,086 of common stock. -1- --- TABLE OF CONTENTS PART I | FINANCIAL INFORMATION | PAGE ------------+-----------------------------------------------------------------------------------------------------+----- Item 1. | Financial Statements | 3 ------------+-----------------------------------------------------------------------------------------------------+----- | Balance Sheet as of September 30, 2017 (Unaudited) and December 31, 2016 | 3 ------------+-----------------------------------------------------------------------------------------------------+----- | Statement of Operations for nine and three months ended September 30, 2017 and 2016 (Unaudited) | 4 ------------+-----------------------------------------------------------------------------------------------------+----- | Statement of Cash Flows for nine and three months ended September 30, 2017 and 2016 (Unaudited) | 5 ------------+-----------------------------------------------------------------------------------------------------+----- | Notes to Financial Statements (Unaudited) | 6 ------------+-----------------------------------------------------------------------------------------------------+----- Item 2. | Management's Discussion and Analysis of Financial Condition and Results of Operations | 16 ------------+-----------------------------------------------------------------------------------------------------+----- Item 3. | Quantitative and Qualitative Disclosures About Market Risk | 22 ------------+-----------------------------------------------------------------------------------------------------+----- Item 4. | Controls and Procedures | 22 ------------+-----------------------------------------------------------------------------------------------------+----- PART II | | ------------+-----------------------------------------------------------------------------------------------------+----- Item 1. | Legal Proceedings | 23 ------------+-----------------------------------------------------------------------------------------------------+----- Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | 23 ------------+-----------------------------------------------------------------------------------------------------+----- Item 3. | Defaults Upon Senior Securities | 23 ------------+-----------------------------------------------------------------------------------------------------+----- Item 4. | Mine Safety Disclosures | 23 ------------+-----------------------------------------------------------------------------------------------------+----- Item 5. | Other Information | 23 ------------+-----------------------------------------------------------------------------------------------------+----- Item 6. | Exhibits | 23 ------------+-----------------------------------------------------------------------------------------------------+----- | Signatures | 24 ------------+-----------------------------------------------------------------------------------------------------+----- -2- --- PART I - FINANCIAL INFORMATION Item 1. Financial Statements. AMERICATOWNE Inc. and Subsidiaries -------------------------------------------------------------------- Consolidated Balance Sheets -------------------------------------------------------------------- | September 30 | | December 31 ---------------------------------------------------------------------+------------------+------------+---------------- | 2017 | | 2016 ---------------------------------------------------------------------+------------------+------------+---------------- | (Unaudited) | | ---------------------------------------------------------------------+------------------+------------+---------------- ASSETS | | | | | | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Current Assets | | | | | | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Cash and cash equivalents | $ | 1,061,297 | | $ | 973,015 | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Notes receivable - related parties | | 15,000 | | | — | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Accounts receivable, net | | 657,872 | | | 610,715 | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Accounts receivable, net - related parties | | 1,998,447 | | | 687,966 | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Other receivables | | 7,903 | | | | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Other receivables - related parties | | 257,177 | | | 259,569 | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Prepayment-current | | 146,717 | | | 644 | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Total Current Assets | | 4,144,413 | | | 2,531,909 | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Prepayment-non current | | 7,035 | | | 7,675 | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Property, plant and equipment, net | | 22,152 | | | 25,861 | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Goodwill | | 393,656 | | | 393,656 | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Investments | | 3,860 | | | 3,860 | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Total Assets | $ | 4,571,116 | | $ | 2,962,961 | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- LIABILITIES AND SHAREHOLDERS' EQUITY | | | | | | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Current Liabilities | | | | | | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Accounts payable and accrued expenses | $ | 223,677 | | $ | 240,287 | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Deferred revenues-current | | 1,008,929 | | | 328,929 | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Notes payable | | — | | | — | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Other payables | | 560 | | | 5,016 | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Deposit from customers | | 1,469 | | | — | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Due to related parties | | 2,106 | | | 42,839 | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Income tax payable | | 37,776 | | | 32,198 | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Total Current Liabilities | | 1,274,517 | | | 649,269 | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Deferred revenues-non current | | 50,576 | | | 53,981 | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Total Liabilities | | 1,325,093 | | | 703,250 | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Commitments & Contingencies | | | | | | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Shareholders' Equity | | | | | | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Preferred stock, $0.0001 par value; 5,000,000 shares authorized; | | | | | | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- none issued and outstanding | | — | | | — | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Common stock, $0.0001 par value; 100,000,000 shares authorized, | | | | | | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- 48,947,267 and 26,974,775 shares issued and outstanding | | 4,895 | | | 2,697 | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Common stock subscribed | | 85 | | | 90 | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Additional paid-in capital | | 5,838,101 | | | 3,595,714 | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Deferred compensation | | (2,576,548 | ) | | (1,450,842 | ) ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Receivable for issuance of stock | | (115,493 | ) | | (65,223 | ) ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Retained Earnings | | (43,964 | ) | | 84,782 | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Noncontrolling interest | | 138,947 | | | 92,493 | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Shareholders' Equity | | 3,246,023 | | | 2,259,711 | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- Total Liabilities and Shareholders' Equity | $ | 4,571,116 | | $ | 2,962,961 | ---------------------------------------------------------------------+------------------+------------+-----------------+---+------------+-- See Notes to Consolidated Financial Statements -------------------------------------------------- -3- --- AMERICATOWNE Inc. and Subsidiaries --------------------------------------------------------------------- Consolidated Statements of Operations --------------------------------------------------------------------- (Unaudited) --------------------------------------------------------------------- | For the Three Months Ended | | For the Nine Months Ended ----------------------------------------------------------------------+--------------------------------+------------+------------------------------ | September 30, 2017 | | September 30, 2016 | September 30, 2017 | | September 30, 2016 ----------------------------------------------------------------------+--------------------------------+------------+-------------------------------+------------------------+------------+----------------------- Revenues | | | | | | | | | | | | ----------------------------------------------------------------------+--------------------------------+------------+-------------------------------+------------------------+------------+------------------------+---+------------+---+---+------------+-- Sales | $ | 166,134 | | $ | 1,135 | | $ | 228,404 | | $ | 1,002,405 | ----------------------------------------------------------------------+--------------------------------+------------+-------------------------------+------------------------+------------+------------------------+---+------------+---+---+------------+-- Services-related parties | | 591,750 | | | 50,000 | | | 1,081,992 | | | 325,000 | ----------------------------------------------------------------------+--------------------------------+------------+-------------------------------+------------------------+------------+------------------------+---+------------+---+---+------------+-- | | 757,884 | | | 51,135 | | | 1,310,396 | | | 1,327,405 | ----------------------------------------------------------------------+--------------------------------+------------+-------------------------------+------------------------+------------+------------------------+---+------------+---+---+------------+-- Cost of Revenues-Related Parties | | 35,498 | | | 162 | | | 113,076 | | | 460,066 | ----------------------------------------------------------------------+--------------------------------+------------+-------------------------------+------------------------+------------+------------------------+---+------------+---+---+------------+-- Gross Profit | | 722,386 | | | 50,973 | | | 1,197,320 | | | 867,339 | ----------------------------------------------------------------------+--------------------------------+------------+-------------------------------+------------------------+------------+------------------------+---+------------+---+---+------------+-- Operating Expenses | | | | | | | | | | | | ----------------------------------------------------------------------+--------------------------------+------------+-------------------------------+------------------------+------------+------------------------+---+------------+---+---+------------+-- General and administrative | | 466,771 | | | 258,365 | | | 1,067,843 | | | 766,964 | ----------------------------------------------------------------------+--------------------------------+------------+-------------------------------+------------------------+------------+------------------------+---+------------+---+---+------------+-- Professional fees | | 100,100 | | | 70,316 | | | 256,121 | | | 186,512 | ----------------------------------------------------------------------+--------------------------------+------------+-------------------------------+------------------------+------------+------------------------+---+------------+---+---+------------+-- Total operating expenses | | 566,871 | | | 328,681 | | | 1,323,964 | | | 953,476 | ----------------------------------------------------------------------+--------------------------------+------------+-------------------------------+------------------------+------------+------------------------+---+------------+---+---+------------+-- Income from operations | | 155,515 | | | (277,708 | ) | | (126,644 | ) | | (86,137 | ) ----------------------------------------------------------------------+--------------------------------+------------+-------------------------------+------------------------+------------+------------------------+---+------------+---+---+------------+-- Other Expenses (Income) | | (308 | ) | | 409 | | | (229 | ) | | (2,638 | ) ----------------------------------------------------------------------+--------------------------------+------------+-------------------------------+------------------------+------------+------------------------+---+------------+---+---+------------+-- Provision for income taxes | | 408 | | | (20,561 | ) | | 7,247 | | | 12,517 | ----------------------------------------------------------------------+--------------------------------+------------+-------------------------------+------------------------+------------+------------------------+---+------------+---+---+------------+-- Net Income (Loss) | | 155,415 | | | (257,556 | ) | | (133,662 | ) | | (96,016 | ) ----------------------------------------------------------------------+--------------------------------+------------+-------------------------------+------------------------+------------+------------------------+---+------------+---+---+------------+-- Less: Net income attributable to the non-controlling interest | | 7,155 | | | (4,178 | ) | | 12,653 | | | (17,516 | ) ----------------------------------------------------------------------+--------------------------------+------------+-------------------------------+------------------------+------------+------------------------+---+------------+---+---+------------+-- Net income attributable to AmericaTowne, Inc. common stockholders | $ | 162,570 | | $ | (261,734 | ) | $ | (121,009 | ) | $ | (113,532 | ) ----------------------------------------------------------------------+--------------------------------+------------+-------------------------------+------------------------+------------+------------------------+---+------------+---+---+------------+-- Earnings per share - basic and diluted | $ | 0.00 | | $ | (0.01 | ) | $ | (0.00 | ) | $ | (0.00 | ) ----------------------------------------------------------------------+--------------------------------+------------+-------------------------------+------------------------+------------+------------------------+---+------------+---+---+------------+-- Weighted average shares outstanding- basic and diluted | | 37,165,014 | | | 26,833,837 | | | 30,816,291 | | | 26,510,465 | ----------------------------------------------------------------------+--------------------------------+------------+-------------------------------+------------------------+------------+------------------------+---+------------+---+---+------------+-- See Notes to Consolidated Financial Statements. --------------------------------------------------- -4- --- AMERICATOWNE Inc. and Subsidiaries -------------------------------------------------------------------------- Consolidated Statements of Cash Flows -------------------------------------------------------------------------- (Unaudited) -------------------------------------------------------------------------- | For the Nine Months Ended ---------------------------------------------------------------------------+------------------------------ | September 30, 2017 | | September 30, 2017 ---------------------------------------------------------------------------+-------------------------------+------------+----------------------- Operating Activities: | | | | | | ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Net income (loss) | $ | (133,661 | ) | $ | (96,016 | ) ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Adjustments to reconcile net income to net cash provided by operations | | | | | | ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Depreciation | | 8,653 | | | 3,180 | ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Stock compensation | | 395,288 | | | 287,390 | ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Stock issued for services | | — | | | 875 | ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Bad debt provision | | 156,967 | | | 49,852 | ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Changes in operating assets and liabilities: | | | | | | ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Accounts receivable, net | | (1,454,517 | ) | | (1,036,780 | ) ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Other receivable | | (7,903 | ) | | — | ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Other receivable - related parties | | 4,393 | | | (44,317 | ) ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Prepayment | | (145,433 | ) | | (97,564 | ) ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Accounts payable and accrued expenses | | (79,860 | ) | | 3,92,443 | ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Deferred revenues | | 676,595 | | | (33,405 | ) ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Other payables | | (4,456 | ) | | 5,016 | ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Deposit from customers | | 1,469 | | | 530,000 | ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Due to related parties | | 61,047 | | | — | ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Income tax payable | | 5,578 | | | 35,996 | ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Net cash used in operating activities | | (515,842 | ) | | (3,330 | ) ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Investing Activities: | | | | | | ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Purchase of fixed assets | | (4,944 | ) | | (5,921 | ) ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Issuance of notes receivable | | (15,000 | ) | | | ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Acquisition of subsidiaries | | — | | | (175,000 | ) ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Net cash used in Investing activities | | (19,944 | ) | | (180,921 | ) ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Financing Activities: | | | | | | ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Proceeds from issuance of common stock | | 624,068 | | | 375,211 | ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Net cash provided by financing activities | | 624,068 | | | 375,211 | ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Increase (Decrease) in cash and cash equivalents | | 88,282 | | | 190,960 | ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Cash and cash equivalents at beginning of period | | 973,015 | | | 641,663 | ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Cash and cash equivalents at end of period | $ | 1,061,297 | | | 832,623 | ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Supplemental disclosure of cash flow information | | — | | | | ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Interest paid | $ | — | | $ | — | ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- Income taxes paid | $ | — | | $ | — | ---------------------------------------------------------------------------+-------------------------------+------------+------------------------+---+------------+-- See Notes to Consolidated Financial Statements. --------------------------------------------------- -5- --- AMERICATOWNE Inc. Notes to Consolidated Financial Statements (Unaudited) NOTE 1. ORGANIZATION AND DESCRIPTION OF BUSINESS AmericaTowne, Inc. (the “Company”) was incorporated under the laws of the State of Delaware on April 22, 2014. The Company is engaged in exporting and consulting in the exportation of American made goods, products and services to China and Africa through strategic relationships in China and in the United States, which is referred to internally by the Company as the “AmericaTowne Platform”. The Company’s forward-looking vision is to create a physical location called AmericaTowne in China that incorporates business selling the “American experience” in housing, retail, education, senior care and entertainment. On June 6, 2016, the Company purchased the majority and controlling interest in ATI Modular Technology Corp (“ATI Modular”), formerly Global Recycle Energy, Inc. through the acquisition of 100,000,000 shares (86%) of restricted common stock. The Stock Purchase and Sale Agreement dated June 2, 2016 (the “SPA”) closed on June 6, 2016 with the $175,000 payment of the purchase price to Joseph Arcaro, prior shareholder, and sole director and officer of ATI Modular. ATI Modular is engaged in the development and the exporting of modular energy efficient technology and processes that allow government and private enterprises in China to use US based methods for creating modular spaces, facilities, and properties. The Company's forward-looking vision is to create a physical location and manufacturing facility that promotes the export of US based technology, equipment, and process that focuses on building modular buildings, and structures of all types that will be used by both the public and private building and technology sectors in China. On October 3, 2016, the Company purchased the majority and controlling interest in ATI Nationwide Holding Corp (“ATI Nationwide”), formerly EXA, Inc. OTC:Pinks (EXAI) through the acquisition of 65,000,000 shares (65.5%) shares of restricted common stock. The Stock Purchase and Sale Agreement dated October 3, 2016 (the “SPA EXAI”) closed on October 10, 2016 with the $175,000 payment of the purchase price to Joseph C. Passalaqua, prior shareholder and director and officer of ATI Nationwide. -6- --- The Company intends on using this acquisition to facilitate its performance under the July 11, 2016 Master Joint Venture and Operational Agreement with Nationwide Microfinance Limited, a Ghanaian corporation, as disclosed in the Company’s July 14, 2016 Form 8-K (see exhibit table above). In both acquisitions, the Company purchased the shares with the intent to hold in its personal account on a restricted basis absent registration or qualification under an exemption to registration. The Stock Purchase Agreements were privately negotiated between the parties without facilitation through brokers or promotors, or third-parties, except legal counsel, and were approved by the Company’s Board of Directors as being in the best interests of the Company. The source of funds was working capital from the Company. There is no material relationship between the Company and any of the parties under the Stock Purchase Agreements. As with any business plan that is aspirational in nature, there is no assurance we will be able to accomplish all our objective or that we will be able to meet our financing needs to accomplish our objectives. NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation These financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America ("U.S. GAAP"). Principles of Consolidation The consolidated financial statements include the accounts of the Company and all its majority-owned subsidiaries which require consolidation. Inter-company transactions have been eliminated in consolidation. Interim Financial Statements These interim unaudited financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information. They do not include all of the information and footnotes required by generally accepted accounting principles for complete consolidated financial statements. Therefore, these consolidated financial statements should be read in conjunction with the Company's audited financial statements and notes thereto contained in its report on Form 10-K for the years ended December 31, 2016 The consolidated financial statements included herein are unaudited; however, they contain all normal recurring accruals and adjustments that, in the opinion of management, are necessary to present fairly the Company's financial position at September 30, 2017, and the results of its operations and cash flows for the nine months ended September 30, 2017. The results of operations for the period ended September 30, 2017 are not necessarily indicative of the results to be expected for future quarters or the full year. Accounting Method The Company's financial statements are prepared using the accrual method of accounting. The Company has elected a fiscal year ending on December 31. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. In the opinion of management, all adjustments necessary in order to make the financial statements not misleading have been included. Actual results could differ from those estimates. -7- --- Financial Instruments The carrying amount reported in the balance sheet for cash, accounts receivable, accounts payable, accrued expenses, interest payable and short-term notes payable approximate fair value because of the immediate or short-term maturity of these financial instruments. Cash Equivalents The Company considers all highly liquid investments with maturity of three months or less when purchased to be cash equivalents. Concentration of Credit Risk Financial instruments that potentially subject the Company to a significant concentration of credit risk consist primarily of cash and cash equivalents. The Company maintains deposits in federally insured financial institutions in excess of federally insured limits. However, management believes the Company is not exposed to significant credit risk due to the financial position of the depository institutions in which those deposits are held. Property, Plant, and Equipment Property, plant and equipment are initially recognized recorded at cost. Gains or losses on disposals are reflected as gain or loss in the period of disposal. The cost of improvements that extend the life of plant and equipment are capitalized. These capitalized costs may include structural improvements, equipment and fixtures. All ordinary repairs and maintenance costs are expensed as incurred. Depreciation for financial reporting purposes is provided using the straight-line method over the estimated useful lives of the assets: Office equipment | 5 years ---------------------+------------ For the nine months ended September 30, 2017 and 2016, depreciation expense is $8,653 and $3,180, respectively. Investments Investments primarily include cost method investments. On September 30, 2017 and December 31, 2016, the carrying amount of investments was $3,860 and $3,860, respectively. There are no identified events or changes in circumstances that may have a significant adverse effect on fair value of the investment as of September 30, 2017. Income Taxes Income taxes are provided in accordance with Statement of Financial Accounting Standards ASC 740 Accounting for Income Taxes. A deferred tax asset or liability is recorded for all temporary differences between financial and tax reporting and net operating loss carry forwards. Deferred tax expense (benefit) results from the net change during the year of deferred tax assets and liabilities. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion of all of the deferred tax assets will be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. -8- --- The Company was established under the laws of the State of Delaware and is subject to U.S. federal income tax and Delaware state income tax. Deferred income tax assets and liabilities are computed for differences between the financial statement and tax bases of assets and liabilities that will result in future taxable or deductible amounts and are based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred income tax assets to the amount expected to be realized. On September 30, 2017 and December 31, 2016, there are no deferred tax assets and liabilities. The Company had $37,776 and $32,198 of income tax liability as of September 30, 2017 and December 31, 2016, respectively. Earnings per Share In February 1997, the FASB issued ASC 260, "Earnings per Share", which specifies the computation, presentation and disclosure requirements for earnings (loss) per share for entities with publicly held common stock. ASC 260 supersedes the provisions of APB No. 15, and requires the presentation of basic earnings (loss) per share and diluted earnings (loss) per share. The Company has adopted the provisions of ASC 260 effective (inception). Basic earnings (loss) per common share is computed by dividing net income (loss) available to common shareholders by the weighted-average number of shares of common stock outstanding during the period. Diluted earnings per common share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the period increased to include the number of additional shares of common stock that would have been outstanding if potentially dilutive securities had been issued. There were no potentially dilutive securities outstanding during the periods presented. For the nine months ended September 30, 2017 and 2016, diluted earnings per share are the same as basic earnings per share due to the lack of dilutive items in the Company. Segment Information The standard, "Disclosures about Segments of an Enterprise and Related Information", codified with ASC 280, requires certain financial and supplementary information to be disclosed on an annual and interim basis for each reportable segment of an enterprise. The Company believes that it operates in business segment of marketing and sales in China while the Company's general administration function is performed in the United States. On September 30, 2017, all assets and liabilities are in the United States where the income and expense has been incurred since inception to September 30, 2017. Impact of New Accounting Standards The Company does not expect the adoption of recently issued accounting pronouncements to have a significant impact on the Company's results of operations, financial position, or cash flow. Pushdown Accounting and Goodwill Pursuant to applicable rules (FASB ASC 805-50-S99) the Company used push down accounting to reflect Yilaime Corporation's purchase of 100% of the shares of the Company's common stock. Richard Chiang, the Company's prior sole shareholder entered into an agreement to sell an aggregate of 10,000,000 shares of the Company's common stock to Yilaime Corporation effective upon the closing date of the Share Purchase Agreement dated June 26, 2014. Richard Chiang executed the agreement and owned no shares of the Company's common stock. This transaction resulted in Yilaime Corporation retaining rights, title and interest to all issued and outstanding shares of common stock in the Company. -9- --- Purchased goodwill from acquisitions is $178,325 and $175,000 for acquiring ATI Modular and ATI Nationwide, respectively in 2016, none of which is deductible for tax purposes. Revenue Recognition The Company's revenue recognition policies comply with FASB ASC Topic 605. Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the price is fixed or determinable, collectability is reasonably assured, and there are no significant subsequent obligations for the Company to assume. Prior to an agreement, the Company assesses whether collectability from the potential customer is reasonably assured. The Company reviews the customer's financial condition, which is an indicator of both its ability to pay, and, in turn, whether or not revenue is realizable. The ability to pay is an important criterion for entrance into an agreement with the customer. If management believes that the potential customer does not have the ability to pay, normally an agreement is not entered into with the customer. If, at the outset an arrangement is entered into and the Company determines that the collectability of the revenue amount from the customer is questionable, management would not recognize revenue until it receives the amount due or conditions change so that collectability is reasonably assured. If collectability is reasonably assured at the outset of an arrangement, but subsequent changes in facts and circumstances indicate collection from the customer is no longer probable, the amount is recorded as bad debt expense. There are two primary customer agreements currently offered to the Company's customers - (a) Licensing, Lease and Use Agreement ("Licensing Agreement"), and (b) Exporter Services Agreement ("Exporter Agreement"). (a) Licensing, Lease and Use Agreement For the License, Lease and Use Agreement, the Company reflects revenue recognition over the course of the term. (b) Exporter Services Agreement. For services provided in the Exporter Service Agreement, the Company has two primary types of services called the Service Fee and Transaction Fee. Additionally, under certain circumstances, the Company may charge an Extension Fee. The customer under the Exporter Services Agreement is defined in this section as the "Exporter." The Service Fee Upon signing the Exporters Agreement, the Exporter is provided with services consisting of eight related components including: 1) market analysis; 2) review of proposed goods and services; 3) expectations for supply and demand in the market; 4) conducting export business in China; 5) information on financing; 6) information on the export tax savings programs; 7) international trade center assistance; and 8) selecting and assigning a tax saving company. All eight components of the Service Fee are delivered as one deliverable upon the signing or shortly thereafter of the Exporter Service Agreement with the exporter. The Company completes the earnings process upon the signing the Exporter Service Agreement since the one service fee deliverable has been delivered and we have no further obligations. Revenue is not recognized until the completion of these eight components and the Company has no further obligations. -10- ---- The Transaction Fee During this process, the Exporter's goods and services are tested in the market, buyers or identified, deals or negotiated and the exporter products and services are delivered, and payment is made. The Transaction Fee is normally a percentage of each transaction. The Transaction Fee process includes the Exporter's participation in three programs: 1) the Sample and Test Market Program; 2) Market Acceptance Program; and 3) Export Delivery Action. In the Sample and Test Market Program, an Exporter's products and services are tested in the market; sources of goods and services are confirmed; price indications are confirmed; and an Exporter and buyer match occurs. In the Market Acceptance Program, the export deal is identified and negotiated. Finally, in the Export Delivery Action, the goods are shipped and delivered and payment is made. The Company does not recognize revenue until completion of these three programs and the Company has no further obligations. Throughout the life of the Exporter Agreement, the Company expects Exporters to complete multiple transactions. Each transaction is a separate and independent process. The Extension Fee The Extension Fee is an independent accounting unit. The Extension Fee is a fee charged to those Exporters who in rare cases for whatever reason fail to avail themselves of the Transaction Process. The Exporter has one-year to participate in the Sample and Test Market Program. Afterwards, provided no transaction has occurred and the Exporter agrees to pay a fee equal to 25% of the original Service fee within thirty (30) days (the "Extension Fee"), the Exporter may continue the Transaction Process. If the Extension Fee is not paid, the Exporter's participation and membership in the Sample and Test Program terminates. In the event of termination, the balance of any prior fees is still due and payable. Provided that the Exporter agrees to pay the Extension Fee and continues with the Transaction Process, at the end of the Transaction Process and the last Transaction Fee deliverable is made, the Transaction Fee Process is completed. Upon completion, the Company has no further obligations, revenue is recognized, and the Exporter is invoiced for both the Extension Fee and the Transaction Fee. After the Exporter pays the Extension Fee, if no transaction has occurred for sixty (60) calendars days, the Company is exempt from any obligation to provide further Transaction Process services and it recognizes revenue of the Extension Fee. The Company recognizes revenue on a gross basis. We have gross presentation for services provided by Yilaime, a contractor to the Company prior to the consummation of an arrangement. In accordance with ASC605-45-45, the gross basis to recognize revenue applies since the Company is the primary obligor in the arrangement. The Company expects to realize revenue for export funding and support, and franchise and license fees for United States support locations, and education initiatives. Additionally, if and when the Company further develops AmericaTowne, revenues would be expected to be recognized for (a) villa sales, rentals, timeshare and leasing; (b) hotel leasing and or operational revenues and sales; (c) theme park and performing art center operations, sales and/or leasing; and (d) senior care facilities, operations and or sales. The Company does not provide unconditional right of return, price protection or any other concessions to its customers. -11- ---- There were no sales returns and allowances from inception to September 30, 2017. Valuation of Goodwill We assess goodwill for potential impairments at the end of each fiscal year, or during the year if an event or other circumstance indicates that we may not be able to recover the carrying amount of the asset. In evaluating goodwill for impairment, we first assess qualitative factors to determine whether it is more likely than not (that is, a likelihood of more than 50 percent) that the fair value of a reporting unit is less than its carrying amount. If we conclude that it is not more likely than not that the fair value of a reporting unit is less than its carrying value, then no further testing of the goodwill assigned to the reporting unit is required. However, if we conclude that it is more likely than not that the fair value of a reporting unit is less than its carrying value, then we perform a two-step goodwill impairment test to identify potential goodwill impairment and measure the amount of goodwill impairment to be recognized, if any. In the first step of the review process, we compare the estimated fair value of the reporting unit with its carrying value. If the estimated fair value of the reporting unit exceeds its carrying amount, no further analysis is needed. If the estimated fair value of the reporting unit is less than its carrying amount, we proceed to the second step of the review process to calculate the implied fair value of the reporting unit goodwill in order to determine whether any impairment is required. We calculate the implied fair value of the reporting unit goodwill by allocating the estimated fair value of the reporting unit to all of the assets and liabilities of the reporting unit as if the reporting unit had been acquired in a business combination. If the carrying value of the reporting unit's goodwill exceeds the implied fair value of the goodwill, we recognize an impairment loss for that excess amount. In allocating the estimated fair value of the reporting unit to all of the assets and liabilities of the reporting unit, we use industry and market data, as well as knowledge of the industry and our past experiences. We base our calculation of the estimated fair value of a reporting unit on the income approach. For the income approach, we use internally developed discounted cash flow models that include, among others, the following assumptions: projections of revenues and expenses and related cash flows based on assumed long-term growth rates and demand trends; expected future investments to grow new units; and estimated discount rates. We base these assumptions on our historical data and experience, third-party appraisals, industry projections, micro and macro general economic condition projections, and our expectations. We have had no goodwill impairment charges for the nine months ended September 30, 2017. The estimated fair value of each of our reporting units exceeded its' respective carrying amount by more than 100 percent based on our models and assumptions. NOTE 3. NOTES RECEIVABLE – RELATED PARTIES On July 12, 2017, the Company issued $15,000 secured promissory note to a shareholder with annual 6% interest rate. The note is due on October 30, 2017. The interest rate is 9% after the due date. The note is secured by the personal guarantee of the borrower and the borrower’s stock of the Company. NOTE 4. ACCOUNTS RECEIVABLE The nature of the net accounts receivable for September 30, 2017, in the amount of $3,030,636 are for Export Service Agreements. The Company's allowance for bad debt is $374,317 which provides a net receivable balance of $2,656,319 Accounts' receivable is stated at the amount management expects to collect from outstanding balances. Management provides for probable uncollected amounts through a charge to earnings and a credit to an allowance for bad debts based on its assessment of the current status of individual accounts. Balances that are still outstanding after management has used reasonable collection efforts are written off through a charge to the allowance for bad debts and a credit to accounts receivable. Accounts receivable consist of the following: | September 30 | | December 31 ------------------------------------------+-------------------+-----------+---------------- | 2017 | | 2016 ------------------------------------------+-------------------+-----------+---------------- Accounts receivable | $ | 916,335 | | $ | 1,215,377 | ------------------------------------------+-------------------+-----------+-----------------+---+-----------+-- Accounts receivable- related parties | | 2,114,301 | | | 304,525 | ------------------------------------------+-------------------+-----------+-----------------+---+-----------+-- Less: Allowance for doubtful accounts | | (374,317 | ) | | (221,221 | ) ------------------------------------------+-------------------+-----------+-----------------+---+-----------+-- Accounts receivable, net | $ | 2,656,319 | | $ | 1,298,681 | ------------------------------------------+-------------------+-----------+-----------------+---+-----------+-- Bad debt expense was $156,967 and $49,852 for the nine months ended September 30, 2017 and 2016, respectively. -12- ---- Allowance for bad debt policy Our bad debt policy is determined by the Company's periodic review of each account receivable for reasonable assurance of collection. Factors considered are the exporter's financial condition, past payment history if any, any conversations with the exporter about the exporter's financial conditions and any other extenuating circumstances. Based upon the above factors the Company makes a determination whether the receivable are reasonable assured of collection. Based upon our review if required we adjust the allowance for bad debt. NOTE 5. SHAREHOLDER'S EQUITY The Company incorporates by reference all prior disclosures for the period identified herein. See Part II, Item 6. The stockholders' equity section of the Company contains the following classes of capital stock as of September 30, 2017: Common stock, $ 0.0001 par value: 100,000,000 shares authorized; 48,947,267 shares issued and outstanding Preferred stock, $ 0.0001 par value: 5,000,000 shares authorized; but not issued and outstanding. NOTE 6. DEFFERED REVENUE ATI Modular receives $250,000 quarterly fee from Yilaime for Sales and Support Services Agreement. In accordance with ASC 605-50-45, the Company defers and recognizes as a reduction to the future costs for quarterly fee. For the nine months September 30, 2017, $750,000 fee from exclusive agreement incurred; $1,004,387 is booked deferred revenue as current liability on September 30, 2017 and $70,000 went against cost charged by Yilaime. NOTE 7. STOCK BASED COMPENSATION For the nine months ended September 30, 2017 and 2016, $395,288 and $287,390 of stock compensation were charged to operating expenses, respectively. $2,576,548 and $1,450,842 were recorded as deferred compensation on September 30, 2017 and December 31, 2016, respectively. ATI Modular entered into an employment lock-up agreement on July 1, 2016 with Alton Perkins to serve as the Chairman of the Board, President, Chief Executive Officer, Chief Financial Officer and Secretary. The term of Mr. Perkins' agreement is five years with ATI Modular retaining an option to extend in one-year periods. In consideration for Mr. Perkins' services, ATI Modular has agreed to issue to his designee, the Alton & Xiang Mei Lin Perkins Family Trust, 10,000,000 shares of common stock. ATI Modular may elect in the future to include money compensation to Mr. Perkins or his designee for his services provided there is sufficient cash flow. On June 20, 2017, the Company signed the “First Amendment Employment Agreement with Alton Perkins amending the original Employment Agreement dated November 21, 2014. The new Agreement lifts up any lock-up provisions related to shares issued to Alton Perkins or its designee. In addition, in accordance with the new Agreement, the Company issued Alton Perkins additional 10,000,000 shares of restricted common stock and extend his employment until June 19, 2022. On September 11, 2017, the Company signed the “Second Amendment Employment Agreement with Alton Perkins amending the original Employment Agreement dated November 21, 2014, as amended on June 20, 2017. Mr. Perkins agreed to serve as the Chairman and Chief Executive of AmericaTowne Holdings, Inc. as well as continue to serve for five years through September 11, 2022, in the same capacity for AmericaTowne, Inc., ATI Modular Technology Corp, and its subsidiary Anhui Ao De Xin Modular New Building Material Co., Ltd. In accordance with the new amended Agreement, the Company issued Alton Perkins and or his designee 8,831,145 shares of restricted common stock. -13- ---- NOTE 8. RELATED PARTY TRANSACTIONS Yilaime Corporation, a Nevada corporation ("Yilaime") and Yilaime Corporation of NC ("Yilaime NC") are related parties to the Company. Yilaime is a "Control Party" to AmericaTowne because it has title to greater than 50% of the issued and outstanding shares of common stock in the Company. Alton Perkins is the majority shareholder and controlling principal of Yilaime, Yilaime NC, Perkins DISC and the Company. Additionally, for those “trade centers” set forth below, Mr. Perkins directs all major activities and operating policies of each entity. The common control may result in operating results or a financial position significantly different from that, which would have been obtained if the enterprises were autonomous. Further, pursuant to ASC 850-10-50-6 the Company lists and provides details for all material Related Party transactions so that readers of the financial statements can better assess and predict the possible impact on performance. Nature of Related Parties' Relationship On October 8, 2014, the Company entered into the Stock Exchange Agreement with Yilaime NC. Pursuant to the terms of the Stock Exchange Agreement, in consideration for the issuance of 3,616,059 shares of common stock in the Company to Yilaime NC, Yilaime NC conveyed 10,848,178 shares of its restricted common stock to the Company. The intent of the parties in executing and performing under the Stock Exchange Agreement is to effectuate tax-free reorganization under Section 368 of the Internal Revenue Code of 1986. The Company issued the 3,616,059 shares of common stock to Yilaime NC on May 14, 2015. As result of receiving 10,848,178 shares of issued and outstanding common stock in Yilaime (4.5% of issued and outstanding), the Company recorded a $3,860 investment in use of Cost Method. The Company authorized Yilaime NC to transfer 3,616,059 of these shares pursuant to the Company's effective registration statement on Form S-1/A on November 5, 2015. The Company entered into a Service Provider Agreement with Yilaime on October 27, 2014 (the "Service Agreement") wherein certain "Export Funding and Support Services" and "Occupancy Services," as defined therein, are provided to the Company in consideration for a fee. In addition to these fees, Yilaime has to pay an Operations Fee to the Company for exclusive rights. Mr. Perkins is the Chief Executive Officer of the Company and is the majority shareholder and controlling person of Yilaime. The Company also leased office space from Yilaime NC for $3,516 per month. On June 27, 2016, ATI Modular entered into a Sales and Support Services Agreement with Yilaime. Under the Services Agreement, Yilaime will provide ATI Modular with marketing, sales and support services in the ATI Modular’s pursuit of ATI Modular business in China in consideration of a commission equal to 10% of the gross amount of monies procured for ATI Modular through Yilaime’s services. In consideration of the right to receive this commission, Yilaime has agreed to pay ATI Modular a quarterly fee of $250,000 starting on July 1, 2016. The Services Agreement is set to expire on June 10, 2020, absent early termination for breach thereof by either party. Yilaime retains an option to extend the term under its sole discretion until June 10, 2025 by providing written notice to ATI Modular by March 10, 2019. Yilaime has agreed to be ATI Modular’s exclusive independent contractor in providing the services in the Services Agreement, and has agreed to a non-compete and non-circumvent agreement. Yilaime is obligated to provide support services only in a manner that is deemed commercially acceptable by Yilaime and Yilaime has the sole right to determine the means, manner and method by which services will be provided and at the time and location of its choosing. Furthermore, as the control person of Yilaime, Mr. Perkins might make decisions he deems are in the best interests of Yilaime, which might be to the detriment of the goals and objectives of ATI Modular. -14- ---- Pursuant to ASC 850-10-50-6, the Company makes the following transaction disclosures for nine months ending September 30, Consolidated Operating Statement Related Party Transactions (for nine months ending September 30, 2017 and 2016). (a) $150,000 and $150,000 in revenues for Yilaime's exclusive agreement with the Company; (b) $901,750 and $175,000 in Trade Center Service Agreement Revenue; (c) $30,242 and $0 in commission revenue with Nationwide Microfinance Limited; (d) $112,916 and $117,062 in costs of revenues to Yilaime for services pursuant to the Service Agreement; (e) $555,871 and $463,000 for general and administrative expenses for commissions and fees. (f) For the nine months ended, September 30, 2017, $31,947 for general and administrative expenses for rent expenses the Company paid to Yilaime towards its lease agreement; For the nine months ended, September 30, 2017, $22,500 for general and administrative expenses for rent expenses ATI Modular paid to Yilaime towards its lease agreement. For the nine months ended, September 30, 2017, $22,500 for general and administrative expenses for rent expenses ATI Nationwide paid to Yilaime towards its lease agreement. For the nine months ended, September 30, 2016, $22,665 for general and administrative expenses for rent expenses the Company paid to Yilaime towards its lease agreement; $7,500 for general and administrative expenses for rent expenses ATI Modular paid to Yilaime towards its lease agreement. (g) $395,288 and $287,390 for general and administrative operating expenses recorded as stock compensation for respective employment agreements. Consolidated Balance Sheet Related Party Transactions (on September 30, 2017 and December 31, 2016) (a) $15,000 and $0 notes receivable to a shareholder; (b) $932,811 and $405,817 net account receivables Yilaime owes to the Company; (c) $115,459 and $42,839 due to Yilaime; (d) $1,065,636 and $282,149 Trade Center receivables owed to the Company; (e) On September 30, 2017, other receivables include $208,180 owed by Perkins Hsu Export Corporation and $14,677 purchase mining equipment and advances for Yilaime Nairobi Ltd On December 31, 2016, other receivables include $69,120 owed by Yilaime $175,772 owed by Perkins Hsu Export Corporation and $14,677 purchase mining equipment and advances for Yilaime Nairobi Ltd; -15- ---- Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. Special Note Regarding Forward-Looking Statements Information included or incorporated by reference in this Quarterly Report on Form 10-Q contains forward-looking statements. All forward-looking statements are inherently uncertain as they are based on current expectations and assumptions concerning future events or future performance of the Company. Readers are cautioned not to place undue reliance on these forward-looking statements, which are only predictions and speak only as of the date hereof. Forward-looking statements may contain the words “believes,” “project,” “expects,” “anticipates,” “estimates,” “forecasts,” “intends,” “strategy,” “plan,” “may,” “will,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions, and are subject to numerous known and unknown risks and uncertainties. Additionally, statements relating to implementation of business strategy, future financial performance, acquisition strategies, capital raising transactions, performance of contractual obligations, and similar statements may contain forward-looking statements. In evaluating such statements, prospective investors and shareholders should carefully review various risks and uncertainties identified in this Report, including the matters set forth under the captions “Risk Factors” and in the Company’s other SEC filings. These risks and uncertainties could cause the Company’s actual results to differ materially from those indicated in the forward-looking statements. The Company disclaims any obligation to update or publicly announce revisions to any forward-looking statements to reflect future events or developments. Although forward-looking statements in this Form 10-Q reflect the good faith judgment of our management, such statements can only be based on facts and factors currently known by us. Consequently, forward-looking statements are inherently subject to risks and uncertainties, and actual results and outcomes may differ materially from the results and outcomes discussed in or anticipated by the forward-looking statements. Factors that could cause or contribute to such differences in results and outcomes include, without limitation, those specifically addressed under the heading “Risk Factors Related to Our Business” below, as well as those discussed elsewhere in this Form 10-Q. Readers are urged not to place undue reliance on these forward-looking statements, which speak only as of the date of this Form 10-Q. We file reports with the Securities and Exchange Commission (“SEC”). You can read and copy any materials we file with the SEC at the SEC’s Public Reference Room, 100 F. Street, NE, Washington, D.C. 20549. You can obtain additional information about the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains an Internet site (www.sec.gov) that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC, including us. We disclaim any obligation to revise or update any forward-looking statements in order to reflect any event or circumstance that may arise after the date of this Quarterly Report on Form 10-Q. Readers are urged to carefully review and consider the various disclosures made throughout the entirety of this Quarterly Report and the Company’s Annual Report on Form 10-K, which attempt to advise interested parties of the risks and factors that may affect our business, financial condition, results of operations and prospects. -16- ---- General Description of Business For a general overview of business operations, the Company hereby incorporates by reference the disclosures and narrative recently provided in its Annual Report on Form 10-K. We plan to raise capital following our recent change in status to an operating entity through the offering of shares of common stock or preferred stock to investors. We anticipate we will need to pursue capital to fund our operations over the next twelve months. We believe we will be able to raise the necessary capital to carry out our business plan, but there is no assurance that we will be able to do so. We plan to earn revenues and income, and generate cash, by focusing on our four core business operations and initiatives, as set forth above. At this point, the Company's revenue is generated from our Service Provider and Exporter Service Agreements. We generate revenues and cash by servicing these agreements. We work with exporters carefully and focus on our accounts receivable as part of managing our projected tight liquidity position. Additionally, we work with exporters closely in developing export strategies for the goods and services they planned to export. At present, the bulk of our operations take place at our Raleigh, North Carolina office, which acts as a model for plans for our United States Trade Center operations. We are in the process of outfitting our operations in Meishan and possibly other locations in China. We have hired two full-time managers to operate the facilities located at Meishan and other locations in China. -17- ---- Our short-term operational objectives are to develop our exporter pipeline, grow revenues and increase operations and facilities in the United States while bringing our facilities online in Chizhou, China. Our focus currently is on enhancing our exporter base, including working with state export agencies to identify exporters as well as sources of goods and services made in the United States that are in demand in China. Along with increasing our United States operations, we are hoping to identify additional key staff in the United States and China that can help us implement our plan. While we feel optimistic about meeting the challenges as well as the opportunities before us, there is no assurance that we will be able to meet the challenges or take advantage of opportunities we perceive are available. To achieve its long-term objectives, the Company intends on shifting its revenue stream from a United Stated-based to a China-based stream by fully operating all planned activities at the planned locations and other trade centers, and activities within our AmericaTowne complexes and Chinese-based internet sites. Each of the Company's four core initiatives presents challenges, risks, and opportunities. We believe that we see positive trends in the export area. Additionally, the Company plans to pursue opportunities in export not often thought of as an "exported commodity. Along with our planned core AmericaTowne communities, trade centers in the United States and China, and Internet operations, the Company plans on pursuing opportunities that are traditionally not thought of as an export commodity. While we are developing our core export businesses we will seek too diverse by acquiring and or partnering with other businesses that we expect to provide sustained long term growth. There is no assurance we will be able to pursue these opportunities successfully. Additionally, our short and long-term liquidity position is impacted by the success we achieve in implementing our plans. We do plan on pursuing the full range of available funding opportunities. Additionally, we expect to help those in our exporting program with funding opportunities and various programs that may be available to them in the private community, and at the state and national level within the United States. Additionally, going forward we expect to take advantage of the various export tax laws that will help our cash flow position as well as assist our exporters with their growth. There is no assurance that our plans will be successful. There will be cost to bring all of the planned facilities online in China, including the costs involved with the Trade Center in Meishan and other locations in China. While we do have a plan to cover these costs, there can be no assurance that our plan will be successful. While we have discussed the possibility of outside investments in various forms, there are no agreements in place or any assurance that they will be realized in the future. The uncertainty of implementing our business plan in China and the various laws and policies in China and how they may impact our Company going forward is real. There is no assurance that we will be able to navigate the laws and policies at the national or local level that will allow us to achieve objectives outlined in our business plan. Though our results of operations thus far have been effective, there can be no assurance that we will obtain the same results going forward. We can make no assurances that we will find commercial success in any of our products. We also rely upon the Service Agreement with Yilaime NC, November 11, 2014 Form 8K, under Item 15(a)(3) 10.8, for revenues. We are a new company and thus have very limited experience in sales expectations and forecasting. We also have not fully discovered any seasonality to our business as we began operations for the first quarter of 2016. We intend on relying on Yilaime for operational support. If we cannot achieve independent commercial success, we may need to continue to rely on Yilaime for support. If Yilaime at any time decides to alter or change materially our arrangement, we could experience a material adverse effect on the Company. Emerging Growth Company We qualify as an “emerging growth company” under the JOBS Act. As a result, we are permitted to, and intend to, rely on exemptions from certain disclosure requirements. For so long as we are an emerging growth company, we will not be required to: have an auditor report on our internal controls over financial reporting pursuant to Section 404(b) of the Sarbanes-Oxley Act; comply with any requirement that may be adopted by the Public Company Accounting Oversight Board regarding mandatory audit firm rotation or a supplement to the auditor's report providing additional information about the audit and the financial statements (i.e., an auditor discussion and analysis); submit certain executive compensation matters to shareholder advisory votes, such as "say-on-pay" and "say-on-frequency;" and disclose certain executive compensation related items such as the correlation between executive compensation and performance and comparisons of the CEO's compensation to median employee compensation. -18- ---- In addition, Section 107 of the JOBS Act also provides that an emerging growth company can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. In other words, an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have elected to take advantage of the benefits of this extended transition period. Our financial statements may therefore not be comparable to those of companies that comply with such new or revised accounting standards. We will remain an “emerging growth company” for up to five (5) years, or until the earliest of (i) the last day of the first fiscal year in which our total annual gross revenues exceed $1 billion, (ii) the date that we become a "large accelerated filer" as defined in Rule 12b-2 under the Securities Exchange Act of 1934, which would occur if the market value of our ordinary shares that is held by non-affiliates exceeds $700 million as of the last business day of our most recently completed second fiscal quarter or (iii) the date on which we have issued more than $1 billion in non-convertible debt during the preceding three year period. As an emerging growth company, the company is exempt from Section 14A and B of the Securities Exchange Act of 1934 which require the shareholder approval of executive compensation and golden parachutes. The Company is an Emerging Growth Company under the JOBS Act of 2012, but the Company has irrevocably opted out of the extended transition period for complying with new or revised accounting standards pursuant to Section 107(B) of the JOBS Act. Results of Operations for the Nine Months Ended September 30, 2017 and 2016 The following table sets forth the summary income statement for the nine month period ended September 30, 2017 and 2016: | Nine Months Ended -------------------------------------+----------------------- | September 30, 2017 | | September 30, 2016 -------------------------------------+------------------------+-----------+----------------------- Revenue | $ | 1,310,39 | | $ | 1,327,405 -------------------------------------+------------------------+-----------+------------------------+---+---------- Cost of Revenues-Related Parties | $ | 113,076 | | $ | 460,066 -------------------------------------+------------------------+-----------+------------------------+---+---------- Operating Expense | $ | 1,323,964 | | $ | 953,476 -------------------------------------+------------------------+-----------+------------------------+---+---------- Net Income (Loss) | $ | (133,662) | | $ | (96,016) -------------------------------------+------------------------+-----------+------------------------+---+---------- Revenues For the nine months ended September 30, 2017, the Company had revenues of $1,310,396, of which $1,081,992 were related party sales which included $901,750 in Trade Center agreements. Additionally, the Company had sales of $225,000 in Export Service Agreements -19- ---- Operating Expenses Our expenses for the nine months ended September 30, 2017 and 2016 are outlined in the table below: | Nine Months Ended -------------------------------+----------------------- | September 30, 2017 | | September 30, 2016 -------------------------------+------------------------+-----------+----------------------- General and Administrative | $ | 1,067,843 | | $ | 766,964 -------------------------------+------------------------+-----------+------------------------+---+-------- Professional Fees | $ | 256,121 | | $ | 186,512 -------------------------------+------------------------+-----------+------------------------+---+-------- Total Operating Expenses | $ | 1,323,964 | | $ | 953,476 -------------------------------+------------------------+-----------+------------------------+---+-------- Our operating expenses are largely attributable to commissions and professional fees related to our reporting requirements as a public company and implementation of our business plan. Compared to the same period in 2016, the increase of operating expenses in 2017 is due to higher commissions. Net Loss As a result of our operations, the Company reported net loss of $133,662 for the nine months ended September 30, 2017. Liquidity and Capital Resources Working Capital | September 30, 2017 | | December 31, 2016 ------------------------+------------------------+-----------+---------------------- Current Assets | $ | 4,144,413 | | $ | 2,531,909 ------------------------+------------------------+-----------+-----------------------+---+---------- Current Liabilities | $ | 1,274,517 | | $ | 649,269 ------------------------+------------------------+-----------+-----------------------+---+---------- Working Capital | $ | 2,869,896 | | $ | 1,882,640 ------------------------+------------------------+-----------+-----------------------+---+---------- Cash Flow | Nine Months Ended ----------------------------------------------+----------------------- | September 30, 2017 | | September 30, 2016 ----------------------------------------------+------------------------+---------+----------------------- Net Cash Used in Operating Activities | $ | 515,842 | | $ | 3,330 ----------------------------------------------+------------------------+---------+------------------------+---+-------- Net Cash Used in Investing Activities | $ | 19,944 | | $ | 180,921 ----------------------------------------------+------------------------+---------+------------------------+---+-------- Net Cash Provided by Financing Activities | $ | 624,068 | | $ | 375,211 ----------------------------------------------+------------------------+---------+------------------------+---+-------- Increase in Cash and Cash Equivalents | $ | 88,282 | | $ | 190,960 ----------------------------------------------+------------------------+---------+------------------------+---+-------- Cash Used in Operating Activities Higher net cash used in operating activities for the nine months ended September 30, 2017 is due to higher net loss and increase in accounts receivable. Cash Used in Investing Activities We spent $4,944 and $5,921 on fixed assets for nine months ended September 30, 2017 and 2016, respectively. In addition, we spent $15,000 in issuance of notes receivable for the nine months ended September 30, 2016. -20- ---- Cash Provided by Financing Activities We received proceeds of $624,068 and $375,211 from issuing common stock for the nine months ended September 30, 2017 and 2016, respectively. Off-Balance Sheet Arrangements We have not entered into any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. Critical Accounting Policies Our financial statements and related public financial information are based on the application of accounting principles generally accepted in the United States ("US GAAP"). US GAAP requires the use of estimates; assumptions, judgments and subjective interpretations of accounting principles that have an impact on the assets, liabilities, revenues and expenses amounts reported. These estimates can also affect supplemental information contained in our external disclosures including information regarding contingencies, risk and financial condition. We believe our use of estimates and underlying accounting assumptions adhere to GAAP and are consistently and conservatively applied. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ materially from these estimates under different assumptions or conditions. We continue to monitor significant estimates made during the preparation of our financial statements. We believe the following is among the most critical accounting policies that impact our consolidated financial statements. We suggest that our significant accounting policies, as described in our financial statements in the Summary of Significant Accounting Policies, be read in conjunction with this Management's Discussion and Analysis of Financial Condition and Results of Operations. Revenue Recognition The Company recognizes revenue at the date of delivery to customers when a formal arrangement exists, the price is fixed or determinable, the delivery is completed, no other significant obligations of the Company exist and collectability is reasonably assured. The Company's Revenue Recognition policy is provided in detail at Note 2 of the Financial Statements. Income Taxes The Company accounts for income taxes in accordance with ASC Topic 740, "Income Taxes." ASC 740 requires a company to use the asset and liability method of accounting for income taxes, whereby deferred tax assets are recognized for deductible temporary differences, and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion, or all of, the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. Under ASC 740, a tax position is recognized as a benefit only if it is "more likely than not" that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the "more likely than not" test, no tax benefit is recorded. The adoption had no effect on the Company's consolidated financial statements. -21- ---- Recent Accounting Pronouncements The Company does not expect the adoption of recently issued accounting pronouncements to have a significant impact on the Company's results of operations, financial position, or cash flow. Item 3. Quantitative and Qualitative Disclosures About Market Risk. As a smaller reporting company, as defined in 17 CFR § 229.10(f)(1), we are not required to provide the information requested by this Item. Item 4. Controls and Procedures. Disclosure of Controls and Procedures As required by Rule 13a-15 of the Securities Exchange Act of 1934, our principal executive officer and principal financial officer evaluated our company's disclosure controls and procedures (as defined in Rules 13a-15(e) of the Securities Exchange Act of 1934) as of the end of the period covered by this report. Based on this evaluation, our principal executive officer and principal financial officer concluded that as of the end of the period covered by this report, these disclosure controls and procedures were not effective to ensure that the information required to be disclosed by our company in reports it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities Exchange Commission and to ensure that such information is accumulated and communicated to our company's management, including our principal executive officer and principal financial officer, to allow timely decisions regarding required disclosure. The conclusion that our disclosure controls and procedures were not effective was due to the presence of the following material weaknesses in internal control over financial reporting which are indicative of many small companies with small staff: (i) inadequate segregation of duties and effective risk assessment; and (ii) insufficient written policies and procedures for accounting and financial reporting with respect to the requirements and application of both United States generally accepted accounting principles and Securities and Exchange Commission guidelines. Management anticipates that such disclosure controls and procedures will not be effective until the material weaknesses are remediated. As described in Basis of Presentation in this Third Quarter Report for fiscal year 2017, the Company recently determined that a material weakness existed in the Firm's internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934) as of September 30, 2017. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis. As a result of that determination, the Company's Chief Executive Officer and Chief Financial Officer have since concluded that the Firm's disclosure controls and procedures were not effective as of September 30, 2017. We plan to take steps to enhance and improve the design of our internal controls over financial reporting. During the period covered by this quarterly report on Form 10-Q, we have not been able to remediate the material weaknesses identified above. To remediate such weaknesses, we plan to implement the following changes during our fiscal year ending December 31, 2017, subject to obtaining additional financing: (i) appoint additional qualified personnel to address inadequate segregation of duties and ineffective risk management; and (ii) adopt sufficient written policies and procedures for accounting and financial reporting. The remediation efforts set out above are largely dependent upon our securing additional financing to cover the costs of implementing the changes required. If we are unsuccessful in securing such funds, remediation efforts may be adversely affected in a material manner. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues, if any, within our company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. -22- ---- Changes in Internal Control over Financial Reporting There were no changes in our internal control over financial reporting during the nine months ended September 30, 2017 that have materially affected or are reasonably likely to materially affect, our internal control over financial reporting. PART II - OTHER INFORMATION Item 1. Legal Proceedings. There are not presently any material pending legal proceedings to which the Company is a party or as to which any of its property is subject, and no such proceedings are known to the Company to be threatened or contemplated against it. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds. None. Item 3. Defaults Upon Senior Securities. None. Item 4. Mine Safety Disclosures. Not applicable. Item 5. Other Information. The Company incorporates by reference all prior disclosures for the period identified herein reported on Forms 8-K. Item 6. Exhibits. | | | | Incorporated by reference --------+----------------------------------------------------------------------------------------------------------------------------------------+--------------------+------+------------------------------ Exhibit | Exhibit Description | Filed herewith | Form | Period ending | Exhibit | Filing date --------+----------------------------------------------------------------------------------------------------------------------------------------+--------------------+------+-------------------------------+---------+---------------- 31.1 | Certification of the Chief Executive Officer and Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | X | | | | --------+----------------------------------------------------------------------------------------------------------------------------------------+--------------------+------+-------------------------------+---------+---------------- 32.1 | Certification of the Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | X | | | | --------+----------------------------------------------------------------------------------------------------------------------------------------+--------------------+------+-------------------------------+---------+---------------- -23- ---- SIGNATURES Pursuant to the requirements of the Securities Act of 1933, this registration statement has been signed by the following persons in the capacities and on the dates indicated. /s/Alton Perkins AMERICATOWNE, INC. By: Alton Perkins Its: Chairman of the Board, Chief Executive Officer, Chief Financial Officer Date: November 13, 2017 -24- ----

ASURE SOFTWARE INC

884144

10-Q

0001185185-17-002334

UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) ☒ | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 --+---------------------------------------------------------------------------------------- For the quarterly period ended September 30, 2017 OR ☐ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 --+----------------------------------------------------------------------------------------- For the transition period from to Commission file number: 0-20008 ASURE SOFTWARE, INC. (Exact Name of Registrant as Specified in its Charter) Delaware | 74-2415696 -----------------------------------------+-------------------- (State or other jurisdiction of | (I.R.S. Employer -----------------------------------------+-------------------- incorporation or organization) | Identification No.) -----------------------------------------+-------------------- 3700 N. Capital of Texas Hwy #350 | -----------------------------------------+-------------------- Austin, Texas | 78746 -----------------------------------------+-------------------- (Address of Principal Executive Offices) | (Zip Code) -----------------------------------------+-------------------- (512) 437-2700 (Registrant’s Telephone Number, including Area Code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No ☐ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large accelerated filer ☐ | Accelerated filer ☐ | Non-accelerated filer ☐ | Smaller reporting company ☒ --------------------------+---------------------+-------------------------+---------------------------- Emerging growth company ☐ | | | --------------------------+---------------------+-------------------------+---------------------------- If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provide pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒ As of November 9, 2017, the registrant had outstanding 12,466,820 shares of its Common Stock, $0.01 par value. TABLE OF CONTENTS | | Page -------------------------------+----------------------------------------------------------------------------------------------------------------------------------+------- | | Number -------------------------------+----------------------------------------------------------------------------------------------------------------------------------+------- PART I - FINANCIAL INFORMATION ------------------------------ Item 1. | Financial Statements (Unaudited) | -------------------------------+----------------------------------------------------------------------------------------------------------------------------------+------- | Condensed Consolidated Balance Sheets as of September 30, 2017 and December 31, 2016 | 3 -------------------------------+----------------------------------------------------------------------------------------------------------------------------------+------- | Condensed Consolidated Statements of Comprehensive Income (Loss) for the Three and Nine Months ended September 30, 2017 and 2016 | 4 -------------------------------+----------------------------------------------------------------------------------------------------------------------------------+------- | Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2017 and 2016 | 5 -------------------------------+----------------------------------------------------------------------------------------------------------------------------------+------- | Notes to Condensed Consolidated Financial Statements | 6 -------------------------------+----------------------------------------------------------------------------------------------------------------------------------+------- Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations | 20 -------------------------------+----------------------------------------------------------------------------------------------------------------------------------+------- Item 3. | Quantitative and Qualitative Disclosures About Market Risk | 25 -------------------------------+----------------------------------------------------------------------------------------------------------------------------------+------- Item 4. | Controls and Procedures | 25 -------------------------------+----------------------------------------------------------------------------------------------------------------------------------+------- PART II - OTHER INFORMATION ------------------------------ Item 1. | Legal Proceedings | 26 -------------------------------+----------------------------------------------------------------------------------------------------------------------------------+------- Item 1A. | Risk Factors | 26 -------------------------------+----------------------------------------------------------------------------------------------------------------------------------+------- Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | 26 -------------------------------+----------------------------------------------------------------------------------------------------------------------------------+------- Item 3. | Defaults upon Senior Securities | 26 -------------------------------+----------------------------------------------------------------------------------------------------------------------------------+------- Item 6. | Exhibits | 26 -------------------------------+----------------------------------------------------------------------------------------------------------------------------------+------- Signatures | 27 -------------------------------+--------------------------------------------------------------------------------------------------------------------------------- PART I – FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS ASURE SOFTWARE, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (Amounts in thousands) | September 30, 2017 (Unaudited) | | | December 31, 2016 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+-- Assets | | | | | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+-- Current assets: | | | | | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+-- Cash and cash equivalents | $ | 27,464 | | | $ | 12,767 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Accounts and note receivable, net of allowance for doubtful accounts of $592 and $338 at September 30, 2017 and December 31, 2016, respectively | | 13,887 | | | | 8,108 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Inventory | | 781 | | | | 487 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Prepaid expenses and other current assets | | 1,899 | | | | 1,256 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Total current assets before funds held for clients | | 44,031 | | | | 22,618 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Funds held for clients | | 23,217 | | | | 22,981 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Total current assets | | 67,248 | | | | 45,599 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Restricted cash | | 200 | | | | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Property and equipment, net | | 2,763 | | | | 1,878 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Goodwill | | 75,855 | | | | 26,259 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Intangible assets, net | | 34,046 | | | | 12,048 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Other assets | | 2,225 | | | | 39 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Total assets | $ | 182,337 | | | $ | 85,823 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Liabilities and stockholders’ equity | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Current liabilities: | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Current portion of notes payable, net of debt issuance cost and debt discount | $ | 8,724 | | | $ | 5,455 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Accounts payable | | 1,581 | | | | 1,576 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Accrued compensation and benefits | | 1,812 | | | | 1,192 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Other accrued liabilities | | 1,115 | | | | 936 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Deferred revenue | | 12,065 | | | | 9,252 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Total current liabilities before client fund obligations | | 25,297 | | | | 18,411 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Client fund obligations | | 23,217 | | | | 22,981 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Total current liabilities | | 48,514 | | | | 41,392 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Long-term liabilities: | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Deferred revenue | | 1,450 | | | | 769 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Notes payable, net of current portion of debt issuance cost and debt discount | | 66,980 | | | | 24,581 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Other liabilities | | 1,009 | | | | 835 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Total long-term liabilities | | 69,439 | | | | 26,185 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Total liabilities | | 117,953 | | | | 67,577 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Stockholders’ equity: | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Preferred stock, $.01 par value; 1,500 shares authorized; none issued or outstanding | | - | | | | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Common stock, $.01 par value; 22,000 shares authorized; 12,805 and 8,901 shares issued, 12,421 and 8,517 shares outstanding at September 30, 2017 and December 31, 2016, respectively | | 128 | | | | 89 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Treasury stock at cost, 384 shares at September 30, 2017 and December 31, 2016 | | (5,017 | ) | | | (5,017 | ) --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Additional paid-in capital | | 345,383 | | | | 295,044 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Accumulated deficit | | (276,052 | ) | | | (271,875 | ) --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Accumulated other comprehensive (loss) income | | (58 | ) | | | 5 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Total stockholders’ equity | | 64,384 | | | | 18,246 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- Total liabilities and stockholders’ equity | $ | 182,337 | | | $ | 85,823 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------------------+----------+---+-------------------+---+----------+-- The accompanying notes are an integral part of these condensed consolidated financial statements. 3 ASURE SOFTWARE, INC. CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (Amounts in thousands, except share and per share data) (Unaudited) | FOR THE THREE MONTHS ENDED September 30, | | | FOR THE NINE MONTHS ENDED September 30, | --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+-- | 2017 | | | 2016 | | | 2017 | | 2016 | --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+-- Revenues: | | | | | | | | | | --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+-- Cloud revenue | $ | 11,062 | | | $ | 5,630 | | $ | 27,724 | | $ | 14,881 | --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+---+---+-----------+-- Hardware revenue | | 1,003 | | | | 676 | | | 3,651 | | | 2,644 | --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+---+---+-----------+-- Maintenance and support revenue | | 1,178 | | | | 1,078 | | | 3,276 | | | 3,509 | --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+---+---+-----------+-- On premise software license revenue | | 599 | | | | 754 | | | 1,049 | | | 1,352 | --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+---+---+-----------+-- Professional services revenue | | 1,685 | | | | 1,302 | | | 3,434 | | | 3,440 | --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+---+---+-----------+-- Total revenues | | 15,527 | | | | 9,440 | | | 39,134 | | | 25,826 | --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+---+---+-----------+-- Cost of sales | | 3,396 | | | | 2,026 | | | 8,660 | | | 5,932 | --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+---+---+-----------+-- Gross margin | | 12,131 | | | | 7,414 | | | 30,474 | | | 19,894 | --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+---+---+-----------+-- Operating expenses | | | | | | | | | | | | | --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+---+---+-----------+-- Selling, general and administrative | | 9,459 | | | | 5,046 | | | 25,286 | | | 15,559 | --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+---+---+-----------+-- Research and development | | 883 | | | | 761 | | | 2,488 | | | 2,217 | --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+---+---+-----------+-- Amortization of intangible assets | | 1,341 | | | | 625 | | | 3,230 | | | 1,628 | --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+---+---+-----------+-- Total operating expenses | | 11,683 | | | | 6,432 | | | 31,004 | | | 19,404 | --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+---+---+-----------+-- Income (loss) from operations | | 448 | | | | 982 | | | (530 | ) | | 490 | --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+---+---+-----------+-- Other income (loss) | | | | | | | | | | | | | --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+---+---+-----------+-- Interest expense and other | | (1,644 | ) | | | (620 | ) | | (3,279 | ) | | (1,460 | ) --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+---+---+-----------+-- Total other loss | | (1,644 | ) | | | (620 | ) | | (3,279 | ) | | (1,460 | ) --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+---+---+-----------+-- Income (loss) from operations before income taxes | | (1,196 | ) | | | 362 | | | (3,809 | ) | | (970 | ) --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+---+---+-----------+-- Income tax provision | | (85 | ) | | | (47 | ) | | (368 | ) | | (133 | ) --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+---+---+-----------+-- Net income (loss) | $ | (1,281 | ) | | $ | 315 | | $ | (4,177 | ) | $ | (1,103 | ) --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+---+---+-----------+-- Other comprehensive income (loss) | | | | | | | | | | | | | --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+---+---+-----------+-- Foreign currency gain (loss) | | (6 | ) | | | 26 | | | (63 | ) | | 142 | --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+---+---+-----------+-- Other comprehensive income (loss) | $ | (1,287 | ) | | | 341 | | $ | (4,240 | ) | $ | (961 | ) --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+---+---+-----------+-- Basic and diluted net income (loss) per share | | | | | | | | | | | | | --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+---+---+-----------+-- Basic | $ | (0.10 | ) | | $ | 0.05 | | $ | (0.40 | ) | $ | (0.17 | ) --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+---+---+-----------+-- Diluted | $ | (0.10 | ) | | $ | 0.05 | | $ | (0.40 | ) | $ | (0.17 | ) --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+---+---+-----------+-- Weighted average basic and diluted shares | | | | | | | | | | | | | --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+---+---+-----------+-- Basic | | 12,418,000 | | | | 6,534,000 | | | 10,355,000 | | | 6,383,000 | --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+---+---+-----------+-- Diluted | | 12,418,000 | | | | 6,548,000 | | | 10,355,000 | | | 6,383,000 | --------------------------------------------------+------------------------------------------+------------+---+-----------------------------------------+---+-----------+------+---+------------+---+---+-----------+-- The accompanying notes are an integral part of these condensed consolidated financial statements. 4 ASURE SOFTWARE, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Amounts in thousands) (Unaudited) | FOR THE NINE MONTHS ENDED SEPTEMBER 30, | ------------------------------------------------------------------+-----------------------------------------+-------- | 2017 | | | 2016 | ------------------------------------------------------------------+-----------------------------------------+---------+---+------+-- CASH FLOWS FROM OPERATING ACTIVITIES: | | | | | ------------------------------------------------------------------+-----------------------------------------+---------+---+------+-- Net loss | $ | (4,177 | ) | | $ | (1,103 | ) ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Adjustments to reconcile net loss to net cash used in operations: | | | | | | | ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Depreciation and amortization | | 4,344 | | | | 2,686 | ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Provision for doubtful accounts | | 320 | | | | 50 | ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Share-based compensation | | 363 | | | | 166 | ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Other | | - | | | | 94 | ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Changes in operating assets and liabilities: | | | | | | | ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Accounts receivable | | (4,450 | ) | | | (1,678 | ) ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Inventory | | (287 | ) | | | 169 | ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Prepaid expenses and other assets | | (471 | ) | | | 124 | ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Accounts payable | | (569 | ) | | | (189 | ) ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Accrued expenses and other long-term obligations | | 881 | | | | 951 | ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Deferred revenue | | 1,963 | | | | (2,000 | ) ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Net cash used in operating activities | | (2,083 | ) | | | (730 | ) ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- CASH FLOWS FROM INVESTING ACTIVITIES: | | | | | | | ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Acquisitions net of cash acquired | | (45,472 | ) | | | (12,000 | ) ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Purchases of property and equipment | | (942 | ) | | | (128 | ) ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Software capitalization costs | | (804 | ) | | | - | ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Collection of note receivable | | - | | | | 223 | ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Net change in funds held for clients | | 8,867 | | | | 4,155 | ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Net cash used in investing activities | | (38,351 | ) | | | (7,750 | ) ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- CASH FLOWS FROM FINANCING ACTIVITIES: | | | | | | | ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Proceeds from notes payable | | 45,777 | | | | 16,823 | ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Payments on notes payable | | (8,098 | ) | | | (5,173 | ) ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Debt financing fees | | (1,433 | ) | | | (438 | ) ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Payments on capital leases | | (131 | ) | | | (158 | ) ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Net proceeds from issuance of common stock | | 27,820 | | | | 561 | ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Net change in client fund obligations | | (8,812 | ) | | | (4,155 | ) ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Net cash provided by financing activities | | 55,123 | | | | 7,460 | ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Effect of foreign exchange rates | | 8 | | | | 151 | ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Net increase (decrease) in cash and cash equivalents | | 14,697 | | | | (869 | ) ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Cash and cash equivalents at beginning of period | | 12,767 | | | | 1,158 | ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Cash and cash equivalents at end of period | $ | 27,464 | | | $ | 289 | ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- SUPPLEMENTAL INFORMATION: | | | | | | | ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Cash paid for: | | | | | | | ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Interest | $ | 2,180 | | | $ | 817 | ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Non-cash Investing and Financing Activities: | | | | | | | ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Subordinated notes payable –acquisitions | | 8,165 | | | | 6,000 | ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- Equity issued in connection with acquisitions | | 21,825 | | | | - | ------------------------------------------------------------------+-----------------------------------------+---------+---+------+---+---------+-- The accompanying notes are an integral part of these consolidated financial statements. 5 ASURE SOFTWARE, INC. NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (Amounts in thousands, except share and per share data unless otherwise noted) NOTE 1 – THE COMPANY AND BASIS OF PRESENTATION Asure Software, Inc. (“Asure”, the “Company”, “we” and “our”), a Delaware corporation, is a provider of cloud-based software-as-a-service (“SaaS”) time and labor management and Agile Workplace management solutions that enable organizations to manage their office environments as well as their human resource and payroll processes effectively and efficiently. Asure develops, markets, sells and supports its offerings worldwide through its principal office in Austin, Texas and through additional offices in Tampa, Florida, Traverse City, Michigan, Vermont, and London, United Kingdom. We have prepared the accompanying unaudited condensed consolidated financial statements in accordance with the rules and regulations of the Securities and Exchange Commission and accordingly, they do not include all information and footnotes required under U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, these interim financial statements contain all adjustments, consisting of normal, recurring adjustments, necessary for a fair presentation of our financial position as of September 30, 2017, the results of operations for the three and nine months ended September 30, 2017 and 2016, and the cash flows for the nine months ended September 30, 2017 and 2016. You should read these condensed consolidated financial statements in conjunction with our audited consolidated financial statements and notes thereto filed with the Securities and Exchange Commission in our annual report on Form 10-K for the fiscal year ended December 31, 2016. The results for the interim periods are not necessarily indicative of results for a full fiscal year. NOTE 2 – SIGNIFICANT ACCOUNTING POLICIES CASH AND CASH EQUIVALENTS Cash and cash equivalents include cash deposits and highly liquid investments with an original maturity of three months or less when purchased. RESTRICTED CASH Restricted cash represents a certificate of deposit held in a cash collateral account as required by our operating lease for iSystems, LLC, which we acquired in May 2017. See Note 4- Acquisitions for further detail of the acquisition. LIQUIDITY As of September 30, 2017, Asure’s principal sources of liquidity consisted of approximately $27,464 of cash and cash equivalents, future cash generated from operations and $5,000 available for borrowing under our Wells Fargo revolver discussed in Note 6 – Notes Payable. We believe that we have and/or will generate sufficient cash for our short- and long-term needs, including meeting the requirements of our term loan, and the related debt covenant requirements. We continue to seek reductions in our expenses as a percentage of revenue on an annual basis and thus may utilize our cash balances in the short-term to reduce long-term costs. Based on current internal projections, we believe that we have and/or will generate sufficient cash for our operational needs, including any required debt payments, for at least the next twelve months from the issuance of the condensed consolidated financial statements. Management is focused on growing our existing product offering, as well as our customer base, to increase our recurring revenues. We have made and will continue to explore additional strategic acquisitions. We expect to fund any future acquisitions with equity, available cash, future cash from operations, or debt from outside sources. We cannot assure that we can grow our cash balances or limit our cash consumption and thus maintain sufficient cash balances for our planned operations or future acquisitions. Future business demands may lead to cash utilization at levels greater than recently experienced. We may need to raise additional capital in the future. However, we cannot assure that we will be able to raise additional capital on acceptable terms, or at all. Subject to the foregoing, management believes that we have sufficient capital and liquidity to fund and cultivate the growth of our current and future operations for at least the next twelve months from the issuance of these financial statements and to maintain compliance with the terms of our debt agreements and related covenants or to obtain compliance through debt repayments made with the available cash on hand or anticipated for receipt in the ordinary course of operations. 6 ASURE SOFTWARE, INC. NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (Amounts in thousands, except share and per share data unless otherwise noted) RECENT ACCOUNTING STANDARDS Recently Adopted Standards In July 2015, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2015-11, “Simplifying the Measurement of Inventory”. Inventory within the scope of this update is required to be measured at the lower of its cost or net realizable value, with net realizable value being the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. This ASU is effective prospectively for fiscal years and interim periods beginning after December 15, 2016, with early adoption permitted. We adopted the provisions of ASU 2015-11 on January 1, 2017. This adoption did not have any impact on our consolidated financial statements. In March 2016, the FASB issued ASU 2016-09, “Compensation – Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting.”. The purpose of ASU 2016-09 is to simplify the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification of such activity on the statement of cash flows. ASU 2016-09 is effective for fiscal years beginning after December 15, 2016, including interim periods within that year. Prospective, retrospective, or modified retrospective application may be used dependent on the specific requirements of the amendments within ASU 2016-09. Effective January 1, 2017, the Company adopted ASU 2016-09 on a prospective basis. As such, prior periods have not been adjusted. In January 2017, the FASB issued ASU 2017-04, “Simplifying the Test for Goodwill Impairment (Topic 350)”, which eliminates Step 2 from the goodwill impairment test. ASU 2017-04 is effective for annual and interim periods in fiscal years beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed after January 1, 2017 and should be applied prospectively. We adopted the provisions of ASU 2017-04 on January 1, 2017. The adoption did not have any impact on our consolidated financial statements. In January 2017, the FASB issued ASU No. 2017-01, “Business Combinations (Topic 806): Clarifying the Definition of a Business”, which provides guidance in evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. The definition of a business affects many areas of accounting, including acquisitions, disposals, goodwill, and consolidation. The guidance is effective for public companies for fiscal years beginning after December 15, 2017. We adopted this standard early as of January 1, 2017 as permitted under the standard. The adoption did not have any impact on our consolidated financial statements. Standards Yet To Be Adopted In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”). ASU 2014-09 supersedes a majority of existing revenue recognition guidance under US GAAP, and requires companies to recognize revenue when it transfers goods or services to a customer in an amount that reflects the consideration to which a company expects to be entitled. Companies may need to apply more judgment and estimation techniques or methods while recognizing revenue, which could result in additional disclosures to the financial statements. In addition, in March 2016, April 2016, May 2016 and December 2016 the FASB issued ASU 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net) (“ASU 2016-08”), ASU 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing (“ASU 2016-10”), ASU 2016-12, Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients (“ASU 2016-12”) and ASU 2016-20, Technical Corrections and Improvements to Topic 606, Revenue from Contracts with Customers (“ASU 2016-20”), respectively, to amend certain guidance in ASU 2014-09. Topic 606 allows for either a retrospective or cumulative effect transition method. ASU 2014-09 was originally effective for fiscal years beginning after December 15, 2016. In July 2015, the FASB approved a one-year deferral of ASU 2014-09 and all amendments to it, with a new effective date for fiscal years beginning after December 15, 2017 with early adoption permitted as of the original effective date. We plan to adopt ASU 2014-09, as well as other clarifications and technical guidance issued by the FASB related to this new revenue standard, on January 1, 2018. We have developed our plan for implementing the new standard, which includes, but is not limited to, identifying contract populations and “in scope” customer contracts, identifying performance obligations in those customer contracts, and evaluating any impact of variable consideration. The Company has evaluated the transition methods and will likely apply the modified retrospective transition method, which would result in an adjustment to retained earnings for the cumulative effect, if any, of applying the standard to contracts that are not completed at the date of initial application. Under this method, we would not restate the prior financial statements presented, therefore the new standard requires us to provide additional disclosures of the amount by which each financial statement line item is affected in the current reporting period during 2018, as compared to the guidance that was in effect before the change, and an explanation of the reasons for significant changes, if any. 7 ASURE SOFTWARE, INC. NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (Amounts in thousands, except share and per share data unless otherwise noted) The impact that the new revenue recognition standard will have on our consolidated financial statements and disclosures has not yet been fully assessed. However, we do not expect the provisions of the new standard to have a material effect on the timing or amount of revenue we recognize. Our assessment also includes determining the impact the new standard may have on the revenue reporting processes, including disclosures, ensuring internal controls will operate effectively with the new standard and performing gap analyses on collected data and determining the relative accounting positions where applicable. Included in our assessment of the new standard, is the potential impact on sales commissions and the term over which they will amortize. In February 2016, the FASB issued ASU No. 2016-02, “Leases (Topic 842)”. The core principle of the standard is that a lessee should recognize the assets and liabilities that arise from leases. A lessee should recognize in its statement of financial position a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the underlying asset for the lease term. We will be required to adopt the new standard in the first quarter of 2019. We are currently evaluating the impact ASU 2016-02 will have on our consolidated financial statements. In August 2016, the FASB issued ASU 2016-15, “Statement of Cash Flows (Topic 230) Classification of Certain Cash Receipts and Cash Payments” which eliminates the diversity in practice related to eight cash flow classification issues. This ASU is effective for on January 1, 2018 with early adoption permitted. We believe its adoption will not significantly impact our consolidated financial statements. In November 2016, the FASB issued ASU 2016-18, “Statement of Cash Flows (Topic 230): Restricted Cash,” which requires the change in restricted cash or cash equivalents to be included with other changes in cash and cash equivalents in the statement of cash flows. The ASU is effective for fiscal years beginning after December 15, 2017, with early adoption permitted. We believe its adoption will not significantly impact our consolidated financial statements. In May 2017, the FASB issued ASU 2017-09, “Compensation – Stock Compensation (Topic 718) Scope of Modification Accounting,” which clarifies when to account for a change in the terms or conditions of a share-based payment award as a modification. ASU 2017-09 requires modification accounting only if the fair value, the vesting conditions, or the classification of the award (as equity or liability) changes as a result of the change in terms or conditions. ASU 2017-09 is effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. We do not expect the adoption of this accounting standard to have a material impact on our financial position, results of operations, cash flows, or presentation thereof. CONTINGENCIES Although Asure has been, and in the future may be, the defendant or plaintiff in various actions arising in the normal course of business, as of September 30, 2017, we were not party to any pending legal proceedings. NOTE 3 – FAIR VALUE MEASUREMENTS Accounting Standards Codification (“ASC”) 820, Fair Value Measurements and Disclosures defines fair value, establishes a framework for measuring fair value in U.S. generally accepted accounting principles and expands disclosures about fair value measurements. ASC 820 establishes a three-tier fair value hierarchy, which is based on the reliability of the inputs used in measuring fair values. These tiers include: Level 1: | Quoted prices in active markets for identical assets or liabilities; ---------+--------------------------------------------------------------------- Level 2: | Quoted prices in active markets for similar assets or liabilities; quoted prices in markets that are not active for identical or similar assets or liabilities; and model-driven valuations whose significant inputs are observable; and ---------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Level 3: | Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. ---------+------------------------------------------------------------------------------------------------------------------------------------------------ 8 ASURE SOFTWARE, INC. NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (Amounts in thousands, except share and per share data unless otherwise noted) The following table presents the fair value hierarchy for our financial assets measured at fair value on a recurring basis as of September 30, 2017 and December 31, 2016, respectively: | | | Fair Value Measure at September 30, 2017 | --------------------------+---------------+--------+------------------------------------------+-- | Total | | Quoted | | | Significant | | --------------------------+---------------+--------+------------------------------------------+---+--------+-------------+---+------------- | Carrying | | Prices | | | Other | | Significant --------------------------+---------------+--------+------------------------------------------+---+--------+-------------+---+------------- | Value at | | in Active | | | Observable | | Unobservable --------------------------+---------------+--------+------------------------------------------+---+--------+-------------+---+------------- | September 30, | | Market | | | Inputs | | Inputs --------------------------+---------------+--------+------------------------------------------+---+--------+-------------+---+------------- Description | 2017 | | (Level 1) | | | (Level 2) | | (Level 3) --------------------------+---------------+--------+------------------------------------------+---+--------+-------------+---+------------- Assets: | | | | | | | | --------------------------+---------------+--------+------------------------------------------+---+--------+-------------+---+------------- Cash and cash equivalents | $ | 27,464 | | $ | 27,464 | | $ | - | $ | - --------------------------+---------------+--------+------------------------------------------+---+--------+-------------+---+--------------+---+-- Total | $ | 27,464 | | $ | 27,464 | | $ | - | $ | - --------------------------+---------------+--------+------------------------------------------+---+--------+-------------+---+--------------+---+-- | | | Fair Value Measure at December 31, 2016 | --------------------------+--------------+--------+-----------------------------------------+-- | Total | | Quoted | | | Significant | | --------------------------+--------------+--------+-----------------------------------------+---+--------+-------------+---+------------- | Carrying | | Prices | | | Other | | Significant --------------------------+--------------+--------+-----------------------------------------+---+--------+-------------+---+------------- | Value at | | in Active | | | Observable | | Unobservable --------------------------+--------------+--------+-----------------------------------------+---+--------+-------------+---+------------- | December 31, | | Market | | | Inputs | | Inputs --------------------------+--------------+--------+-----------------------------------------+---+--------+-------------+---+------------- Description | 2016 | | (Level 1) | | | (Level 2) | | (Level 3) --------------------------+--------------+--------+-----------------------------------------+---+--------+-------------+---+------------- Assets: | | | | | | | | --------------------------+--------------+--------+-----------------------------------------+---+--------+-------------+---+------------- Cash and cash equivalents | $ | 12,767 | | $ | 12,767 | | $ | - | $ | - --------------------------+--------------+--------+-----------------------------------------+---+--------+-------------+---+--------------+---+-- Total | $ | 12,767 | | $ | 12,767 | | $ | - | $ | - --------------------------+--------------+--------+-----------------------------------------+---+--------+-------------+---+--------------+---+-- NOTE 4 – ACQUISITIONS 2017 Acquisitions In January 2017, we closed three strategic acquisitions: Personnel Management Systems, Inc., a provider of outsourced HR solutions; Corporate Payroll, Inc. (Payroll Division), a provider of payroll services; and Payroll Specialties NW, Inc., a provider of payroll services. In May 2017, we closed two strategic acquisitions: iSystems, LLC and Compass HRM. iSystems LLC, through its flagship product, Evolution HCM, offers payroll, tax management and HR software combined with comprehensive back-end service bureau tools to service providers across the United States. Tampa-based Compass HRM is a current reseller of our HCM offering (formerly Mangrove), which provides human resources solutions that enhance organizations, people, and profits through payroll and HR solutions. The acquisition of Compass HRM expands our reach in the Southeast, particularly Florida. Stock Purchase Agreement In January 2017, we closed on the acquisition of all of the outstanding shares of common stock (the “Shares”) of Personnel Management Systems, Inc., a Washington corporation (“PMSI”), pursuant to a Stock Purchase Agreement (the “Stock Purchase Agreement”), among us, PMSI, the sellers identified therein, and the stockholders’ representative named therein. The aggregate consideration for the Shares consisted of (i) $3,875 in cash and (ii) a subordinated promissory note (the “PMSI Note”) in the principal amount of $1,125 subject to adjustment as provided in the Stock Purchase Agreement. We funded the cash payment with proceeds from our recent underwritten public offering in June 2017. The PMSI Note bears interest at an annual rate of 2.0% and matures on April 30, 2018. The entire unpaid principal and all accrued interest under the PMSI Note is payable at maturity. The Stock Purchase Agreement contains certain customary representations, warranties, indemnities and covenants. 9 ASURE SOFTWARE, INC. NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (Amounts in thousands, except per share data unless otherwise noted) Asset Purchase Agreement In January 2017, we closed on the acquisition of substantially all the assets of Corporate Payroll, Inc., an Ohio corporation (“CPI”), relating to its payroll service bureau business, pursuant to an Asset Purchase Agreement (the “CPI Asset Purchase Agreement”). The aggregate consideration for the assets consisted of (i) $1,500 in cash, (ii) a subordinated promissory note (the “CPI Note”) in the principal amount of $500 and (iii) 112,166 shares of our common stock valued at $1,000, subject to adjustment as provided in the CPI Asset Purchase Agreement. We funded the cash payment with proceeds from our recent underwritten public offering in June 2017. The CPI Note bears no interest and matures on April 30, 2018. The entire unpaid principal under the CPI Note is payable at maturity. The recipient of the shares of our common stock entered into a six month lock-up agreement with us. The CPI Asset Purchase Agreement contains certain customary representations, warranties, indemnities and covenants. Asset Purchase Agreement In January 2017, we closed on the acquisition of substantially all the assets of Payroll Specialties NW, Inc., an Oregon corporation (“PSNW”), pursuant to an Asset Purchase Agreement (the “PSNW Asset Purchase Agreement”). The aggregate consideration for the assets consisted of (i) $3,010 in cash and (ii) a subordinated promissory note (the “PSNW Note”) in the principal amount of $600, subject to adjustment as provided in the PSNW Asset Purchase Agreement. We funded the cash payment with proceeds from our recent underwritten public offering in June 2017. The PSNW Note bears interest at an annual rate of 2.0% and matures on April 30, 2018. The entire unpaid principal and all accrued interest under the PSNW Note is payable at maturity. The PSNW Asset Purchase Agreement contains certain customary representations, warranties, indemnities and covenants. Equity Purchase Agreement In May 2017, we entered into an equity purchase agreement (the “Equity Purchase Agreement”) with iSystems Holdings, LLC, a Delaware limited liability company (“Seller”), and iSystems Intermediate Holdco, Inc., a Delaware corporation (“iSystems”), pursuant to which we acquired 100% of the outstanding equity interests of iSystems for an aggregate purchase price of $55,000, subject to adjustment as provided in the Equity Purchase Agreement. The aggregate purchase price consists of (i) $32,000 in cash, subject to adjustment, (ii) a secured subordinated promissory note (“iSystems Note”) in the principal amount of $5,000, subject to adjustment, and (iii) 1,526,332 shares of unregistered common stock valued at $18,000 based on a volume-weighted average of the closing prices of our common stock during a 90-day period. The iSystems Note bears interest at an annual rate of 3.5% and matures on May 25, 2019. The unpaid principal and all accrued interest under the promissory note is payable in two installments of $2.5 million on May 25, 2018 and May 25, 2019, subject to adjustment. The Equity Purchase Agreement contains certain customary representations, warranties, indemnities and covenants. To finance the iSystems acquisition, we amended and restated our existing credit agreement with Wells Fargo Bank, National Association, as administrative agent (the “Restated Credit Agreement”) to add an additional term loan in the amount of approximately $40,000, of which we borrowed approximately $32,000 to complete the iSystems acquisition. See Note 6- Notes Payable for further detail. In connection with the iSystems acquisition, we also entered into an investor rights agreement (the “Investor Rights Agreement”) with the Seller. Pursuant to the terms of the Investor Rights Agreement, until May 2018, the holders of the registrable securities received in connection with the acquisition have agreed not to directly or indirectly transfer, sell, make any short sale or otherwise dispose of any of our equity securities and not to vote any of our equity securities or solicit proxies other than in favor of each director that our board recommends for election, against any director that our board has not nominated for election, and in accordance with the recommendation of our board on any other matters, subject to certain exceptions. In addition, under the Investor Rights Agreement, holders of the registrable securities have demand registration rights which allow a registration statement to be filed on or about March 31, 2018 and piggyback registration rights which become effective in May 2018. In addition, under the terms of the Investor Rights Agreement, such holders have the right to nominate one director to our board of directors until the first date that the holders of the registrable securities no longer hold more than the lesser of (x) 5% of our outstanding common stock (as equitably adjusted for any stock splits, stock combinations, reorganizations, exchanges, merger, recapitalizations or similar transaction after the date hereof) and (y) 90% of the shares of our common stock held by such holders as of May 25, 2017. The director nominee appointed by the holders is Daniel Gill. Our board appointed him to serve as a director on June 6, 2017. Mr. Gill is a founder and a co-managing partner of Silver Oak Services Partners, a private equity firm. In 2014 Silver Oak acquired iSystems, LLC (currently, a wholly owned subsidiary of iSystems) and Mr. Gill served on the board of directors of iSystems, LLC. 10 ASURE SOFTWARE, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (Amounts in thousands, except share and per share data or otherwise noted) Stock Purchase Agreement In May 2017, we entered into a stock purchase agreement (the “Stock Purchase Agreement”) with Compass HRM, Inc. (“Compass”) and the sellers and seller representative named therein, pursuant to which the sellers sold 100% of the outstanding shares of capital stock of Compass to us for an aggregate purchase price of $6,000, subject to adjustment as provided in the Stock Purchase Agreement. The aggregate purchase price consists of $4,500 in cash and a subordinated promissory note (“Compass Note”) in the principal amount of $1,500, subject to adjustment. The Compass Note bears interest at an annual rate of 2.0% and matures on May 25, 2022. The Compass Note is payable in five annual installments of $300 on the anniversary of the closing date, subject to adjustment. Compass is headquartered in Tampa, Florida, and provides cloud-based human resource management software, including payroll, benefits, time and attendance, and performance management. To finance the Compass acquisition, we incurred approximately $4,500 of additional indebtedness pursuant to an additional term loan under our Restated Credit Agreement. See Note 6 –Notes Payable for further details. Purchase Price Allocation Following is the purchase price allocation for the 2017 acquisitions. We based the preliminary fair value estimate for the assets acquired and liabilities assumed for these acquisitions upon preliminary calculations and valuations. Our estimates and assumptions for these acquisition are subject to change as we obtain additional information for our estimates during the respective measurement periods (up to one year from the acquisition date). The primary areas of those preliminary estimates that we have not yet finalized relate to certain tangible assets and liabilities acquired, and income and non-income based taxes. We recorded the transactions using the acquisition method of accounting and recognized assets and liabilities assumed at their fair value as of the dates of acquisitions. The $24,628 of intangible assets subject to amortization consist of $21,505 allocated to Customer Relationships, $1,521 for Trade Names, $1,010 for Developed Technology, and $592 for Noncompete. To value the Trade Names, we employed the relief from royalty method under the market approach. For the Noncompetes, we employed a form of the income approach which analyzes the Company’s profitability with these assets in place, in contrast to the Company’s profitability without them. For the Customer Relationships and Developed Technology, we employed a form of the excess earnings method, which is a form of the income approach. The discount rate used in valuing these assets ranged from 14.0% to 17.0%, which reflects the risk associated with the intangible assets related to the other assets and the overall business operations to us. We estimated the fair values of the Trade Names using the relief from royalty method based upon a 1.7% royalty rate. We believe significant synergies are expected to arise from these strategic acquisitions. This factor contributed to a purchase price that was in excess of the fair value of the net assets acquired and, as a result, we recorded goodwill for each acquisition. A portion of acquired goodwill will be deductible for tax purposes. We based the allocations on fair values at the date of acquisition: Assets Acquired | CPI | | PMSI | | PSNW | iSystems | Compass | | Total --------------------------+-----+-------+------+-------+------+----------+---------+--------+------ Cash & cash equivalents | $ | 126 | | 131 | | 53 | | 211 | | 207 | $ | 728 --------------------------+-----+-------+------+-------+------+----------+---------+--------+-------+-------+---+------- Accounts receivable | | 22 | | 347 | | 111 | | 951 | | 241 | | 1,672 --------------------------+-----+-------+------+-------+------+----------+---------+--------+-------+-------+---+------- Restricted cash | | - | | - | | - | | 200 | | - | | 200 --------------------------+-----+-------+------+-------+------+----------+---------+--------+-------+-------+---+------- Fixed assets | | - | | 130 | | 7 | | 681 | | 38 | | 856 --------------------------+-----+-------+------+-------+------+----------+---------+--------+-------+-------+---+------- Other assets | | - | | 17 | | 17 | | 699 | | 33 | | 766 --------------------------+-----+-------+------+-------+------+----------+---------+--------+-------+-------+---+------- Funds held for clients | | 2,809 | | - | | 6,294 | | - | | - | | 9,103 --------------------------+-----+-------+------+-------+------+----------+---------+--------+-------+-------+---+------- Goodwill | | 1,190 | | 2,247 | | 1,579 | | 42,253 | | 2,049 | | 49,318 --------------------------+-----+-------+------+-------+------+----------+---------+--------+-------+-------+---+------- Intangibles | | 1,563 | | 2,646 | | 1,879 | | 15,070 | | 3,470 | | 24,628 --------------------------+-----+-------+------+-------+------+----------+---------+--------+-------+-------+---+------- Total assets acquired | $ | 5,710 | | 5,518 | | 9,940 | | 60,065 | | 6,038 | $ | 87,271 --------------------------+-----+-------+------+-------+------+----------+---------+--------+-------+-------+---+------- Liabilities assumed | | | | | | | | | | | | --------------------------+-----+-------+------+-------+------+----------+---------+--------+-------+-------+---+------- Accounts payable | | 51 | | 19 | | 28 | | 392 | | 65 | | 555 --------------------------+-----+-------+------+-------+------+----------+---------+--------+-------+-------+---+------- Accrued other liabilities | | - | | 191 | | 40 | | 791 | | 45 | | 1,067 --------------------------+-----+-------+------+-------+------+----------+---------+--------+-------+-------+---+------- Deferred revenue | | - | | 370 | | - | | 1,073 | | - | | 1,443 --------------------------+-----+-------+------+-------+------+----------+---------+--------+-------+-------+---+------- Client fund obligations | | 2,754 | | - | | 6,294 | | - | | - | | 9,048 --------------------------+-----+-------+------+-------+------+----------+---------+--------+-------+-------+---+------- Total liabilities assumed | | 2,805 | | 580 | | 6,362 | | 2,256 | | 110 | | 12,113 --------------------------+-----+-------+------+-------+------+----------+---------+--------+-------+-------+---+------- Net assets acquired | $ | 2,905 | | 4,938 | | 3,578 | | 57,809 | | 5,928 | $ | 75,158 --------------------------+-----+-------+------+-------+------+----------+---------+--------+-------+-------+---+------- 11 ASURE SOFTWARE, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (Amounts in thousands, except share and per share data or otherwise noted) The following is a reconciliation of the purchase price to the fair value of net assets acquired at the date of acquisition: | CPI | | | PMSI | | PSNW | iSystems | | Compass | | | Total -------------------------------------------------+-----+-------+---+------+-------+------+----------+---+---------+--------+---+------ Purchase price | $ | 3,000 | | | 5,000 | | 3,610 | | | 55,000 | | | 6,000 | | $ | 72,610 | -------------------------------------------------+-----+-------+---+------+-------+------+----------+---+---------+--------+---+-------+-------+---+---+--------+-- Working capital adjustment | | - | | | - | | - | | | 202 | | | 81 | | | 283 | -------------------------------------------------+-----+-------+---+------+-------+------+----------+---+---------+--------+---+-------+-------+---+---+--------+-- Adjustment to fair value of Asure’s stock issued | | (54 | ) | | - | | - | | | 2,880 | | | - | | | 2,826 | -------------------------------------------------+-----+-------+---+------+-------+------+----------+---+---------+--------+---+-------+-------+---+---+--------+-- Debt discount | | (41 | ) | | (62 | ) | (32 | ) | | (273 | ) | | (153 | ) | | (561 | ) -------------------------------------------------+-----+-------+---+------+-------+------+----------+---+---------+--------+---+-------+-------+---+---+--------+-- Fair value of net assets acquired | $ | 2,905 | | | 4,938 | | 3,578 | | | 57,809 | | | 5,928 | | $ | 75,158 | -------------------------------------------------+-----+-------+---+------+-------+------+----------+---+---------+--------+---+-------+-------+---+---+--------+-- Transaction costs for the 2017 acquisitions were $1,387 and were expensed as incurred and included in selling, general and administrative expenses. 2016 Acquisitions Through the stock and asset purchases described below, we have entered into the human resource management, payroll processing and benefits administration services businesses, which we intend to integrate into our existing AsureForce® product line. Stock Purchase Agreement In March 2016, we acquired all of the issued and outstanding shares of common stock (the “Shares”) of Mangrove Employer Services, Inc. of Tampa, Florida (“Mangrove”). Pursuant to this stock purchase, we acquired the payroll division of Mangrove, which is engaged in the human resource management and payroll processing businesses. The aggregate consideration for the Shares consisted of (i) $11,348 in cash, a portion of which was used to pay certain obligations of Mangrove and (ii) a secured subordinated promissory note (the “Note”) in the principal amount of $6,000, subject to adjustment as provided in the Stock Purchase Agreement. We funded the cash payment with proceeds from our credit agreement with Wells Fargo. The Note was paid in full in the first quarter of 2017. The Stock Purchase Agreement contains certain customary representations, warranties, indemnities and covenants. Details regarding the financing of the acquisition are described under Note 6- Notes Payable. Transaction costs for this acquisition were $706 and we expensed them as incurred and included in selling, general and administrative expenses. Asset Purchase Agreement In March 2016, we also acquired substantially all the assets of Mangrove COBRAsource Inc., a benefits administration services business which then was a wholly owned subsidiary of Mangrove. The aggregate consideration for the assets was $1,036, which Mangrove COBRAsource applied to pay off certain loan balances. The Asset Purchase Agreement contains certain customary representations, warranties, indemnities and covenants. Purchase Price Allocation Following is the purchase price allocation for the acquisition of Mangrove. We recorded the transaction using the acquisition method of accounting and recognized assets and liabilities assumed at their fair value as of the date of acquisition. The $8,700 of intangible assets subject to amortization consist of $1,200 allocated to Customer Relationships, $6,900 in Developed Technology and $600 for Trade Names. We estimated the fair value of the Customer Relationships and Developed Technology using the excess earnings method, a form of the income approach. We discounted cash flow projections using a rate of 18.1%, which reflects the risk associated with the intangible asset related to the other assets and the overall business operations to us. We estimated the fair value of the Trade Names using the relief from royalty method based upon a 1.2% royalty rate for the payroll division and 0.5% for the benefits administration services business. We believe significant synergies are expected to arise from this strategic acquisition. This factor contributed to a purchase price that was in excess of the fair value of the net assets acquired and, as a result, we recorded goodwill. A portion of acquired goodwill will be deductible for tax purposes. 12 ASURE SOFTWARE, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (Amounts in thousands, except share and per share data or otherwise noted) We based the allocations on fair values at the date of acquisition: | Amount | --------------------------+--------+------- Assets acquired | | --------------------------+--------+------- Accounts receivable | $ | 523 --------------------------+--------+------- Funds held for clients | | 16,419 --------------------------+--------+------- Fixed assets | | 258 --------------------------+--------+------- Other assets | | 28 --------------------------+--------+------- Goodwill | | 9,016 --------------------------+--------+------- Intangibles | | 8,700 --------------------------+--------+------- Total assets acquired | $ | 34,944 --------------------------+--------+------- Liabilities assumed | | --------------------------+--------+------- Accounts payable | | 64 --------------------------+--------+------- Accrued other liabilities | | 461 --------------------------+--------+------- Client fund obligations | | 16,419 --------------------------+--------+------- Total liabilities assumed | $ | 16,944 --------------------------+--------+------- Net assets acquired | $ | 18,000 --------------------------+--------+------- Unaudited Pro Forma Financial Information The following unaudited summary of pro forma combined results of operations for the three and nine months ended September 30, 2017 and 2016 gives effect to the acquisitions of Mangrove, PMSI, iSystems and Compass and the acquisition of assets of COBRAsource, PSNW and CPI as if we had completed them on January 1, 2016. This pro forma summary does not reflect any operating efficiencies, cost savings or revenue enhancements that we may achieve by combining operations. In addition, we have not reflected certain non-recurring expenses, such as legal expenses and other transactions expenses for the first 12 months after the acquisition, in the pro forma summary. We present this pro forma summary for informational purposes only and it is not necessarily indicative of what our actual results of operations would have been had the acquisitions taken place as January 1, 2016, nor is it indicative of future consolidated results of operations. | FOR THE THREE MONTHS ENDED | | | FOR THE THREE MONTHS ENDED | -------------------------------------+----------------------------+--------+---+----------------------------+-- | SEPTEMBER 30, | | | SEPTEMBER 30, | -------------------------------------+----------------------------+--------+---+----------------------------+-- | 2017 | | | 2016 | -------------------------------------+----------------------------+--------+---+----------------------------+-- Revenues | $ | 15,527 | | | $ | 14,905 -------------------------------------+----------------------------+--------+---+----------------------------+---+------- Net income (loss) | $ | (927 | ) | | $ | 185 -------------------------------------+----------------------------+--------+---+----------------------------+---+------- Net income (loss) per common share: | | | | | | -------------------------------------+----------------------------+--------+---+----------------------------+---+------- Basic and diluted | $ | (0.07 | ) | | $ | 0.02 -------------------------------------+----------------------------+--------+---+----------------------------+---+------- Weighted average shares outstanding: | | | | | | -------------------------------------+----------------------------+--------+---+----------------------------+---+------- Basic and diluted | | 12,418 | | | | 8,186 -------------------------------------+----------------------------+--------+---+----------------------------+---+------- | FOR THE NINE MONTHS ENDED SEPTEMBER 30, | | | FOR THE NINE MONTHS ENDED SEPTEMBER 30, | -------------------------------------+-----------------------------------------+--------+---+-----------------------------------------+-- | 2017 | | | 2016 | -------------------------------------+-----------------------------------------+--------+---+-----------------------------------------+-- Revenues | $ | 45,743 | | | $ | 45,416 | -------------------------------------+-----------------------------------------+--------+---+-----------------------------------------+---+--------+-- Net loss | $ | (4,552 | ) | | $ | (4,221 | ) -------------------------------------+-----------------------------------------+--------+---+-----------------------------------------+---+--------+-- Net loss per common share: | | | | | | | -------------------------------------+-----------------------------------------+--------+---+-----------------------------------------+---+--------+-- Basic and diluted | $ | (0.40 | ) | | $ | (0.53 | ) -------------------------------------+-----------------------------------------+--------+---+-----------------------------------------+---+--------+-- Weighted average shares outstanding: | | | | | | | -------------------------------------+-----------------------------------------+--------+---+-----------------------------------------+---+--------+-- Basic and diluted | $ | 11,272 | | | $ | 8,021 | -------------------------------------+-----------------------------------------+--------+---+-----------------------------------------+---+--------+-- 13 ASURE SOFTWARE, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (Amounts in thousands, except share and per share data or otherwise noted) NOTE 5 – GOODWILL AND OTHER INTANGIBLE ASSETS Asure accounted for its historical acquisitions in accordance with ASC 805, Business Combinations . We recorded the amount exceeding the fair value of net assets acquired at the date of acquisition as goodwill. We recorded intangible assets apart from goodwill if the assets had contractual or other legal rights or if the assets could be separated and sold, transferred, licensed, rented or exchanged. Asure’s goodwill relates to the following acquisitions: ADI and Legiant in 2011, PeopleCube in 2012, FotoPunch and Roomtag in 2014, Mangrove in 2016, PMSI, CPI and PSNW in January 2017, and iSystems and Compass in May 2017. As part of the acquisition of iSystems in May 2017, we acquired software development costs. We continue to invest in software development. We are developing products which we intend to offer utilizing software as-a-service (“SaaS”).We follow the guidance of ASC 350-40, Intangibles- Goodwill and Other- Internal Use Software , for development costs related to these new products. Cost incurred in the planning stage are expensed as incurred while costs incurred in the application and infrastructure stage are capitalized, assuming such costs are deemed to be recoverable. Costs incurred in the operating stage are generally expensed as incurred except for significant upgrades and enhancements. Capitalized software costs are amortized over the software’s estimated useful life, which management has determined to be three years. During the three and nine months ended September 30, 2017, we capitalized $702 and $804, respectively, of software development costs. No software development costs were recorded in 2016. In accordance with ASC 350, Intangibles-Goodwill and Other, we review and evaluate our long-lived assets, including intangible assets with finite lives, for impairment whenever events or changes in circumstances indicate that we may not recover their net book value. We test goodwill for impairment on an annual basis in the fourth fiscal quarter of each year, and between annual tests, if indicators of potential impairment exist, using a fair-value-based approach. There has been no impairment of goodwill for the periods presented. We amortize intangible assets not considered to have an indefinite useful life using the straight-line method over their estimated period of benefit, which generally ranges from one to nine years. Each reporting period, we evaluate the estimated remaining useful life of intangible assets and assess whether events or changes in circumstances warrant a revision to the remaining period of amortization or indicate that impairment exists. We have not identified any impairments of finite-lived intangible assets during any of the periods presented. The following table summarizes the changes in our goodwill: Balance at December 31, 2016 | $ | 26,259 -------------------------------------------------------------------------------+---+------- Goodwill recognized upon acquisitions of PMSI, CPI, PSNW, iSystems and Compass | | 49,318 -------------------------------------------------------------------------------+---+------- Adjustment to Goodwill associated with acquisition of Mangrove | | 272 -------------------------------------------------------------------------------+---+------- Foreign exchange adjustment to goodwill | | 6 -------------------------------------------------------------------------------+---+------- Balance at September 30, 2017 | $ | 75,855 -------------------------------------------------------------------------------+---+------- The gross carrying amount and accumulated amortization of our intangible assets as of September 30, 2017 and December 31, 2016 are as follows: | | | September 30, 2017 | ---------------------------+-------------------------------------------------+------+--------------------+-- Intangible Assets | Weighted Average Amortization Period (in Years) | | Gross | | | Accumulated Amortization | | Net | ---------------------------+-------------------------------------------------+------+--------------------+---+--------+--------------------------+---+---------+-- Developed Technology | | 11.8 | | $ | 11,925 | | $ | (4,585 | ) | $ | 7,340 ---------------------------+-------------------------------------------------+------+--------------------+---+--------+--------------------------+---+---------+---+---+------- Customer Relationships | | 7.5 | | | 35,516 | | | (12,354 | ) | | 23,162 ---------------------------+-------------------------------------------------+------+--------------------+---+--------+--------------------------+---+---------+---+---+------- Reseller Relationships | | 7.0 | | | 853 | | | (731 | ) | | 122 ---------------------------+-------------------------------------------------+------+--------------------+---+--------+--------------------------+---+---------+---+---+------- Trade Names | | 14.8 | | | 2,815 | | | (787 | ) | | 2,028 ---------------------------+-------------------------------------------------+------+--------------------+---+--------+--------------------------+---+---------+---+---+------- Noncompete | | 2.9 | | | 592 | | | (108 | ) | | 484 ---------------------------+-------------------------------------------------+------+--------------------+---+--------+--------------------------+---+---------+---+---+------- Software development costs | | 3.0 | | | 919 | | | (9 | ) | | 910 ---------------------------+-------------------------------------------------+------+--------------------+---+--------+--------------------------+---+---------+---+---+------- | | 8.7 | | $ | 52,620 | | $ | (18,574 | ) | $ | 34,046 ---------------------------+-------------------------------------------------+------+--------------------+---+--------+--------------------------+---+---------+---+---+------- 14 ASURE SOFTWARE, INC. NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (Amounts in thousands, except share and per share data unless otherwise noted) | | | December 31, 2016 | -----------------------+-------------------------------------------------+------+-------------------+-- Intangible Assets | Weighted Average Amortization Period (in Years) | | Gross | | | Accumulated Amortization | | Net | -----------------------+-------------------------------------------------+------+-------------------+---+--------+--------------------------+---+---------+-- Developed Technology | | 12.7 | | $ | 10,915 | | $ | (3,408 | ) | $ | 7,507 -----------------------+-------------------------------------------------+------+-------------------+---+--------+--------------------------+---+---------+---+---+------- Customer Relationships | | 7.3 | | | 14,011 | | | (10,270 | ) | | 3,741 -----------------------+-------------------------------------------------+------+-------------------+---+--------+--------------------------+---+---------+---+---+------- Reseller Relationships | | 7.0 | | | 853 | | | (640 | ) | | 213 -----------------------+-------------------------------------------------+------+-------------------+---+--------+--------------------------+---+---------+---+---+------- Trade Names | | 14.5 | | | 1,294 | | | (707 | ) | | 587 -----------------------+-------------------------------------------------+------+-------------------+---+--------+--------------------------+---+---------+---+---+------- | | 9.8 | | $ | 27,073 | | $ | (15,025 | ) | $ | 12,048 -----------------------+-------------------------------------------------+------+-------------------+---+--------+--------------------------+---+---------+---+---+------- We record amortization expense using the straight-line method over the estimated useful lives of the intangible assets, as noted above. Amortization expenses for the three months ended September 30, 2017 and 2016 were $1,341 and $625, respectively, included in Operating Expenses. Amortization expenses recorded in Cost of Sales were $106 and $106 for the three months ended September 30, 2017 and 2016, respectively. Amortization expenses for the nine months ended September 30, 2017 and 2016 were $3,230 and $1,628 included in Operating Expenses, and $319 and $319, respectively, included in Cost of Sales. The following table summarizes the future estimated amortization expense relating to our intangible assets as of September 30, 2017: Calendar Years | | -----------------------------------------------------+---+------- 2017 (July to December) | $ | 1,438 -----------------------------------------------------+---+------- 2018 | | 5,424 -----------------------------------------------------+---+------- 2019 | | 4,650 -----------------------------------------------------+---+------- 2020 | | 3,803 -----------------------------------------------------+---+------- 2021 | | 3,848 -----------------------------------------------------+---+------- Thereafter | | 14,079 -----------------------------------------------------+---+------- Subtotal | $ | 33,242 -----------------------------------------------------+---+------- Software development costs not yet placed in service | | 804 -----------------------------------------------------+---+------- | $ | 34,046 -----------------------------------------------------+---+------- NOTE 6 – NOTES PAYABLE The following table summarizes our outstanding debt as of the dates indicated: Notes Payable | Maturity | Stated Interest Rate | | | Balance as of September 30, 2017 | | | Balance as of December 31, 2016 -------------------------------------------------+-----------+----------------------+------+---+----------------------------------+---+--------+-------------------------------- Subordinated Notes Payable- Mangrove acquisition | 3/18/2018 | | 3.50 | % | | $ | - | | $ | 6,000 -------------------------------------------------+-----------+----------------------+------+---+----------------------------------+---+--------+---------------------------------+---+------- Subordinated Notes Payable- PMSI acquisition | 4/30/2018 | | 2.00 | % | | | 1,125 | | | - -------------------------------------------------+-----------+----------------------+------+---+----------------------------------+---+--------+---------------------------------+---+------- Subordinated Notes Payable- CPI acquisition | 4/30/2018 | | - | % | | | 500 | | | - -------------------------------------------------+-----------+----------------------+------+---+----------------------------------+---+--------+---------------------------------+---+------- Subordinated Notes Payable- PSNW acquisition | 3/31/2018 | | 2.00 | % | | | 600 | | | - -------------------------------------------------+-----------+----------------------+------+---+----------------------------------+---+--------+---------------------------------+---+------- Subordinated Notes Payable- iSystems acquisition | 5/25/2019 | | 3.50 | % | | | 5,000 | | | - -------------------------------------------------+-----------+----------------------+------+---+----------------------------------+---+--------+---------------------------------+---+------- Subordinated Notes Payable- Compass acquisition | 5/25/2022 | | 2.0 | % | | | 1,500 | | | - -------------------------------------------------+-----------+----------------------+------+---+----------------------------------+---+--------+---------------------------------+---+------- Term Loan – Wells Fargo Syndicate Partner | 5/25/2022 | | 9.53 | % | | | 34,562 | | | - -------------------------------------------------+-----------+----------------------+------+---+----------------------------------+---+--------+---------------------------------+---+------- Term Loan - Wells Fargo | 5/25/2022 | | 4.53 | % | | | 34,563 | | | 24,715 -------------------------------------------------+-----------+----------------------+------+---+----------------------------------+---+--------+---------------------------------+---+------- Total Notes Payable | | | | | | $ | 77,850 | | $ | 30,715 -------------------------------------------------+-----------+----------------------+------+---+----------------------------------+---+--------+---------------------------------+---+------- Short-term notes payable | | | | | | $ | 8,869 | | $ | 5,455 -------------------------------------------------+-----------+----------------------+------+---+----------------------------------+---+--------+---------------------------------+---+------- Long-term notes payable | | | | | | $ | 68,981 | | $ | 25,260 -------------------------------------------------+-----------+----------------------+------+---+----------------------------------+---+--------+---------------------------------+---+------- 15 ASURE SOFTWARE, INC. NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (Amounts in thousands, except share and per share data unless otherwise noted) The following table summarizes the debt issuance costs as of the dates indicated: Notes Payable | Gross Notes Payable at September 30, 2017 | | Debt Issuance Costs and Debt Discount | | | Net Notes Payable at September 30, 2017 --------------------------------------+-------------------------------------------+--------+---------------------------------------+---+--------+---------------------------------------- Notes payable, current portion | $ | 8,869 | | $ | (145 | ) | $ | 8,724 --------------------------------------+-------------------------------------------+--------+---------------------------------------+---+--------+-----------------------------------------+---+------- Notes payable, net of current portion | | 68,981 | | | (2,001 | ) | | 66,980 --------------------------------------+-------------------------------------------+--------+---------------------------------------+---+--------+-----------------------------------------+---+------- Total Notes Payable | $ | 77,850 | | $ | (2,146 | ) | $ | 75,704 --------------------------------------+-------------------------------------------+--------+---------------------------------------+---+--------+-----------------------------------------+---+------- Notes Payable | Gross Notes Payable at December 31, 2016 | | Debt Issuance Costs and Debt Discount | | | Net Notes Payable at December 31, 2016 --------------------------------------+------------------------------------------+--------+---------------------------------------+---+------+--------------------------------------- Notes payable, current portion | $ | 5,455 | | $ | - | | $ | 5,455 --------------------------------------+------------------------------------------+--------+---------------------------------------+---+------+----------------------------------------+---+------- Notes payable, net of current portion | | 25,260 | | | (679 | ) | | 24,581 --------------------------------------+------------------------------------------+--------+---------------------------------------+---+------+----------------------------------------+---+------- Total Notes Payable | $ | 30,715 | | $ | (679 | ) | $ | 30,036 --------------------------------------+------------------------------------------+--------+---------------------------------------+---+------+----------------------------------------+---+------- The following table summarizes the future principal payments related to our outstanding debt: Year Ended | Gross Amount | ----------------------------------------+--------------+------- December 31, 2017 (October to December) | $ | 875 ----------------------------------------+--------------+------- December 31, 2018 | | 8,525 ----------------------------------------+--------------+------- December 31, 2019 | | 6,300 ----------------------------------------+--------------+------- December 31, 2020 | | 3,800 ----------------------------------------+--------------+------- December 31, 2021 | | 3,800 ----------------------------------------+--------------+------- Thereafter | | 54,550 ----------------------------------------+--------------+------- Gross Notes Payable | $ | 77,850 ----------------------------------------+--------------+------- Subordinated Notes Payable- PMSI Acquisition In January 2017, we acquired all of the outstanding shares of common stock (the “Shares”) of Personnel Management Systems, Inc., a Washington corporation (“PMSI”), pursuant to a Stock Purchase Agreement (the “Stock Purchase Agreement”). The aggregate consideration for the Shares consisted of (i) $3,875 in cash and (ii) a subordinated promissory note (the “PMSI Note”) in the principal amount of $1,125 subject to adjustment as provided in the Stock Purchase Agreement. We funded the cash payment with proceeds from our recent public stock offering. The PMSI Note bears interest at an annual rate of 2.0% and matures on April 30, 2018. The entire unpaid principal and all accrued interest under the PMSI Note is payable at maturity. Subordinated Notes Payable- CPI Acquisition In January 2017, we acquired substantially all the assets of Corporate Payroll, Inc., an Ohio corporation (“CPI”), relating to its payroll service bureau business, pursuant to an Asset Purchase Agreement (the “CPI Asset Purchase Agreement”). The aggregate consideration for the assets consisted of (i) $1,500 in cash, (ii) a subordinated promissory note (the “CPI Note”) in the principal amount of $500 and (iii) 112,166 shares of our common stock valued at $1,000, subject to adjustment as provided in the CPI Asset Purchase Agreement. We funded the cash payment with proceeds from our recent public stock offering. The CPI Note bears no interest and matures on April 30, 2018. The entire unpaid principal under the CPI Note is payable at maturity. Subordinated Notes Payable – PSNW Acquisition In January 2017, we acquired substantially all the assets of Payroll Specialties NW, Inc., an Oregon corporation (“PSNW”), pursuant to an Asset Purchase Agreement (the “PSNW Asset Purchase Agreement”). The aggregate consideration for the assets consisted of (i) $3,010 in cash and (ii) a subordinated promissory note (the “PSNW Note”) in the principal amount of $600, subject to adjustment as provided in the PSNW Asset Purchase Agreement. We funded the cash payment with proceeds from our recent public stock offering. The PSNW Note bears interest at an annual rate of 2.0% and matures on April 30, 2018. The entire unpaid principal and all accrued interest under the PSNW Note is payable at maturity. 16 ASURE SOFTWARE, INC. NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (Amounts in thousands, except share and per share data unless otherwise noted) Subordinated Notes Payable- iSystems Acquisition In May 2017 we acquired 100% of the outstanding equity interests of iSystems Intermediate Holdco, Inc., a Delaware corporation (“iSystems”), pursuant to an equity purchase agreement (the “Equity Purchase Agreement”). The aggregate purchase price consisted of (i) $32,000 in cash, subject to adjustment as provided in the Equity Purchase Agreement, (ii) a secured subordinated promissory note (“iSystems Note”) in the principal amount of $5,000, subject to adjustment as provided in the Equity Purchase Agreement, and (iii) 1,526,332 shares of unregistered common stock valued at $18,000. The iSystems Note bears interest at an annual rate of 3.5% and matures on May 25, 2019. The unpaid principal and all accrued interest under the promissory note is payable in two installments of $2.5 million on May 25, 2018 and May 25, 2019, subject to adjustment. Subordinated Notes Payable- Compass Acquisition In May 2017, we acquired 100% of the outstanding shares of capital stock of Compass HRM, Inc. (“Compass”) pursuant to a stock purchase agreement (the “Stock Purchase Agreement”). The aggregate purchase price consisted of $4,500 in cash and a subordinated promissory note (“Compass Note”) in the principal amount of $1,500, subject to adjustment as provided in the Stock Purchase Agreement. The Compass Note bears interest at an annual rate of 2.0% and matures on May 25, 2022. The Compass Note is payable in five annual installments of $300 on the anniversary of the closing date, subject to adjustment. Subordinated Notes Payable- Mangrove Acquisition In March 2016, we acquired all of the issued and outstanding shares of common stock (the “Shares”) of Mangrove. The aggregate consideration for the Shares consisted of (i) $11,348 in cash, a portion of which was used to pay certain obligations of Mangrove and (ii) a secured subordinated promissory note (the “Note”) in the principal amount of $6,000, subject to adjustment as provided in the Stock Purchase Agreement. We funded the cash payment with proceeds from the Credit Agreement with Wells Fargo. This note was paid in full in the first quarter of 2017. Term Loan - Wells Fargo In March 2014, we entered into a credit agreement (the “Credit Agreement”) with Wells Fargo Bank, N.A., as administrative agent, and the lenders that are party thereto. The Credit Agreement contains customary events of default, including, among others, payment defaults, covenant defaults, judgment defaults, bankruptcy and insolvency events, cross defaults to certain indebtedness, incorrect representations or warranties, and change of control. In some cases, the defaults are subject to customary notice and grace period provisions. In March 2014 and in connection with the Credit Agreement, we and our wholly-owned active subsidiaries entered into a Guaranty and Security Agreement with Wells Fargo Bank. Under the Guaranty and Security Agreement, we and each of our wholly-owned active subsidiaries have guaranteed all obligations under the Credit Agreement and granted a security interest in substantially all of our and our subsidiaries’ assets. The Credit Agreement provided for a term loan in the amount of $15,000 maturing in March 2019. The Credit Agreement also provided for a revolving loan commitment in the aggregate amount of up to $3,000. The outstanding principal amount of the revolving loan is due and payable in March 2019. As of September 30, 2017 and December 31, 2016, $0 was outstanding and $5,000 was available for borrowing under the revolver. Additionally, the Credit Agreement provided for a $10,000 uncommitted incremental term loan facility to support permitted acquisitions. In March 2017, we amended our Credit Agreement with Wells Fargo Bank, N.A to, among other things, obtain an additional term loan in the amount of $5,000. In the first quarter of 2017, we used the proceeds of the additional term loan to repay a portion of all amounts outstanding under the secured subordinated note we issued in connection with the Mangrove acquisition. Amended and Restated Credit Agreement In May 2017, we entered into an amended and restated credit agreement (the “Restated Credit Agreement”) with Wells Fargo Bank, N. A., as administrative agent, and the lenders that are parties thereto, amending and restating the terms of the Credit Agreement dated as of March 2014, as amended. 17 ASURE SOFTWARE, INC. NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (Amounts in thousands, except share and per share data unless otherwise noted) The Restated Credit Agreement provides for an increase in the aggregate principal amount of total commitments from approximately $32,714 to $75,000. This increase includes an additional term loan commitment of approximately $40,286 and an additional revolver commitment of $2,000. The term loan consists of a $35,000 “First Out Loan Obligation” funded by Wells Fargo as administrative agent, and a $35,000 “Last Out Loan Obligation” funded by Wells Fargo’s syndicate partner, Goldman Sachs. The Restated Credit Agreement amends the applicable margin rates for determining the interest rate payable on outstanding First Out and Last Out loan obligations as follows: Leverage Ratio | First Out Base Rate Margin | First Out LIBOR Rate Margin | Last Out Base Rate Margin | Last Out LIBOR Rate Margin ---------------+-----------------------------+------------------------------+----------------------------+---------------------------- < 3.25:1 | 2.00 Percentage Points | 3.00 Percentage Points | 7.00 Percentage Points | 8.00 Percentage Points ---------------+-----------------------------+------------------------------+----------------------------+---------------------------- > 3.25:1 | 2.50 Percentage Points | 3.50 Percentage Points | 7.50 Percentage Points | 8.50 Percentage Points ---------------+-----------------------------+------------------------------+----------------------------+---------------------------- The outstanding principal amount of the term loan is payable in equal installments of $875 beginning on September 30, 2017 and the last day of each fiscal quarter thereafter. The outstanding principal balance and all accrued and unpaid interest on the term loan is due on May 25, 2022. The Restated Credit Agreement also: · amends our leverage ratio covenant to increase the maximum ratio to 5.75:1 at June 30, 2017, stepping down to 3.25:1 at June 30, 2020 and each quarter-end thereafter; · amends our fixed charge coverage ratio to be not less than 1.35:1 at June 30, 2017 and September 30, 2017, not less than 1.45:1 at December 31, 2017, and not less than 1.50:1 beginning with the quarter ending March 31, 2018 and each quarter-end thereafter; and · adds a Trailing Twelve Months (“TTM”) recurring revenue covenant, requiring software-as-a-service, hardware-as-a-service and cloud subscription and maintenance support revenues to be at least $41,000 at June 30, 2017 and stepping up to $60,500 at June 30, 2022 and each quarter-end thereafter. As of September 30, 2017, we were in compliance with all covenants and all payments remain current. We expect to be in compliance or be able to obtain compliance through debt repayments with available cash on hand or cash we expect to generate from the ordinary course of operations over the next twelve months. NOTE 7 – SHARE BASED COMPENSATION Share based compensation for our stock option plans for the three months ended September 30, 2017 and 2016 were $138 and $60, respectively, and $363 and $166 for the nine months ended September 30, 2017 and 2016, respectively. We issued 51,000 shares of common stock related to exercises of stock options granted from our Stock Option Plan for the three months ended September 30, 2017 and 15,000 shares for the three months ended September 30, 2016, respectively. Asure has one active equity plan, the 2009 Equity Plan (the “2009 Plan”). The 2009 Plan provides for the issuance of non-qualified and incentive stock options to our employees and consultants. We generally grant stock options with exercise prices greater than or equal to the fair market value at the time of grant. The options generally vest over three to four years and are exercisable for a period of five to ten years beginning with date of grant. Our shareholders approved an amendment to the 2009 Plan in June 2017 to increase the number of shares reserved under the plan from 1,400,000 to 1,700,000. We have 904,000 options granted and outstanding and 176,000 available for grant pursuant to the 2009 Plan as of September 30, 2017. NOTE 8 – OTHER COMPREHENSIVE LOSS Comprehensive income (loss) represents a measure of all changes in equity that result from recognized transactions and other economic events other than those resulting from investments by and distributions to shareholders. Our other comprehensive income (loss) includes foreign currency translation adjustments. 18 ASURE SOFTWARE, INC. NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (Amounts in thousands, except share and per share data unless otherwise noted) The following table presents the changes in each component of accumulated other comprehensive income (loss), net of tax: | Foreign Currency Items | | | Accumulated Other Comprehensive Loss Items | ------------------------------------------------------------------------+------------------------+-----+---+--------------------------------------------+-- Beginning balance, December 31, 2016 | $ | 5 | | | $ | 5 | ------------------------------------------------------------------------+------------------------+-----+---+--------------------------------------------+---+-----+-- Other comprehensive loss before reclassifications | | (63 | ) | | | (63 | ) ------------------------------------------------------------------------+------------------------+-----+---+--------------------------------------------+---+-----+-- Amounts reclassified from accumulated other comprehensive income (loss) | | — | | | | — | ------------------------------------------------------------------------+------------------------+-----+---+--------------------------------------------+---+-----+-- Net current-period other comprehensive loss | | (63 | ) | | | (63 | ) ------------------------------------------------------------------------+------------------------+-----+---+--------------------------------------------+---+-----+-- Ending balance, September 30, 2017 | $ | (58 | ) | | $ | (58 | ) ------------------------------------------------------------------------+------------------------+-----+---+--------------------------------------------+---+-----+-- The following table presents the tax benefit (expense) allocated to each component of other comprehensive income (loss): | Three Months Ended September 30, 2017 | -----------------------------------------+---------------------------------------+--- | Before Tax | | | Tax Benefit | | | Net of Tax -----------------------------------------+---------------------------------------+----+---+-------------+---+---+----------- Foreign currency translation adjustments | $ | (6 | ) | | $ | — | | $ | (6 | ) -----------------------------------------+---------------------------------------+----+---+-------------+---+---+------------+---+----+-- Other comprehensive loss | $ | (6 | ) | | $ | — | | $ | (6 | ) -----------------------------------------+---------------------------------------+----+---+-------------+---+---+------------+---+----+-- | Nine Months Ended September 30, 2017 | -----------------------------------------+--------------------------------------+---- | Before Tax | | | Tax Benefit | | | Net of Tax -----------------------------------------+--------------------------------------+-----+---+-------------+---+---+----------- Foreign currency translation adjustments | $ | (63 | ) | | $ | — | | $ | (63 | ) -----------------------------------------+--------------------------------------+-----+---+-------------+---+---+------------+---+-----+-- Other comprehensive loss | $ | (63 | ) | | $ | — | | $ | (63 | ) -----------------------------------------+--------------------------------------+-----+---+-------------+---+---+------------+---+-----+-- NOTE 9 – NET LOSS PER SHARE We compute net loss per share based on the weighted average number of common shares outstanding for the period. Diluted net loss per share reflects the maximum dilution that would have resulted from incremental common shares issuable upon the exercise of stock options. We compute the number of common share equivalents, which includes stock options, using the treasury stock method. We have excluded stock options to acquire 904,000 shares for the three and nine months ended September 30, 2017, and 452,000 shares for the nine months ended September 30, 2016 from the computation of the dilutive stock options because the effect of including the stock options would have been anti-dilutive. The following table sets forth the computation of basic and diluted net income (loss) per common share for the three and nine months ended September 30, 2017 and 2016: | For the Three Months | | | For the Nine Months | ----------------------------------------------------------------+----------------------+------------+---+---------------------+-- | Ended September 30, | | | Ended September 30, | ----------------------------------------------------------------+----------------------+------------+---+---------------------+-- | 2017 | | | 2016 | | | 2017 | | 2016 | ----------------------------------------------------------------+----------------------+------------+---+---------------------+---+-----------+------+---+------------+-- Net income (loss) | $ | (1,281 | ) | | $ | 315 | | $ | (4,177 | ) | $ | (1,103 | ) ----------------------------------------------------------------+----------------------+------------+---+---------------------+---+-----------+------+---+------------+---+---+-----------+-- Weighted-average shares of common stock outstanding | | 12,418,000 | | | | 6,534,000 | | | 10,355,000 | | | 6,383,000 | ----------------------------------------------------------------+----------------------+------------+---+---------------------+---+-----------+------+---+------------+---+---+-----------+-- Dilutive effect of employee stock options | | - | | | | 14,000 | | | - | | | - | ----------------------------------------------------------------+----------------------+------------+---+---------------------+---+-----------+------+---+------------+---+---+-----------+-- Weighted average shares for diluted net income (loss) per share | | 12,418,000 | | | | 6,548,000 | | | 10,355,000 | | | 6,383,000 | ----------------------------------------------------------------+----------------------+------------+---+---------------------+---+-----------+------+---+------------+---+---+-----------+-- Basic net (loss) income per share | $ | (0.10 | ) | | $ | 0.05 | | $ | (0.40 | ) | $ | (0.17 | ) ----------------------------------------------------------------+----------------------+------------+---+---------------------+---+-----------+------+---+------------+---+---+-----------+-- Diluted net (loss) income per share | $ | (0.10 | ) | | $ | 0.05 | | $ | (0.40 | ) | $ | (0.17 | ) ----------------------------------------------------------------+----------------------+------------+---+---------------------+---+-----------+------+---+------------+---+---+-----------+-- NOTE 10 - SUBSEQUENT EVENTS Effective October 1, 2017, we closed the strategic acquisition of Associated Data Services, Inc., a leading regional human resources and payroll services bureau in the Southeast and a current reseller of our HCM solution, Evolution. Effective October 9, 2017, our headquarters moved locations in Austin, Texas. Our prior office lease terminated on the date the new lease commenced. The new office space is approximately 14,500 square feet for a period of 60 months. Future minimum payments total approximately $2,073. 19 ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS Certain statements in this Report represent forward-looking statements. These statements involve known and unknown risks, uncertainties and other factors that may cause actual results of operations, levels of activity, economic performance, financial condition or achievements to be materially different from future results of operations, levels of activity, economic performance, financial condition or achievements as expressed or implied by such forward-looking statements. Asure has attempted to identify these forward-looking statements with the words “believes,” “estimates,” “plans,” “expects,” “anticipates,” “may,” “could” and other similar expressions. Although these forward-looking statements reflect management’s current plans and expectations, which we believe are reasonable as of the filing date of this report, they inherently are subject to certain risks and uncertainties. These risks and uncertainties include — but are not limited to — adverse changes in the economy, financial markets, and credit markets; delays or reductions in information technology spending; the development of the market for cloud based workplace applications; product development; market acceptance of new products and product improvements; our ability to retain or increase our customer base; security breaches; errors, disruptions or delays in our services; privacy concerns and laws; changes in our sales cycle; competition, including pricing pressures, entry of new competitors, and new technologies; intellectual property enforcement and litigation; our ability to hire, retain and motivate employees; our ability to manage our growth; our ability to realize benefits from acquisitions; the level of our indebtedness; changes in sales may not be immediately reflected in our operating results due to our subscription model; changes in laws and regulations; changes in the Internet infrastructure; and changes in accounting standards. Asure is under no obligation to update any of the forward-looking statements after the date of this Form 10-Q to conform such statements to actual results. OVERVIEW The following review of Asure’s financial position as of September 30, 2017 and December 31, 2016 and the results of operations and cash flows for the three and nine months ended September 30, 2017 and 2016 should be read in conjunction with our 2016 Annual Report on Form 10-K filed with the Securities and Exchange Commission. Asure’s internet website address is http://www.asuresoftware.com. Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are available through the investor relations page of our internet website free of charge as soon as reasonably practicable after they are electronically filed, or furnished to, the Securities and Exchange Commission. Asure’s internet website and the information contained therein or connected thereto is not incorporated into this Quarterly Report on Form 10-Q. Asure is a leading global provider of cloud-based software-as-a-service (“SaaS”) time and labor management and Agile Workplace management solutions that enable companies of all sizes and complexities to operate more efficiently and proactively manage costs associated with their most expensive assets: real estate, labor and technology. We currently offer two main product lines, AsureSpace™ and AsureForce®. Our AsureSpace™ Agile Workplace management solutions enable organizations to manage their office environments and optimize real estate utilization. Our AsureForce® time and labor management solutions help organizations optimize labor and labor administration costs and activities. With our acquisitions of Mangrove Employer Services, Inc. and the assets of Mangrove COBRAsource Inc. in March 2016, we have entered into the human resource management, payroll processing and benefits administration services businesses, which we are integrating into our existing AsureForce® product line. In January 2017, we closed three strategic acquisitions: Personnel Management Systems, Inc., a provider of outsourced HR solutions; Corporate Payroll, Inc. (Payroll Division), a provider of payroll services; and Payroll Specialties NW, Inc., a provider of payroll services. In May 2017, we closed two strategic acquisitions: iSystems, LLC and Compass HRM. iSystems LLC, through its flagship product, Evolution HCM, offers payroll, tax management and HR software combined with comprehensive back-end service bureau tools to service providers across the United States. Tampa-based Compass HRM is a current reseller of our HCM offering (formerly Mangrove), which provides human resources solutions that enhance organizations, people, and profits through payroll and HR solutions. The acquisition of Compass HRM expands our reach in the Southeast, particularly Florida. For both product lines, support and professional services are other key elements of our software and services business. As an extension of our perpetual software product offerings, Asure offers our customers maintenance and support contracts that provide ready access to qualified support staff, software patches and upgrades to our software products. We also provide installation of and training on our products, add-on software customization and other professional services on a global scale. We target our sales and marketing efforts to a wide range of audiences, from small to medium-sized businesses and divisions of enterprise organizations throughout the United States, Europe and Asia/Pacific. We generate sales of our solutions through our direct sales teams and indirectly through our channel partners. We are expanding our investment in our direct sales teams to continue to address our market opportunity. 20 RESULTS OF OPERATIONS The following table sets forth, for the fiscal periods indicated, the percentage of total revenues represented by certain items in Asure’s Condensed Consolidated Statements of Comprehensive Income (Loss): | FOR THE THREE MONTHS ENDED SEPTEMBER 30, | | | FOR THE NINE MONTHS ENDED SEPTEMBER 30, ------------------------------------+------------------------------------------+-------+---+---------------------------------------- | 2017 | | | 2016 | | 2017 | 2016 | ------------------------------------+------------------------------------------+-------+---+-----------------------------------------+------+------+-------+-- Revenues | | 100 | % | | 100 | % | 100 | % | 100 | % ------------------------------------+------------------------------------------+-------+---+-----------------------------------------+------+------+-------+---+------+-- Gross margin | | 78.1 | | | 78.5 | | 77.9 | | 77.0 | ------------------------------------+------------------------------------------+-------+---+-----------------------------------------+------+------+-------+---+------+-- Selling, general and administrative | | 60.9 | | | 53.5 | | 64.6 | | 60.2 | ------------------------------------+------------------------------------------+-------+---+-----------------------------------------+------+------+-------+---+------+-- Research and development | | 5.7 | | | 8.1 | | 6.4 | | 8.6 | ------------------------------------+------------------------------------------+-------+---+-----------------------------------------+------+------+-------+---+------+-- Amortization of intangible assets | | 8.6 | | | 6.6 | | 8.3 | | 6.3 | ------------------------------------+------------------------------------------+-------+---+-----------------------------------------+------+------+-------+---+------+-- Total operating expenses | | 75.2 | | | 68.1 | | 79.2 | | 75.1 | ------------------------------------+------------------------------------------+-------+---+-----------------------------------------+------+------+-------+---+------+-- Other loss, net | | (10.6 | ) | | (6.6 | ) | (8.4 | ) | (5.7 | ) ------------------------------------+------------------------------------------+-------+---+-----------------------------------------+------+------+-------+---+------+-- Net income (loss) | | (8.3 | ) | | 3.3 | | (10.7 | ) | (4.3 | ) ------------------------------------+------------------------------------------+-------+---+-----------------------------------------+------+------+-------+---+------+-- THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2017 AND 2016 (Amounts in thousands) Revenue Our revenue was derived from the following sources: | FOR THE THREE MONTHS ENDED September 30, | | Increase (Decrease) | | ------------------------------------+------------------------------------------+--------+---------------------+---+------ Revenue | 2017 | | 2016 | | | % | ------------------------------------+------------------------------------------+--------+---------------------+---+-------+---+------ Cloud revenue | $ | 11,062 | | $ | 5,630 | $ | 5,432 | | 96.5 | ------------------------------------+------------------------------------------+--------+---------------------+---+-------+---+-------+---+-------+-- Hardware revenue | | 1,003 | | | 676 | | 327 | | 48.4 | ------------------------------------+------------------------------------------+--------+---------------------+---+-------+---+-------+---+-------+-- Maintenance and support revenue | | 1,178 | | | 1,078 | | 100 | | 9.3 | ------------------------------------+------------------------------------------+--------+---------------------+---+-------+---+-------+---+-------+-- On premise software license revenue | | 599 | | | 754 | | (155 | ) | (20.6 | ) ------------------------------------+------------------------------------------+--------+---------------------+---+-------+---+-------+---+-------+-- Professional services revenue | | 1,685 | | | 1,302 | | 383 | | 29.4 | ------------------------------------+------------------------------------------+--------+---------------------+---+-------+---+-------+---+-------+-- Total revenue | $ | 15,527 | | $ | 9,440 | $ | 6,087 | | 64.5 | ------------------------------------+------------------------------------------+--------+---------------------+---+-------+---+-------+---+-------+-- | FOR THE NINE MONTHS ENDED September 30, | | Increase (Decrease) | | ------------------------------------+-----------------------------------------+--------+---------------------+---+------- Revenue | 2017 | | 2016 | | | % | ------------------------------------+-----------------------------------------+--------+---------------------+---+--------+---+------- Cloud revenue | $ | 27,724 | | $ | 14,881 | $ | 12,843 | | 86.3 | ------------------------------------+-----------------------------------------+--------+---------------------+---+--------+---+--------+---+-------+-- Hardware revenue | | 3,651 | | | 2,644 | | 1,007 | | 38.1 | ------------------------------------+-----------------------------------------+--------+---------------------+---+--------+---+--------+---+-------+-- Maintenance and support revenue | | 3,276 | | | 3,509 | | (233 | ) | (6.6 | ) ------------------------------------+-----------------------------------------+--------+---------------------+---+--------+---+--------+---+-------+-- On premise software license revenue | | 1,049 | | | 1,352 | | (303 | ) | (22.4 | ) ------------------------------------+-----------------------------------------+--------+---------------------+---+--------+---+--------+---+-------+-- Professional services revenue | | 3,434 | | | 3,440 | | (6 | ) | .2 | ------------------------------------+-----------------------------------------+--------+---------------------+---+--------+---+--------+---+-------+-- Total revenue | $ | 39,134 | | $ | 25,826 | $ | 13,308 | | 51.5 | ------------------------------------+-----------------------------------------+--------+---------------------+---+--------+---+--------+---+-------+-- Revenue represents our consolidated revenues, including sales of our scheduling software, time and attendance and human resource software, complementary hardware devices to enhance our software products, software maintenance and support services, installation and training services and other professional services. Our product offerings are categorized into AsureSpace™ and AsureForce®. AsureSpace™ offers workplace management solutions that enable organizations to manage their office environments and optimize real estate utilization, and AsureForce® offers time and labor management solutions which help organizations optimize labor and labor administration costs and activities. Both product groupings include cloud revenue, hardware revenue, maintenance and support revenue, on premise software license revenue and professional services revenue. AsureSpace™ revenues include PeopleCube, Meeting Room Manager and Roomtag revenues. AsureForce® revenues include ADI, Legiant, iEmployee, FotoPunch, Mangrove, iSystems and Compass revenues. 21 Revenue for the three months ended September 30, 2017 was $15,527, an increase of $6,087, or 64.5%, from the $9,440 reported for the three months ended September 30, 2016. The largest increase was in cloud revenue, which increased $5,432, or 96.5% from the third quarter of 2016. Cloud revenue increased due to our continued emphasis on selling integrated cloud based solutions, as well as cloud revenue primarily from 2017 acquisitions. iSystems and PMSI recognized $4,139 of cloud revenue in the three months ended September 30, 2017, representing 68.0% of the increase in the three months ended September 30, 2017. Hardware revenue, professional services revenue and maintenance and support revenue also increased as compared to the three months ended September 30, 2016. This was offset by a small decrease in on premise software license revenue of $155, or 20.6%, as compared to the three months ended September 30, 2016, which is consistent with our focus on cloud revenue. Revenue for the nine months ended September 30, 2017 were $39,134, an increase of $13,308, or 51.5%, from the $25,826 reported for the nine months ended September 30, 2016. This increase was primarily due to an increase in cloud and hardware revenue, of $12,843, or 86.3%, and $1,007, or 38.1%, respectively. This was offset by smaller decreases in maintenance and support revenue, on premise software license revenue and professional services revenue, with the largest decrease in on premise software license revenue of $303, or 22.4% from the nine months ended September 30, 2016, reflecting our continued emphasis on selling cloud based solutions. Although our total customer base is widely spread across industries, our sales are concentrated in certain industry sectors, including corporate, education, healthcare, government, legal and non-profit. We continue to target small and medium sized businesses and divisions of larger enterprises in these same industries as prospective customers. Geographically, we sell our products worldwide, but sales are largely concentrated in the United States, Canada and Europe. Additionally, we have a distribution partner in Australia. As the overall workforce management solutions market continues to experience significant growth related to SaaS products, we will continue to focus on sales of Meeting Room Manager, On Demand, PeopleCube and ADI SaaS products. In addition to continuing to develop our workforce and Agile Workplace management solutions and release new software updates and enhancements, we continue to actively explore other opportunities to acquire additional products or technologies to complement our current software and services. Through acquisitions in 2011 of ADI and Legiant, we expanded our cloud computing time and attendance software and management services business. The 2012 acquisition of PeopleCube gave us a product line that includes software to assist customers in driving integrated facility management of offices, conference rooms, video conferencing, events and training, alternative workspaces and lobby use. The 2014 acquisitions of FotoPunch and Roomtag support our vision to deliver innovative cloud-based Agile Workplace technologies. Our March 2016 acquisitions from Mangrove enable us to enter into the human resource management, payroll processing and benefits administration services businesses, which we are integrating into our existing AsureForce® product line. With respect to the three acquisitions closed in January 2017, PSNW and CPI are top regional service bureaus that resell our HCM products (formerly Mangrove) and integrate seamlessly into our business, while PMSI is a leading HCM service company that expands our solution, service, and implementation capabilities. Our May 2017 acquisition of iSystems, a leading national provider of HCM solutions, provides us with additional cross-sell revenue opportunities and cost synergies and our May 2017 acquisition of Compass HRM, an existing reseller of our HCM offerings, provides us with a regional HR and payroll service bureau in the Southeast. Gross Margin Consolidated gross margin for the three months ended September 30, 2017 was $12,131, an increase of $4,717, or 63.6%, from the $7,414 reported for the three months ended September 30, 2016. Gross margin as a percentage of revenues was 78.1% and 78.5% for the three months ended September 30, 2017 and 2016, respectively. Consolidated gross margin for the nine months ended September 30, 2017 was $30,474, an increase of $10,580 or 53.2%, from the $19,894 reported for the nine months ended September 30, 2016. Gross margins as a percentage of revenues were 77.9% and 77.0% for the nine months ended September 30, 2017 and 2016, respectively. We attribute the increase in gross margin to a shift in the mix of our revenue between our higher margin and lower margin product lines as well as the addition of the acquisitions in 2017. Selling, General and Administrative Expenses Selling, general and administrative (“SG&A”) expenses for the three months ended September 30, 2017 were $9,459, an increase of $4,413, or 87.5%, from the $5,046 reported for the three months ended September 30, 2016. SG&A expenses as a percentage of revenues were 60.9% and 53.5% for the three months ended September 30, 2017 and 2016, respectively. Selling, general and administrative (“SG&A”) expenses for the nine months ended September 30, 2017 were $25,286, an increase of $9,727, or 62.5%, from the $15,559 reported for the nine months ended September 30, 2016. SG&A expenses as a percentage of revenues were 64.6% and 60.2% for the nine months ended September 30, 2017 and 2016, respectively. SG&A expenses were higher in the three and nine months ended September 30, 2017 as compared to the same periods in 2016 primarily due to the acquisition and integration expenses related to the acquisition in the first and second quarters of 2017. We continue to evaluate any unnecessary expenses and any increases in SG&A designed to enhance future revenue growth. 22 Research and Development Expenses Research and development (“R&D”) expenses for the three months ended September 30, 2017 were $883, an increase of $122, or 16.0%, from the $761 reported for the three months ended September 30, 2016. R&D expenses as a percentage of revenues were 5.7% and 8.1% for the three months ended September 30, 2017 and 2016, respectively. Research and development (“R&D”) expenses for the nine months ended September 30, 2017 were $2,488, an increase of $271, or 12.2%, from the $2,217 reported for the nine months ended September 30, 2016. R&D expenses as a percentage of revenues were 6.4% and 8.6% for the nine months ended September 30, 2017 and 2016, respectively. We continue to improve our products and technologies through organic improvements as well as through acquired intellectual property. We believe that our expanded investment in SaaS hosting, mobile and hardware technologies lays the ground work for broader market opportunities, and represents a key aspect of our competitive differentiation. Native mobile applications, QR Code integration, expanded web service integration and other technologies are all part of our initiatives. Our development efforts for future releases and enhancements are driven by feedback received from our existing and potential customers and by gauging market trends. We believe we have the appropriate development team to design and further improve our workforce management solutions. Amortization of Intangible Assets Amortization expenses for the three months ended September 30, 2017 were $1,341, an increase of $716, or 114.6%, from the $625 reported for the three months ended September 30, 2016. Amortization expenses as a percentage of revenues were 8.6% and 6.6% for the three months ended September 30, 2017 and 2016, respectively. Amortization expenses for the nine months ended September 30, 2017 were $3,230, an increase of $1,602, or 98.4% compared to $1,628, reported for the nine months ended September 30, 2016. Amortization expenses as a percentage of revenues were 8.3% and 6.3% for the nine months ended September 30, 2017 and 2016, respectively. The increases are due to the amortization recorded on the intangibles acquired in the acquisitions during 2017. Other Income and Loss Other loss for the three months ended September 30, 2017 was $1,644, an increase of $1,024, or 165.2%, from the $620 reported for the three months ended September 30, 2016. Other loss as a percentage of revenues was 10.6% and 6.6% for the three months ended September 30, 2017 and 2016, respectively. Other loss for the three months ended September 30, 2017 and September 30, 2016 are composed primarily of interest expense on notes payable. Other loss for the nine months ended September 30, 2017 was $3,279, an increase of $1,819, or 124.6%, from the $1,460 reported for the nine months ended September 30, 2016. Other expense as a percentage of revenues was 8.4% and 5.7% for the nine months ended September 30, 2017 and 2016, respectively. Other loss for the nine months ended September 30, 2017 and 2016 are composed primarily of interest expense on notes payable. Interest expense for the three and nine months ended September 30, 2017 increased due to the additional debt amount incurred in May 2017 through our amended and restated credit agreement we entered into with Wells Fargo and Goldman Sachs and a higher interest rate incurred on the debt held with Goldman Sachs. Income Taxes Provision for income tax expense was $85 and $47 for the three months ended September 30, 2017 and 2016, respectively, an increase of $38, or 80.9%, as a result of additional tax deductible goodwill acquired in 2017. Provision for income tax expense for the nine months ended September 30, 2017 was $368, an increase of $235, or 176.7%, from the $133 reported for the nine months ended September 30, 2016, respectively, as a result of additional tax deductible goodwill acquired in 2017. Net Income (Loss) We incurred a net loss of $1,281, or $(0.10) per share, during the three months ended September 30, 2017, compared to net income of $315, or $0.05 per share, during the three months ended September 30, 2016. Net loss as a percentage of total revenues was 8.3% for the three months ended September 30, 2017 compared to net income of 3.3% of total revenues for the three months ended September 30, 2016. 23 We incurred a net loss of $4,177, or $(0.40) per share, during the nine months ended September 30, 2017, compared to a net loss of $1,103, or $(0.17) per share reported for the nine months ended September 30, 2016. Net loss as a percentage of total revenues was 10.7% for the nine months ended September 30, 2017 compared to net loss of 4.3% of total revenues for the nine months ended September 30, 2016. We intend to continue to implement our corporate strategy for growing the software and services business by modestly investing in areas that directly generate revenue and positive cash flows for the Company. However, uncertainties and challenges remain and there can be no assurance that we can successfully grow our revenues or achieve profitability during the remainder of fiscal year 2017. LIQUIDITY AND CAPITAL RESOURCES (Amounts in thousands) | September 30, | | December 31, | --------------------------+---------------+--------+--------------+-- | 2017 | | 2016 | --------------------------+---------------+--------+--------------+-- Working capital | $ | 18,734 | | $ | 4,207 --------------------------+---------------+--------+--------------+---+------- Cash and cash equivalents | | 27,464 | | | 12,767 --------------------------+---------------+--------+--------------+---+------- | For the Nine Months Ended | ------------------------------------------+---------------------------+-------- | September 30, | ------------------------------------------+---------------------------+-------- | 2017 | | | 2016 | ------------------------------------------+---------------------------+---------+---+------+-- Net Cash used in operating activities | $ | (2,083 | ) | | $ | (730 | ) ------------------------------------------+---------------------------+---------+---+------+---+--------+-- Net Cash used in investing activities | | (38,351 | ) | | | (7,750 | ) ------------------------------------------+---------------------------+---------+---+------+---+--------+-- Net Cash provided by financing activities | | 55,123 | | | | 7,460 | ------------------------------------------+---------------------------+---------+---+------+---+--------+-- Working Capital . We had working capital of $18,734 at September 30, 2017, an increase of $14,527 from working capital of $4,207 at December 31, 2016. Working capital at September 30, 2017 and December 31, 2016 includes $12,065 and $9,252 of deferred revenue, respectively. Deferred revenue is an obligation to perform future services. We expect that deferred revenue will convert to future revenue as we perform our services, but this does not represent future payments. Deferred revenue can vary based on seasonality, expiration of initial multi-year contracts and deals that are billed after implementation rather than in advance of service delivery. We attribute the increase in our working capital to the issuance of stock in an underwritten public offering and proceeds from notes payable, offset by the acquisitions of PMSI, CPI and PSNW in the first quarter of 2017 and the acquisitions of iSystems and Compass in the second quarter of 2017. Operating Activities . Net cash used in operating activities was $2,083 for the nine months ended September 30, 2017. The $2,083 of cash used in operating activities during the first nine months of 2017 was primarily driven by a net loss of $4,177, an increase in accounts receivable of $4,450, an increase in prepaids and other assets of $471, and a decrease in accounts payable of $569. This was offset by non-cash adjustments to net loss of $5,027, an increase in deferred revenue of $1,963, and an increase in accrued expenses and other long-term obligations of $881. The $730 of cash used in operating activities during the first nine months of 2016 was primarily driven by a net loss of $1,103, an increase in accounts receivable of $1,678, a decrease in deferred revenue of $2,000, and a decrease in accounts payable of $189. This was offset by non-cash adjustments to net loss of $2,996, an increase in accrued expenses and other long-term obligations of $951, a decrease in inventory of $169, and a decrease in prepaid expenses and other assets of $124. Investing Activities . Net cash used in investing activities was $38,351 and $7,750 for the nine months ended September 30, 2017 and September 30, 2016, respectively. Cash used in investing for the nine months ended September 30, 2017 is primarily due to the acquisitions of PMSI, CPI and PSNW in January 2017, and the acquisitions of iSystems and Compass in May 2017, partially offset by an increase in funds held for clients. The cash used in investing for the nine months ended September 30, 2016 is due primarily to the acquisition of Mangrove, offset by the increase in funds held for clients. Financing Activities . Net cash provided by financing activities was $55,123 for the nine months ended September 30, 2017. We recognized net proceeds from the issuance of common stock of $27,820 in an underwritten public offering in June 2017, as well as incurred $45,777 of indebtedness in connection with the 2017 acquisitions. This was offset by payments on notes payable of $8,098 and debt financing fees of $1,433. In connection with the public offering, we issued 2,185,000 shares of common stock, including 285,000 shares of common stock pursuant to the exercise of the underwriters' over-allotment option, at the public offering price of $13.50 per share. Net cash provided by financing activities was $7,460 for the nine months ended September 30, 2016. We incurred $16,823 of debt, primarily due to the cash used in the acquisition of Mangrove, and proceeds from the exercise of options of $561. This was offset by payments on notes payable of $5,173, the decrease in client fund obligations of $4,155 and debt financing fees of $438. 24 Sources of Liquidity . As of September 30, 2017, Asure’s principal sources of liquidity consisted of approximately $27,464 of cash, future cash generated from operations and $5,000 under our Restated Credit Agreement. We believe that we have and/or will generate sufficient cash for our short- and long-term needs. Based on current internal projections, we believe that we have and/or will generate sufficient cash for our operational needs, including any required debt payments, for at least the next twelve months. We currently project that we can generate positive cash flows from our operating activities for at least the next twelve months. Our management team is focused on growing our existing software operations and is also seeking additional strategic acquisitions for the near future. At present, we plan to fund any future acquisition with equity, existing cash and cash equivalents cash generated from future operations and/or cash or debt raised from outside sources. We cannot assure that we can grow our cash balances or limit our cash consumption and thus maintain sufficient cash balances for our planned operations or future acquisitions. Future business demands may lead to cash utilization at levels greater than recently experienced. We may need to raise additional capital in the future. However, we cannot assure that we will be able to raise additional capital on acceptable terms, or at all. Subject to the foregoing, management believes that we have sufficient capital and liquidity to fund and cultivate the growth of our current and future operations for at least the next twelve months from the issuance of these financial statements and to maintain compliance with the terms of our debt agreements and related covenants or to obtain compliance through debt repayments made with our available cash on hand or anticipated for receipt in the ordinary course of operations. Capital Resources . At September 30, 2017, we had $69,125 outstanding under our Restated Credit Agreement with Wells Fargo. Available funds were $5,000 under the revolving credit facility at September 30, 2017. For further discussion regarding our Restated Credit Agreement and debt financing arrangements, see Note 6 to the accompanying condensed consolidated financial statements. CRITICAL ACCOUNTING POLICIES There were no material changes to our critical accounting policies and estimates since December 31, 2016. For additional information on critical accounting policies, refer to “Management’s Discussion and Analysis” in our 2016 Annual Report on Form 10-K. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are a smaller reporting company as defined by Rule 12b-2 under the Exchange Act and are not required to provide the information required under this item. ITEM 4. CONTROLS AND PROCEDURES Evaluation of Disclosure Control and Procedures Our management is responsible for establishing and maintaining adequate internal control over financial reporting for us. Based on an evaluation under the supervision and with the participation of our management, our principal executive officer and principal financial officer have concluded that our disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act were effective as of as of September 30, 2017 to provide reasonable assurance that information required to be disclosed by us in reports that we file or submit under the Exchange Act is (i) recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms and (ii) accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. Change in Internal Controls over Financial Reporting During the period ended September 30, 2017, there were no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 25 PART II – OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS None ITEM 1A. RISK FACTORS We are a smaller reporting company as defined by Rule 12b-2 of the Exchange Act and are not required to provide the information required under this item. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS None ITEM 3. DEFAULTS UPON SENIOR SECURITIES None ITEM 6. EXHIBITS EXHIBIT NUMBER | DESCRIPTION ---------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.1* | Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. ---------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.2* | Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. ---------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 32.1* | Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. ---------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 32.2* | Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. ---------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101* | The following materials from Asure Software, Inc.’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2017, formatted in XBRL (Extensible Business Reporting Language): (1) the Condensed Consolidated Balance Sheets, (2) the Condensed Consolidated Statements of Comprehensive Loss, (3) the Condensed Consolidated Statements of Cash Flows, and (4) Notes to Condensed Consolidated Financial Statements. ---------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- * Filed herewith 26 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. | ASURE SOFTWARE, INC. | ------------------+----------------------+------------------------ November 13, 2017 | By: | /s/ PATRICK GOEPEL ------------------+----------------------+------------------------ | | Patrick Goepel ------------------+----------------------+------------------------ | | Chief Executive Officer ------------------+----------------------+------------------------ November 13, 2017 | By: | /s/ KELYN BRANNON ------------------+----------------------+------------------------ | | Kelyn Brannon ------------------+----------------------+------------------------ | | Chief Financial Officer ------------------+----------------------+------------------------ 27

ATOSSA GENETICS INC

1488039

10-Q

0001615774-17-006519

UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 FORM 10-Q (Mark One) ☒ | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 --+--------------------------------------------------------------------------------------------- For the quarterly period ended September 30, 2017 OR ☐ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 --+---------------------------------------------------------------------------------------------- For the transition period from _______ to _______ Commission file number: 001-35610 ATOSSA GENETICS INC. (Exact name of registrant as specified in its charter) Delaware | 26-4753208 ---------------------------------------------+------------------------ (State or other jurisdiction of | (I.R.S. Employer ---------------------------------------------+------------------------ incorporation or organization) | Identification No.) ---------------------------------------------+------------------------ 107 Spring Street | 98104 ---------------------------------------------+------------------------ Seattle, WA | (Zip Code) ---------------------------------------------+------------------------ (Address of principal executive offices) | ---------------------------------------------+------------------------ Registrant’s telephone number, including area code: (206) 325-6086 Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No ☐ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer ☐ | Accelerated filer ☐ | Non-accelerated filer ☐ | Smaller reporting company ☒ -------------------------------+--------------------------+------------------------------+--------------------------------- Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒ The number of shares of the registrant’s common stock, $0.015 par value per share, outstanding at November 13, 2017 was 26,522,741. ATOSSA GENETICS INC. FORM 10-Q QUARTERLY REPORT INDEX PART I. FINANCIAL INFORMATION | 3 ------------------------------+---------------------------------------------------------------------------------------------------------------- ITEM 1. | Condensed Consolidated Financial Statements – Unaudited | 3 ------------------------------+-----------------------------------------------------------------------------------------------------------------+--- | Condensed Consolidated Balance Sheets as of September 30, 2017 and December 31, 2016 | 3 ------------------------------+-----------------------------------------------------------------------------------------------------------------+--- | Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2017 and 2016 | 4 ------------------------------+-----------------------------------------------------------------------------------------------------------------+--- | Condensed Consolidated Statement of Stockholders’ Equity for the nine months ended September 30, 2017 | 5 ------------------------------+-----------------------------------------------------------------------------------------------------------------+--- | Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2017 and 2016 | 6 ------------------------------+-----------------------------------------------------------------------------------------------------------------+--- | Notes to Consolidated Financial Statements | 7 ------------------------------+-----------------------------------------------------------------------------------------------------------------+--- ITEM 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations | 22 ------------------------------+-----------------------------------------------------------------------------------------------------------------+--- ITEM 3 | Quantitative and Qualitative Disclosures about Market Risk | 29 ------------------------------+-----------------------------------------------------------------------------------------------------------------+--- ITEM 4. | Controls and Procedures | 29 ------------------------------+-----------------------------------------------------------------------------------------------------------------+--- PART II. OTHER INFORMATION | 30 ------------------------------+---------------------------------------------------------------------------------------------------------------- ITEM 1. | Legal Proceedings | 30 ------------------------------+-----------------------------------------------------------------------------------------------------------------+--- ITEM 1A. | Risk Factors | 30 ------------------------------+-----------------------------------------------------------------------------------------------------------------+--- ITEM 2. | Unregistered Sales of Equity Securities and Use of Proceeds | 31 ------------------------------+-----------------------------------------------------------------------------------------------------------------+--- ITEM 3. | Defaults upon Senior Securities | 32 ------------------------------+-----------------------------------------------------------------------------------------------------------------+--- ITEM 4. | Mine Safety Disclosures | 32 ------------------------------+-----------------------------------------------------------------------------------------------------------------+--- ITEM 5. | Other Information | 32 ------------------------------+-----------------------------------------------------------------------------------------------------------------+--- ITEM 6. | Exhibits | 32 ------------------------------+-----------------------------------------------------------------------------------------------------------------+--- SIGNATURES | 33 ------------------------------+---------------------------------------------------------------------------------------------------------------- 2 PART I. FINANCIAL INFORMATION ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS ATOSSA GENETICS INC. CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED) | September 30, | | | December 31, | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------+-------------+---+------------------+-- | 2017 | | | 2016 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------+-------------+---+------------------+-- Assets | | | | | | | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------+-------------+---+------------------+---+-------------+-- Current assets | | | | | | | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------+-------------+---+------------------+---+-------------+-- Cash and cash equivalents | $ | 2,733,663 | | | $ | 3,027,962 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------+-------------+---+------------------+---+-------------+-- Restricted cash | | 55,000 | | | | 55,000 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------+-------------+---+------------------+---+-------------+-- Prepaid expenses | | 157,406 | | | | 171,601 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------+-------------+---+------------------+---+-------------+-- Other accounts receivable | | 4,040 | | | | | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------+-------------+---+------------------+---+-------------+-- Total current assets | | 2,950,109 | | | | 3,254,563 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------+-------------+---+------------------+---+-------------+-- Furniture and equipment, net | | 14,435 | | | | 55,119 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------+-------------+---+------------------+---+-------------+-- Intangible assets, net | | 561,354 | | | | 640,440 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------+-------------+---+------------------+---+-------------+-- Other assets | | 108,723 | | | | 194,250 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------+-------------+---+------------------+---+-------------+-- Total assets | $ | 3,634,621 | | | $ | 4,144,372 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------+-------------+---+------------------+---+-------------+-- Liabilities and Stockholders’ Equity | | | | | | | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------+-------------+---+------------------+---+-------------+-- Current liabilities | | | | | | | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------+-------------+---+------------------+---+-------------+-- Accounts payable | $ | 380,399 | | | $ | 254,320 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------+-------------+---+------------------+---+-------------+-- Accrued expenses | | 50,542 | | | | 16,964 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------+-------------+---+------------------+---+-------------+-- Payroll liabilities | | 627,587 | | | | 769,899 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------+-------------+---+------------------+---+-------------+-- Other current liabilities | | 13,295 | | | | 6,083 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------+-------------+---+------------------+---+-------------+-- Total current liabilities | | 1,071,823 | | | | 1,047,266 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------+-------------+---+------------------+---+-------------+-- Commitments and contingencies (note 13) | | | | | | | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------+-------------+---+------------------+---+-------------+-- Stockholders’ equity | | | | | | | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------+-------------+---+------------------+---+-------------+-- Preferred stock - $.001 par value; 10,000,000 shares authorized, no shares issued or outstanding | | | | | | | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------+-------------+---+------------------+---+-------------+-- Common stock - $.015 par value; 75,000,000 shares authorized, 14,022,741 and 3,786,913 shares issued and outstanding, as of September 30, 2017 and December 31, 2016, respectively | | 210,341 | | | | 56,804 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------+-------------+---+------------------+---+-------------+-- Additional paid-in capital | | 65,785,758 | | | | 60,344,050 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------+-------------+---+------------------+---+-------------+-- Accumulated deficit | | (63,433,301 | ) | | | (57,303,748 | ) -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------+-------------+---+------------------+---+-------------+-- Total stockholders’ equity | | 2,562,798 | | | | 3,097,106 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------+-------------+---+------------------+---+-------------+-- Total liabilities and stockholders’ equity | $ | 3,634,621 | | | $ | 4,144,372 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------+-------------+---+------------------+---+-------------+-- The accompanying notes are an integral part of these condensed consolidated financial statements. 3 ATOSSA GENETICS INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) | For the Three Months Ended September 30, | | | For The Nine Months Ended September 30, | --------------------------------------------------------------+----------------------------------------------+------------+---+---------------------------------------------+-- | | 2017 | | | | 2016 | | | 2017 | | | 2016 | --------------------------------------------------------------+----------------------------------------------+------------+---+---------------------------------------------+---+------------+---+---+------------+---+---+------------+-- Operating expenses: | | | | | | | | | | | | | --------------------------------------------------------------+----------------------------------------------+------------+---+---------------------------------------------+---+------------+---+---+------------+---+---+------------+-- Research and development | $ | 742,450 | | | $ | 85,000 | | $ | 2,110,846 | | $ | 403,963 | --------------------------------------------------------------+----------------------------------------------+------------+---+---------------------------------------------+---+------------+---+---+------------+---+---+------------+-- General and administrative | | 1,313,477 | | | | 1,473,435 | | | 3,528,189 | | | 5,040,939 | --------------------------------------------------------------+----------------------------------------------+------------+---+---------------------------------------------+---+------------+---+---+------------+---+---+------------+-- Total operating expenses | | 2,055,927 | | | | 1,558,435 | | | 5,639,035 | | | 5,444,902 | --------------------------------------------------------------+----------------------------------------------+------------+---+---------------------------------------------+---+------------+---+---+------------+---+---+------------+-- Operating loss | | (2,055,927 | ) | | | (1,558,435 | ) | | (5,639,035 | ) | | (5,444,902 | ) --------------------------------------------------------------+----------------------------------------------+------------+---+---------------------------------------------+---+------------+---+---+------------+---+---+------------+-- Change in fair value of common stock warrants | | (128,300 | ) | | | | | | (280,747 | ) | | | --------------------------------------------------------------+----------------------------------------------+------------+---+---------------------------------------------+---+------------+---+---+------------+---+---+------------+-- Warrant financing expense | | | | | | | | | (192,817 | ) | | | --------------------------------------------------------------+----------------------------------------------+------------+---+---------------------------------------------+---+------------+---+---+------------+---+---+------------+-- Other income (expense), net | | (283 | ) | | | 1,763,124 | | | (16,954 | ) | | 1,599,667 | --------------------------------------------------------------+----------------------------------------------+------------+---+---------------------------------------------+---+------------+---+---+------------+---+---+------------+-- Income (loss) before income taxes | | (2,184,510 | ) | | | 204,689 | | | (6,129,553 | ) | | (3,845,235 | ) --------------------------------------------------------------+----------------------------------------------+------------+---+---------------------------------------------+---+------------+---+---+------------+---+---+------------+-- Income taxes | | | | | | | | | | | | | --------------------------------------------------------------+----------------------------------------------+------------+---+---------------------------------------------+---+------------+---+---+------------+---+---+------------+-- Net income (loss) | $ | (2,184,510 | ) | | $ | 204,689 | | $ | (6,129,553 | ) | $ | (3,845,235 | ) --------------------------------------------------------------+----------------------------------------------+------------+---+---------------------------------------------+---+------------+---+---+------------+---+---+------------+-- Deemed dividends attributable to Series A Preferred Stock | | | | | | | | | (2,568,132 | ) | | | --------------------------------------------------------------+----------------------------------------------+------------+---+---------------------------------------------+---+------------+---+---+------------+---+---+------------+-- Net income (loss) applicable to common stockholders | $ | (2,184,510 | ) | | $ | 204,689 | | $ | (8,697,685 | ) | $ | (3,845,235 | ) --------------------------------------------------------------+----------------------------------------------+------------+---+---------------------------------------------+---+------------+---+---+------------+---+---+------------+-- Income (loss) per common share - basic and diluted | $ | (0.18 | ) | | $ | 0.07 | | $ | (1.10 | ) | $ | (1.44 | ) --------------------------------------------------------------+----------------------------------------------+------------+---+---------------------------------------------+---+------------+---+---+------------+---+---+------------+-- Weighted average shares outstanding, basic and diluted | | 12,411,145 | | | | 3,024,393 | | | 7,886,210 | | | 2,665,904 | --------------------------------------------------------------+----------------------------------------------+------------+---+---------------------------------------------+---+------------+---+---+------------+---+---+------------+-- The accompanying notes are an integral part of these condensed consolidated financial statements. 4 ATOSSA GENETICS, INC. CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY (UNAUDITED) | Series A Convertible Preferred Stock | | | | | | Common Stock | | Additional | | | | Total | ---------------------------------------------------------------------------------------------------------+------------------------------------------+--------+---+--------+---+----+---------------------+---+-------------+---+--------+------------+---------+-- | | | | | | | Additional | | | | | | Paid-in | | | Accumulated | | Stockholders’ | ---------------------------------------------------------------------------------------------------------+------------------------------------------+--------+---+--------+---+----+---------------------+---+-------------+---+--------+------------+---------+---+---------+-------------+---+---------------+-- | Shares | | | Amount | | | Paid-in Capital | | Shares | | Amount | | Capital | | | Deficit | | Equity | ---------------------------------------------------------------------------------------------------------+------------------------------------------+--------+---+--------+---+----+---------------------+---+-------------+---+--------+------------+---------+---+---------+-------------+---+---------------+-- Balance at December 31, 2016 | | — | | | $ | — | | $ | — | | | 3,786,913 | | $ | 56,804 | | $ | 60,344,050 | | $ | (57,303,748 | ) | $ | 3,097,106 | ---------------------------------------------------------------------------------------------------------+------------------------------------------+--------+---+--------+---+----+---------------------+---+-------------+---+--------+------------+---------+---+---------+-------------+---+---------------+---+---+-------------+---+---+-------------+-- Issuance of common stock in Class A units, net of issuance costs of $65,816 | | | | | | | | | | | | 1,194,000 | | | 17,910 | | | 811,774 | | | | | | 829,684 | ---------------------------------------------------------------------------------------------------------+------------------------------------------+--------+---+--------+---+----+---------------------+---+-------------+---+--------+------------+---------+---+---------+-------------+---+---------------+---+---+-------------+---+---+-------------+-- Allocation of Class A unit proceeds to warrant liability | | | | | | | | | | | | | | | | | | (328,350) | | | | | | (328,350) | ---------------------------------------------------------------------------------------------------------+------------------------------------------+--------+---+--------+---+----+---------------------+---+-------------+---+--------+------------+---------+---+---------+-------------+---+---------------+---+---+-------------+---+---+-------------+-- Issuance of Series A convertible preferred stock in Class B units, net of issuance costs of $267,231 | | 3,502 | | | | 4 | | | 3,234,769 | | | | | | | | | | | | | | | 3,234,773 | ---------------------------------------------------------------------------------------------------------+------------------------------------------+--------+---+--------+---+----+---------------------+---+-------------+---+--------+------------+---------+---+---------+-------------+---+---------------+---+---+-------------+---+---+-------------+-- Allocation of Series A convertible preferred stock to warrants and beneficial conversion feature | | | | | | | | | (2,568,132) | | | | | | | | | 1,284,066 | | | | | | (1,284,066) | ---------------------------------------------------------------------------------------------------------+------------------------------------------+--------+---+--------+---+----+---------------------+---+-------------+---+--------+------------+---------+---+---------+-------------+---+---------------+---+---+-------------+---+---+-------------+-- Deemed Dividends on Series A convertible preferred stock | | | | | | | | | 2,568,132 | | | | | | | | | (2,568,132 | ) | | | | | | ---------------------------------------------------------------------------------------------------------+------------------------------------------+--------+---+--------+---+----+---------------------+---+-------------+---+--------+------------+---------+---+---------+-------------+---+---------------+---+---+-------------+---+---+-------------+-- Conversion of Series A convertible preferred stock to common stock | | (3,502 | ) | | | (4 | ) | | (3,234,769 | ) | | 4,669,329 | | | 70,040 | | | 3,164,733 | | | | | | | ---------------------------------------------------------------------------------------------------------+------------------------------------------+--------+---+--------+---+----+---------------------+---+-------------+---+--------+------------+---------+---+---------+-------------+---+---------------+---+---+-------------+---+---+-------------+-- Reclassification of warrant liability upon exercise of common stock warrants | | | | | | | | | | | | 1,490,833 | | | 22,362 | | | 1,870,798 | | | | | | 1,893,160 | ---------------------------------------------------------------------------------------------------------+------------------------------------------+--------+---+--------+---+----+---------------------+---+-------------+---+--------+------------+---------+---+---------+-------------+---+---------------+---+---+-------------+---+---+-------------+-- Issuance of common stock upon warrant exercise for cash | | | | | | | | | | | | 2,881,666 | | | 43,225 | | | 706,008 | | | | | | 749,233 | ---------------------------------------------------------------------------------------------------------+------------------------------------------+--------+---+--------+---+----+---------------------+---+-------------+---+--------+------------+---------+---+---------+-------------+---+---------------+---+---+-------------+---+---+-------------+-- Amortization of commitment shares | | | | | | | | | | | | | | | | | | (59,558 | ) | | | | | (59,558 | ) ---------------------------------------------------------------------------------------------------------+------------------------------------------+--------+---+--------+---+----+---------------------+---+-------------+---+--------+------------+---------+---+---------+-------------+---+---------------+---+---+-------------+---+---+-------------+-- Compensation cost for stock options granted to executives and employees | | | | | | | | | | | | | | | | | | 560,369 | | | | | | 560,369 | ---------------------------------------------------------------------------------------------------------+------------------------------------------+--------+---+--------+---+----+---------------------+---+-------------+---+--------+------------+---------+---+---------+-------------+---+---------------+---+---+-------------+---+---+-------------+-- Net loss | | | | | | | | | | | | | | | | | | | | | (6,129,553 | ) | | (6,129,553 | ) ---------------------------------------------------------------------------------------------------------+------------------------------------------+--------+---+--------+---+----+---------------------+---+-------------+---+--------+------------+---------+---+---------+-------------+---+---------------+---+---+-------------+---+---+-------------+-- Balance at September 30, 2017 | | | | | $ | | | $ | | | | 14,022,741 | | $ | 210,341 | | $ | 65,785,758 | | $ | (63,433,301 | ) | $ | 2,562,798 | ---------------------------------------------------------------------------------------------------------+------------------------------------------+--------+---+--------+---+----+---------------------+---+-------------+---+--------+------------+---------+---+---------+-------------+---+---------------+---+---+-------------+---+---+-------------+-- The accompanying notes are an integral part of these condensed consolidated financial statements. 5 ATOSSA GENETICS INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) | For the Nine Months Ended September 30, | -------------------------------------------------------------------------------+---------------------------------------------+----------- | 2017 | | | 2016 | -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+-- CASH FLOWS FROM OPERATING ACTIVITIES | | | | | | | -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- Net loss | $ | (6,129,553 | ) | | $ | (3,845,235 | ) -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- Compensation cost for stock options granted | | 560,369 | | | | 650,053 | -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- Loss on disposal of intangible asset | | 17,695 | | | | 163,333 | -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- Depreciation and amortization | | 102,074 | | | | 227,387 | -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- Change in fair value of common stock warrants | | 280,747 | | | | | -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- Warrant financing expense | | 192,817 | | | | | -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- Changes in operating assets and liabilities: | | | | | | | -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- Change in restricted cash | | | | | | 220,000 | -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- Prepaid expenses | | 14,195 | | | | 72,542 | -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- Other assets | | 25,831 | | | | 131,176 | -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- Accounts payable | | 126,079 | | | | (617,094 | ) -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- Payroll liabilities | | (142,312 | ) | | | (524,288 | ) -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- Accrued expenses | | 33,578 | | | | (451,196 | ) -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- Other current liabilities | | 7,212 | | | | (45,242 | ) -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- Net cash used in operating activities | | (4,911,268 | ) | | | (4,018,564 | ) -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- CASH FLOWS FROM INVESTING ACTIVITIES | | | | | | | -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- Purchase of furniture and equipment | | | | | | (5,023 | ) -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- Net cash used in investing activities | | | | | | (5,023 | ) -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- CASH FLOWS FROM FINANCING ACTIVITIES | | | | | | | -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- Proceeds from issuance of Class A and Class B Units, net of issuance costs | | 3,871,636 | | | | | -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- Proceeds from exercise of warrants | | 745,333 | | | | | -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- Proceeds from issuance of common stock, net of issuance costs | | | | | | 4,695,869 | -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- Net cash provided by financing activities | | 4,616,969 | | | | 4,695,869 | -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS | | (294,299) | | | | 672,282 | -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- CASH AND CASH EQUIVALENTS, BEGINNING BALANCE | | 3,027,962 | | | | 3,715,895 | -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- CASH AND CASH EQUIVALENTS, ENDING BALANCE | $ | 2,733,663 | | | $ | 4,388,177 | -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- SUPPLEMENTAL DISCLOSURES: | | | | | | | -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- Interest paid | $ | | | | $ | 1,304 | -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- NONCASH INVESTING AND FINANCING ACTIVITIES: | | | | | | | -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- Reclassification of warrant liability upon exercise of common stock warrants | $ | 1,893,160 | | | $ | | -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- Amount receivable for warrant exercise | | 3,900 | | | | | -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- Allocation of Class A and Class B Unit proceeds to warrant liability | | 1,612,413 | | | | | -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- Common stock issued as commitment fee under stock purchase agreement | | | | | | 198,523 | -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- Amortization of commitment shares | $ | 59,558 | | | $ | 26,470 | -------------------------------------------------------------------------------+---------------------------------------------+------------+---+------+---+------------+-- The accompanying notes are an integral part of these condensed consolidated financial statements. 6 ATOSSA GENETICS INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE 1: NATURE OF OPERATIONS Atossa Genetics Inc. (the “Company”) was incorporated on April 30, 2009 in the State of Delaware. The Company was formed to develop and market medical devices, laboratory tests and therapeutics to address breast health conditions. The Company’s fiscal year ends on December 31. The Company is focused on development of its pharmaceutical and drug delivery programs. NOTE 2: GOING CONCERN The Company’s consolidated financial statements are prepared using Generally Accepted Accounting Principles in the United States of America applicable to a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The Company has incurred net losses and negative operating cash flows since inception. For the nine months ended September 30, 2017, the Company recorded a net loss of approximately $6.1 million and used approximately $4.9 million of cash in operating activities. As of September 30, 2017, the Company had approximately $2.7 million in cash and cash equivalents and working capital of approximately $1.9 million. The Company has not yet established an ongoing source of revenue sufficient to cover its operating costs and allow it to continue as a going concern. The ability of the Company to continue as a going concern is dependent on the Company obtaining adequate capital to fund operating losses until it becomes profitable. The Company can give no assurances that any additional capital that it is able to obtain, if any, will be sufficient to meet its needs, or that any such capital will be obtained on acceptable terms. If the Company is unable to obtain adequate capital, it could be forced to cease operations or substantially curtail its activities. These conditions raise substantial doubt as to the Company’s ability to continue as a going concern. The accompanying consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts and classification of liabilities should the Company be unable to continue as a going concern. Management’s plan to continue as a going concern is as follows. In order to continue as a going concern, the Company will need, among other things, additional capital resources. Management’s plans to obtain such resources for the Company include obtaining capital from the sale of its equity securities and short-term borrowings from banks, stockholders or other related party(ies), if needed. However, management cannot provide any assurance that the Company will be successful in accomplishing any of its plans. As of the date of filing this quarterly report, we expect that our existing resources will be sufficient to fund our planned operations for the next 8-12 months; however, additional capital resources will be needed to fund operations longer-term. The ability of the Company to continue as a going concern is dependent upon its ability to successfully accomplish the plans described in the preceding paragraphs and eventually to secure other sources of financing and attain profitable operations. On October 26, 2017, the Company entered into an underwriting agreement with Maxim Group LLC relating to a public offering of common stock which closed on October 30, 2017. The offering generated gross proceeds to the Company of approximately $5.5 million and net proceeds of $5.1 million after deducting underwriting discounts and commission. 7 NOTE 3: SUMMARY OF ACCOUNTING POLICIES Basis of Presentation: The accompanying unaudited Condensed Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. They do not include all information and notes required by GAAP for complete financial statements. However, except as disclosed herein, there has been no material change in the information disclosed in the Notes to Consolidated Financial Statements included in the Annual Report on Form 10-K of the Company for the year ended December 31, 2016. In the opinion of management, all adjustments (including normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and nine months ended September 30, 2017 are not necessarily indicative of the results that may be expected for the year ending December 31, 2017. On August 26, 2016, the Company completed a 1-for-15 reverse stock split of the shares of the Company’s common stock (the “Reverse Stock Split”). As a result of the Reverse Stock Split, every 15 shares of issued and outstanding common stock were combined into one issued and outstanding share of Common Stock, and the par value per share was changed to $.015 per share. No fractional shares were issued because of the Reverse Stock Split and any fractional shares that would otherwise have resulted from the Reverse Stock Split were paid in cash. The number of authorized shares of common stock was not reduced as a result of the Reverse Stock Split. The Company’s common stock began trading on a reverse stock split-adjusted basis on August 26, 2016. All share and per share data included in this report has been retroactively restated to reflect the Reverse Stock Split. Use of Estimates: The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of expenses during the reporting period. Actual results could differ from those estimates. Financial Instruments with Characteristics of Both Liabilities and Equity: During the nine months ended September 30, 2017, the Company issued certain financial instruments, consisting of warrants to purchase common stock, which have characteristics of both liability and equity. Financial instruments such as warrants that are classified as liabilities are fair valued upon issuance and are remeasured at fair value at subsequent reporting periods with the resulting change in fair value recorded in “change in fair value of common stock warrants”. The fair value of warrants is estimated using valuation models that require the input of subjective assumptions including stock price volatility, expected life, and the probability of future equity issuances and their impact to the price protection feature. Recently Issued Accounting Pronouncements: In February 2016, Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2016-02, Lease Accounting Topic 842. This ASU requires a lessee to recognize lease assets and liabilities on the balance sheet for all arrangements with terms longer than 12 months. The new standard applies a right-of-use (ROU) model that requires a lessee to record, for all leases with a lease term of more than 12 months, an asset representing its right to use the underlying asset for the lease term and a liability to make lease payments. The lease term is the non-cancellable period of the lease, and includes both periods covered by an option to extend the lease, if the lessee is reasonably certain to exercise that option, and periods covered by an option to terminate the lease, if the lessee is reasonably certain not to exercise that termination option. For leases with a lease term of 12 months or less, a practical expedient is available whereby a lessee may elect, by class of underlying asset, not to recognize an ROU asset or lease liability. A lessee making this accounting policy election would recognize lease expense over the term of the lease, generally in a straight-line pattern. The lessor accounting remains largely consistent with existing U.S. GAAP. The new standard takes effect in 2019 for public business entities. The Company has not adopted the provisions of ASU No. 2016-02. The Company is currently evaluating the impact of adopting ASU 2016-02 on its consolidated financial statements. 8 In April 2016, the FASB issued ASU No. 2016-09, Compensation - Stock Compensation, simplifying the accounting for share-based payment transactions including the income tax consequences, classification of awards as either equity or liabilities and classification on the statements of cash flows. Under the new standard, all excess tax benefits and tax deficiencies (including tax benefits of dividends on share-based payment awards) should be recognized as income tax expense or benefit on the statements of income. We adopted ASU No. 2016-09 effective January 1, 2017. As a result of the adoption of this guidance, we made an accounting policy election to recognize the effect of forfeitures in compensation cost when they occur. There was an immaterial impact on results of operations and financial position and no impact on cash flows at adoption. In November 2016, the FASB issued ASU No. 2016-18, Statement of Cash Flows, amending the presentation of restricted cash within the statement of cash flows. The new guidance requires that restricted cash be included within cash and cash equivalents on the statement of cash flows. The ASU is effective retrospectively for reporting periods beginning after December 15, 2017, with early adoption permitted. The Company has not yet adopted the provisions of ASU No. 2016-18 and does not expect it will have a material impact on the financial statements upon adoption. In July 2017, the FASB issued ASU 2017-11, Accounting for Certain Financial Instruments with Down Round Features and Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests with a Scope Exception. Part I of this ASU addresses the complexity of accounting for certain financial instruments with down round features. Down round features are features of certain equity-linked instruments (or embedded features) that result in the strike price being reduced on the basis of future equity offerings. Current accounting guidance requires financial instruments with down round features to be accounted for at fair value. Part II of the Update applies only to nonpublic companies and is therefore not applicable to the Company. The amendments in Part I of the Update change the classification analysis of certain equity-linked financial instruments (or embedded features) with down round features. When determining whether certain financial instruments should be classified as liabilities or equity instruments, a down round feature no longer precludes equity classification when assessing whether the instrument is indexed to an entity’s own stock. As a result, a freestanding equity-linked financial instrument (or embedded conversion option) no longer would be accounted for as a derivative liability at fair value as a result of the existence of a down round feature. For freestanding equity-classified financial instruments, the amendments require entities that present earnings per share (EPS) in accordance with Topic 260 to recognize the effect of the down round feature when it is triggered. That effect is treated as a dividend and as a reduction of income available to common shareholders in basic EPS. This Update is effective for public entities for fiscal years beginning after December 15, 2018. Early adoption is permitted. The Company has not yet determined when it will adopt the provisions of this Update and has not yet determined the impact on its consolidated financial statements upon adoption. NOTE 4: PREPAID EXPENSES Prepaid expenses consisted of the following: | September 30, 2017 | | December 31, 2016 | -------------------------------+--------------------+---------+-------------------+-- Prepaid insurance | $ | 39,132 | | $ | 121,333 -------------------------------+--------------------+---------+-------------------+---+-------- Trade show | | | | | 20,000 -------------------------------+--------------------+---------+-------------------+---+-------- Retainer and security deposits | | 14,218 | | | 14,218 -------------------------------+--------------------+---------+-------------------+---+-------- Professional services | | 81,250 | | | -------------------------------+--------------------+---------+-------------------+---+-------- Financial exchange fees | | 10,500 | | | -------------------------------+--------------------+---------+-------------------+---+-------- Other | | 12,306 | | | 16,050 -------------------------------+--------------------+---------+-------------------+---+-------- Total prepaid expenses | $ | 157,406 | | $ | 171,601 -------------------------------+--------------------+---------+-------------------+---+-------- 9 NOTE 5: FURNITURE AND EQUIPMENT Furniture and equipment consisted of the following: | September 30, 2017 | | | December 31, 2016 | -----------------------------------+--------------------+----------+---+-------------------+-- Furniture and equipment | $ | 170,917 | | | $ | 210,528 | -----------------------------------+--------------------+----------+---+-------------------+---+----------+-- Less: Accumulated depreciation | | (156,482 | ) | | | (155,409 | ) -----------------------------------+--------------------+----------+---+-------------------+---+----------+-- Total furniture and equipment, net | $ | 14,435 | | | $ | 55,119 | -----------------------------------+--------------------+----------+---+-------------------+---+----------+-- Depreciation expense for the three months ended September 30, 2017 and 2016 was $4,554 and $29,698, respectively, and $22,988, and $92,054, for the nine months ended September 30, 2017 and 2016, respectively. NOTE 6: INTANGIBLE ASSETS Intangible assets consisted of the following: | September 30, 2017 | | | December 31, 2016 | -------------------------------+---------------------+----------+---+--------------------+-- Patents | $ | 639,000 | | | $ | 639,000 | -------------------------------+---------------------+----------+---+--------------------+---+----------+-- Software | | 113,540 | | | | 113,540 | -------------------------------+---------------------+----------+---+--------------------+---+----------+-- Total intangible assets | | 752,540 | | | | 752,540 | -------------------------------+---------------------+----------+---+--------------------+---+----------+-- Less: Accumulated amortization | | (191,186 | ) | | | (112,100 | ) -------------------------------+---------------------+----------+---+--------------------+---+----------+-- Total intangible assets, net | $ | 561,354 | | | $ | 640,440 | -------------------------------+---------------------+----------+---+--------------------+---+----------+-- Software amounted to $113,540 as of September 30, 2017 and December 31, 2016. The amortization period for the purchased software is three years. Amortization expense related to software for the three months ended September 30, 2017 and 2016 was $6,759 and $7,857, respectively, and was $26,373 and $23,572, for the nine months ended September 30, 2017 and 2016, respectively. Patents amounted to $639,000 as of September 30, 2017 and December 31, 2016, and mainly consisted of patents acquired from Acueity on September 30, 2012 in an asset purchase transaction. Patent assets are amortized based on their determined useful life, and tested annually for impairment. The amortization period is from 7 to 12 years. Amortization expense related to patents was $17,571 and $37,253 for the three months ended September 30, 2017 and 2016, respectively and was $52,713 and $111,761 for the nine months ended September 30, 2017 and 2016, respectively. Future estimated amortization expenses as of September 30, 2017 for the five succeeding years is as follows: For the years ending December 31, | Amounts | ----------------------------------------------+---------+-------- 2017 (includes the remainder of the year) | $ | 23,952 ----------------------------------------------+---------+-------- 2018 | | 73,433 ----------------------------------------------+---------+-------- 2019 | | 70,285 ----------------------------------------------+---------+-------- 2020 | | 70,285 ----------------------------------------------+---------+-------- 2021 | | 70,285 ----------------------------------------------+---------+-------- Thereafter | | 253,114 ----------------------------------------------+---------+-------- | $ | 561,354 ----------------------------------------------+---------+-------- 10 NOTE 7: PAYROLL LIABILITIES Payroll liabilities consisted of the following: | September 30, 2017 | | December 31, 2016 | ----------------------------+---------------------+---------+-------------------+-- Accrued bonus payable | $ | 423,000 | | $ | 609,337 ----------------------------+---------------------+---------+-------------------+---+-------- Accrued vacation | | 140,384 | | | 94,514 ----------------------------+---------------------+---------+-------------------+---+-------- Accrued payroll liabilities | | 64,203 | | | 66,048 ----------------------------+---------------------+---------+-------------------+---+-------- Total payroll liabilities | $ | 627,587 | | $ | 769,899 ----------------------------+---------------------+---------+-------------------+---+-------- NOTE 8: STOCKHOLDERS’ EQUITY The Company is authorized to issue a total of 85,000,000 shares of stock consisting of 75,000,000 shares of common stock, par value $0.015 per share, and 10,000,000 shares of preferred stock, par value $0.001 per share. The Company has designated 750,000 shares of Series A Junior Participating Preferred Stock, par value $0.001 per share, and 4,000 shares of Series A convertible preferred stock, par value $0.001 per share through the filings of certificates of designation with the Delaware Secretary of State, none of which are issued and outstanding as of September 30, 2017. 11 On May 19, 2014, the Company adopted a stockholder rights agreement which provides that all stockholders of record on May 26, 2014 received a non-taxable distribution of one preferred stock purchase right for each share of the Company’s common stock held by such stockholder. Each right is attached to and trades with the associated share of common stock. The rights will become exercisable only if one of the following occurs: (1) a person becomes an “Acquiring Person” by acquiring beneficial ownership of 15% or more of the Company’s common stock (or, in the case of a person who beneficially owned 15% or more of the Company’s common stock on the date the stockholder rights agreement was executed, by acquiring beneficial ownership of additional shares representing 2.0% of the Company’s common stock then outstanding (excluding compensatory arrangements)), or (2) a person commences a tender offer that, if consummated, would result in such person becoming an Acquiring Person. If a person becomes an Acquiring Person, each right will entitle the holder, other than the Acquiring Person and certain related parties, to purchase a number of shares of the Company’s common stock with a market value that equals twice the exercise price of the right. The initial exercise price of each right is $15.00, so each holder (other than the Acquiring Person and certain related parties) exercising a right would be entitled to receive $30.00 worth of the Company’s common stock. If the Company is acquired in a merger or similar business combination transaction at any time after a person has become an Acquiring Person, each holder of a right (other than the Acquiring Person and certain related parties) will be entitled to purchase a similar amount of stock of the acquiring entity. 2016 Issuances of Additional Shares to Aspire Capital On November 11, 2015, we terminated our prior agreement with Aspire Capital Fund, LLC (“Aspire Capital”) and entered into a new common stock purchase agreement. Concurrently with entering into the new purchase agreement, we also entered into a registration rights agreement with Aspire Capital in which we agreed to register 405,747 shares of our common stock. During the first quarter of 2016, we sold a total of 405,747 shares of common stock to Aspire Capital under the stock purchase agreement dated November 11, 2015 with aggregate gross proceeds to the Company of $2,177,083, or net proceeds of $2,133,973 after deducting costs of the offering. On May 25, 2016, the Company terminated the November 11, 2015 stock purchase agreement with Aspire Capital and entered into a new common stock purchase agreement with Aspire Capital which provided that, upon the terms and subject to the conditions and limitations set forth therein, Aspire Capital is committed to purchase up to an aggregate of $10.0 million of shares of our common stock over the 30-month term of the purchase agreement, subject to the terms and conditions set forth therein. Concurrently with entering into the purchase agreement, the Company also entered into a registration rights agreement with Aspire Capital, in which the Company agreed to file one or more registration statements, as permissible and necessary to register under the Securities Act of 1933, registering the sale of the shares of our common stock that have been and may be issued to Aspire Capital under the purchase agreement. As part of the stock purchase agreement we issued 49,736 common shares as a commitment fee. The value of the common shares issued as a commitment fee of $198,523 has been reflected as an addition to common stock and additional paid in capital of $746 and $197,777, respectively, which is amortized over the life of the stock purchase agreement. As of the date of filing this Quarterly Report with the SEC no shares of stock have been sold to Aspire Capital under the May 25, 2016 purchase agreement. In connection with our public offering that closed on April 3, 2017, we agreed not to utilize the financing arrangement with Aspire Capital for 90 days after that financing and on June 30, 2017 in connection with the temporary modification of our common stock warrants to allow for the net exercise of those warrants we agreed to extend this stand still for an additional 45 days. As of September 30, 2017, 467,650 shares are available for sale to Aspire Capital under the May 25, 2016 purchase agreement. 2016 Public Offering of Common Stock In August 2016, the Company completed an underwritten public offering of 1,150,000 shares of common stock at a price per share of $2.50, with gross proceeds of $2,875,000 to the Company, or net proceeds of $2,561,896 after deducting underwriter discounts, commissions, non-accountable expense allowance and expense reimbursement. 2017 Public Offering of Class A and Class B Units Consisting of Common Stock, Series A Convertible Preferred Stock and Warrants On March 28, 2017, the Company entered into an underwriting agreement with Aegis Capital Corp. relating to a public offering which closed on April 3, 2017. The offering generated gross proceeds to the Company of approximately $4.4 million and net proceeds of approximately $3.9 million after deducting underwriting discounts and commissions and other offering expenses paid by the Company. The offering included 664,000 Class A Units at a public offering price of $0.75 per Class A Unit, which consisted of 664,000 shares of common stock and warrants to purchase 664,000 shares of common stock. The offering also included 3,502 Class B Units at a public offering price of $1,000 per Class B Unit, which consisted of 3,502 shares of Series A convertible preferred stock convertible into a total of 4,669,329 shares of common stock and warrants to purchase 4,669,329 shares of common stock. In addition, the underwriter exercised the over-allotment to purchase an additional 530,000 shares of common stock and warrants to purchase 530,000 shares of common stock, which are included in the gross proceeds of $4.4 million. The warrants had a per share exercise price of $0.9375, were exercisable immediately and were scheduled to expire five years from the date of issuance. As of September 30, 2017, all of the warrants issued in the April 3, 2017 offering have been exercised and are no longer outstanding and all of the shares of Series A convertible preferred stock have been converted into shares of common stock. 12 Accounting Treatment The Company allocated the proceeds from the sale of the Class A and Class B units to the separate securities issued. The Company determined that, on the date of issuance, the warrants were not considered indexed to its own stock because the underlying instruments were not “fixed-for-fixed” due to the price protection and fundamental transaction provisions and, therefore, the warrants should be accounted for as liabilities. At the end of each reporting period, the changes in fair value of the warrants during the period are recorded in non-operating income (expense) in the consolidated statement of operations. The Company allocated the amount representing the fair value of the warrants at the date of issuance separately to the warrant liability and recorded the remaining proceeds as common stock, in the case of the Class A units, or as Series A convertible preferred stock, in the case of the Class B units. Due to the allocation of a portion of the proceeds to the warrants, the Series A convertible preferred stock contained a beneficial conversion feature upon issuance, which was recorded in the amount of $1,284,066 based on the intrinsic value of the beneficial conversion feature. The discount on the Series A convertible preferred stock of $1,284,066 caused by allocation of the proceeds to the warrant was recorded as a deemed dividend upon issuance of the Series A convertible preferred stock. As a result, total deemed dividends of $2,568,132 was recorded upon issuance of the Series A convertible preferred stock, which is reflected as an addition to net loss in the consolidated statement of operations to arrive at net loss applicable to common shareholders. 13 Exercise of 2017 Warrants On June 29, 2017, the Company offered to modify the rights of the holders of the warrants issued in the public offering the Company completed on April 3, 2017. The temporary modification included (a) lowering the exercise price of the warrants to $0.26 per share, (b) setting the applicable volume-weighted average price (VWAP) at $0.52 per share, and (c) allowing for temporary cashless exercise of the warrants for all holders that accepted the temporary modification before 8:00 a.m. Eastern daylight time on June 30, 2017. Holders of warrants to purchase a total of approximately 3.0 million shares of Common Stock accepted the offer resulting in the cancellation of those warrants and the issuance by the Company of a total of approximately 1.5 million shares of Common Stock (including shares held in abeyance). The shares of Common Stock are registered under the Securities Act of 1933, as amended. If delivery of the shares of Common Stock pursuant to the foregoing would result in the holder exceeding the 4.99% “Beneficial Ownership Limitation” (as defined in the warrant) then the shares in excess of such 4.99% will be held in abeyance by the Company pending further instruction from the holder. In connection with the temporary modification, the Company agreed to extend the “Lock-up Period” of the underwriting agreement between the Company and Aegis Capital Corp., dated March 28, 2017, by 45 days and the Company agreed not to enter into any further amendments to the warrants during such extended Lock-up Period without the prior written consent of each holder. During the three months ended September 30, 2017, all remaining warrants were exercised for cash so that no warrants issued in the April 3, 2017 financing remain outstanding. Upon exercise of these warrants, the amount of the warrant liability at the date of exercise was reclassified from warrant liability to additional paid-in capital. The following table summarizes the 2017 liability warrant activity: | Shares | | | Weighted Average Exercise Price | -------------------------------------+--------+------------+---+---------------------------------+-- Outstanding as of December 31, 2016 | | | | | | -------------------------------------+--------+------------+---+---------------------------------+---+------- Warrants granted | | 5,863,332 | | | $ | 0.9375 -------------------------------------+--------+------------+---+---------------------------------+---+------- Warrants exercised | | (5,863,332 | ) | | | 0.26 -------------------------------------+--------+------------+---+---------------------------------+---+------- Outstanding as of September 30, 2017 | | | | | $ | -------------------------------------+--------+------------+---+---------------------------------+---+------- 14 The Company estimated the fair value of the warrants using the Monte Carlo simulation (MCS) model, which is a type of income approach, where the current value of an asset is expressed as the sum of probable future cash flows across various scenarios and time frames discounted for risk and time. The significant assumptions include timing of future rounds of financing, timing and success rates of oncology clinical trials, and the probability of a merger and acquisition adjusted for a lack of marketability discount. The MCS model also includes a full term and an early conversion scenario that are each weighted at 50% in the final concluded fair value. Inputs used in the valuation of the warrants at the issuance date of April 3, 2017 and June 30, 2017 are set forth below. All remaining warrants were exercised during the quarter and no warrants issued in the April 2017 financing remain outstanding at September 30, 2017. Initial valuation | | ------------------------+---+------------- Common stock price | $ | 0.75 | ------------------------+---+--------------+-- Exercise price | $ | 0.9375 | ------------------------+---+--------------+-- Expected Volatility | | 50 | % ------------------------+---+--------------+-- Dividend Yield | | 0 | % ------------------------+---+--------------+-- Risk-Free Interest Rate | | 0.79% - 1.88 | % ------------------------+---+--------------+-- Expected Term (years) | | 0.24 - 5 | ------------------------+---+--------------+-- June 30, 2017 valuation | | | ------------------------+---+--------------+-- Common stock price | $ | 0.50 | ------------------------+---+--------------+-- Exercise price | $ | 0.26 | ------------------------+---+--------------+-- Expected Volatility | | 50 | % ------------------------+---+--------------+-- Dividend Yield | | 0 | % ------------------------+---+--------------+-- Risk-Free Interest Rate | | 0.79-1.88 | % ------------------------+---+--------------+-- Expected Term (years) | | 0.08-4.76 | ------------------------+---+--------------+-- 15 Outstanding Warrants As of September 30, 2017, warrants to purchase 380,561 shares of common stock were outstanding including: | Outstanding Warrants to Purchase Shares | | Exercise Price | | | Expiration Date -------------------------------------------------+------------------------------------------------+---------+--------------------+---+--------------------+-------------------- 2011 private placement | | 283,470 | | $ | 18.75 - 24.00 | | May 8, 2018 -------------------------------------------------+------------------------------------------------+---------+--------------------+---+--------------------+---------------------+--------------------------- 2014 public offering | | 77,790 | | | 45.00 | | January 29, 2019 -------------------------------------------------+------------------------------------------------+---------+--------------------+---+--------------------+---------------------+--------------------------- Placement agent fees for Company’s offerings | | 16,135 | | | 31.80 - 186.45 | | March - November, 2018 -------------------------------------------------+------------------------------------------------+---------+--------------------+---+--------------------+---------------------+--------------------------- Outside consulting | | 3,166 | | | 63.60 | | January 14, 2018 -------------------------------------------------+------------------------------------------------+---------+--------------------+---+--------------------+---------------------+--------------------------- | | 380,561 | | | | | -------------------------------------------------+------------------------------------------------+---------+--------------------+---+--------------------+---------------------+--------------------------- Conversion of Series A Convertible Preferred Stock During the three months ended September 30, 2017, certain holders of the Series A convertible preferred stock exercised their conversion option and converted an aggregate of 839 shares of Series A convertible preferred stock into 1,118,665 shares of the Company’s common stock based on the conversion ratio of 1,333.33 shares of common stock for each share of Series A convertible preferred stock. During the nine months ended September 30, 2017, certain holders of the Series A convertible preferred stock exercised their conversion option and converted an aggregate of 3,502 shares of Series A convertible preferred stock into 4,669,329 shares of the Company’s common stock. As of September 30, 2017, no shares of Series A convertible preferred stock are outstanding. NOTE 9: FAIR VALUE OF FINANCIAL INSTRUMENTS Pursuant to the accounting guidance for fair value measurement and its subsequent updates, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (i.e., the “exit price”) in an orderly transaction between market participants at the measurement date. The accounting guidance establishes a hierarchy for inputs used in measuring fair value that minimizes the use of unobservable inputs by requiring the use of observable market data when available. Observable inputs are inputs that market participants would use in pricing the asset or liability based on active market data. Unobservable inputs are inputs that reflect the assumptions market participants would use in pricing the asset or liability based on the best information available in the circumstances. The fair value hierarchy is broken down into the three input levels summarized below: ● Level 1 —Valuations are based on quoted prices in active markets for identical assets or liabilities and readily accessible by us at the reporting date. Examples of assets and liabilities utilizing Level 1 inputs are certain money market funds, U.S. Treasuries and trading securities with quoted prices on active markets. ● Level 2 —Valuations based on inputs other than the quoted prices in active markets that are observable either directly or indirectly in active markets. Examples of assets and liabilities utilizing Level 2 inputs are U.S. government agency bonds, corporate bonds, commercial paper, certificates of deposit and over-the- counter derivatives. 16 ● Level 3 —Valuations based on unobservable inputs in which there are little or no market data, which require the Company to develop its own assumptions. There were no financial assets outstanding that were required to be measured at fair value at September 30, 2017 or December 31, 2016. Warrants issued in the April 3, 2017 offering contained provisions that could have required the Company to settle the warrants in cash in an event outside the Company’s control or had price protection rights and were therefore accounted for as liabilities while they were outstanding, with changes in the fair values included in net loss for the respective periods. Because some of the inputs to the valuation model were either not observable or were not derived principally from or corroborated by observable market data by correlation or other means, the warrant liability was classified as Level 3 in the fair value hierarchy. The following table summarizes the changes in the Company’s Level 3 warrant liability for the nine months ended September 30, 2017: Warrant liability | | | --------------------------+---+------------+-- Beginning balance | $ | | --------------------------+---+------------+-- Issuances of warrants | | 1,612,413 | --------------------------+---+------------+-- Warrant exercises | | (1,893,160 | ) --------------------------+---+------------+-- Change in fair value | | 280,747 | --------------------------+---+------------+-- Ending balance | | | --------------------------+---+------------+-- There were no transfers between Level 1, Level 2 or Level 3 for the three and nine months ended September 30, 2017 or the year ended December 31, 2016. NOTE 10: NET INCOME (LOSS) PER SHARE The Company accounts for and discloses net income (loss) per common share in accordance with FASB Accounting Standards Codification (“ASC”) Topic 260, Earnings Per Share. Basic net income (loss) per common share is computed by dividing net income (loss) attributable to common stockholders by the weighted average number of common shares outstanding. In addition, in computing the dilutive effect of convertible securities, the numerator is adjusted to add back any convertible preferred dividends. Diluted net income (loss) per common share is computed by dividing net income (loss) attributable to common stockholders by the weighted average number of common shares that would have been outstanding during the period assuming the issuance of common shares for all potential dilutive common shares outstanding. Potential common shares consist of shares issuable upon the conversion of Series A convertible preferred stock, and potential future exercises of outstanding stock options and common stock warrants. Because the inclusion of potential common shares would be anti-dilutive for all periods presented except for the three months ended September 30, 2016, diluted net loss per common share is the same as basic net loss per common share for those periods. Diluted net income per share was the same as basic net income per share for the three months end September 30, 2016 as the impact of potential common shares included in earnings per share was insignificant. The following table summarizes the Company’s calculation of net income (loss) per common share: | Three Months Ended September 30, | | | Nine Months Ended September 30, | ------------------------------------------------------+----------------------------------+------------+---+---------------------------------+-- | 2017 | | | 2016 | | | 2017 | | 2016 | ------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+-----------+------+---+------------+-- Net income (loss) Per share | | | | | | | | | | ------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+-----------+------+---+------------+-- Numerator | | | | | | | | | | ------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+-----------+------+---+------------+-- Net income (loss) | $ | (2,184,510 | ) | | $ | 204,689 | | $ | (6,129,553 | ) | $ | (3,845,235 | ) ------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+-----------+------+---+------------+---+---+------------+-- Deemed dividend attributable to preferred stock | | | | | | | | | (2,568,132 | ) | | | ------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+-----------+------+---+------------+---+---+------------+-- Net income (loss) attributable to common shareholders | $ | (2,184,510 | ) | | $ | 204,689 | | $ | (8,697,685 | ) | $ | (3,845,235 | ) ------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+-----------+------+---+------------+---+---+------------+-- Denominator | | | | | | | | | | | | | ------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+-----------+------+---+------------+---+---+------------+-- Weighted average common shares outstanding | | 12,411,145 | | | | 3,024,393 | | | 7,886,210 | | | 2,665,904 | ------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+-----------+------+---+------------+---+---+------------+-- Basic and diluted net income (loss) per share | $ | (0.18 | ) | | $ | 0.07 | | $ | (1.10 | ) | $ | (1.44 | ) ------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+-----------+------+---+------------+---+---+------------+-- 17 The following table sets forth the number of potential common shares excluded from the calculation of net income (loss) per diluted share for the three months and nine months ended September 30, 2017 and 2016 because the effect of them would be anti-dilutive: | Three Months Ended September 30, | | Nine Months Ended September 30, -----------------------------------------+----------------------------------------+-----------+------------------------------------- | 2017 | | 2016 | | 2017 | 2016 -----------------------------------------+----------------------------------------+-----------+--------------------------------------+---------+------+---------- Options to purchase common stock | | 2,118,021 | | 390,424 | | 1,206,057 | 390,424 -----------------------------------------+----------------------------------------+-----------+--------------------------------------+---------+------+-----------+-------- Series A convertible preferred stock | | 509,762 | | | | 895,809 | -----------------------------------------+----------------------------------------+-----------+--------------------------------------+---------+------+-----------+-------- Warrants to purchase common stock | | 1,660,379 | | 402,228 | | 2,726,751 | 402,228 -----------------------------------------+----------------------------------------+-----------+--------------------------------------+---------+------+-----------+-------- Total | | 4,288,162 | | 792,652 | | 4,828,617 | 792,652 -----------------------------------------+----------------------------------------+-----------+--------------------------------------+---------+------+-----------+-------- NOTE 11: INCOME TAXES Deferred income tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial reporting and tax bases of assets and liabilities and are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. A valuation allowance is provided for the amount of deferred tax assets that, based on available evidence, are not expected to be realized. As a result of the Company’s cumulative losses, management has concluded that a full valuation allowance against the Company’s net deferred tax assets is appropriate. No income tax liabilities existed as of September 30, 2017 and December 31, 2016 due to the Company’s continuing operating losses. NOTE 12: CONCENTRATION OF CREDIT RISK Financial instruments that potentially subject the Company to concentration of credit risk consist principally of cash deposits. Accounts at each institution are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to $250,000. At September 30, 2017 and December 31, 2016, the Company had $2,483,663 and $2,777,962 in excess of the FDIC insured limit, respectively. 18 NOTE 13: COMMITMENTS AND CONTINGENCIES Lease Commitments The future minimum lease payments due subsequent to September 30, 2017 under all non-cancelable operating and capital leases for the next five years are as follows: Year Ending December 31, | Operating Leases Amount | ---------------------------------+-------------------------+------- 2017 (remainder of year) | $ | 7,395 ---------------------------------+-------------------------+------- 2018 | | 22,185 ---------------------------------+-------------------------+------- Total minimum lease payments | $ | 29,580 ---------------------------------+-------------------------+------- The total rent expense for the three months ended September 30, 2017 and 2016 was $7,395 and $87,315, respectively, and $25,775 and $238,565 for the nine months ended September 30, 2017 and 2016, respectively. Rent expense was included in general and administrative expenses for both years. Litigation and Contingencies On October 10, 2013, a putative securities class action complaint, captioned Cook v. Atossa Genetics, Inc., et al., No. 2:13-cv-01836-RSM, was filed in the United States District Court for the Western District of Washington against us, certain of our directors and officers and the underwriters of our November 2012 initial public offering. The complaint alleged that all defendants violated Sections 11 and 12(a)(2), and that we and certain of our directors and officers violated Section 15, of the Securities Act by making material false and misleading statements and omissions in the offering’s registration statement, and that we and certain of our directors and officers violated Sections 10(b) and 20A of the Exchange Act and SEC Rule 10b-5 promulgated thereunder by making false and misleading statements and omissions in the registration statement and in certain of our subsequent press releases and SEC filings with respect to our NAF specimen collection process, our ForeCYTE Breast Health Test and our MASCT device. The complaint sought, on behalf of persons who purchased our common stock between November 8, 2012 and October 4, 2013, inclusive, damages of an unspecific amount. On February 14, 2014, the district court appointed plaintiffs Miko Levi, Bandar Almosa and Gregory Harrison (collectively, the “Levi Group”) as lead plaintiffs, and approved their selection of co-lead counsel and liaison counsel. The Court also amended the caption of the case to read In re Atossa Genetics, Inc. Securities Litigation No. 2:13-cv-01836-RSM. An amended complaint was filed on April 15, 2014. The Company and other defendants filed motions to dismiss the amended complaint on May 30, 2014. On October 6, 2014 the Court granted defendants’ motion dismissing all claims against Atossa and all other defendants. On October 30, 2014, the Court entered a final order of dismissal. On November 3, 2014, plaintiffs filed a notice of appeal with the Court and appealed the Court’s dismissal order to the U.S. Court of Appeals for the Ninth Circuit. On August 18, 2017, the Ninth Circuit affirmed in part and reversed in part the district court’s judgment. On September 11, 2017, the Ninth Circuit entered an order and mandate remanding the case to the United States District Court for the Western District of Washington. On October 19, 2017, plaintiffs filed an amended complaint that conforms to the ruling by the Ninth Circuit. Defendants’ answer to the amended complaint is due December 8, 2017. Since the claims under Sections 11, 12(a)(2) and 15 were dismissed by the district court and not appealed, the amended complaint only alleges violations of Section 10(b) and 20A of the Exchange Act and SEC Rule 10b-5 promulgated thereunder against the company and one officer. All other claims and defendants have been dismissed. The alleged class period in the amended complaint is December 20, 2012 through October 4, 2013. 19 The Company believes this lawsuit is without merit and plans to defend itself vigorously; however, failure by the Company to obtain a favorable resolution of the claims set forth in the complaint could have a material adverse effect on the Company’s business, results of operations and financial condition. Currently, the amount of such material adverse effect cannot be reasonably estimated, and no provision or liability has been recorded for these claims as of September 30, 2017. The costs associated with defending and resolving the lawsuit and ultimate outcome cannot be predicted. These matters are subject to inherent uncertainties and the actual cost, as well as the distraction from the conduct of the Company’s business, will depend upon many unknown factors and management’s view of these may change in the future. NOTE 14: STOCK BASED COMPENSATION Stock Options and Incentive Plan On September 28, 2010, the Board of Directors approved the adoption of the 2010 Stock Option and Incentive Plan (“2010 Plan”) to provide for the grant of equity-based awards to employees, officers, non-employee directors and other key persons providing services to the Company. Awards of incentive options may be granted under the 2010 Plan until September 2020. No other awards may be granted under the 2010 Plan after the date that is 10 years from the date of stockholder approval. An aggregate of 66,667 shares were initially reserved for issuance in connection with awards granted under the 2010 Plan and on May 18, 2016, an additional 133,333 shares were reserved for issuance under the 2010 Plan. On May 9, 2017, the stockholders approved an additional 1,500,000 shares for issuance under the 2010 Plan. The following table presents the automatic additions to the 2010 Plan since inception pursuant to the “evergreen” terms of the 2010 Plan: January 1, | Number of shares | ----------------------------+----------------------+-------- 2012 | | 30,018 ----------------------------+----------------------+-------- 2013 | | 34,452 ----------------------------+----------------------+-------- 2014 | | 49,532 ----------------------------+----------------------+-------- 2015 | | 65,557 ----------------------------+----------------------+-------- 2016 | | 220,419 ----------------------------+----------------------+-------- 2017 | | 151,477 ----------------------------+----------------------+-------- Total additional shares | | 551,455 ----------------------------+----------------------+-------- The Company granted 0 and 1,716,323 options to purchase shares of common stock during the three and nine months ended September 30, 2017. No options were exercised during the three or nine months ended September 30, 2017. There are 100,456 shares available for grant under the 2010 Plan as of September 30, 2017. Compensation costs associated with the Company’s stock options are recognized, based on the grant-date fair values of these options, over the requisite service period, or vesting period. Accordingly, the Company recognized stock based compensation expense of $224,254 and $257,389 for the three months ended September 30, 2017 and 2016, respectively, and $560,369 and $650,053 for the nine months ended September 30, 2017 and 2016, respectively. The fair value of stock options granted for the nine months ended September 30, 2017 and 2016 was calculated using the Black-Scholes option-pricing model applying the following assumptions: | Period ended September 30, | ------------------------+--------------------------------+------------------ | 2017 | | 2016 ------------------------+--------------------------------+-------------------+----- Risk free interest rate | | 1.86% - 2.04% | | 1.48% - 1.55% ------------------------+--------------------------------+-------------------+------+------------------ Expected term | | 5.32- 6.36 years | | 5.58 - 6.06 years ------------------------+--------------------------------+-------------------+------+------------------ Dividend yield | | - % | | - % ------------------------+--------------------------------+-------------------+------+------------------ Expected volatility | | 112.86% - 114.19% | | 115.52% - 115.58% ------------------------+--------------------------------+-------------------+------+------------------ 20 Options issued and outstanding as of September 30, 2017 and their activities during the nine months then ended are as follows: | Number of Underlying Shares | | | Weighted- Average Exercise Price Per Share | | | Weighted- Average Contractual Life Remaining in Years | Aggregate Intrinsic Value -----------------------------------------+---------------------------------+-----------+---+--------------------------------------------+---+-------+-------------------------------------------------------+-------------------------- Outstanding as of January 1, 2017 | | 378,924 | | | $ | 26.25 | | | $ | -----------------------------------------+---------------------------------+-----------+---+--------------------------------------------+---+-------+-------------------------------------------------------+---------------------------+---+-------- Granted | | 1,716,323 | | | | 0.47 | | | | -----------------------------------------+---------------------------------+-----------+---+--------------------------------------------+---+-------+-------------------------------------------------------+---------------------------+---+-------- Forfeited | | (3,167 | ) | | | 15.00 | | | | -----------------------------------------+---------------------------------+-----------+---+--------------------------------------------+---+-------+-------------------------------------------------------+---------------------------+---+-------- Expired | | (19,081 | ) | | | 25.05 | | | | -----------------------------------------+---------------------------------+-----------+---+--------------------------------------------+---+-------+-------------------------------------------------------+---------------------------+---+-------- Outstanding as of September 30, 2017 | | 2,072,999 | | | | 4.10 | | 9.29 | $ | 102,679 -----------------------------------------+---------------------------------+-----------+---+--------------------------------------------+---+-------+-------------------------------------------------------+---------------------------+---+-------- Exercisable as of September 30, 2017 | | 418,636 | | | | 16.39 | | 8.44 | $ | 9,645 -----------------------------------------+---------------------------------+-----------+---+--------------------------------------------+---+-------+-------------------------------------------------------+---------------------------+---+-------- Vested and expected to vest | | 2,072,999 | | | $ | 4.10 | | 9.29 | $ | 102,679 -----------------------------------------+---------------------------------+-----------+---+--------------------------------------------+---+-------+-------------------------------------------------------+---------------------------+---+-------- At September 30, 2017, there were 1,651,052 unvested options outstanding and the related unrecognized total compensation cost associated with these options was approximately $1,203,000. This expense is expected to be recognized over a weighted-average period of 2.0 years. NOTE 15: SUBSEQUENT EVENTS On October 26, 2017, the Company entered into an underwriting agreement with Maxim Group LLC relating to a public offering of common stock which closed on October 30, 2017. The offering generated gross proceeds to the Company of approximately $5.5 million and net proceeds of $5.1 million after deducting underwriting discounts and commission. The offering included 11,500,000 shares of common stock at a public offering price of $0.44 per share. In addition, the underwriter exercised the over-allotment to purchase an additional 1,000,000 shares of common stock, which are included in the estimated gross proceeds of $5.5 million. 21 ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion of the financial condition and results of operations should be read in conjunction with the financial statements and the related notes included elsewhere in this report. This discussion contains forward-looking statements, which are based on assumptions about the future of the Company’s business. The actual results could differ materially from those contained in the forward-looking statements. Please read “Forward-Looking Statements” included below for additional information regarding forward-looking statements. Forward-Looking Statements This report contains, in addition to historical information, certain information, assumptions and discussions that may constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). We have made these statements in reliance on the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements are subject to certain risks and uncertainties, which could cause actual results to differ materially from those projected or anticipated. Although we believe our assumptions underlying our forward-looking statements are reasonable as of the date of this report, we cannot assure you that the forward-looking statements set out in this report will prove to be accurate. We typically identify these forward-looking statements by the use of forward-looking words such as “expect,” “potential,” “continue,” “may,” “will,” “should,” “could,” “would,” “seek,” “intend,” “plan,” “estimate,” “anticipate” or the negative version of those words or other comparable words. Forward-looking statements contained in this report include, but are not limited to, statements about: ● | whether we can obtain approval from the U.S. Food and Drug Administration, or FDA, and foreign regulatory bodies, to sell, market and distribute our therapeutics and devices under development; --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ● | our ability to successfully complete clinical trials of our pharmaceutical candidates under development, including endoxifen and our intraductal microcatheters to administer therapeutics, including our study using fulvestrant; --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ● | the success, cost and timing of our product and drug development activities and clinical trials, including whether the ongoing clinical study using our intraductal microcatheters to administer fulvestrant will enroll a sufficient number of subjects or be completed in a timely fashion or at all; --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ● | our ability to contract with third-party suppliers, manufacturers and service providers, including clinical research organizations, and their ability to perform adequately; --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ● | our ability to successfully develop and commercialize new therapeutics currently in development or that we might identify in the future and in the time frames currently expected; --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ● | our ability to successfully defend ongoing litigation, including the November 3, 2014 appeal of a dismissal of a securities class action law suit filed against us, and other similar complaints that may be brought in the future, in a timely manner and within the coverage, scope and limits of our insurance policies; --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ● | our ability to establish and maintain intellectual property rights covering our products; --+---------------------------------------------------------------------------------------------- ● | our expectations regarding, and our ability to satisfy, federal, state and foreign regulatory requirements; --+---------------------------------------------------------------------------------------------------------------- ● | the accuracy of our estimates of the size and characteristics of the markets that our products and services may address; --+----------------------------------------------------------------------------------------------------------------------------- ● | our expectations as to future financial performance, expense levels and capital sources; --+--------------------------------------------------------------------------------------------- ● | whether the final study results will vary from preliminary study results that we may announce; and --+--------------------------------------------------------------------------------------------------- ● | our ability to attract and retain key personnel; --+----------------------------------------------------- 22 These and other forward-looking statements made in this report are presented as of the date on which the statements are made. We have included important factors in the cautionary statements included in this report, particularly in the section titled “ITEM 1A. RISK FACTORS,” that we believe could cause actual results or events to differ materially from the anticipated results as set forth in the forward-looking statements that we make. Our forward-looking statements do not reflect the potential impact of any new information, future events or circumstances that may affect our business after the date of this report. Except as required by law, we do not intend to update any forward-looking statements after the date on which the statement is made, whether as a result of new information, future events or circumstances or otherwise. Company Overview We are a clinical-stage pharmaceutical company focused on developing novel, proprietary therapeutics and delivery methods for the treatment of breast cancer and other breast conditions. We are developing Endoxifen with two routes of delivery: a topical formulation, applied like a lotion, for the treatment of a condition called mammographic breast density (or, MBD), and an oral formulation for breast cancer survivors who do not benefit from taking oral tamoxifen which is the current FDA-approved standard of care. We are also developing our patented intraductal microcatheter technology to potentially target the delivery of therapies, including fulvestrant and CAR-T cell therapies, directly to the site of breast cancer. Endoxifen Oral tamoxifen has been widely used for over 30 years to both treat and prevent breast cancer. Tamoxifen, however, has significant drawbacks: First, it can cause side effects including headaches, nausea and early menopausal symptoms as well as rare but serious side effects such as cataracts, strokes and cancer of the uterus. Second, tamoxifen is a “pro-drug,” meaning that it must be processed by the liver in order to produce therapeutic metabolites. The metabolite in tamoxifen that accounts for most of its therapeutic activity is called Endoxifen. Unfortunately, up to 50% of breast cancer survivors who are taking tamoxifen do not produce therapeutic levels of Endoxifen (meaning they are “refractory”) for a number of reasons including that they do not have the requisite liver enzymes. We are developing Endoxifen because of these drawbacks to tamoxifen. We are developing two different presentations of proprietary Endoxifen for two different potential treatment settings: First, we are developing topical Endoxifen for women with MBD for transdermal administration. Legislation that has been recently enacted in approximately 30 states (and that is now pending on the federal level) currently requires that women be notified if they have MBD and those notifications typically state that women with MBD have a higher risk of developing breast cancer, and that mammography may not be as effective because of the MBD. We estimate that approximately ten million women in the Unites States have MBD, for which there is no FDA-approved treatment. Although oral tamoxifen is approved to prevent breast cancer in “high-risk” women, it is used by less than 5% of women with an increased risk of developing breast cancer because of the actual or perceived side effects and risks of tamoxifen. We believe our topical Endoxifen may provide an effective treatment for MBD because, unlike an oral medication, it is applied directly to the breast and penetrates the skin; it does not require metabolism by the liver; and it may produce fewer side effects than tamoxifen. Second, we are developing oral Endoxifen for breast cancer patients who are refractory to tamoxifen. Approximately one million breast cancer patients take tamoxifen to prevent recurrence and new breast cancer; however, up to 50% of those patients are refractory to tamoxifen. We believe our oral Endoxifen may provide an effective treatment supplement or option for these refractory patients because Endoxifen, unlike tamoxifen, does not require liver metabolism. We recently completed a comprehensive Phase 1 study in 48 healthy women in Australia using both the topical and oral forms of our proprietary Endoxifen. The objectives of this double-blinded, placebo-controlled, Phase 1 study were to assess the pharmacokinetics of our proprietary Endoxifen dosage forms as single (oral) and repeat (oral and topical) doses, as well as to assess safety and tolerability. The study was conducted in two parts based on route of administration. 23 In September 2017, we reported preliminary results for the topical arm of the study and in October 2017 we reported preliminary results for the oral arm of the study. We concluded that all objectives were successfully met in both arms of the study: there were no clinically significant safety signals and no clinically significant adverse events and both the oral and topical Endoxifen were well tolerated. In the topical arm of the study, there were low but measurable Endoxifen levels detected in the blood in a dose-dependent fashion and in the oral arm of the study participants exhibited dose-dependent Endoxifen levels in published reports of the therapeutic range. In September 2017, we contracted Stockholm South General Hospital in Sweden to conduct a Phase 2 study of our topical Endoxifen. The study will be led by principal investigator Dr. Per Hall, MD, Ph.D., Head of the Department of Medical Epidemiology and Biostatistics at Karolinska Institutet. We have applied for approval from the Institutional Review Board and Swedish regulatory authority (Medical Products Agency) to begin enrollment. The placebo-controlled, double-blinded study is expected to enroll up to 480 subjects. The primary endpoint is MBD reduction, which will be measured after six and twelve months of dosing, as well as safety and tolerability. We are planning to start enrollment in this study in the first quarter of 2018. We plan to commence a Phase 2 clinical study of our oral Endoxifen for patients who are refractory to tamoxifen. We currently expect that we will retain a clinical research organization to manage the study and that we will commence the study the first quarter of 2018. Proprietary Intraductal Microcatheter Technology In October 2017, we announced a new program using Chimeric Antigen Receptor Therapy, or CAR-T. We plan to use our proprietary intraductal microcatheter technology for the potential transpapillary, or “TRAP,” delivery of T-cells that have been genetically modified to attack breast cancer cells. We believe this method has several potential advantages: reduced toxicity by limiting systemic exposure of the T-cells; improved efficacy by placing the T-cells in direct contact with the target ductal epithelial cells that are undergoing malignant transformation; and, lymphatic migration of the CAR-T cells along the same path taken by migrating cancer cells, potentially extending their cytotoxic actions into the regional lymph system, which could limit tumor cell dissemination. This program is in the research and development phase and has not been approved by the FDA or any other regulatory body. Pre-clinical studies, and clinical studies demonstrating safety and efficacy among other things, and regulatory approvals will be required before commercialization. We have developed a foundational intellectual property position with respect to TRAP CAR-T, and we intend to continue research and development through partnership with leading investigators, institutions, and organizations around the world, bringing our technology and expertise in TRAP delivery together with experts in cancer immunology and T-cell biology. We are currently conducting a Phase 2 study using our microcatheter technology to deliver fulvestrant at Montefiore Medical Center. This trial is a Phase 2 study in women with ductal carcinoma in situ (“DCIS”) or Stage 1 or 2 breast cancer (invasive ductal carcinoma) scheduled for mastectomy or lumpectomy within 30 to 45 days. This study is assessing the safety, tolerability, cellular activity and distribution of fulvestrant when delivered directly into breast milk ducts of these patients compared to those who receive the same drug by injection. Of the 30 patients required for full enrollment, six will receive the standard intramuscular injection of fulvestrant and 24 will receive fulvestrant with our microcatheter device. The primary endpoint of the clinical trial is to compare the safety, tolerability and distribution of fulvestrant between the two routes of administration (intramuscular injection or through our microcatheters). The secondary endpoint of the study is to determine if there are changes in the expression of Ki67 (a measure of cellular proliferation that correlates with tumor growth) as well as estrogen and progesterone receptors between a pre-fulvestrant biopsy and post-fulvestrant surgical specimens. Digital breast imaging before and after drug administration in both groups will also be performed to determine the effect of fulvestrant on any lesions as well as breast density of the participant. 24 Research and Development Phase We are in the research and development phase and are not currently marketing any products or services. We do not anticipate generating revenue unless and until we develop and launch our pharmaceutical programs. Critical Accounting Policies and Estimates In our Annual Report on Form 10-K/A for the year ended December 31, 2016, we disclosed our critical accounting policies and estimates upon which our financial statements are derived. There have been no changes to these policies since December 31, 2016, other than discussed in the following paragraph. Readers are encouraged to review these disclosures in conjunction with the review of this report. Financial Instruments with Characteristics of Both Liabilities and Equity During the nine months ended September 30, 2017, the Company issued certain financial instruments, consisting of warrants to purchase common stock, which have characteristics of both liability and equity. Financial instruments such as warrants that are classified as liabilities are fair valued upon issuance and are remeasured at fair value at subsequent reporting periods with the resulting change in fair value recorded in other income/(expense). The fair value of warrants is estimated using valuation models that require the input of subjective assumptions including stock price volatility, expected life, and the probability of future equity issuances and their impact to the price protection feature. Results of Operations Three and Nine Months Ended September 30, 2017 and 2016 Operating Expenses: Total operating expenses were approximately $2.1 million and $5.6 million for the three and nine months ended September 30, 2017, respectively, consisting of general and administrative (G&A) expenses of approximately $1.3 million and $3.5 million, respectively, and research and development (R&D) expenses of approximately $0.7 million and $2.1 million, respectively. Total operating expenses were approximately $1.6 million and $5.4 million for the three and nine months ended September 30, 2016, respectively, consisting of G&A expense of approximately $1.5 million and $5.0 million, respectively and R&D expenses of $0.1 million and $0.4 million, respectively. Total operating expenses for the three and nine months ended September 30, 2017 as compared to the same periods of 2016 increased approximately $0.5 million or 32.0% and increased $0.2 million or 3.6%, respectively. 25 General and Administrative Expenses: G&A expenses for the three months ended September 30, 2017 were approximately $1,314,000, a decrease of $159,000 or 10.8%, from approximately $1,473,000, for the same period in 2016. G&A expenses for the nine months ended September 30, 2017 were approximately $3,528,000, a decrease of $1,513,000 or 30.0%, from approximately $5,041,000 for the same period in 2016. G&A expenses consist primarily of personnel and related benefit costs, facilities, professional services, insurance, and public company related expenses. The decrease in G&A expenses is mainly attributed to a reduction in payroll expenses resulting from a decrease in headcount, rent, and exit costs incurred in 2016 that were not incurred in 2017. Research and Development Expenses: R&D expenses for the three and nine months ended September 30, 2017 were approximately $743,000 and $2,111,000, respectively, an increase of approximately $658,000, or 774.1% and $1,707,000 or 422.5% from the three months and nine months ended September 30, 2016, respectively. The increase in R&D expenses is attributed to salaries, manufacturing and clinical trial expenses associated with our Endoxifen program for which manufacturing commenced at the beginning of 2017 and the clinical studies which commenced in the second quarter of 2017. We expect our R&D expenses to increase throughout 2017 as we continue the clinical trial of fulvestrant administered via our microcatheters and as we continue the development of Endoxifen and potentially other indications and pharmaceuticals. Other Income Expense: In August 2016, the Company received a termination payment of $1,762,931 pursuant to the settlement agreement with Besins Healthcare Luxembourg SARL. There were no settlement payments received by the Company for the three and nine months ended September 30, 2017. Liquidity and Capital Resources We have a history of operating losses as we have focused our efforts on raising capital and building our products and services in our pipeline. The Company’s consolidated financial statements are prepared using generally accepted accounting principles in the United States of America applicable to a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The Company has incurred net losses and negative operating cash flows since inception. For the nine months ended September 30, 2017, the Company recorded a net loss of approximately $6.1 million, and used approximately $4.9 million of cash in operating activities. As of September 30, 2017, the Company had approximately $2.7 million in cash and cash equivalents and working capital of approximately $1.9 million. The Company has not yet established an ongoing source of revenue sufficient to cover its operating costs and allow it to continue as a going concern. The ability of the Company to continue as a going concern is dependent on the Company obtaining adequate capital to fund operating losses until it becomes profitable. The Company can give no assurances that any additional capital that it is able to obtain, if any, will be sufficient to meet its needs, or that any such financing will be obtainable on acceptable terms. If the Company is unable to obtain adequate capital, it could be forced to cease operations or substantially curtail is commercial activities. These conditions raise substantial doubt as to the Company’s ability to continue as a going concern. The accompanying financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts and classification of liabilities should the Company be unable to continue as a going concern. 26 As of the date of filing this quarterly report, we expect that our existing resources will be sufficient to fund our planned operations for the next 8-12 months; however, additional capital resources will be needed to fund operations longer-term. On October 26, 2017, the Company entered into an underwriting agreement with Maxim Group LLC relating to a public offering of common stock which closed on October 30, 2017. The offering generated gross proceeds to the Company of approximately $5.5 million and net proceeds of $5.1 million after deducting underwriting discounts and commission. As of the date of filing his quarterly report, the Company has in excess of $5 million in total stockholders equity. Our ability to continue as a going concern is dependent on our obtaining additional adequate capital to fund additional operating losses until we become profitable. If we are unable to obtain adequate capital, we could be forced to cease operations. Cash Flows As of September 30, 2017 the Company had cash and cash equivalents of $2.7 million. Net Cash Flows from Operating Activities: Net cash used in operating activities was approximately $4.9 million for the nine months ended September 30, 2017, compared with approximately $4.0 million for the nine months ended September 30, 2016. We spent approximately $2.1 million on research and development for the nine month period ended September 30, 2017, compared to $400,000 for the same period in 2016; this increase was offset by reductions in compensation expense from reduced headcount, reduced occupancy expense, reduced consulting fees, and from severance payments in 2016 that were not incurred in 2017. Net Cash Flows from Investing Activities: There was no net cash used in investing activities for the nine months ended September 30, 2017, compared with approximately $5,000 for nine months ended Sept 30, 2016. The decrease in 2017 was attributable to the reduction in purchases of fixed asset equipment in 2017 as compared to 2016. Net Cash Flows from Financing Activities: Net cash provided by financing activities generated proceeds of $4.6 million for the nine months ended September 30, 2017, as compared with $4.7 million for the nine months ended June 30, 2016. In both of the periods ended September 30, 2017 and 2016 the Company completed public offerings. Funding Requirements We expect to incur ongoing operating losses for the foreseeable future as we continue to develop our planned therapeutic programs including related clinical studies and other programs in the pipeline. We expect that as of the date of filing this quarterly report, our existing resources will be sufficient to fund our planned operations for at least the next 8-12 months. On October 26, 2017, the Company entered into an underwriting agreement with Maxim Group LLC relating to a public offering of common stock which closed on October 30, 2017. The offering generated gross proceeds to the Company of approximately $5.5 million and net proceeds of $5.1 million after deducting underwriting discounts and commission. If we are unable to raise additional capital when needed, however, we could be forced to curtail or cease operations. Our future capital uses and requirements depend on the time and expenses needed to begin and continue clinical trials for our new drug developments. Additional funding may not be available to us on acceptable terms or at all. In addition, the terms of any financing may adversely affect the holdings or the rights of our stockholders. For example, if we raise additional funds by issuing equity securities or by selling debt securities, if convertible, further dilution to our existing stockholders would result. To the extent our capital resources are insufficient to meet our future capital requirements, we will need to finance our future cash needs through public or private equity offerings, collaboration agreements, debt financings or licensing arrangements. If adequate funds are not available, we may be required to terminate, significantly modify or delay our development programs, reduce our planned commercialization efforts, or obtain funds through collaborators that may require us to relinquish rights to our technologies or product candidates that we might otherwise seek to develop or commercialize independently. Further, we may elect to raise additional funds even before we need them if we believe the conditions for raising capital are favorable. 27 Off-Balance Sheet Arrangements We do not currently have, nor have we ever had, any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In addition, we do not engage in trading activities involving non-exchange traded contracts. Recent Accounting Pronouncements In February 2016, Financial Accounting Standards Board (“FASB”) issued Accounting Standards Updated (“ASU”) No. 2016-02, Lease Accounting Topic 842. This ASU requires a lessee to recognize lease assets and liabilities on the balance sheet for all arrangements with terms longer than 12 months. The new standard applies a right-of-use (ROU) model that requires a lessee to record, for all leases with a lease term of more than 12 months, an asset representing its right to use the underlying asset for the lease term and a liability to make lease payments. The lease term is the non-cancellable period of the lease, and includes both periods covered by an option to extend the lease, if the lessee is reasonably certain to exercise that option, and periods covered by an option to terminate the lease, if the lessee is reasonably certain not to exercise that termination option. For leases with a lease term of 12 months or less, a practical expedient is available whereby a lessee may elect, by class of underlying asset, not to recognize an ROU asset or lease liability. A lessee making this accounting policy election would recognize lease expense over the term of the lease, generally in a straight-line pattern. The Lessor accounting remains largely consistent with existing U.S. GAAP. The new standard takes effect in 2019 for public business entities. The Company has not adopted the provisions of ASU No. 2016-02. We are currently evaluating the impact of our pending adoption of ASU 2016-02 on our consolidated financial statements. In April 2016, the FASB issued ASU No. 2016-09, Compensation - Stock Compensation simplifying the accounting for share-based payment transactions including the income tax consequences, classification of awards as either equity or liabilities and classification on the statements of cash flows. Under the new standard, all excess tax benefits and tax deficiencies (including tax benefits of dividends on share-based payment awards) should be recognized as income tax expense or benefit on the statements of income. We adopted ASU No. 2016-09 effective January 1, 2017. As a result of the adoption of this guidance, we made an accounting policy election to recognize the effect of forfeitures in compensation cost when they occur. There was an immaterial impact on results of operations and financial position and no impact on cash flows at adoption. In November 2016, the FASB issued ASU No. 2016-18, Statement of Cash Flows, amending the presentation of restricted cash within the statement of cash flows. The new guidance requires that restricted cash be included within cash and cash equivalents on the statement of cash flows. The ASU is effective retrospectively for reporting periods beginning after December 15, 2017, with early adoption permitted. The Company has not yet adopted the provisions of ASU No. 2016-18 and does not expect it will have a material impact on the financial statements upon adoption. In July 2017, the FASB issued ASU 2017-11, Accounting for Certain Financial Instruments with Down Round Features and Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests with a Scope Exception. Part I of this ASU addresses the complexity of accounting for certain financial instruments with down round features. Down round features are features of certain equity-linked instruments (or embedded features) that result in the strike price being reduced on the basis of future equity offerings. Current accounting guidance requires financial instruments with down round features to be accounted for at fair value. Part II of the Update applies only to nonpublic companies and is therefore not applicable to the Company. The amendments in Part I of the Update change the classification analysis of certain equity-linked financial instruments (or embedded features) with down round features. When determining whether certain financial instruments should be classified as liabilities or equity instruments, a down round feature no longer precludes equity classification when assessing whether the instrument is indexed to an entity’s own stock. As a result, a freestanding equity-linked financial instrument (or embedded conversion option) no longer would be accounted for as a derivative liability at fair value as a result of the existence of a down round feature. For freestanding equity-classified financial instruments, the amendments require entities that present earnings per share (EPS) in accordance with Topic 260 to recognize the effect of the down round feature when it is triggered. That effect is treated as a dividend and as a reduction of income available to common shareholders in basic EPS. This Update is effective for public entities for fiscal years beginning after December 15, 2018. Early adoption is permitted. The Company has not yet determined when it will adopt the provisions of this Update and has not yet determined the impact on its consolidated financial statements upon adoption. 28 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. Not applicable. ITEM 4. CONTROLS AND PROCEDURES. Our management, with the participation of our principal executive officer and principal financial officer, evaluated the effectiveness of our disclosure controls and procedures as of September 30, 2017. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (“Exchange Act”), means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Our principal executive officer and principal financial officer concluded that, as of September 30, 2017, the Company’s disclosure controls and procedures were not effective at the reasonable assurance level. No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the quarter ended September 30, 2017 that has materially affected, or is reasonably likely to materially affect our disclosure controls and procedures. For the year ended December 31, 2016, we identified a material weakness in that we did not design and maintain effective controls over the preparation of the 2016 impairment analysis of the Acueity patents, primarily because we did not include potential income taxes in the discounted cash flow model we used to estimate the fair value of the Acueity patents at December 31, 2016. This resulted in an initial overstatement of the fair value of the Acueity patents at December 31, 2016 in the amount of $366,000 and an initial understatement of the 2016 impairment charge and net loss by the same amount. We corrected our estimate and the related accounts prior to the issuance of the consolidated financial statements contained in our Annual Report on Form 10-K/A. Management’s remediation plan, which we are in the process of implementing, is to use appropriate valuation methodologies in future analyses that may be required to determine the fair value of these intangible assets and to seek the assistance of outside valuation resources, if necessary, in performing such analyses. For the year ended December 31, 2016, we also identified a material weakness in that we did not design and maintain effective controls over the calculation of the weighted average number of shares outstanding and basic and diluted loss per share for the year ended December 31, 2016 because the calculation of weighted average shares outstanding did not include the shares of common stock we issued in August 2016. The preparation and review of the weighted average share calculation was not performed at an appropriately detailed level to prevent or detect this error, which led to a material error in our calculation of the weighted average number of shares outstanding and the net loss per share for the year ended December 31, 2016. During the first and second quarter of 2017, we began implementing a remediation plan to enhance the procedures performed to document our preparation of and to independently review the calculation of weighted average shares outstanding and income (loss) per share. Our enhanced review procedures and documentation standards were in place during the first, second and third quarter of 2017. The material weakness cannot be considered remediated until the control has operated for a sufficient period of time and until management has concluded that the control is operating effectively. 29 PART II OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS On October 10, 2013, a putative securities class action complaint, captioned Cook v. Atossa Genetics, Inc., et al., No. 2:13-cv-01836-RSM, was filed in the United States District Court for the Western District of Washington against us, certain of our directors and officers and the underwriters of our November 2012 initial public offering. The complaint alleged that all defendants violated Sections 11 and 12(a)(2), and that we and certain of our directors and officers violated Section 15, of the Securities Act by making material false and misleading statements and omissions in the offering’s registration statement, and that we and certain of our directors and officers violated Sections 10(b) and 20A of the Exchange Act and SEC Rule 10b-5 promulgated thereunder by making false and misleading statements and omissions in the registration statement and in certain of our subsequent press releases and SEC filings with respect to our NAF specimen collection process, our ForeCYTE Breast Health Test and our MASCT device. The complaint sought, on behalf of persons who purchased our common stock between November 8, 2012 and October 4, 2013, inclusive, damages of an unspecific amount. On February 14, 2014, the district court appointed plaintiffs Miko Levi, Bandar Almosa and Gregory Harrison (collectively, the “Levi Group”) as lead plaintiffs, and approved their selection of co-lead counsel and liaison counsel. The Court also amended the caption of the case to read In re Atossa Genetics, Inc. Securities Litigation No. 2:13-cv-01836-RSM. An amended complaint was filed on April 15, 2014. The Company and other defendants filed motions to dismiss the amended complaint on May 30, 2014. On October 6, 2014 the Court granted defendants’ motion dismissing all claims against Atossa and all other defendants. On October 30, 2014, the Court entered a final order of dismissal. On November 3, 2014, plaintiffs filed a notice of appeal with the Court and appealed the Court’s dismissal order to the U.S. Court of Appeals for the Ninth Circuit. On August 18, 2017, the Ninth Circuit affirmed in part and reversed in part the district court’s judgment. On September 11, 2017, the Ninth Circuit entered an order and mandate remanding the case to the United States District Court for the Western District of Washington. On October 19, 2017, plaintiffs filed an amended complaint that conforms to the ruling by the Ninth Circuit. Defendants’ answer to the amended complaint is due December 8, 2017. Since the claims under Sections 11, 12(a)(2) and 15 were dismissed by the district court and not appealed, the amended complaint only alleges violations of Section 10(b) and 20A of the Exchange Act and SEC Rule 10b-5 promulgated thereunder against the company and one officer. All other claims and defendants have been dismissed. The alleged class period in the amended complaint is December 20, 2012 through October 4, 2013. We believe this complaint is without merit and plan to defend ourselves vigorously; however failure to obtain a favorable resolution of the claims set forth in the complaint could have a material adverse effect on our business, results of operations and financial condition. Currently, the amount of such material adverse effect cannot be reasonably estimated, and no provision or liability has been recorded for these claims as of September 30, 2017. The costs associated with defending and resolving the complaint and ultimate outcome cannot be predicted. These matters are subject to inherent uncertainties and the actual cost, as well as the distraction from the conduct of our business, will depend upon many unknown factors and management’s view of these may change in the future. ITEM 1A. RISK FACTORS RISK FACTORS A purchase of our shares of Common Stock is an investment in our securities and involves a high degree of risk. You should carefully consider the following information about these risks, together with the other information contained in this report, before purchasing our securities. If any of the following risks actually occur, our business, financial condition and results of operations would likely suffer. In that case, the market price of the Common Stock could decline, and you may lose part or all of your investment in our company. Additional risks of which we are not presently aware or that we currently believe are immaterial may also harm our business and results of operations. 30 There have been no material changes to the risk factors described in our Annual Report on Form 10-K/A, as filed with the SEC on March 21, 2017 except as follows: Our shares of Common Stock are listed on The NASDAQ Capital Market, but we cannot guarantee that we will be able to satisfy the continued listing standards going forward. Although our shares of Common Stock are listed on The NASDAQ Capital Market, we cannot ensure that we will be able to satisfy the continued listing standards of The NASDAQ Capital Market going forward. If we cannot satisfy the continued listing standards going forward, NASDAQ may commence delisting procedures against us, which could result in our stock being removed from listing on The NASDAQ Capital Market. On May 11, 2017, we received a letter from NASDAQ stating we are not in compliance with Rule 5550(a)(2) because our common stock failed to maintain a minimum closing bid price of $1.00 per share for 30 consecutive business days. We had until November 7, 2017 to either regain compliance, or request additional time to regain compliance. On November 2, 2017, we requested an additional 180 days to regain compliance. If our stock price does not satisfy the $1.00 minimum bid price requirement or we otherwise fail to satisfy other continued listing requirements, we may be delisted from NASDAQ, which could adversely affect our stock price, liquidity, and our ability to raise funding. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS Not applicable. 31 ITEM 3. DEFAULTS UPON SENIOR SECURITIES Not applicable. ITEM 4. MINE SAFETY DISCLOSURES Not applicable. ITEM 5. OTHER INFORMATION ITEM 6. EXHIBITS (a) | Exhibits ----+--------- | | Incorporated by Reference Herein | ------------+---------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------+----------------- Exhibit No. | Description | Form | Date ------------+---------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------+----------------- 10.1 | Underwriting Agreement between Atossa Genetics Inc. and Maxim Corp. as representative of the several underwriters, dated Oct 26, 2017 | Current Report on Form 8-K, as Exhibit 1.1 | October 30, 2017 ------------+---------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------+----------------- 31.1 | Certification pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934 of Steven C. Quay | Filed herewith | ------------+---------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------+----------------- 31.2 | Certification pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934 of Kyle Guse | Filed herewith | ------------+---------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------+----------------- 32.1 | Certification pursuant to 18 U.S.C. Section 1350 of Steven C. Quay | Filed herewith | ------------+---------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------+----------------- 32.2 | Certification pursuant to 18 U.S.C. Section 1350 of Kyle Guse | Filed herewith | ------------+---------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------+----------------- 101 | Interactive Data Files pursuant to Rule 405 of Regulation S-T | Filed herewith | ------------+---------------------------------------------------------------------------------------------------------------------------------------+--------------------------------------------+----------------- 32 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Date: November 13, 2017 /s/ Steven C. Quay ------------------------------------- President and Chief Executive Officer ------------------------------------- (On behalf of the Registrant) ------------------------------------- /s/ Kyle Guse ------------------------------------------------------ Kyle Guse ------------------------------------------------------ Chief Financial Officer, General Counsel and Secretary ------------------------------------------------------ (As Principal Financial and Accounting Officer) ------------------------------------------------------ 33

AVIAT NETWORKS, INC.

1377789

10-Q

0001377789-17-000057

AVIAT 10-Q Q1FY18 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ________________________________ Form 10-Q (Mark One) x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 --+---------------------------------------------------------------------------------------- For the quarterly period ended September 29, 2017 or ¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 --+----------------------------------------------------------------------------------------- For the transition period from _______ to _______ Commission File Number 001-33278 AVIAT NETWORKS, INC.(Exact name of registrant as specified in its charter) -------------------------------------------------------------------------- Delaware | 20-5961564 ---------------------------------------------------------------+------------------------------------- (State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) ---------------------------------------------------------------+------------------------------------- 860 N. McCarthy Blvd., Suite 200, Milpitas, California | 95035 ---------------------------------------------------------------+------------------------------------- (Address of principal executive offices) | (Zip Code) ---------------------------------------------------------------+------------------------------------- (408) 941-7100 (Registrant’s telephone number, including area code) No changes (Former name, former address and former fiscal year, if changed since last report) __________________________ Indicate by checkmark whether the registrant (l) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. Large accelerated filer | o | Accelerated filer | o ------------------------+--------------------------------------------------+---------------------------+-- Non-accelerated filer | x (Do not check if a smaller reporting company) | Smaller reporting company | o ------------------------+--------------------------------------------------+---------------------------+-- Emerging growth company | o | | ------------------------+--------------------------------------------------+---------------------------+-- If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 7(a)(2)(B) of the Securities Act . ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x The number of shares outstanding of the registrant’s Common Stock as of October 30, 2017 was 5,318,218 shares. AVIAT NETWORKS, INC. QUARTERLY REPORT ON FORM 10-Q For the Quarterly Period Ended September 29, 2017 Table of Contents | Page ----------------------------------------------------------------------------------------------+----- Part I. Financial Information | 3 ----------------------------------------------------------------------------------------------+----- Item 1. Financial Statements | 3 ----------------------------------------------------------------------------------------------+----- Condensed Consolidated Balance Sheets (Unaudited) | 3 ----------------------------------------------------------------------------------------------+----- Condensed Consolidated Statements of Operations (Unaudited) | 4 ----------------------------------------------------------------------------------------------+----- Condensed Consolidated Statements of Comprehensive Loss (Unaudited) | 5 ----------------------------------------------------------------------------------------------+----- Condensed Consolidated Statements of Cash Flows (Unaudited) | 6 ----------------------------------------------------------------------------------------------+----- Notes to Condensed Consolidated Financial Statements (Unaudited) | 7 ----------------------------------------------------------------------------------------------+----- Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations | 17 ----------------------------------------------------------------------------------------------+----- Item 3. Quantitative and Qualitative Disclosures About Market Risk | 23 ----------------------------------------------------------------------------------------------+----- Item 4. Controls and Procedures | 24 ----------------------------------------------------------------------------------------------+----- Part II. Other Information | 26 ----------------------------------------------------------------------------------------------+----- Item 1. Legal Proceedings | 26 ----------------------------------------------------------------------------------------------+----- Item 1A. Risk Factors | 26 ----------------------------------------------------------------------------------------------+----- Item 2. Unregistered Sales of Equity Securities and Use of Proceeds | 26 ----------------------------------------------------------------------------------------------+----- Item 3. Defaults upon Senior Securities | 26 ----------------------------------------------------------------------------------------------+----- Item 4. Mine Safety Disclosures | 26 ----------------------------------------------------------------------------------------------+----- Item 5. Other Information | 26 ----------------------------------------------------------------------------------------------+----- Item 6. Exhibits | 26 ----------------------------------------------------------------------------------------------+----- Signature | 27 ----------------------------------------------------------------------------------------------+----- Exhibit Index | 28 ----------------------------------------------------------------------------------------------+----- 2 PART I. FINANCIAL INFORMATION Item 1. | Financial Statements --------+--------------------- AVIAT NETWORKS, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited) (In thousands, except share and par value amounts) | September 29, 2017 | | June 30, 2017 --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+-------------- ASSETS | | | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+-------------- Current Assets: | | | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+-------------- Cash and cash equivalents | $ | 39,103 | | | $ | 35,658 --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+---+-------- Restricted cash | 541 | | | 541 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+-- Short-term investments | 265 | | | 264 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+-- Accounts receivable, net | 43,635 | | | 45,945 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+-- Unbilled receivables | 8,297 | | | 12,110 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+-- Inventories | 23,143 | | | 21,794 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+-- Customer service inventories | 1,633 | | | 1,871 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+-- Other current assets | 7,246 | | | 6,402 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+-- Total current assets | 123,863 | | | 124,585 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+-- Property, plant and equipment, net | 16,934 | | | 16,406 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+-- Deferred income taxes | 5,735 | | | 6,178 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+-- Other assets | 5,682 | | | 5,407 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+-- TOTAL ASSETS | $ | 152,214 | | | $ | 152,576 --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+---+-------- LIABILITIES AND EQUITY | | | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+-------------- Current Liabilities: | | | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+-------------- Short-term debt | $ | 9,000 | | | $ | 9,000 --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+---+-------- Accounts payable | 34,443 | | | 33,606 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+-- Accrued expenses | 21,478 | | | 21,933 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+-- Advance payments and unearned income | 20,087 | | | 20,004 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+-- Restructuring liabilities | 827 | | | 1,475 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+-- Total current liabilities | 85,835 | | | 86,018 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+-- Unearned income | 6,745 | | | 7,062 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+-- Other long-term liabilities | 1,024 | | | 1,022 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+-- Reserve for uncertain tax positions | 2,408 | | | 2,453 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+-- Deferred income taxes | 1,781 | | | 1,681 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+-- Total liabilities | 97,793 | | | 98,236 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+-- Commitments and contingencies (Note 10) | | | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+-------------- Equity: | | | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+-------------- Preferred stock, $0.01 par value, 50,000,000 shares authorized, no shares issued or outstanding | — | | | — | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+-- Common stock, $0.01 par value, 300,000,000 shares authorized, 5,318,218 shares issued and outstanding at September 29, 2017; 5,317,766 shares issued and outstanding at June 30, 2017 | 53 | | | 53 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+-- Additional paid-in-capital | 814,314 | | | 813,733 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+-- Accumulated deficit | (748,861 | ) | | (748,204 | ) --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+-- Accumulated other comprehensive loss | (11,720 | ) | | (11,785 | ) --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+-- Noncontrolling interests | 635 | | | 543 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+-- Total equity | 54,421 | | | 54,340 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+-- TOTAL LIABILITIES AND EQUITY | $ | 152,214 | | | $ | 152,576 --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+---------+---------------+----------+---+-------- See accompanying Notes to Unaudited Condensed Consolidated Financial Statements 3 AVIAT NETWORKS, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) | Three Months Ended ----------------------------------------------------------------------+------------------- (In thousands, except per share amounts) | September 29, 2017 | | September 30, 2016 ----------------------------------------------------------------------+--------------------+--------+------------------- Revenues: | | | ----------------------------------------------------------------------+--------------------+--------+------------------- Revenue from product sales | $ | 35,067 | | | $ | 34,724 | ----------------------------------------------------------------------+--------------------+--------+--------------------+--------+---+--------+-- Revenue from services | 21,115 | | | 23,483 | ----------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Total revenues | 56,182 | | | 58,207 | ----------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Cost of revenues: | | | ----------------------------------------------------------------------+--------------------+--------+------------------- Cost of product sales | 23,663 | | | 24,860 | ----------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Cost of services | 15,223 | | | 15,982 | ----------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Total cost of revenues | 38,886 | | | 40,842 | ----------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Gross margin | 17,296 | | | 17,365 | ----------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Operating expenses: | | | ----------------------------------------------------------------------+--------------------+--------+------------------- Research and development expenses | 4,798 | | | 4,943 | ----------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Selling and administrative expenses | 13,722 | | | 15,187 | ----------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Restructuring charges | 2 | | | 160 | ----------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Total operating expenses | 18,522 | | | 20,290 | ----------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Operating loss | (1,226 | ) | | (2,925 | ) ----------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Interest income | 58 | | | 54 | ----------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Interest expense | (6 | ) | | (18 | ) ----------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Other expense | (30 | ) | | (182 | ) ----------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Loss before income taxes | (1,204 | ) | | (3,071 | ) ----------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Benefit from income taxes | (639 | ) | | (2,470 | ) ----------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Net loss | (565 | ) | | (601 | ) ----------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Less: Net income attributable to noncontrolling interests, net of tax | 92 | | | 28 | ----------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Net loss attributable to Aviat Networks’ common stockholders | $ | (657 | ) | | $ | (629 | ) ----------------------------------------------------------------------+--------------------+--------+--------------------+--------+---+--------+-- Net loss per share of common stock outstanding, basic and diluted | $ | (0.12 | ) | | $ | (0.12 | ) ----------------------------------------------------------------------+--------------------+--------+--------------------+--------+---+--------+-- Weighted average shares outstanding, basic and diluted | 5,316 | | | 5,259 | ----------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- See accompanying Notes to Unaudited Condensed Consolidated Financial Statements 4 AVIAT NETWORKS, INC. CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS (Unaudited) | Three Months Ended --------------------------------------------------------------------------------+------------------- (In thousands) | September 29, 2017 | | September 30, 2016 --------------------------------------------------------------------------------+--------------------+------+------------------- Net loss | $ | (565 | ) | | $ | (601 | ) --------------------------------------------------------------------------------+--------------------+------+--------------------+------+---+------+-- Other comprehensive income (loss): | | | --------------------------------------------------------------------------------+--------------------+------+------------------- Net change in cumulative translation adjustments | 65 | | | (370 | ) --------------------------------------------------------------------------------+--------------------+------+--------------------+------+-- Other comprehensive income (loss) | 65 | | | (370 | ) --------------------------------------------------------------------------------+--------------------+------+--------------------+------+-- Comprehensive loss | (500 | ) | | (971 | ) --------------------------------------------------------------------------------+--------------------+------+--------------------+------+-- Less: Comprehensive income attributable to noncontrolling interests, net of tax | 92 | | | 28 | --------------------------------------------------------------------------------+--------------------+------+--------------------+------+-- Comprehensive loss attributable to Aviat Networks | $ | (592 | ) | | $ | (999 | ) --------------------------------------------------------------------------------+--------------------+------+--------------------+------+---+------+-- See accompanying Notes to Unaudited Condensed Consolidated Financial Statements 5 AVIAT NETWORKS, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) | Three Months Ended --------------------------------------------------------------------------------+------------------- (In thousands) | September 29, 2017 | | September 30, 2016 --------------------------------------------------------------------------------+--------------------+--------+------------------- Operating Activities | | | --------------------------------------------------------------------------------+--------------------+--------+------------------- Net loss | $ | (565 | ) | | $ | (601 | ) --------------------------------------------------------------------------------+--------------------+--------+--------------------+--------+---+--------+-- Adjustments to reconcile net loss to net cash provided by operating activities: | | | --------------------------------------------------------------------------------+--------------------+--------+------------------- Depreciation and amortization of property, plant and equipment | 1,282 | | | 1,670 | --------------------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Provision for uncollectible receivables | 7 | | | 110 | --------------------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Share-based compensation | 574 | | | 458 | --------------------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Deferred tax assets, net | 574 | | | 10 | --------------------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Charges for inventory and customer service inventory write-downs | 153 | | | 761 | --------------------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Loss on disposition of property, plant and equipment | 1 | | | 9 | --------------------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Changes in operating assets and liabilities: | | | --------------------------------------------------------------------------------+--------------------+--------+------------------- Accounts receivable | 2,339 | | | 13,894 | --------------------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Unbilled receivables | 3,815 | | | (2,532 | ) --------------------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Inventories | (1,582 | ) | | 3,169 | --------------------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Customer service inventories | 47 | | | (7 | ) --------------------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Accounts payable | 429 | | | (3,952 | ) --------------------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Accrued expenses | (313 | ) | | (871 | ) --------------------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Advance payments and unearned income | 83 | | | (6,748 | ) --------------------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Income taxes payable or receivable | (198 | ) | | 854 | --------------------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Other assets and liabilities | (1,742 | ) | | (2,941 | ) --------------------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Net cash provided by operating activities | 4,904 | | | 3,283 | --------------------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Investing Activities | | | --------------------------------------------------------------------------------+--------------------+--------+------------------- Payments for acquisition of property, plant and equipment | (1,378 | ) | | (1,323 | ) --------------------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Net cash used in investing activities | (1,378 | ) | | (1,323 | ) --------------------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Financing Activities | | | --------------------------------------------------------------------------------+--------------------+--------+------------------- Proceeds from borrowings | 9,000 | | | 8,000 | --------------------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Repayments of borrowings | (9,000 | ) | | (9,000 | ) --------------------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Proceeds from issuance of common stock under employee stock plans | 7 | | | 2 | --------------------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Net cash provided by (used in) financing activities | 7 | | | (998 | ) --------------------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Effect of exchange rate changes on cash, cash equivalents and restricted cash | (97 | ) | | (245 | ) --------------------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Net Increase in Cash, Cash Equivalents, and Restricted Cash | 3,436 | | | 717 | --------------------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Cash, Cash Equivalents and Restricted Cash, Beginning of Period | 36,569 | | | 31,425 | --------------------------------------------------------------------------------+--------------------+--------+--------------------+--------+-- Cash, Cash Equivalents and Restricted Cash, End of Period | $ | 40,005 | | | $ | 32,142 | --------------------------------------------------------------------------------+--------------------+--------+--------------------+--------+---+--------+-- See accompanying Notes to Unaudited Condensed Consolidated Financial Statements 6 AVIAT NETWORKS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) Note 1. The Company and Basis of Presentation The Company Aviat Networks, Inc. (the “Company,” “we,” “us,” and “our”) designs, manufactures and sells a range of wireless networking solutions and services to mobile and fixed telephone service providers, private network operators, government agencies, transportation and utility companies, public safety agencies and broadcast system operators across the globe. Due to the volume of our international sales, especially in developing countries, we may be susceptible to a number of political, economic and geographic risks that could harm our business as outlined in “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended June 30, 2017 . Our products include broadband wireless access base stations and customer premises equipment for fixed and mobile, point-to-point digital microwave radio systems for access, backhaul, trunking and license-exempt applications, supporting new network deployments, network expansion, and capacity upgrades. Basis of Presentation The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States (“U.S. GAAP”) and with the rules and regulations of the Securities and Exchange Commission (“SEC”) for interim financial information. Accordingly, the statements do not include all information and footnotes required by U.S. GAAP for annual consolidated financial statements. In the opinion of our management, such interim financial statements reflect all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of financial position, results of operations and cash flows for such periods. The results for the three months ended September 29, 2017 are not necessarily indicative of the results that may be expected for the full fiscal year or future operating periods. The information included in this Quarterly Report on Form 10-Q should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and footnotes thereto included in our Annual Report on Form 10-K for the fiscal year ended June 30, 2017 . The unaudited condensed consolidated financial statements include the accounts of the Company and its wholly-owned and majority-owned subsidiaries. All intercompany transactions and accounts have been eliminated. Certain amounts in the consolidated financial statements of the prior period have been reclassified to conform to the presentation for the current period. We operate on a 52 -week or 53 -week year ending on the Friday closest to June 30. The first quarter of fiscal 2018 and fiscal 2017 included 13 weeks in each quarter. Fiscal year 2018 will be comprised of 52 weeks and will end on June 29, 2018 . Use of Estimates The preparation of unaudited condensed consolidated financial statements in accordance with U.S. GAAP requires us to make estimates, assumptions and judgments affecting the amounts reported and related disclosures. Estimates are based upon historical factors, current circumstances and the experience and judgment of our management. We evaluate our estimates and assumptions on an ongoing basis and may employ outside experts to assist us in making these evaluations. Changes in such estimates, based on more accurate information, or different assumptions or conditions, may affect amounts reported in future periods. Such estimates affect significant items, including revenue recognition, provision for uncollectible receivables, inventory valuation, valuation allowances for deferred tax assets, uncertainties in income taxes, restructuring obligations, product warranty obligations, share-based awards, contingencies, recoverability of long-lived assets and useful lives of property, plant and equipment. Summary of Significant Accounting Policies There have been no material changes in our significant accounting policies as of and for the three months ended September 29, 2017 , as compared to the significant accounting policies described in our Annual Report on Form 10-K for the fiscal year ended June 30, 2017 . 7 Accounting Standards Adopted In October 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-16 (Topic 740), Accounting for Income Taxes: Intra-Entity Transfers of Assets Other than Inventory , which requires that an entity recognizes the tax expense from the sale of intra-entity sales of assets, other than inventory, in the seller’s tax jurisdiction when the transfer occurs, even though the pre-tax effects of that transaction are eliminate in consolidation. We adopted this update during the first quarter of fiscal 2018. The adoption had no material impact on our unaudited condensed consolidated financial statements. In July 2015, the FASB issued ASU 2015-11 (Topic 330), Simplifying the Measurement of Inventory , which provides guidance to companies who account for inventory using either the first-in, first-out or average cost methods. The guidance states that companies should measure inventory at the lower of cost and net realizable value. Net realizable value is defined as the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation. We adopted this update prospectively during the first quarter of fiscal 2018. The adoption had no material impact on our unaudited condensed consolidated financial statements. Accounting Standards Not Yet Adopted In May 2014, the FASB issued ASU 2014-09 (ASC Topic 606), Revenue from Contracts with Customers , which along with amendments issued in 2015 and 2016, will supersede nearly all current U.S. GAAP guidance on this topic and eliminate industry-specific guidance. The amendments are based on the principle that revenue should be recognized to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Additional disclosures will also be required to enable users to understand the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. This accounting standard update, as amended, will be effective for us in the first quarter of fiscal year 2019. The new revenue standard may be applied retrospectively to each prior period presented or retrospectively with the cumulative effect recognized in retained earnings as of the date of adoption. We continue to evaluate the impact of the new standard on our Consolidated Financial Statements and disclosures. The ultimate impact on revenue resulting from the application of the new standard will be subject to assessments that are dependent on many variables, including, but not limited to, the terms of our contractual arrangements and our mix of business. We have established a cross-functional implementation team to implement the standard update related to the recognition of revenue from contracts with customers. We have identified and are int he process of evaluating changes to our systems, processes and internal controls to meet the reporting and increased disclosure requirements associated with this standard update. We expect the timing of revenue recognition to change in certain areas, including our services segment’s installation revenue, which upon adoption will be recognized as revenue and costs over a period of time. Also, since we currently expense sales commissions as incurred, the requirement in the new standard to capitalize certain in-scope sales commissions is being evaluated to determine its potential impact in our financial statements in the year of adoption. We expect to adopt the new standard on a modified retrospective basis in the first quarter of fiscal 2019. We are continuing to assess all potential impacts of the guidance on our consolidated financial statements and given normal ongoing business dynamics, preliminary conclusions are subject to change. In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842) , which introduces the recognition of lease assets and lease liabilities by lessees for those leases classified as operating leases under previous guidance. This standard will become effective for interim and annual periods beginning after December 15, 2018, with early adoption permitted. The guidance is required to be adopted at the earliest period presented using a modified retrospective approach. We expect that most of our operating lease commitments will be subject to the new standard and recognized as right-of-use assets and operating lease liabilities upon the adoption of ASU 2016-02. We are evaluating the effect the adoption of the standard will have on our consolidated financial statements. In January 2016, the FASB issued ASU 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities . This guidance retains the current accounting for classifying and measuring investments in debt securities and loans, but requires equity investments to be measured at fair value with subsequent changes recognized in net income, except for those accounted for under the equity method or requiring consolidation. The guidance also changes the accounting for investments without a readily determinable fair value and do not qualify for the practical expedient to estimate fair value. A policy election can be made for these investments whereby estimated fair value may be measured at cost and adjusted in subsequent periods for any impairment or changes in observable prices of identical or similar investments. This ASU is effective for fiscal years beginning after December 15, 2017. We do not expect the adoption of this standard to have a material impact on our consolidated financial statements. 8 Note 2. Net Loss Per Share of Common Stock Net loss per share is computed using the two-class method, by dividing net loss attributable to us by the weighted-average number of shares of our outstanding common stock and participating securities outstanding. Our restricted shares contain rights to receive non-forfeitable dividends and therefore are considered to be participating securities and included in the calculations of net income per basic and diluted common share. However, we incurred a net loss in all periods presented. Undistributed losses are not allocated to unvested restricted shares due to the fact that the unvested restricted shares are not contractually obligated to share our losses. The impact on earnings per share of the participating securities under the two-class method is immaterial. The following table summarizes the weighted-average equity awards that were excluded from the diluted net loss per share calculations: | Three Months Ended ----------------------------------------------------+------------------- (In thousands) | September 29, 2017 | September 30, 2016 ----------------------------------------------------+--------------------+------------------- Stock options | 372 | | 443 ----------------------------------------------------+--------------------+--------------------+---- Restricted stocks units and performance stock units | 450 | | 334 ----------------------------------------------------+--------------------+--------------------+---- Total potential shares of common stock excluded | 822 | | 777 ----------------------------------------------------+--------------------+--------------------+---- Note 3. Balance Sheet Components Cash, Cash Equivalents, and Restricted Cash The following table provides a summary of our cash, cash equivalents, and restricted cash: (In thousands) | September 29, 2017 | | June 30, 2017 --------------------------------------------------+--------------------+--------+-------------- Cash and cash equivalents | $ | 39,103 | | | $ | 35,658 --------------------------------------------------+--------------------+--------+---------------+-----+---+------- Restricted cash | 541 | | | 541 | --------------------------------------------------+--------------------+--------+---------------+-----+-- Restricted cash included in Other assets | 361 | | | 370 | --------------------------------------------------+--------------------+--------+---------------+-----+-- Total cash, cash equivalents, and restricted cash | $ | 40,005 | | | $ | 36,569 --------------------------------------------------+--------------------+--------+---------------+-----+---+------- Accounts Receivable, net Our net accounts receivable were as follows: (In thousands) | September 29, 2017 | | June 30, 2017 --------------------------------------+--------------------+--------+-------------- Accounts receivable | $ | 47,816 | | | $ | 49,864 --------------------------------------+--------------------+--------+---------------+--------+---+------- Less allowances for collection losses | (4,181 | ) | | (3,919 | ) --------------------------------------+--------------------+--------+---------------+--------+-- | $ | 43,635 | | | $ | 45,945 --------------------------------------+--------------------+--------+---------------+--------+---+------- 9 Inventories Our inventories were as follows: (In thousands) | September 29, 2017 | | June 30, 2017 -----------------------------------------------------------------+--------------------+--------+-------------- Finished products | $ | 18,037 | | | $ | 16,619 -----------------------------------------------------------------+--------------------+--------+---------------+-------+---+------- Work in process | 3,068 | | | 3,088 | -----------------------------------------------------------------+--------------------+--------+---------------+-------+-- Raw materials and supplies | 2,038 | | | 2,087 | -----------------------------------------------------------------+--------------------+--------+---------------+-------+-- Total inventories | $ | 23,143 | | | $ | 21,794 -----------------------------------------------------------------+--------------------+--------+---------------+-------+---+------- Deferred cost of revenue included within finished goods | $ | 5,898 | | | $ | 7,120 -----------------------------------------------------------------+--------------------+--------+---------------+-------+---+------- Consigned inventories included within raw materials and supplies | $ | 1,196 | | | $ | 1,268 -----------------------------------------------------------------+--------------------+--------+---------------+-------+---+------- During the three months ended September 29, 2017 and September 30, 2016, we recorded recovery or charges to adjust our inventory and customer service inventory due to excess and obsolete inventory resulting from lower sales forecast, product transitioning or discontinuance. During the three months ended September 29, 2017 , we recorded a recovery of $37 thousand related to previously reserved inventory due to sell through. Such recovery or charges during the three months ended September 29, 2017 and September 30, 2016 were classified in cost of product sales as follows: | Three Months Ended -------------------------------------------------+------------------- (In thousands) | September 29, 2017 | | September 30, 2016 -------------------------------------------------+--------------------+-----+------------------- Excess and obsolete inventory (recovery) charges | $ | (37 | ) | | $ | 474 -------------------------------------------------+--------------------+-----+--------------------+-----+---+---- Customer service inventory write-downs | 190 | | | 287 | -------------------------------------------------+--------------------+-----+--------------------+-----+-- | $ | 153 | | | $ | 761 -------------------------------------------------+--------------------+-----+--------------------+-----+---+---- Property, Plant and Equipment, net Our property, plant and equipment, net were as follows: (In thousands) | September 29, 2017 | | June 30, 2017 -----------------------------------------------+--------------------+--------+-------------- Land | $ | 710 | | | $ | 710 -----------------------------------------------+--------------------+--------+---------------+---------+---+------- Buildings and leasehold improvements | 11,445 | | | 11,442 | -----------------------------------------------+--------------------+--------+---------------+---------+-- Software | 15,464 | | | 14,803 | -----------------------------------------------+--------------------+--------+---------------+---------+-- Machinery and equipment | 44,476 | | | 43,174 | -----------------------------------------------+--------------------+--------+---------------+---------+-- | 72,095 | | | 70,129 | -----------------------------------------------+--------------------+--------+---------------+---------+-- Less accumulated depreciation and amortization | (55,161 | ) | | (53,723 | ) -----------------------------------------------+--------------------+--------+---------------+---------+-- | $ | 16,934 | | | $ | 16,406 -----------------------------------------------+--------------------+--------+---------------+---------+---+------- Depreciation and amortization expense related to property, plant and equipment, including amortization of software developed for internal use, was as follows: | Three Months Ended ------------------------------+------------------- (In thousands) | September 29, 2017 | | September 30, 2016 ------------------------------+--------------------+-------+------------------- Depreciation and amortization | $ | 1,282 | | $ | 1,670 ------------------------------+--------------------+-------+--------------------+---+------ 10 Accrued Expenses Our accrued expenses are summarized below: (In thousands) | September 29, 2017 | | June 30, 2017 ----------------------------------+--------------------+--------+-------------- Accrued compensation and benefits | $ | 9,049 | | | $ | 8,317 ----------------------------------+--------------------+--------+---------------+-------+---+------- Accrued agent commissions | 1,619 | | | 1,911 | ----------------------------------+--------------------+--------+---------------+-------+-- Accrued warranties | 2,964 | | | 3,056 | ----------------------------------+--------------------+--------+---------------+-------+-- Other | 7,846 | | | 8,649 | ----------------------------------+--------------------+--------+---------------+-------+-- | $ | 21,478 | | | $ | 21,933 ----------------------------------+--------------------+--------+---------------+-------+---+------- Accrued Warranties We accrue for the estimated cost to repair or replace products under warranty at the time of sale. Changes in our warranty liability, which is included as a component of accrued expenses in the unaudited condensed consolidated balance sheets were as follows: | Three Months Ended ----------------------------------------------+------------------- (In thousands) | September 29, 2017 | | September 30, 2016 ----------------------------------------------+--------------------+-------+------------------- Balance as of the beginning of the period | $ | 3,056 | | | $ | 3,944 ----------------------------------------------+--------------------+-------+--------------------+------+---+------ Warranty provision recorded during the period | 431 | | | 337 | ----------------------------------------------+--------------------+-------+--------------------+------+-- Consumption during the period | (523 | ) | | (577 | ) ----------------------------------------------+--------------------+-------+--------------------+------+-- Balance as of the end of the period | $ | 2,964 | | | $ | 3,704 ----------------------------------------------+--------------------+-------+--------------------+------+---+------ Advanced payments and Unearned Income Our advanced payments and unearned income are summarized below: (In thousands) | September 29, 2017 | | June 30, 2017 ------------------+--------------------+--------+-------------- Advanced payments | $ | 7,122 | | | $ | 8,760 ------------------+--------------------+--------+---------------+--------+---+------- Unearned income | 12,965 | | | 11,244 | ------------------+--------------------+--------+---------------+--------+-- | $ | 20,087 | | | $ | 20,004 ------------------+--------------------+--------+---------------+--------+---+------- Note 4. Fair Value Measurements of Assets and Liabilities Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in the principal market (or most advantageous market, in the absence of a principal market) for the asset or liability in an orderly transaction between market participants as of the measurement date. We maximize the use of observable inputs and minimize the use of unobservable inputs in measuring fair value and establish a three-level fair value hierarchy that prioritizes the inputs used to measure fair value. The three levels of inputs used to measure fair value are as follows: • | Level 1 — Observable inputs such as quoted prices in active markets for identical assets or liabilities; --+--------------------------------------------------------------------------------------------------------- • | Level 2 — Observable market-based inputs or observable inputs that are corroborated by market data; and --+-------------------------------------------------------------------------------------------------------- • | Level 3 — Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. --+---------------------------------------------------------------------------------------------------------------------------------------------------------- 11 The carrying amounts, estimated fair values and valuation input levels of our assets and liabilities that are measured at fair value on a recurring basis as of September 29, 2017 and June 30, 2017 were as follows: | September 29, 2017 | | June 30, 2017 | Valuation Inputs -----------------------------------+--------------------+--------+---------------+----------------- (In thousands) | Cost | | Fair Value | Cost | | Fair Value -----------------------------------+--------------------+--------+---------------+------------------+--------+----------- Assets: | | | | | | | -----------------------------------+--------------------+--------+---------------+------------------+--------+------------+-- Cash equivalents: | | | | | | | -----------------------------------+--------------------+--------+---------------+------------------+--------+------------+-- Money market funds | $ | 17,134 | | $ | 17,134 | | $ | 22,059 | $ | 22,059 | Level 1 -----------------------------------+--------------------+--------+---------------+------------------+--------+------------+---+--------+---+--------+-------- Bank certificates of deposit | $ | — | | $ | — | | $ | 66 | $ | 66 | Level 2 -----------------------------------+--------------------+--------+---------------+------------------+--------+------------+---+--------+---+--------+-------- Short term investments: | | | | | | | -----------------------------------+--------------------+--------+---------------+------------------+--------+------------+-- Bank certificates of deposit | $ | 264 | | $ | 240 | | $ | 264 | $ | 264 | Level 2 -----------------------------------+--------------------+--------+---------------+------------------+--------+------------+---+--------+---+--------+-------- Other current assets: | | | | | | | -----------------------------------+--------------------+--------+---------------+------------------+--------+------------+-- Foreign exchange forward contracts | $ | 25 | | $ | 5 | | $ | — | $ | — | Level 2 -----------------------------------+--------------------+--------+---------------+------------------+--------+------------+---+--------+---+--------+-------- Liabilities: | | | | | | | -----------------------------------+--------------------+--------+---------------+------------------+--------+------------+-- Other accrued expenses: | | | | | | | -----------------------------------+--------------------+--------+---------------+------------------+--------+------------+-- Foreign exchange forward contracts | $ | 5 | | $ | 5 | | $ | 5 | $ | 5 | Level 2 -----------------------------------+--------------------+--------+---------------+------------------+--------+------------+---+--------+---+--------+-------- We classify items within Level 1 if quoted prices are available in active markets. Our Level 1 items mainly are money market funds. As of September 29, 2017 and June 30, 2017 , these money market funds were valued at $ 1.00 net asset value per share. We classify items in Level 2 if the observable inputs to quoted market prices, benchmark yields, reported trades, broker/dealer quotes or alternative pricing sources are available with reasonable levels of price transparency. Our bank certificates of deposit and foreign exchange forward contracts are classified within Level 2. Foreign currency forward contracts are measured at fair value using observable foreign currency exchange rates. The changes in fair value related to our foreign currency forward contracts were recorded in cost of revenues on our unaudited condensed consolidated statements of operations. As of September 29, 2017 and June 30, 2017 , we did not have any recurring assets or liabilities that were valued using significant unobservable inputs. Our policy is to recognize asset or liability transfers among Level 1, Level 2 and Level 3 as of the actual date of the events or change in circumstances that caused the transfer. During the first three months of fiscal 2018 and 2017 , we had no transfers between levels of the fair value hierarchy of our assets or liabilities measured at fair value. Note 5. Credit Facility and Debt On March 28, 2014, we entered into a Second Amended and Restated Loan Agreement with Silicon Valley Bank (the “SVB Credit Facility”). The SVB Credit Facility expires on June 30, 2018. The SVB Credit Facility provides for a committed amount of up to $30.0 million , with a $30.0 million sublimit that can be borrowed by our Singapore subsidiary. Borrowings may be advanced under the SVB Credit Facility at the lesser of $30.0 million or a borrowing base equal to a specified percentage of the value of eligible accounts receivable and U.S. unbilled accounts of the Company, subject to certain reserves and eligibility criteria. The SVB Credit Facility can also be utilized to issue letters of credit with a $12.0 million sublimit. If the SVB Credit Facility is terminated by us in certain circumstances prior to its expiration, we are subject to an early termination fee equal to 1% of the revolving line. In September 2017, the SVB Credit Facility was amended to allow up to 30% of our Singapore subsidiary’s accounts receivable to be included in the calculation of the borrowing base and the inclusion of the accounts receivable of certain high credit quality customers that are aged 90 to 120 days to be included in the calculation of the borrowing base. Our outstanding debt under the SVB Credit Facility was $9.0 million as of September 29, 2017 and June 30, 2017 . The SVB Credit Facility carries an interest rate computed at the daily prime rate as published in the Wall Street Journal plus a spread of 0.50% to 1.50% , with such spread determined based on our adjusted quick ratio. During the first three months of fiscal year 2017, the weighted average interest rate on our outstanding loan was 4.75% . As of September 29, 2017 , available credit under the SVB Credit Facility was $7.9 million reflecting the calculated borrowing base of $19.6 million less existing borrowings of $9.0 million and outstanding letters of credit of $2.7 million . 12 The SVB Credit Facility contains quarterly financial covenants including minimum adjusted quick ratio and minimum profitability (EBITDA) requirements. In the event our adjusted quick ratio falls below a certain level, cash received in our accounts with SVB may be directly applied to reduce outstanding obligations under the SVB Credit Facility. The SVB Credit Facility also imposes certain restrictions on our ability to dispose of assets, permit a change in control, merge or consolidate, make acquisitions, incur indebtedness, grant liens, make investments, make certain restricted payments and enter into transactions with affiliates under certain circumstances. Certain of our assets, including accounts receivable, inventory, and equipment, are pledged as collateral for the SVB Credit Facility. Upon an event of default, outstanding obligations would be immediately due and payable. Under certain circumstances, a default interest rate will apply on all obligations during the existence of an event of default at a per annum rate of interest equal to 2% above the applicable interest rate. As of September 29, 2017 , we were in compliance with the quarterly financial covenants, as amended, contained in the SVB Credit Facility. In addition, we have an uncommitted short-term line of credit of $0.4 million from a bank in New Zealand to support the operations of our subsidiary located there. This line of credit provides for $0.3 million in short-term advances at various interest rates, all of which was available as of September 29, 2017 and June 30, 2017 . The line of credit also provides for the issuance of standby letters of credit and company credit cards, of which $0.1 million was outstanding as of September 29, 2017 . This facility may be terminated upon notice, is reviewed annually for renewal or modification, and is supported by a corporate guarantee. Note 6. Restructuring Activities The following table summarizes our restructuring related activities during the first three months of fiscal 2018 : | Severance and Benefits | | Facilities and Other | | Total ------------------------------------+------------------------+-----+----------------------+---+--------------------- (In thousands) | Fiscal 2016-2017Plan | | Fiscal 2015-2016Plan | | Fiscal 2013-2014Plan | | Fiscal 2015-2016Plan | Fiscal 2014-2015Plan | | Fiscal 2013-2014Plan ------------------------------------+------------------------+-----+----------------------+---+----------------------+-----+----------------------+----------------------+----+--------------------- Accrual balance, June 30, 2017 | $ | 315 | | | $ | 99 | | $ | 64 | | $ | 563 | | $ | 168 | | | $ | 505 | $ | 1,714 ------------------------------------+------------------------+-----+----------------------+---+----------------------+-----+----------------------+----------------------+----+----------------------+------+-----+------+---+-----+------+---+---+-----+---+------ Charges, net | (3 | ) | | — | | | — | | — | | 1 | | 4 | | | 2 | ------------------------------------+------------------------+-----+----------------------+---+----------------------+-----+----------------------+----------------------+----+----------------------+------+-----+------+---+-----+------+-- Cash payments | (253 | ) | | — | | | — | | — | | (102 | ) | (306 | ) | | (661 | ) ------------------------------------+------------------------+-----+----------------------+---+----------------------+-----+----------------------+----------------------+----+----------------------+------+-----+------+---+-----+------+-- Foreign exchange impact | (1 | ) | | 2 | | | — | | 18 | | — | | — | | | 19 | ------------------------------------+------------------------+-----+----------------------+---+----------------------+-----+----------------------+----------------------+----+----------------------+------+-----+------+---+-----+------+-- Accrual balance, September 29, 2017 | $ | 58 | | | $ | 101 | | $ | 64 | | $ | 581 | | $ | 67 | | | $ | 203 | $ | 1,074 ------------------------------------+------------------------+-----+----------------------+---+----------------------+-----+----------------------+----------------------+----+----------------------+------+-----+------+---+-----+------+---+---+-----+---+------ As of September 29, 2017 , $0.8 million of the accrual balance was in short-term restructuring liabilities while $0.2 million was included in other long-term liabilities on the unaudited condensed consolidated balance sheets. We completed the restructuring activities under each of the plans referenced in the table above. Remaining payments for these plans will be paid through fiscal 2020. Note 7. Stockholders’ Equity As of September 29, 2017 , we had one stock incentive plan for our employees and nonemployee directors, the 2007 Stock Equity Plan, as amended and restated effective November 13, 2015 (the “2007 Stock Plan”). During the first three months of fiscal 2018 , we issued 261 shares of common stock under the Employee Stock Purchase Plan (ESPP), and 191 shares of common stock for options exercised. 13 Total compensation expense for share-based awards included in our unaudited condensed consolidated statements of operations was as follows: | Three Months Ended --------------------------------------------------+------------------- (In thousands) | September 29, 2017 | | September 30, 2016 --------------------------------------------------+--------------------+-----+------------------- By Expense Category: | | | --------------------------------------------------+--------------------+-----+------------------- Cost of revenues | $ | 44 | | | $ | 41 --------------------------------------------------+--------------------+-----+--------------------+-----+---+---- Research and development | 39 | | | 23 | --------------------------------------------------+--------------------+-----+--------------------+-----+-- Selling and administrative | 491 | | | 394 | --------------------------------------------------+--------------------+-----+--------------------+-----+-- Total share-based compensation expense | $ | 574 | | | $ | 458 --------------------------------------------------+--------------------+-----+--------------------+-----+---+---- By Types of Award: | | | --------------------------------------------------+--------------------+-----+------------------- Options | $ | 34 | | | $ | 146 --------------------------------------------------+--------------------+-----+--------------------+-----+---+---- Restricted and performance stock awards and units | 540 | | | 312 | --------------------------------------------------+--------------------+-----+--------------------+-----+-- Total share-based compensation expense | $ | 574 | | | $ | 458 --------------------------------------------------+--------------------+-----+--------------------+-----+---+---- As of September 29, 2017 , there was $0.1 million of total unrecognized compensation expense related to nonvested stock options granted under our 2007 Stock Plan. This expense is expected to be recognized over a weighted average period of 0.8 years. As of September 29, 2017 , there was $2.8 million of total unrecognized compensation expense related to nonvested stock awards and units granted under our 2007 Stock Plan. This expense is expected to be recognized over a weighted average period of 1.4 years. Note 8. Segment and Geographic Information We operate in one reportable business segment: the design, manufacturing and sale of a range of wireless networking products, solutions and services. We conduct business globally and our sales and support activities are managed on a geographic basis. Our Chief Executive Officer is our Chief Operating Decision Maker. We report revenue by region and country based on the location where our customers accept delivery of our products and services. Revenue by region for the three months ended September 29, 2017 and September 30, 2016 were as follows: | Three Months Ended -------------------------------+------------------- (In thousands) | September 29, 2017 | | September 30, 2016 -------------------------------+--------------------+--------+------------------- North America | $ | 31,002 | | | $ | 28,584 -------------------------------+--------------------+--------+--------------------+--------+---+------- Africa and Middle East | 13,462 | | | 14,349 | -------------------------------+--------------------+--------+--------------------+--------+-- Europe and Russia | 4,446 | | | 4,507 | -------------------------------+--------------------+--------+--------------------+--------+-- Latin America and Asia Pacific | 7,272 | | | 10,767 | -------------------------------+--------------------+--------+--------------------+--------+-- Total Revenue | $ | 56,182 | | | $ | 58,207 -------------------------------+--------------------+--------+--------------------+--------+---+------- Motorola Solutions, Inc. (Motorola) and Mobile Telephone Networks Group (MTN Group) accounted for 16% and 14% , respectively, of our accounts receivable as of September 29, 2017 . MTN Group also accounted for 26% of our accounts receivable as of June 30, 2017 . During the three months ended September 29, 2017 and September 30, 2016 , MTN Group accounted for 14% and 10% , respectively, of our total revenue. We have entered into separate and distinct contracts with MTN Group and Motorola, as well as separate arrangements with their various subsidiaries. The loss of all business from MTN Group, Motorola, or any other significant customers, could adversely affect our results of operations, cash flows and financial position. Note 9. Income Taxes Our effective tax rate varies from the U.S. federal statutory rate of 35% due to results of foreign operations that are subject to income taxes at different statutory rates, certain jurisdictions where we cannot recognize tax benefits on current losses and tax benefit from a foreign tax refund. During interim periods, we accrue tax expenses for jurisdictions that are anticipated to be profitable for fiscal 2018. 14 The determination of our provision for the first three months of fiscal 2018 and 2017 was based on our estimated annual effective tax rate adjusted for losses in certain jurisdictions for which no tax benefit can be recognized. The tax expense for the first three months of fiscal 2018 and 2017 were primarily attributable to tax expense related to profitable subsidiaries, net against the foreign tax refunds received from the Inland Revenue Authority of Singapore (“IRAS”). During the fiscal year 2014, we received an assessment letter from IRAS related to deductions claimed in prior years and made a payment of $13.2 million related to tax years 2007 through 2010, reflecting all the taxes incrementally assessed by IRAS. Since the initial assessment, we continued to challenge this assessment. During the first quarter of fiscal 2017, we received an initial refund of $3.7 million from IRAS. During the first quarter of fiscal 2018, we received an additional refund of $1.3 million from IRAS which represents a final settlement. These refunds were recorded as a discrete tax benefit during the quarter the respective payment was received. We have a number of years with open tax audits which vary from jurisdiction to jurisdiction. Our major tax jurisdictions include the U.S., Singapore, Nigeria and the Ivory Coast. The earliest years that are open and subject to potential audits for these jurisdictions are as follows: U.S. — 2003; Singapore — 2011; Nigeria — 2011, and Ivory Coast — 2016. We account for interest and penalties related to unrecognized tax benefits as part of our provision for federal, foreign and state income taxes. Such interest expense was not material for the three months ended September 29, 2017 and September 30, 2016 . Note 10. Commitments and Contingencies Operating Lease Commitments We lease office and manufacturing facilities under non-cancelable operating leases expiring at various dates through 2024. We lease approximately 19,000 square feet of office space in Milpitas, California as our corporate headquarters. As of September 29, 2017 , our future minimum lease payments under all non-cancelable operating leases with an initial lease term in excess of one year were as follows: Fiscal Years | Amounts --------------------------------+--------------- | (In thousands) --------------------------------+--------------- 2018 (three quarters remaining) | $ | 1,975 --------------------------------+----------------+------ 2019 | 1,443 | --------------------------------+----------------+------ 2020 | 988 | --------------------------------+----------------+------ 2021 | 908 | --------------------------------+----------------+------ 2022 | 208 | --------------------------------+----------------+------ Thereafter | 2,023 | --------------------------------+----------------+------ Total | $ | 7,545 --------------------------------+----------------+------ These commitments do not contain any material rent escalations, rent holidays, contingent rent, rent concessions, leasehold improvement incentives or unusual provisions or conditions. We sublease a portion of our facilities to third parties and the total minimum rents to be received in the future under our non-cancelable subleases were $0.1 million as of September 29, 2017 . The future minimum lease payments are not reduced by the minimum sublease rents. Rental expense for operating leases, including rentals on a month-to-month basis, was as follows: | Three Months Ended ---------------+------------------- (In thousands) | September 29, 2017 | | September 30, 2016 ---------------+--------------------+-----+------------------- Rent expense | $ | 927 | | $ | 1,201 ---------------+--------------------+-----+--------------------+---+------ Purchase Orders and Other Commitments From time to time in the normal course of business we may enter into purchasing agreements with our suppliers that require us to accept delivery of, and remit full payment for, finished products that we have ordered, finished products that we requested be held as safety stock, and work in process started on our behalf, in the event we cancel or terminate the purchasing agreement. Because these agreements do not specify fixed or minimum quantities, do not specify minimum or 15 variable price provisions, and do not specify the approximate timing of the transaction, and we have no present intention to cancel or terminate any of these agreements, we currently do not believe that we have any future liability under these agreements. As of September 29, 2017 , we had outstanding purchase obligations with our suppliers or contract manufacturers of $21.8 million . In addition, we had contractual obligations of approximately $0.9 million associated with software licenses as of September 29, 2017 . Financial Guarantees and Commercial Commitments Guarantees issued by banks, insurance companies or other financial institutions are contingent commitments issued to guarantee our performance under borrowing arrangements, such as bank overdraft facilities, tax and customs obligations and similar transactions or to ensure our performance under customer or vendor contracts. The terms of the guarantees are generally equal to the remaining term of the related debt or other obligations and are generally limited to two years or less. As of September 29, 2017 , we had no guarantees applicable to our debt arrangements. We have entered into commercial commitments in the normal course of business including surety bonds, standby letters of credit agreements and other arrangements with financial institutions primarily relating to the guarantee of future performance on certain contracts to provide products and services to customers. As of September 29, 2017 , we had commercial commitments of $45.8 million outstanding that were not recorded in our unaudited condensed consolidated balance sheets. We do not believe, based on historical experience and information currently available, that it is probable that any significant amounts will be required to be paid on the performance guarantees in the future. Indemnifications Under the terms of substantially all of our license agreements, we have agreed to defend and pay any final judgment against our customers arising from claims against such customers that our products infringe the intellectual property rights of a third party. As of September 29, 2017 , we have not received any notice that any customer is subject to an infringement claim arising from the use of our products; we have not received any request to defend any customers from infringement claims arising from the use of our products; and we have not paid any final judgment on behalf of any customer related to an infringement claim arising from the use of our products. Because the outcome of infringement disputes is related to the specific facts of each case, and given the lack of previous or current indemnification claims, we cannot estimate the maximum amount of potential future payments, if any, related to our indemnification provisions. As of September 29, 2017 , we had not recorded any liabilities related to these indemnifications. Legal Proceedings We are subject from time to time to disputes with customers concerning our products and services. In May 2016, we received notification of a claim for $1.0 million in damages from a customer in Austria alleging that certain of our products were defective. We are continuing to investigate this claim, and at this time an estimate of the reasonably possible loss or range of loss cannot be made. We believe that we have numerous contractual and legal defenses to these disputes, and we intend to dispute them vigorously. From time to time, we may be involved in various other legal claims and litigation that arise in the normal course of our operations. We are aggressively defending all current litigation matters. Although there can be no assurances and the outcome of these matters is currently not determinable, we currently believe that none of these claims or proceedings are likely to have a material adverse effect on our financial position. We expect to defend each of these disputes vigorously. There are many uncertainties associated with any litigations and these actions or other third-party claims against us may cause us to incur costly litigation and/or substantial settlement charges. As a result, our business, financial condition, results of operations, and cash flows could be adversely affected. The actual liability in any such matters may be materially different from our estimates, if any. We record accruals for our outstanding legal proceedings, investigations or claims when it is probable that a liability will be incurred and the amount of loss can be reasonably estimated. We evaluate, at least on a quarterly basis, developments in legal proceedings, investigations or claims that could affect the amount of any accrual, as well as any developments that would result in a loss contingency to become both probable and reasonably estimable. We have not recorded any accrual for loss contingencies associated with such legal claims or litigation discussed above. 16 Contingent Liabilities We record a loss contingency as a charge to operations when (i) it is probable that an asset has been impaired or a liability has been incurred at the date of the unaudited condensed consolidated financial statements; and (ii) the amount of the loss can be reasonably estimated. Disclosure in the notes to the unaudited condensed consolidated financial statements is required for loss contingencies that do not meet both those conditions if there is a reasonable possibility that a loss may have been incurred. Gain contingencies are not recorded until realized. We expense all legal costs incurred to resolve regulatory, legal and tax matters as incurred. Periodically, we review the status of each significant matter to assess the potential financial exposure. If a potential loss is considered probable and the amount can be reasonably estimated, we reflect the estimated loss in our results of operations. Significant judgment is required to determine the probability that a liability has been incurred or an asset impaired and whether such loss is reasonably estimable. Further, estimates of this nature are highly subjective, and the final outcome of these matters could vary significantly from the amounts that have been included in our unaudited condensed consolidated financial statements. As additional information becomes available, we reassess the potential liability related to our pending claims and litigation and may revise estimates accordingly. Such revisions in the estimates of the potential liabilities could have a material impact on our results of operations and financial position. Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations This Quarterly Report on Form 10-Q, including “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they do not materialize or prove correct, could cause our results to differ materially from those expressed or implied by such forward-looking statements. All statements other than statements of historical fact are statements that could be deemed to be forward-looking statements, including statements of, about, concerning or regarding: our plans, strategies and objectives for future operations, including with respect to growing our business and sustaining profitability; our restructuring efforts; our research and development efforts and new product releases and services; trends in revenue; drivers of our business and the markets in which we operate; future economic conditions, performance or outlook and changes in our industry and the markets we serve; the outcome of contingencies; the value of our contract awards; beliefs or expectations; the sufficiency of our cash and our capital needs and expenditures; our intellectual property protection; our compliance with regulatory requirements and the associated expenses; expectations regarding litigation; our intention not to pay cash dividends; seasonality of our business; the impact of foreign exchange and inflation; taxes; and assumptions underlying any of the foregoing. Forward-looking statements may be identified by the use of forward-looking terminology, such as “anticipates,” “believes,” “expects,” “may,” “should,” “would,” “will,” “intends,” “plans,” “estimates,” “strategy,” “projects,” “targets,” “goals,” “seeing,” “delivering,” “continues,” “forecasts,” “future,” “predict,” “might,” “could,” “potential,” or the negative of these terms, and similar words or expressions. These forward-looking statements are based on estimates reflecting the current beliefs of the senior management of the Company. These forward-looking statements involve a number of risks and uncertainties that could cause actual results to differ materially from those suggested by the forward-looking statements. Forward-looking statements should therefore be considered in light of various important factors, including those set forth in this document. Important factors that could cause actual results to differ materially from estimates or projections contained in the forward-looking statements include, but are not limited to, the following: • | continued price and margin erosion as a result of increased competition in the microwave transmission industry; --+---------------------------------------------------------------------------------------------------------------- • | the impact of the volume, timing and customer, product and geographic mix of our product orders; --+------------------------------------------------------------------------------------------------- • | our ability to meet financial covenant requirements which could impact, among other things, our liquidity; --+----------------------------------------------------------------------------------------------------------- • | the timing of our receipt of payment for products or services from our customers; --+---------------------------------------------------------------------------------- • | our ability to meet projected new product development dates or anticipated cost reductions of new products; --+------------------------------------------------------------------------------------------------------------ • | our suppliers’ inability to perform and deliver on time as a result of their financial condition, component shortages or other supply chain constraints; --+--------------------------------------------------------------------------------------------------------------------------------------------------------- • | customer acceptance of new products; --+------------------------------------- • | the ability of our subcontractors to timely perform; --+----------------------------------------------------- • | continued weakness in the global economy affecting customer spending; --+---------------------------------------------------------------------- • | retention of our key personnel; --+-------------------------------- 17 • | our ability to manage and maintain key customer relationships; --+--------------------------------------------------------------- • | uncertain economic conditions in the telecommunications sector combined with operator and supplier consolidation; --+------------------------------------------------------------------------------------------------------------------ • | our failure to protect our intellectual property rights or defend against intellectual property infringement claims by others; --+------------------------------------------------------------------------------------------------------------------------------- • | the results of our restructuring efforts; --+------------------------------------------ • | the ability to preserve and use our net operating loss carryforwards; --+---------------------------------------------------------------------- • | the effects of currency and interest rate risks; --+------------------------------------------------- • | the conduct of unethical business practices in developing countries; and --+------------------------------------------------------------------------- • | the impact of political turmoil in countries where we have significant business. --+--------------------------------------------------------------------------------- Other factors besides those listed here also could adversely affect us. See “Item 1A. Risk Factors” in our fiscal 2017 Annual Report on Form 10-K filed with the SEC on September 6, 2017 for more information regarding factors that may cause our results to differ materially from those expressed or implied by the forward-looking statements contained in this Quarterly Report on Form 10-Q. You should not place undue reliance on these forward-looking statements, which reflect our management’s opinions only as of the date of the filing of this Quarterly Report on Form 10-Q. Forward-looking statements are made in reliance upon the safe harbor provisions of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), along with provisions of the Private Securities Litigation Reform Act of 1995, and we undertake no obligation, other than as imposed by law, to update any forward-looking statements to reflect further developments or information obtained after the date of filing of this Quarterly Report on Form 10-Q or, in the case of any document incorporated by reference, the date of that document. Overview of Business; Operating Environment and Key Factors Impacting Fiscal 2018 and 2017 Results The following Management’s Discussion and Analysis (“MD&A”) is intended to help the reader understand our results of operations and financial condition. MD&A is provided as a supplement to, and should be read in conjunction with, our unaudited condensed consolidated financial statements and the accompanying notes. In the discussion below, our fiscal year ending June 29, 2018 is referred to as “fiscal 2018 ” or “ 2018 ” and our fiscal year ended June 30, 2017 is referred to as “fiscal 2017 ” or “ 2017 ”. We generate revenue by designing, developing, manufacturing and supporting a range of wireless networking products, solutions and services for mobile and fixed communications service providers, private network operators, government agencies, transportation, energy and utility companies, public safety agencies and broadcast network operators across the world. Our products include point-to-point digital microwave transmission systems designed for first/last mile access, middle mile/backhaul, and long distance trunking applications. We also provide network management software solutions to enable operators to deploy, monitor and manage our systems, third party equipment such as antennas, routers, optical transmission equipment and other equipment necessary to build and deploy a complete telecommunications transmission network. We provide a full suite of professional services for planning, deployment, operations and maintenance of our customers’ networks. We work continuously to improve our established brands and to create new products that meet our customers’ evolving needs and preferences. Our fundamental business goal is to generate superior returns for our stockholders over the long term. We believe that increases in revenue, operating profits and earnings per share are the key measures of financial performance for our business. However, within the industry there continues to be strong price competition for new business and periodic large customer consolidations that intensify competition in all regions. Our strategic focus is to continue to accelerate innovation and optimize our product portfolio, improve costs and operational efficiencies, grow our revenue and create a sustainable, profitable business model. To do this, we continue to examine our products, markets, facilities, development programs, and operational flows to ensure we are focused on what we do well and what will differentiate us in the future. We will continue working to streamline management processes to attain the efficiency levels required by the markets in which we do business. Although the general trend of increasing demand for bandwidth to support mobile networks applies in all markets, we expect to see quarter-to-quarter fluctuations within markets and with individual customers based on customers’ past purchasing patterns. Seasonality is also a factor that impacts our business. Our fiscal third quarter revenue and orders have 18 historically been lower than the revenue and orders in our second fiscal quarter because many of our customers utilize a significant portion of their capital budgets at the end of their fiscal years, which is typically the calendar year end and coincides with our second fiscal quarter. The majority of our customers begin a new fiscal year on January 1, and capital expenditures tend to be lower in an organization’s first quarter than in its fourth quarter. We anticipate that this seasonality will continue. The seasonality between the second quarter and third quarter may be affected by a variety of additional factors, including changes in the global economy. In line with industry trends, we expect to provide increased managed services, including network design, inventory management, final configuration and warehousing services, to certain customers in certain geographies. Our operating results may be impacted by providing these services to the extent that we may need to postpone the recognition of revenue and incur upfront and ongoing expenses that are not offset with additional revenue from product sales associated with these services until a future period. We continue to explore strategic alternatives to improve the market position and profitability of our product offerings in the marketplace, generate additional liquidity and enhance our valuation. We may pursue our goals during the next twelve months through organic growth and through strategic alternatives. Some of these alternatives have included, and could continue to include, selective acquisitions, divestitures, the sale of assets or securities, a sale or merger of our company or a restructuring of our company. We have also provided, and may from time to time in the future provide, information to interested parties. Operations Review The market for mobile backhaul continues to be our primary addressable market segment and, over the long term, the demand for increasing the backhaul capacity in our customers’ networks continues to grow. In North America, we supported long-term evolution (“LTE”) deployments of our mobile operator customers, public safety network deployments for state and local governments, and private network implementations for utilities and other customers. In international markets, our business continued to rely on a combination of customers increasing their capacity to handle subscriber growth, the ongoing build-out of some large 3G deployments, and the emergence of early stage LTE deployments. Our international business continues to be adversely affected by constrained availability of U.S. dollars in countries with economies highly dependent on resource exports, particularly oil. This condition, along with decline in local purchasing power because of currency devaluations relative to the U.S. dollar, limits capital spending and slows payments from customers in those locations. Our position continues to be to support our customers for LTE readiness and ensure that our technology roadmap is well aligned with evolving market requirements. We continue to find that our strength in turnkey and after-sale support services is a differentiating factor that wins business for us and enables us to expand our business with existing customers in all markets. However, as disclosed above and in the “Risk Factors” section in Item 1A of our fiscal 2017 Annual Report on Form 10-K, a number of factors could prevent us from achieving our objectives, including ongoing pricing pressures attributable to competition and macroeconomic conditions in the geographic markets that we service. Revenue We manage our sales activities primarily on a geographic basis in North America and three international geographic regions: (1) Africa and Middle East, (2) Europe and Russia, and (3) Latin America and Asia Pacific. Revenue by region for the three months ended September 29, 2017 and September 30, 2016 and the related changes were shown in the table below: | Three Months Ended -----------------------------------+------------------- (In thousands, except percentages) | September 29, 2017 | | September 30, 2016 | | $ Change | | % Change -----------------------------------+--------------------+--------+--------------------+--------+----------+--------+--------- North America | $ | 31,002 | | | $ | 28,584 | | | $ | 2,418 | | 8.5 | % -----------------------------------+--------------------+--------+--------------------+--------+----------+--------+----------+---+---+--------+----+------+--- Africa and Middle East | 13,462 | | | 14,349 | | | (887 | ) | | (6.2 | )% -----------------------------------+--------------------+--------+--------------------+--------+----------+--------+----------+---+---+--------+--- Europe and Russia | 4,446 | | | 4,507 | | | (61 | ) | | (1.4 | )% -----------------------------------+--------------------+--------+--------------------+--------+----------+--------+----------+---+---+--------+--- Latin America and Asia Pacific | 7,272 | | | 10,767 | | | (3,495 | ) | | (32.5 | )% -----------------------------------+--------------------+--------+--------------------+--------+----------+--------+----------+---+---+--------+--- Total Revenue | $ | 56,182 | | | $ | 58,207 | | | $ | (2,025 | ) | (3.5 | )% -----------------------------------+--------------------+--------+--------------------+--------+----------+--------+----------+---+---+--------+----+------+--- Our revenue in North America increased $2.4 million , or 8.5% , during the first three months of fiscal 2018 compared with the same period of fiscal 2017 . North America revenue increased primarily due to completion of various private network projects along with an increase in deliveries to mobile operators. 19 Our revenue in Africa and the Middle East decreased $0.9 million , or 6.2% , for the first three months of fiscal 2018 compared with the same period of fiscal 2017 . The decrease in revenue was primarily due to lower sales volume to our large operator customers in East Africa. Revenue in Latin America and Asia Pacific decreased $3.5 million , or 32.5% , during the first three months of fiscal 2018 compared with the same period in fiscal 2017 . The decrease was primarily due to decreased deliveries to our larger customers in the Asia Pacific region. | Three Months Ended -----------------------------------+------------------- (In thousands, except percentages) | September 29, 2017 | | September 30, 2016 | | $ Change | | % Change -----------------------------------+--------------------+--------+--------------------+--------+----------+--------+--------- Product sales | $ | 35,067 | | | $ | 34,724 | | | $ | 343 | | 1.0 | % -----------------------------------+--------------------+--------+--------------------+--------+----------+--------+----------+---+---+--------+----+------+--- Services | 21,115 | | | 23,483 | | | (2,368 | ) | | (10.1 | )% -----------------------------------+--------------------+--------+--------------------+--------+----------+--------+----------+---+---+--------+--- Total Revenue | $ | 56,182 | | | $ | 58,207 | | | $ | (2,025 | ) | (3.5 | )% -----------------------------------+--------------------+--------+--------------------+--------+----------+--------+----------+---+---+--------+----+------+--- Our revenue from product sales increased $0.3 million , or 1.0% , for the first three months of fiscal 2018 compared with the same period in fiscal 2017 . Product volumes were $3.2 million higher in North America, offset by a $2.9 million decrease in other regions. Our services revenue decreased by $2.4 million , or 10.1% , during the first three months of fiscal 2018 compared with the same period of fiscal 2017 , due to reduced service activities in most regions except for Europe. Gross Margin | Three Months Ended -----------------------------------+------------------- (In thousands, except percentages) | September 29, 2017 | | September 30, 2016 | | $ Change | | % Change -----------------------------------+--------------------+--------+--------------------+--------+----------+--------+--------- Revenue | $ | 56,182 | | | $ | 58,207 | | | $ | (2,025 | ) | (3.5 | )% -----------------------------------+--------------------+--------+--------------------+--------+----------+--------+----------+---+---+--------+----+------+--- Cost of revenue | 38,886 | | | 40,842 | | | (1,956 | ) | | (4.8 | )% -----------------------------------+--------------------+--------+--------------------+--------+----------+--------+----------+---+---+--------+--- Gross margin | $ | 17,296 | | | $ | 17,365 | | | $ | (69 | ) | (0.4 | )% -----------------------------------+--------------------+--------+--------------------+--------+----------+--------+----------+---+---+--------+----+------+--- % of revenue | 30.8 | % | | 29.8 | % | | | | -----------------------------------+--------------------+--------+--------------------+--------+----------+--------+----------+---+-- Product margin % | 32.5 | % | | 28.4 | % | | | | -----------------------------------+--------------------+--------+--------------------+--------+----------+--------+----------+---+-- Service margin % | 27.9 | % | | 31.9 | % | | | | -----------------------------------+--------------------+--------+--------------------+--------+----------+--------+----------+---+-- Gross margin for the three months ended September 29, 2017 decreased by $0.1 million , or 0.4% , compared with the three months ended September 30, 2016 . The margin decrease resulted from lower profitability of service projects in all regions which was offset by better product margins coming from reduced supply chain costs. Gross margin as a percentage of revenue increased in the first three months of fiscal 2018 compared with the same period in fiscal 2017 due to improved product margin and lower supply chain costs. Product margin as a percentage of product revenue increased from the prior year quarter primarily due to lower supply chain costs. Service margin as a percentage of service revenue decreased due to lower profitability of our field services projects. Research and Development Expenses | Three Months Ended -----------------------------------+------------------- (In thousands, except percentages) | September 29, 2017 | | September 30, 2016 | | $ Change | | % Change -----------------------------------+--------------------+-------+--------------------+-----+----------+-------+--------- Research and development | $ | 4,798 | | | $ | 4,943 | | $ | (145 | ) | (2.9 | )% -----------------------------------+--------------------+-------+--------------------+-----+----------+-------+----------+---+------+---+------+--- % of revenue | 8.5 | % | | 8.5 | % | | | -----------------------------------+--------------------+-------+--------------------+-----+----------+-------+----------+-- Our research and development expenses decreased $0.1 million , or 2.9% , in the first three months of fiscal 2018 compared with the same period in fiscal 2017 . The decrease was due to a $0.3 million reduction in professional costs, and a $0.1 million reduction in facility costs, offset by a $0.3 million increase in compensation expenses. 20 Selling and Administrative Expenses | Three Months Ended -----------------------------------+------------------- (In thousands, except percentages) | September 29, 2017 | | September 30, 2016 | | $ Change | | % Change -----------------------------------+--------------------+--------+--------------------+------+----------+--------+--------- Selling and administrative | $ | 13,722 | | | $ | 15,187 | | $ | (1,465 | ) | (9.6 | )% -----------------------------------+--------------------+--------+--------------------+------+----------+--------+----------+---+--------+---+------+--- % of revenue | 24.4 | % | | 26.1 | % | | | -----------------------------------+--------------------+--------+--------------------+------+----------+--------+----------+-- Our selling and administrative expenses declined $1.5 million , or 9.6% , in the three months ended September 29, 2017 compared with the same periods in fiscal 2017 . The decrease for the first three months of fiscal 2018 compared with the same quarter in fiscal 2017 was primarily due to reduction in compensation costs, professional services expenses and savings under facilities costs due to our relocation to a new facility. Restructuring Charges | Three Months Ended -----------------------------------+------------------- (In thousands, except percentages) | September 29, 2017 | | September 30, 2016 | $ Change | | % Change -----------------------------------+--------------------+---+--------------------+----------+-----+--------- Restructuring Charges | $ | 2 | | $ | 160 | | $ | (158 | ) | (98.8 | )% -----------------------------------+--------------------+---+--------------------+----------+-----+----------+---+------+---+-------+--- Our restructuring expenses in the three months ended September 30, 2016 consisted primarily of the facility costs related to our previous headquarters in Santa Clara. Interest Income, Interest Expense and Other Expense | Three Months Ended -----------------------------------+------------------- (In thousands, except percentages) | September 29, 2017 | | September 30, 2016 | $ Change | | % Change -----------------------------------+--------------------+-----+--------------------+----------+------+--------- Interest income | $ | 58 | | $ | 54 | | $ | 4 | 7.4 | % -----------------------------------+--------------------+-----+--------------------+----------+------+----------+---+-----+-------+--- Interest expense | $ | (6 | ) | $ | (18 | ) | $ | 12 | (66.7 | )% -----------------------------------+--------------------+-----+--------------------+----------+------+----------+---+-----+-------+--- Other expense | $ | (30 | ) | $ | (182 | ) | $ | 152 | (83.5 | )% -----------------------------------+--------------------+-----+--------------------+----------+------+----------+---+-----+-------+--- Interest income reflected interest earned on our cash equivalents which were comprised of money market funds and certificates of deposit. Interest expense was primarily related to interest associated with borrowings under the SVB Credit Facility and discounts on customer letters of credit. Other expense in the three months ended September 30, 2016 were primarily comprised of a foreign exchange loss on a dividend declared by our Nigeria entity (a partnership for U.S. tax purposes) to our Aviat U.S. entity. Income Taxes | Three Months Ended -----------------------------------+------------------- (In thousands, except percentages) | September 29, 2017 | | September 30, 2016 | $ Change | | % Change -----------------------------------+--------------------+--------+--------------------+----------+--------+--------- Loss before income taxes | $ | (1,204 | ) | $ | (3,071 | ) | $ | 1,867 | (60.8 | )% -----------------------------------+--------------------+--------+--------------------+----------+--------+----------+---+-------+-------+--- Benefit from income taxes | $ | (639 | ) | $ | (2,470 | ) | $ | 1,831 | (74.1 | )% -----------------------------------+--------------------+--------+--------------------+----------+--------+----------+---+-------+-------+--- We estimate our annual effective tax rate at the end of each quarterly period, and we record the tax effect of certain discrete items in the interim period in which they occur, including changes in judgment about uncertain tax positions and deferred tax valuation allowances. During the first quarter of fiscal 2017, we received a tax refund of $3.7 million from the Inland Revenue Authority of Singapore (“IRAS”) related to an assessment we paid in fiscal year 2014 related to deductions claimed in tax years 2007 through 2010. During the first quarter of fiscal 2018, we received an additional refund of $1.3 million from IRAS which represents a final settlement. Both tax refunds were recorded as a discrete tax benefit during the quarter the respective payment was received. The determination of the effective tax rate reflects tax expense and benefit generated in certain jurisdictions. However, jurisdictions with a year-to-date loss where no tax benefit can be recognized are excluded from the annual effective tax rate. 21 Liquidity, Capital Resources and Financial Strategies Sources of Cash As of September 29, 2017 , our total cash, cash equivalents and short-term investments were $ 39.4 million . Approximately $15.5 million , or 39.3% was held in the United States. The remaining balance of $23.9 million , or 61% , was held by entities outside the United States. Of the amount of cash, cash equivalents and short-term investments held by our foreign subsidiaries as of September 29, 2017 , $4.4 million was held in jurisdictions where our undistributed earnings are indefinitely reinvested, and if repatriated, would be subject to U.S. taxes, which would be nominal. Cash provided by operating activities was $4.9 million in the first three months of fiscal 2018 as compared to cash provided by operating activities of $3.3 million in the first three months of fiscal 2017 . Cash provided by operating activities is presented as net loss adjusted for non-cash items and changes in operating assets and liabilities. Net contribution of non-cash items to cash provided by operating activities decreased by $0.4 million and net contribution of changes in operating assets and liabilities to cash provided by operating activities increased by $2.0 million for the first three months of fiscal 2018 as compared to the same period in fiscal 2017 . The $0.4 million decrease in the net contribution of non-cash items to cash provided by operating activities was primarily due to a $0.6 million decrease in charges for inventory write-downs, a $0.1 million decrease in bad debt expense, a $0.4 million decrease in depreciation and amortization of property, plant and equipment, offset by a $0.6 million increase in deferred tax expense, and a $0.1 million increase in share-based compensation expense. Changes in operating assets and liabilities resulted in a net increase of $2.0 million to cash provided by operating activities for the first three months of fiscal 2018 as compared to the same period in 2017. Accounts receivable and unbilled costs fluctuate from period to period, depending on the amount, timing of sales and billing activities as well as cash collections. The fluctuations in accounts payable and accrued expenses were primarily due to the timing of liabilities incurred and vendor payments. The change in inventories and in customer service inventories were primarily due to demand and our focus on improving our inventory management. The decrease in customer advance payments and unearned income was due to the timing of payment from customers and revenue recognition. We used $0.7 million in cash during the first three months of fiscal 2018 on expenses related to restructuring liabilities. During the remainder of fiscal year 2018, we expect to spend approximately $6.0 million for capital expenditures, primarily on equipment for development and manufacturing of new products and to support customer managed services. As of September 29, 2017 , our principal sources of liquidity consisted of the $39.4 million in cash, cash equivalents and short-term investments, $7.9 million of available credit under our $30.0 million SVB Credit Facility which expires on June 30, 2018 and future collections of receivables from customers. We regularly require letters of credit from some customers, and, from time to time, these letters of credit are discounted without recourse shortly after shipment occurs in order to meet immediate liquidity requirements and to reduce our credit and sovereign risk. Historically our primary sources of liquidity have been cash flows from operations and credit facilities. We believe that our existing cash and cash equivalents, the available line of credit under the SVB Credit Facility and future cash collections from customers will be sufficient to provide for our anticipated requirements for working capital and capital expenditures for at least the next 12 months. Our SVB Credit Facility expires on June 30, 2018. While we intend to renew and expect the SVB Credit Facility to be renewed, there can be no assurance that the SVB Credit Facility will be renewed. In addition, there can be no assurance that our business will generate cash flow from operations, we will be in compliance with the quarterly financial covenants contained in the SVB Credit Facility, or that we will have a sufficient borrowing base under such facility, or that anticipated operational improvements will be achieved. If we are not in compliance with the financial covenants or do not have sufficient eligible accounts receivable to support our borrowing base, the availability of our credit facility is not certain or may be diminished. Over the longer term, if we are unable to maintain cash balances or generate sufficient cash flow from operations to service our obligations that may arise in the future, we may be required to sell assets, reduce capital expenditures, or obtain financing. If we need to obtain additional financing, we cannot be assured that it will be available on favorable terms, or at all. Our ability to make scheduled principal payments or pay interest on or refinance any future indebtedness depends on our future performance and financial results, which, to a certain extent, are subject to general conditions in or affecting the microwave communications market and to general economic, political, financial, competitive, legislative and regulatory factors beyond our control. 22 Restructuring Payments We had liabilities for restructuring activities totaling $1.1 million as of September 29, 2017 , $0.8 million of which was classified as current liabilities and expected to be paid out in cash over the next 12 months. We expect to fund these future payments with available cash and cash provided by operations. Contractual Obligations and Commercial Commitments The amounts disclosed in our fiscal 2017 Annual Report on Form 10-K filed with the SEC on September 6, 2017 include our commercial commitments and contractual obligations. During the first three months of fiscal 2018 , no material changes occurred in our contractual obligations to purchase goods and services and to make payments under operating leases or our commercial commitments and contingent liabilities on outstanding letters of credit, guarantees and other arrangements as disclosed in our fiscal 2017 Annual Report on Form 10-K. Please refer to Note 10 Commitments and Contingencies of the Notes to Condensed Consolidated Financial Statements (Unaudited) in this Quarterly Report on Form 10-Q. Critical Accounting Estimates For information about our critical accounting estimates, see the “Critical Accounting Estimates” section of “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our fiscal 2017 Annual Report on Form 10-K. Item 3. Quantitative and Qualitative Disclosures about Market Risk. In the normal course of doing business, we are exposed to the risks associated with foreign currency exchange rates and changes in interest rates. We employ established policies and procedures governing the use of financial instruments to manage our exposure to such risks. Exchange Rate Risk We conduct business globally in numerous currencies and are therefore exposed to foreign currency risks. We use derivative instruments to reduce the volatility of earnings and cash flows associated with changes in foreign currency exchange rates. We do not hold or issue derivatives for trading purposes or make speculative investments in foreign currencies. We use foreign exchange forward contracts to hedge forecasted foreign currency transactions relating to forecasted sales and purchase transactions. Beginning the fourth quarter of fiscal 2015, we no longer prepared contemporaneous documentation of hedges for the new foreign exchange forward contracts we entered into. As a result, the foreign exchange hedges no longer qualified as cash flow hedges. The changes in fair value related to the hedges were recorded in income or expenses line items on our statements of operations. We also enter into foreign exchange forward contracts to mitigate the change in fair value of specific non-functional currency assets and liabilities on the balance sheet. All balance sheet hedges are marked to market through earnings every period. Changes in the fair value of these derivatives are largely offset by re-measurement of the underlying assets and liabilities. As of September 29, 2017 , we had foreign currency forward contracts outstanding with a total notional amount of $1.8 million consisting of three different currencies as follows: Currency | Notional ContractAmount(Local Currency) | NotionalContractAmount(USD) ----------------------------------------+-----------------------------------------+---------------------------- | (In thousands) ----------------------------------------+---------------------------------------- New Zealand dollar | 1,000 | | $ | 727 ----------------------------------------+-----------------------------------------+-----------------------------+-------+---- Great Britain pound | 500 | | 656 | ----------------------------------------+-----------------------------------------+-----------------------------+-------+---- Euro | 350 | | 415 | ----------------------------------------+-----------------------------------------+-----------------------------+-------+---- Total of all currency forward contracts | | $ | 1,798 | ----------------------------------------+-----------------------------------------+-----------------------------+-------+---- 23 Net foreign exchange income (loss) recorded in our unaudited condensed consolidated statements of operations during the first three months of fiscal 2018 and 2017 was as follows: | Three Months Ended -------------------------------------+------------------- (In thousands) | September 29, 2017 | | September 30, 2016 -------------------------------------+--------------------+-----+------------------- Amount included in costs of revenues | $ | 9 | | | $ | (216 | ) -------------------------------------+--------------------+-----+--------------------+------+---+------+-- Amount included in other expense | (30 | ) | | (210 | ) -------------------------------------+--------------------+-----+--------------------+------+-- Total foreign exchange loss, net | $ | (21 | ) | | $ | (426 | ) -------------------------------------+--------------------+-----+--------------------+------+---+------+-- A 10% adverse change in currency exchange rates for our foreign currency derivatives held as of September 29, 2017 would have an impact of approximately $ 0.2 million on the fair value of such instruments. Certain of our international business are transacted in non-U.S. dollar currency. As discussed above, we utilize foreign currency hedging instruments to minimize the currency risk of international transactions. The impact of translating the assets and liabilities of foreign operations to U.S. dollars for the first three months of fiscal 2018 was $0.1 million and was included as a component of stockholders’ equity. As of September 29, 2017 and June 30, 2017 , the cumulative translation adjustment decreased our stockholders’ equity by $11.7 million and $11.8 million , respectively. Interest Rate Risk Our exposure to market risk for changes in interest rates relates primarily to our cash equivalents and borrowings under our credit facility. Exposure on Cash Equivalents and Short-term Investments We had $39.4 million in total cash, cash equivalents and short-term investments as of September 29, 2017 . Cash equivalents and short-term investments totaled $17.4 million as of September 29, 2017 and were comprised of money market funds and bank certificates of deposit. Cash equivalents and short-term investments have been recorded at fair value on our balance sheet. Our cash equivalents and short-term investments earn interest at fixed rates; therefore, changes in interest rates will not generate a gain or loss on these investments unless they are sold prior to maturity. Actual gains and losses due to the sale of our investments prior to maturity have been immaterial. The weighted average days to maturity for cash equivalents and short-term investments held as of September 29, 2017 was 155 days, and these investments had an average yield of 6.81% per annum. A 10% change in interest rates on our cash equivalents and short-term investments is not expected to have a material impact on our financial position, results of operations or cash flows. Exposure on Borrowings During the first three months of fiscal 2018 , we had $9.0 million of borrowings outstanding under the SVB Credit Facility that incurred interest at the prime rate plus a spread of 0.50% to 1.50% with such spread determined based on our adjusted quick ratio. During the first three months of fiscal 2018 , our weighted average interest rate was 4.75% and the interest expense on these borrowings was insignificant. A 10% change in interest rates on the current borrowings or on future borrowings is not expected to have a material impact on our financial position, results of operations or cash flows since interest on our borrowings is not material to our overall financial position. Item 4. Controls and Procedures Evaluation of Disclosure Controls and Procedures Based on management’s evaluation, with participation of our Chief Executive Officer (CEO) and Chief Financial Officer (CFO), as of the end of the period covered by this report, our CEO and CFO have concluded that our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as of September 29, 2017 , are effective to provide reasonable assurance that the information required to be disclosed in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported 24 within the time periods specified in the Securities and Exchange Commission rules and forms, and is accumulated and communicated to management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosures. Changes in Internal Controls Over Financial Reporting There were no changes to our internal control over financial reporting as defined in Rules 13a-15(f) or 15d-15(f) that occurred during our first three months of fiscal 2018 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Inherent Limitations on Effectiveness of Controls Our management, including the CEO and CFO, does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all errors and all fraud. A control system, no matter how well-designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. The design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, have been detected. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Projections of any evaluation of the effectiveness of controls to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. 25 PART II. OTHER INFORMATION Item 1. Legal Proceedings Please refer to Legal Proceedings under Note 10 Commitments and Contingencies of the Notes to Condensed Consolidated Financial Statements (Unaudited) in this Quarterly Report on Form 10-Q. Item 1A. Risk Factors Investors should carefully review and consider the information regarding certain factors which could materially affect our business, operating results, cash flows and financial condition set forth under Item 1A, Risk Factors, in our fiscal 2017 Annual Report on Form 10-K filed with the SEC on September 6, 2017 . We do not believe that there have been any other material additions or changes to the risk factors previously disclosed in our fiscal 2017 Annual Report on Form 10-K, although we may disclose changes to such factors or disclose additional factors from time to time in our future filings with the SEC. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds Not applicable. Item 3. Defaults upon Senior Securities Not applicable. Item 4. Mine Safety Disclosures Not applicable. Item 5. Other Information Not applicable. Item 6. Exhibits The information required by this Item is set forth on the Exhibit Index (following the Signature section of this report) and is included, or incorporated by reference, in this Form 10-Q. 26 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. AVIAT NETWORKS, INC.(Registrant) -------------------------------- Date: November 13, 2017 By: | /s/ Eric Chang ----+------------------------------------------------------------------------------------------------------------------------------------------ | Eric ChangVice President, Corporate Controller and Principal Accounting Officer(Principal accounting officer and duly authorized officer) ----+------------------------------------------------------------------------------------------------------------------------------------------ 27 EXHIBIT INDEX The following exhibits are filed herewith or incorporated by reference to exhibits previously filed with the SEC: Exhibit Number | Descriptions ---------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3.1 | Amended and Restated Certificate of Incorporation of Aviat Networks, Inc., as amended (incorporate by reference to Exhibit 3.1 to the Current Report on Form 10-Q filed with the SEC on February 10, 2017, File No. 001-33278) ---------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3.2 | Amended and Restated Bylaws of Aviat Networks, Inc. (incorporate by reference to Exhibit 3.2 to the Current Report on Form 8-K filed with the SEC on October 2, 2015, File No. 001-33278) ---------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.1 | Tax Benefit Preservation Plan, dated as of September 6, 2016, by and between Aviat Networks, Inc. and Computershare Inc., as Rights Agent (incorporated by reference to Exhibit 4.1 to the Current Report on Form 8-K filed with the SEC on September 7, 2016, File No. 011-33278) ---------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.1 | Amendment No. 8 to Second Amended and Restated Loan and Security Agreement, dated as of September 21, 2017, by and among Aviat Networks, Inc., Aviat U.S., Inc., Aviat Networks (S) Pte. Ltd. and Silicon Valley Bank (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed with the SEC on September 22, 2017, File No. 001-33278) ---------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.1 | Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer ---------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.2 | Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer ---------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 32.1 | Section 1350 Certification of Chief Executive Officer and Chief Financial Officer ---------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.INS | XBRL Instance Document ---------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.SCH | XBRL Taxonomy Extension Schema Document ---------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document ---------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document ---------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.LAB | XBRL Taxonomy Extension Label Linkbase Document ---------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document ---------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 28

Acacia Diversified Holdings, Inc.

1001463

10-Q

0001185185-17-002324

UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) ---------- ☒ | QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 -----------+---------------------------------------------------------------------------------- | For the quarterly period ended September 30, 2017 -----------+---------------------------------------------------------------------------------- r | TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT -----------+---------------------------------------------------------------------------------- | For the transition period from __________________ to ______________ -----------+---------------------------------------------------------------------------------- Commission file number: 001-14088 Acacia Diversified Holdings, Inc. (Exact name of small business issuer as specified in its charter) Texas | 75-2095676 ---------------------------------------------------------------+---------------------------------- (State or other jurisdiction of incorporation or organization) | (IRS Employer Identification No.) ---------------------------------------------------------------+---------------------------------- 13575 58th St. North #138 Clearwater, FL | 33760 ---------------------------------------------------------------+---------------------------------- (Address of principal executive offices) | (Zip Code) ---------------------------------------------------------------+---------------------------------- (727) 678-4420 (Registrant’s telephone number) (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. (1) Yes ☒ No r (2) Yes ☒ No r Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No r Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See definition of “large accelerated filer,” accelerated filer” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act: Large accelerated filer r | Accelerated filer r ---------------------------+---------------------------- Non-accelerated filer r | Smaller Reporting Company ☒ ---------------------------+---------------------------- Emerging growth company r | ---------------------------+---------------------------- If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes r No ☒ APPLICABLE ONLY TO CORPORATE ISSUERS State the number of shares outstanding of each of the issuer’s classes of common equity, as of November 7 , 2017 is 17,529,982 common shares. TABLE OF CONTENTS | | Page ------------------------------+---------------------------------------------------------------------------------------+----- PART I. Financial Information | ------------------------------+-------------------------------------------------------------------------------------- Item 1. | Financial Statements | F-1 ------------------------------+---------------------------------------------------------------------------------------+----- Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations | 1 ------------------------------+---------------------------------------------------------------------------------------+----- Item 3. | Quantitative and Qualitative Disclosures About Market Risk. | 5 ------------------------------+---------------------------------------------------------------------------------------+----- Item 4. | Controls and Procedures | 5 ------------------------------+---------------------------------------------------------------------------------------+----- PART II. Other Information | ------------------------------+-------------------------------------------------------------------------------------- Item 1. | Legal Proceedings | 6 ------------------------------+---------------------------------------------------------------------------------------+----- Item 1A. | Risk Factors | 6 ------------------------------+---------------------------------------------------------------------------------------+----- Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | 6 ------------------------------+---------------------------------------------------------------------------------------+----- Item 3. | Defaults Upon Senior Securities | 6 ------------------------------+---------------------------------------------------------------------------------------+----- Item 4. | Mine Safety Disclosures | 6 ------------------------------+---------------------------------------------------------------------------------------+----- Item 5. | Other Information | 6 ------------------------------+---------------------------------------------------------------------------------------+----- Item 6. | Exhibits | 7 ------------------------------+---------------------------------------------------------------------------------------+----- Signatures | 8 ------------------------------+-------------------------------------------------------------------------------------- PART I. FINANCIAL INFORMATION Item 1. Financial Statements ACACIA DIVERSIFIED HOLDINGS, INC. CONSOLIDATED BALANCE SHEETS | September 30, 2017 | | | December 31, 2016 | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+-- | (Unaudited) | | | (Audited) | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+-- ASSETS | | | | | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+-- CURRENT ASSETS: | | | | | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+-- Cash and cash equivalents | $ | 36,883 | | | $ | 43,878 | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+---+------------+-- Accounts receivable | | 95,100 | | | | 35,630 | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+---+------------+-- Inventories | | 57,471 | | | | 63,085 | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+---+------------+-- Prepaid expenses and other current assets | | 13,536 | | | | 60,502 | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+---+------------+-- Total Current Assets | | 202,990 | | | | 203,095 | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+---+------------+-- PROPERTY AND EQUIPMENT, net of accumulated depreciation of $166,762 and $108,886 in 2017 and 2016, respectively | | 474,890 | | | | 480,847 | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+---+------------+-- OTHER ASSETS: | | | | | | | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+---+------------+-- Deferred offering cost | | 240,900 | | | | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+---+------------+-- Deposits | | 841 | | | | 841 | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+---+------------+-- Total Other Assets | | 241,741 | | | | 841 | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+---+------------+-- TOTAL ASSETS | $ | 919,621 | | | $ | 684,783 | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+---+------------+-- LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT) | | | | | | | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+---+------------+-- CURRENT LIABILITIES: | | | | | | | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+---+------------+-- Accounts payable | $ | 61,605 | | | $ | 69,938 | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+---+------------+-- Accrued expenses | | 276,685 | | | | 320,592 | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+---+------------+-- Note payable to related party | | 558,400 | | | | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+---+------------+-- Payable to related parties | | 65,984 | | | | 4,000 | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+---+------------+-- Total Current Liabilities | | 962,674 | | | | 394,530 | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+---+------------+-- Total Liabilities | | 962,674 | | | | 394,530 | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+---+------------+-- Commitments and contingencies | | - | | | | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+---+------------+-- STOCKHOLDERS’ EQUITY (DEFICIT) | | | | | | | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+---+------------+-- Common stock, $0.001 par value; 150,000,000 shares authorized; 17,539,982 and 16,931,816 shares issued and outstanding at September 30, 2017 and December 31, 2016, respectively | | 17,540 | | | | 16,932 | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+---+------------+-- Additional paid-in capital | | 4,433,161 | | | | 3,393,539 | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+---+------------+-- Accumulated deficit | | (4,493,754 | ) | | | (3,120,218 | ) ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+---+------------+-- Total Stockholders’ Equity (Deficit) | | (43,053 | ) | | | 290,253 | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+---+------------+-- TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT) | $ | 919,621 | | | $ | 684,783 | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+------------+---+-------------------+---+------------+-- The accompanying notes are an integral part of these consolidated financial statements. F-1 ACACIA DIVERSIFIED HOLDINGS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2017 AND 2016 (UNAUDITED) | Three Months Ended September 30, | | | Nine Months Ended September 30, | ------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+-- | 2017 | | | 2016 | | | 2017 | | 2016 | ------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+-- REVENUE | $ | 63,772 | | | $ | 9,726 | | $ | 344,133 | | $ | 235,092 | ------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- COSTS OF GOODS SOLD | | | | | | | | | | | | | ------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- Costs of goods sold | | 700 | | | | 29,231 | | | 129,338 | | | 107,488 | ------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- Depreciation expense | | 18,297 | | | | 18,020 | | | 54,400 | | | 52,827 | ------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- | | 18,997 | | | | 47,251 | | | 183,738 | | | 160,315 | ------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- GROSS PROFIT (LOSS) | | 44,775 | | | | (37,525 | ) | | 160,395 | | | 74,777 | ------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- SELLING, GENERAL AND ADMINISTRATIVE EXPENSES | | | | | | | | | | | | | ------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- Employee compensation expenses | | 101,941 | | | | 156,148 | | | 540,902 | | | 432,155 | ------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- General and administrative expenses | | 83,418 | | | | 168,428 | | | 569,754 | | | 524,455 | ------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- Depreciation expense | | 969 | | | | 1,135 | | | 4,227 | | | 3,759 | ------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- | | 186,328 | | | | 325,711 | | | 1,114,883 | | | 960,369 | ------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- LOSS FROM OPERATIONS | | (141,553 | ) | | | (363,236 | ) | | (954,488 | ) | | (885,592 | ) ------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- OTHER INCOME (EXPENSES) | | | | | | | | | | | | | ------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- Loss on sale of equipment to related party | | - | | | | - | | | (4,249 | ) | | (42,987 | ) ------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- Interest expense | | (13,178 | ) | | | (10 | ) | | (416,311 | ) | | (48 | ) ------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- Other income | | 513 | | | | 140 | | | 1,512 | | | 140 | ------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- TOTAL OTHER EXPENSES | | (12,665 | ) | | | 130 | | | (419,048 | ) | | (42,895 | ) ------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- NET LOSS BEFORE INCOME TAXES | $ | (154,218 | ) | | $ | (363,106 | ) | $ | (1,373,536 | ) | $ | (928,487 | ) ------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- Income taxes | | - | | | | - | | | - | | | - | ------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- NET LOSS | $ | (154,218 | ) | | $ | (363,106 | ) | $ | (1,373,536 | ) | $ | (928,487 | ) ------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- NET LOSS PER COMMON SHARE, BASIC AND DILUTED | $ | (0.01 | ) | | $ | (0.02 | ) | $ | (0.08 | ) | $ | (0.06 | ) ------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- WEIGHTED AVERAGE NUMBER OF COMMON SHARES OUTSTANDING, BASIC AND DILUTED | | 17,528,342 | | | | 15,446,356 | | | 17,330,720 | | | 15,436,696 | ------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+------------+---+---+------------+-- The accompanying notes are an integral part of these consolidated financial statements. F-2 ACACIA DIVERSIFIED HOLDINGS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2017 AND 2016 (UNAUDITED) | 2017 | | | 2016 | -------------------------------------------------------------------------------------------------+------+------------+---+------+-- CASH FLOWS FROM OPERATING ACTIVITIES: | | | | | -------------------------------------------------------------------------------------------------+------+------------+---+------+-- Net loss | $ | (1,373,536 | ) | | $ | (928,487 | ) -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Adjustments to reconcile net loss to net cash and cash equivalents used by operating activities: | | | | | | | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Depreciation | | 58,627 | | | | 56,945 | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Common stock issued for services | | 337,469 | | | | 14,955 | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Employee stock plan | | 44,738 | | | | - | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Common stock issued for interest | | 366,400 | | | | - | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Amortization of debt discount | | 15,000 | | | | - | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Loss on sale of equipment to related party | | 4,249 | | | | 42,987 | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- (Increase) decrease in: | | | | | | | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Accounts receivable | | (59,470 | ) | | | 135,200 | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Inventories | | 5,614 | | | | (80,363 | ) -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Prepaid expenses and other current assets | | 46,965 | | | | (9,905 | ) -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Increase (decrease) in: | | | | | | | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Accounts payable | | (8,332 | ) | | | 21,530 | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Accrued expenses | | (20,557 | ) | | | 7,874 | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Payable to related parties | | 89,984 | | | | - | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Net cash used by operating activities | | (492,849 | ) | | | (739,264 | ) -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- CASH FLOWS FROM INVESTING ACTIVITIES: | | | | | | | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Acquisition of property and equipment | | (6,196 | ) | | | (35,414 | ) -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Net cash used by investing activities | | (6,196 | ) | | | (35,414 | ) -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- CASH FLOWS FROM FINANCING ACTIVITIES: | | | | | | | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Proceeds from payable to related party | | 130,050 | | | | 510,000 | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Payment on due to related party | | (28,000 | ) | | | - | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Proceeds from issuance of convertible note payable, net | | 85,000 | | | | - | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Repayment on convertible note payable | | (100,000 | ) | | | - | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Proceeds from issuance of note payable to related party | | 405,000 | | | | - | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Proceeds from issuance of common stock | | - | | | | 150 | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Proceeds from reverse acquisition | | - | | | | 180,854 | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Net cash provided by financing activities | | 492,050 | | | | 691,004 | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Net change in cash and cash equivalents | | (6,995 | ) | | | (83,674 | ) -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Cash and cash equivalents, beginning of the period | | 43,878 | | | | 221,174 | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Cash and cash equivalents, end of the period | $ | 36,883 | | | $ | 137,500 | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- SUPPLEMENTAL CASH FLOW INFORMATION: | | | | | | | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Cash paid for interest | $ | 5,000 | | | $ | 48 | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Cash paid for income taxes | $ | - | | | $ | - | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- NON-CASH FINANCING AND INVESTING ACTIVITIES: | | | | | | | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Common stock issued for acquisition of property | $ | 50,723 | | | $ | - | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Common stock issued for deferred offering cost | $ | 240,900 | | | $ | - | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Consolidation of notes payable to related party, including accrued interest | $ | 153,400 | | | $ | - | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Changes in operating assets and liabilities due to reverse acquisition: | | | | | | | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Prepaid expenses | $ | - | | | $ | (3,434 | ) -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Property and equipment | $ | - | | | $ | (95,860 | ) -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Accumulated depreciation | $ | - | | | $ | 44,332 | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Deposits | $ | - | | | $ | (841 | ) -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Accounts payable | $ | - | | | $ | 6,973 | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- Additional paid-in capital | $ | - | | | $ | 48,830 | -------------------------------------------------------------------------------------------------+------+------------+---+------+---+----------+-- The accompanying notes are an integral part of these consolidated financial statements. F-3 ACACIA DIVERSIFIED HOLDINGS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 2017 (UNAUDITED) NOTE 1 – THE COMPANY Acacia Diversified Holdings, Inc. (“Acacia” or the “Company”) has three wholly-owned subsidiaries, MariJ Pharmaceuticals, Inc. (“MariJ Pharma”), Canna-Cures Research & Development Center, Inc. (“Canna-Cures”), and Eufloria Medical of Tennessee, Inc. (“EMT”), a company incorporated in the state of Tennessee. The Company formed this new subsidiary to acquire a parcel of land and a license from one of its directors. See details in Note 4 - Related Party Transactions. The Company’s primary source revenue is from the extraction of medicinal cannabis oil, from a non-psychoactive cannabis plant. All extraction services are currently limited to the State of Colorado, as the Company is attempting to obtain various licenses for business in the State of Florida. NOTE 2 – GOING CONCERN The Company has not generated profit to date. The Company expects to continue to incur operating losses as it proceeds with its extraction and research and development activities and continues to navigate through the regulatory process. The Company expects general and administrative costs to increase, as the Company adds personnel and other administrative expenses associated with its current efforts. As such, and without substantially increasing revenue or finding new sources of capital, the Company will find it difficult to continue to meet its obligations as they come due. The Company continues to seek working capital but there can be no assurance that the Company will be successful in its efforts to raise capital, or if it were successful in raising capital, that it would be successful in meeting its business plans. While the services performed by the Company’s MariJ Pharma subsidiary are anticipated to be sufficient to partly meet the Company’s liquidity needs, these factors raise substantial doubt as to the ability of the Company to continue as a going concern. Management’s plans include increasing production at the Company’s MariJ Pharma subsidiary during 2017 and opening a retail store in Tennessee, attempting to start new businesses outside of Colorado, finding additional operational businesses to buy, and attempting to raise funds from the public through an equity offering of the Company’s common stock. Management intends to make every effort to identify and develop all these sources of funds, but there can be no assurance that Management’s plans will be successful. The accompanying consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The Company has incurred losses for all periods presented and has a substantial accumulated deficit. As of September 30, 2017, these factors, among others, raise substantial doubt about the Company’s ability to continue as a going concern. NOTE 3 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION The accompanying consolidated financial statements are unaudited and have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) and reflect all adjustments, which consist solely of normal recurring adjustments, needed to fairly present the financial results for these periods. The consolidated financial statements and notes thereto are presented as prescribed by Form 10-Q. Accordingly, certain information and note disclosures normally included in financial statements prepared in accordance with U.S. GAAP have been omitted. The accompanying consolidated financial statements should be read in conjunction with the financial statements for the fiscal year ended December 31, 2016 and notes thereto in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2016, filed with the Securities and Exchange Commission on March 28, 2017. Operating results for the three and nine months ended September 30, 2017 are not necessarily indicative of the results that may be expected for the entire fiscal year. In the opinion of management, all adjustments have been made, which consist only of normal recurring adjustments necessary for a fair statement of (a) the results of operations for the three and nine-month periods ended September 30, 2017 and 2016, (b) the financial position at September 30, 2017 and (c) cash flows for the nine-month periods ended September 30, 2017 and 2016. PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of Acacia Diversified Holdings, Inc. and its wholly-owned subsidiaries, MariJ Pharmaceuticals, Inc, Canna-Cures Research & Development Center, Inc., and Eufloria Medical of Tennessee, Inc. All significant intercompany accounts and transactions are eliminated in consolidation. F-4 ACACIA DIVERSIFIED HOLDINGS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 2017 (UNAUDITED) USE OF ESTIMATES The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. The actual results may differ materially and adversely from the Company’s estimates. To the extent there are material differences between the estimates and the actual results, future results of operations will be affected. RECLASSIFICATIONS Certain prior year amounts shown in the accompanying consolidated financial statements have been reclassified to conform to the 2017 presentation. These reclassifications did not have any effect on total current assets, total assets, total current liabilities, total liabilities, total stockholders’ equity, net loss or loss per share. DEBT ISSUANCE COSTS In March 2017, the Company incurred direct costs associated with the issuance of a convertible note, as described in Note 6. The Company follows Accounting Standard Update 2015-03 – Simplifying the Presentation of Debt Issuance Costs , which requires these costs to be presented in the balance sheet as a direct reduction from the carrying value of the associated debt liability. These costs should be amortized into interest expense over the contractual term of the note or a shorter amortization period when deemed appropriate. The Company amortizes debt issuance costs for its convertible note immediately upon issuance since the note is convertible on demand. OFFERING COSTS In March 2017, the Company issued shares of its common stock to pay for direct incremental costs associated with the expected future sale of its equity securities, as described in Note 7. These shares are valued at their fair value on commitment date and are recorded as deferred offering costs on the Company’s consolidated balance sheets. These costs will offset any proceeds to be received in the future from the sale of common stock. STOCK BASED COMPENSATION The Company accounts for stock-based compensation under Accounting Standards Codification 718 - Compensation-Stock Compensation (“ASC 718”). ASC 718 requires that all stock-based compensation be recognized as expense in the financial statements and that such cost be measured at the fair value of the award at the grant date and recognized over the period during which an employee is required to provide services (requisite service period). An additional requirement of ASC 718 is that estimated forfeitures be considered in determining compensation expense. Estimating forfeitures did not have a material impact on the determination of compensation expense during the three and nine months ended September 30, 2017 and 2016. The Company accounts for stock based awards based on the fair market value of the instrument using a 10-day volume weighted adjusted price (VWAP) and accounts for stock options issued using the Black-Scholes option pricing model and utilizing certain assumptions including the followings: Risk-free interest rate – This is the yield on U.S. Treasury Securities posted at the date of grant (or date of modification) having a term equal to the expected life of the option. An increase in the risk-free interest rate will increase compensation expense. Expected life—years – This is the period of time over which the options granted are expected to remain outstanding. Options granted by the Company had a maximum term of ten years. An increase in the expected life will increase compensation expense. Expected volatility – Actual changes in the market value of stock are used to calculate the volatility assumption. An increase in the expected volatility will increase compensation expense. Dividend yield – This is the annual rate of dividends per share over the exercise price of the option. An increase in the dividend yield will decrease compensation expense. The Company does not currently pay dividends and has no immediate plans to do so in the near future. F-5 ACACIA DIVERSIFIED HOLDINGS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 2017 (UNAUDITED) The Company accounts for stock-based compensation issued to non-employees and consultants in accordance with the provisions of Accounting Standards Codification 505-50, Equity – Based Payments to Non-Employees . Measurement of share-based payment transactions with non-employees is based on the fair value of whichever is more reliably measurable: (a) the goods or services received; or (b) the equity instruments issued. The value of the common stock is measured at the earlier of (i) the date at which a firm commitment for performance by the counterparty to earn the equity instruments is reached or (ii) the date at which the counterparty’s performance is complete. During the nine months ended September 30, 2017, the board of directors approved issuances of Company’s restricted common stock to consultants and non-employee directors for past and future services: 1. | 10,000 shares to each director for services rendered for fiscal year 2016 and 10,000 shares for services to be rendered for fiscal year 2017, total 60,000 shares, valued at $99,000; ---+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 2. | 17,646 shares to a consultant for investors relations services, valued at $30,000; ---+----------------------------------------------------------------------------------- 3. | 50,000 shares to the Company’s SEC legal counsel for services performed, valued at $82,500; ---+-------------------------------------------------------------------------------------------- 4. | 15,000 shares to a consultant for continuing services, valued at $23,400; and ---+------------------------------------------------------------------------------ 5. | 54,254 shares to a director as other considerations and to purchase and prepare assets acquired by the Company’s subsidiary, valued at $86,806. ---+------------------------------------------------------------------------------------------------------------------------------------------------ The Company valued these shares at fair value on commitment dates and recorded stock based compensation expense over the respective requisite service periods. There was no share-based compensation expense for the three months ended September 30, 2017 and 2016. Share-based compensation expense for the nine months ended September 30, 2017 and 2016 was $321,706 and $0, respectively. FAIR VALUE ESTIMATES – The Company measures assets and liabilities it acquires at fair value in accordance with Accounting Standards Codification 820 – Fair Value Measurement (“ASC 820”). The objective of ASC 820 is to increase consistency and comparability in fair value measurements and to expand disclosures about fair value measurements. ASC 820 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. ASC 820 specifies a valuation hierarchy based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s own assumptions. These two types of inputs have created the following fair value hierarchy: · | Level 1 – Quoted prices for identical instruments in active markets; --+--------------------------------------------------------------------- · | Level 2 – Quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets; and --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | Level 3 – Valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable. --+---------------------------------------------------------------------------------------------------------------------------------------------- This hierarchy requires the Company to minimize the use of unobservable inputs and to use observable market data, if available, when estimating fair value. During the nine months ended September 30, 2017, EMT acquired land and a license from one of the Company’s directors (NOTE 4). The Company determined that the fair value of the land is $26,194 which is a level 2 input. F-6 ACACIA DIVERSIFIED HOLDINGS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 2017 (UNAUDITED) NOTE 4 – RELATED PARTY TRANSACTIONS Notes Payable to Related Party In January 2017, the Company entered into a note agreement in the amount of $300,000 with the Company’s CEO. The note bears interest at a rate of 8% per annum and specifies no due date. The Company accrued interest of $16,504 at September 30, 2017. Interest expense on this note for the three and nine months ended was $4,800 and $11,704, respectively. Concurrently, the board of directors also approved issuance of 100,000 shares of the Company’s common stock as additional interest. These shares were accounted for as debt issuance costs, valued at $182,000. The costs were expensed at the commitment date of the note as interest expense since the note is a short term capital advance with no stated term. This note was convertible into the shares of the Company’s common stock at $0.50/share. During the three months ended September 30, 2017, this note has been consolidated with other notes and advances from this related party. See Consolidated Note Payable to Related Party below. In June 2017, the Company entered into a note agreement in the amount of $105,000 with the Company’s CEO for short term working capital advance. The note bears interest at a rate of 8% per annum and specifies no due date. This note was convertible into the shares of the Company’s common stock at $0.50/share. During the three months ended September 30, 2017, this note has been consolidated with other notes and advances from this related party. See Consolidated Note Payable to Related Party below. Payable to Related Parties Payable to related parties consisted of the followings at September 30, 2017 and December 31, 2016: | September 30, | | December 31, | ------------------------------------------------------------------+---------------+--------+--------------+-- | 2017 | | 2016 | ------------------------------------------------------------------+---------------+--------+--------------+-- Short term loan from related entity (1) | $ | 35,348 | | $ | - ------------------------------------------------------------------+---------------+--------+--------------+---+------ Short term loan from related entity (1) | | 26,636 | | | - ------------------------------------------------------------------+---------------+--------+--------------+---+------ Storage and corporate housing and auto allowances owed to CEO (2) | | 4,000 | | | 4,000 ------------------------------------------------------------------+---------------+--------+--------------+---+------ Working capital advances from CEO (3) | | - | | | - ------------------------------------------------------------------+---------------+--------+--------------+---+------ | $ | 65,984 | | $ | 4,000 ------------------------------------------------------------------+---------------+--------+--------------+---+------ (1) In March 2017 and June 2017, the Company received a working capital advance of $35,348 and $39,000, respectively, from a related entity. These advances are non-interest bearing and were intended as short term capital advances. They have been included in payable to related parties on the consolidated balance sheet as current liabilities at September 30, 2017. (2) On May 1, 2016, the Company entered into an employment agreement with its CEO. The term of the employment is through December 31, 2019. The agreement provides for a monthly storage and corporate housing allowance of $1,000 for a property owned by the CEO and a monthly automobile allowance of $1,000. During the three and nine months ended September 30, 2017, expenses related to the housing and automobile allowances totaled $6,000 and $18,000, respectively, of which $4,000 and $4,000 remained owed to the CEO at September 30, 2017 and December 31, 2016, respectively. (3) In June 2017, the Company’s CEO provided the Company with a short term working capital advance of $130,050. This amount remained outstanding at June 30, 2017. During the three months ended September 30, 2017, this balance has been consolidated with other notes and advances from this related party. See Consolidated Note Payable to Related Party below. F-7 ACACIA DIVERSIFIED HOLDINGS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 2017 (UNAUDITED) Consolidated Note Payable to Related Party During the three months ended September 30, 2017, the board of directors approved the Company to enter into a consolidated note payable agreement to consolidate notes and advances received from a related party, including accrued interests on these notes. Note Date | Note Amount | | | Accrued Interest | ---------------------------------+-------------+---------+---------+------------------+-- January 2017 | $ | 300,000 | | | $ | 16,504 ---------------------------------+-------------+---------+---------+------------------+---+-------- June 2017 | | 105,000 | | | | 2,048 ---------------------------------+-------------+---------+---------+------------------+---+-------- June 2017 | | 130,050 | | | | 2,564 ---------------------------------+-------------+---------+---------+------------------+---+-------- Total notes and accrued interest | | $ | 556,166 | ---------------------------------+-------------+---------+---------+----------------- Expenses owed to related party | | | 2,234 | ---------------------------------+-------------+---------+---------+----------------- | | | | | $ | 558,400 ---------------------------------+-------------+---------+---------+------------------+---+-------- The consolidated note payable bears interest at 8% and is due and payable on demand or first from any capital raised. The note is secured by a first lien on the assets of the Company and its subsidiaries. Other Related Party Transactions In March 2017, the Company’s board of directors approved issuance of 50,000 shares of the Company’s common stock to a director for his service in a financing transaction and the equity purchase agreement described in NOTES 6 and 7. The Company determined that 16,000 shares of the total number of shares represent non-cash debt issuance costs directly related to the convertible notes financing and the remaining 34,000 shares represent non-cash offering costs directly related to the equity purchase agreement with this investor. These shares are valued at $82,500. In May 2017, the Company and EMT entered into an agreement to purchase a parcel of land in Tennessee and an Industrial Hemp Grower License issued by the Tennessee Department of Agriculture from one of the Company’s directors. The purchase price of the transaction was 80,000 shares of the Company’s restricted common stock. These shares were valued at $1.60 per share, or $128,000, on commitment date. EMT allocated the purchase price among the assets acquired based on their fair values as follow: Land | $ | 26,194 -------------------------------+---+-------- Land preparation and cleanup | | 15,000 -------------------------------+---+-------- Industrial Hemp Grower License | | - -------------------------------+---+-------- Other considerations | | 86,806 -------------------------------+---+-------- Total Purchase Price | $ | 128,000 -------------------------------+---+-------- The Company determined the value of the land based on the purchase price paid by the director in December 2016. There has been no significant changes in the value of the land since that time. The Company estimated land preparation and cleanup costs at $15,000. The director applied for and paid a fee of $264 to obtain the license. The Company was not able to determine the value of the license since the license was granted as part of the hemp pilot program in Tennessee. The Company entered into this agreement with its director, in lieu of the state of Tennessee, as a result of the state’s residency requirement to enter into the program in Tennessee. As a result, this director is also a registered agent and a director of EMT, a Tennessee corporation. The remaining purchase price of $86,806 represented other considerations to this director for his effort in preparing the Company for operations in Tennessee. During the three months ended September 30, 2017, this director also incurred $7,760 of expenses in excavating and clearing of the land, installing driveway and calvary and completing the survey for excavation. The board of directors approved issuance of the Company’s common stock to compensate this director for his expenses at a rate of $0.50 per share for each dollar spent. As a result, the Company recorded its commitment to issue 15,520 shares of its common stock valued at $0.61 per share, for a total of $9,529. F-8 ACACIA DIVERSIFIED HOLDINGS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 2017 (UNAUDITED) NOTE 5 – INVENTORIES The Company’s inventories consisted of the followings at September 30, 2017 and December 31, 2016: | September 30, 2017 | | December 31, 2016 | ---------------+--------------------+--------+--------------------+-- Raw materials | $ | 46,880 | | $ | 52,363 ---------------+--------------------+--------+--------------------+---+------- Finished goods | | 10,591 | | | 10,722 ---------------+--------------------+--------+--------------------+---+------- | $ | 57,471 | | $ | 63,085 ---------------+--------------------+--------+--------------------+---+------- NOTE 6 – CONVERTIBLE NOTE PAYABLE In March 2017, the Company entered into a financing agreement with an investor whereby the Company will issue unsecured convertible note agreements to the investor in the aggregate principal amount of $400,000 at 10% discount. The financing will be funded in tranches, each with the issuance of a separate convertible note agreement by the Company. On March 31, 2017, the Company issued the first convertible note agreement (“first note”) in the principal amount of $100,000 at 10% discount. The first note matures on March 31, 2019 and is convertible into the Company’s common stock at a conversion price of $1.60 per share if no event of default has occurred and is converted prior to 180 days after the issuance date. If an event of default has occurred or the date of conversion is 180 days after the issuance date, the conversion price will be the lesser of $1.60 per share, or 70% of the second lowest closing bid price of the Company’s common stock for the 20 trading days immediately preceding the date of the conversion. In connection with the issuance of the first note, the Company paid $2,500 of commitment fee to the investor and $2,500 legal fees. Therefore, the Company received net proceeds of $85,000 at closing. The Company’s board of directors approved issuance of 50,000 shares of the Company’s common stock to a director for his service as a broker for the transaction. The Company determined that 16,000 shares of the total number of shares represent non-cash debt issuance costs directly related to the convertible notes financing and the remaining 34,000 shares represent non-cash offering costs directly related to the sale of the Company’s common stock to this investor (see NOTE 7). As a result, the debt discount of $10,000, commitment fee of $2,500, legal fee of $2,500, commission to a third party consultant of $5,950 and the non-cash debt issuance costs of $26,400, totaling $47,350, were recorded as a direct reduction from the carrying value of the principal amount in the consolidated balance sheet at the time of the agreement. These costs were amortized as interest expense immediately upon issuance because the first note was immediately convertible by the note holder. The principle amount of $100,000 was repaid in June 2017 together with interest expense of $5,000. As of September 30, 2017, the Company did not receive additional funding from the investor and therefore, no additional convertible note agreement was issued. NOTE 7 – STOCKHOLDERS’ EQUITY Common Stock The Company has been authorized to issue 150,000,000 shares of common stock, $.001 par value. Each share of issued and outstanding common stock shall entitle the holder thereof to fully participate in all shareholder meetings, to cast one vote on each matter with respect to which shareholders have the right to vote, and to share ratably in all dividends and other distributions declared and paid with respect to common stock, as well as in the net assets of the corporation upon liquidation or dissolution. During the nine months ended September 30, 2017, the Company issued 608,166 shares of its restricted common stock as follows: 1) | 10,000 shares to each director for services rendered for fiscal year 2016 and 10,000 shares for services to be rendered for fiscal year 2017, total 60,000 shares, valued at $99,000; ---+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 2) | 17,646 shares to a consultant for investors relations services, valued at $30,000; ---+----------------------------------------------------------------------------------- 3) | 50,000 shares to the Company’s SEC legal counsel for services performed, valued at $82,500; ---+-------------------------------------------------------------------------------------------- 4) | 10,000 shares to an employee for services performed, valued at $12,800; ---+------------------------------------------------------------------------ 5) | 110,000 shares to an investor and its affiliate as offering costs, valued at $184,800; ---+--------------------------------------------------------------------------------------- F-9 ACACIA DIVERSIFIED HOLDINGS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 2017 (UNAUDITED) 6) | 50,000 shares to a director for services rendered in the convertible note and equity purchase agreement transactions, valued at $82,500; ---+----------------------------------------------------------------------------------------------------------------------------------------- 7) | 100,000 shares issued as debt issuance cost to CEO for related party advances, valued at $182,000; ---+--------------------------------------------------------------------------------------------------- 8) | 100,000 shares issued as interest expense to CEO for related party advances, valued at $158,000; ---+------------------------------------------------------------------------------------------------- 9) | 15,000 shares to a consultant for continuing services, valued at $23,400; and ---+------------------------------------------------------------------------------ 10) | 80,000 shares to a director as other considerations and to purchase and prepare assets acquired by the Company’s subsidiary, valued at $128,000. ----+------------------------------------------------------------------------------------------------------------------------------------------------- 11) | 15,520 shares to a director for expenses incurred related to land excavation and clean up, valued at $9,529. ----+------------------------------------------------------------------------------------------------------------- Warrants and Options At September 30, 2017, 75,000 options were outstanding and no warrants were outstanding. The Company did not issue any common stock purchase warrants or options during the nine months ended September 30, 2017 and 2016. Equity Purchase Agreement In March 2017, the Company entered into an equity purchase agreement (“agreement”) with an investor whereby the investor will purchase up to $5,000,000 of the Company’s common stock over a period of 24 months from the effective date of the Company’s Registration Statement. The investor will purchase the Company’s common stock at a 10% discount. Pursuant to the agreement, the Company issued to the investor, and its affiliate, 110,000 shares of its common stock as commitment fee. These shares are valued at $184,800 at the commitment date and are recorded as deferred offering costs on the Company’s consolidated balance sheets. These costs will offset any proceeds to be received in the future from the expected sale of common stock. The Company’s board of directors approved issuance of 50,000 shares of the Company’s common stock to a director for his service as a broker of the transaction. The Company determined that 34,000 shares of the total number of shares approved for issuance represent non-cash offering costs directly related the sale of the Company’s common stock to this investor. These shares are valued at $56,100 on commitment date are recorded as deferred offering costs on the Company’s consolidated balance sheets. These costs will offset any proceeds to be received in the future from the expected sale of common stock. Restricted Stock Awards to Key Employees In March 2017, the board of directors approved issuance of 100,000 shares of the Company’s restricted common stock to each of its three key employees. As of the date of the issuance of the financial statements, only two key employees accepted the award. The award for the employees are subject to a four or five-year vesting requirements, i.e. the requisite service period. The shares are issued as the vesting restriction lapses. The Company valued these shares at fair value on commitment date which is the date on which the employee accepted the award and recorded stock based compensation expense over the requisite service period. During the nine months ended September 30, 2017, the board of directors approved issuance of 10,000 shares of the Company’s common stock to one of the key employees as the vesting requirement was met. These shares were valued at $12,800 on commitment date. Stock based compensation expense for these awards for the three and nine months ended September 30, 2017 was $17,877 and $60,501, respectively. NOTE 8 – SUBSEQUENT EVENTS In July 2017, the Company closed its retail location in the state of Colorado and retained all its inventory. The Company anticipates relocating its retail operation to Tennessee. The Company does not anticipate incurring significant costs in connection with this closure. In October, 2017, EMT entered into a lease for its retail space in Tennessee for a period of 24 months, commencing 60 days after the landlord delivers the premise to tenant. Base rent for the first 12 months is $2,500 per month and $2,550 per month for the next 12 months. NOTE 9 – RECENT ACCOUNTING PRONOUNCEMENTS Except as noted in our Form 10-K, the Company’s management does not believe that recent codified pronouncements by the Financial Accounting Standards Board (“FASB”) (including its EITF), the AICPA or the Securities and Exchange Commission will have a material impact on the Company’s current or future consolidated financial statements. F-10 Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations. Forward-Looking Information This Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) contains forward-looking statements within the meaning of the Private Litigation Reform Act of 1995 that involve known and unknown risks, significant uncertainties and other factors that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed, or implied, by those forward-looking statements. You can identify forward-looking statements by the use of the words such as “expects”, “anticipates”, “intends”, “plans”, “believes”, “seeks”, “estimates”, “may”, “will”, “should”, “could”, “predicts”, “potential”, “proposed”, or “continue” or the negative of those terms. These statements are only predictions. In evaluating these statements, you should consider various factors which may cause our actual results to differ materially from any forward-looking statements. Although we believe that the exceptions reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Therefore, actual results may differ materially and adversely from those expressed in any forward-looking statements due to numerous factors, including, but not limited to, availability of financing for operations, successful performance of operations, impact of competition and other risks detailed below as well as those discussed elsewhere in this Form 10-Q and from time to time in the Company’s Securities and Exchange Commission filings and reports. In addition, general economic and market conditions and growth rates could affect such statements. We undertake no obligation to revise or update publicly any forward-looking statements for any reason. General These unaudited interim consolidated financial statements should be read in conjunction with the annual financial statements for the Company most recently completed fiscal year ended December 31, 2016. These unaudited interim consolidated financial statements do not include all disclosures required in annual financial statements, but rather are prepared in accordance with recommendations for interim financial statements in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”). These unaudited interim consolidated financial statements have been prepared using the same accounting policies and methods as those used by the Company in the annual audited financial statements for the year ended December 31, 2016. Discussion on the Company’s Operations and Recent Event MariJ Pharmaceuticals, Inc. MariJ Pharma has a mobile CO2, supercritical extraction unit which was USDA certified Organic on September 28th, 2016, by OneCert , under the US National Organic Program; 7 CFR PART 205. MariJ Pharma extracts and processes very high quality, high-cannabinoid profile content medical grade cannabis oils from medicinal cannabis plants. As such, MariJ Pharma is authorized to process directly for certified organic farms and is able to produce certified organic cannabis oils. The Company intends to acquire, through its MariJ Pharma subsidiary, portions or complete ownership of licenses and grow operations in one or more states and seeking to cultivate, organically extract and process its medicinal cannabis crops year round in indoor facilities. The acquisition of these licenses is anticipated to provide the Company with the opportunity to compound medicinal products using mixtures of high cannabinoid profile oils that have very little hallucinogenic properties but have significantly improved medicinal properties. In addition, MariJ Pharma has the technical expertise and capability to process and formulate the oils and to employ them in its compounding operations. MariJ Pharma will seek to become engaged as owner or co-owner of a grow facility in Florida or other location(s) such as to produce its own plants for processing. MariJ Pharma has also been preparing for its newly-developed, proprietary GeoTraking Technology that is fully compliant with the Health Insurance Portability and Accountability standard (“HIPAA”) utilizing its “plant to patient ” solution. This GeoTraking Technology is designed to provide a full-channel patient care tracking system that is fully compliant under today’s strict HIPAA regulations that require privacy and security of the patients’ information. Beginning with RFID labeling and tracking of every single seed employed in the grow program and continuing through the sale of prescription products in a sophisticated retail Point of Sale delivery system, the GeoTraking Technology will be one of the most advanced system available. The Company’s primary source of revenue is from the extraction of medicinal cannabis oil, from a non-psychoactive cannabis plant. 1 All extraction services are currently limited to the State of Colorado, as the Company is attempting to attain various licenses for business in the State of Florida. It is anticipated that MariJ Pharma could generate revenues from the following activities: 1) | Cannabis oil extraction and processing - MariJ Pharma has a unique mobile cannabis oil processing and extraction unit designed into a heavy-duty truck chassis. The unit has already begun performing extractions and processing of medical hemp oils at various sites in Colorado, and MariJ Pharma is currently developing additional contracts for services. ---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 2) | Wholesale sale of raw and processed medical cannabis oils. ---+----------------------------------------------------------- 3) | Laboratory testing and certification services – As the demand for these services grows in the medical cannabis industry, MariJ Pharma is uniquely positioned to fulfill the growing demand for these services by utilizing its existing mobile laboratory and testing unit built on a heavy-duty truck chassis. ---+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4) | Licensing and support of the Company’s GeoTraking Technology systems. ---+---------------------------------------------------------------------- 5) | Processing and compounding services for medical grade cannabis oils. ---+--------------------------------------------------------------------- The Company is preparing to seek additional investments and financing to pay the costs of constructing its second mobile oil extraction and processing unit, to finance final construction of its mobile laboratory and testing unit for the same industry, and to complete the roll-out of its GeoTraking Technology system. However, there can be no assurance that the Company will be successful in its plans to generate the required capital. Canna-Cures Research and Development Center, Inc. In August 2016, Canna-Cures began engaging in product development activities as well as retail distribution of medicinal Hemp products in Colorado. In July 2017, Canna-Cures closed its retail operations in Colorado and retained all its inventory as the Company begins to focus its developmental activities in Tennessee. Eufloria Medical of Tennessee, Inc. In addition to our current extraction operations in the State of Colorado, the Company has been invited to be part of the hemp pilot program in Tennessee. This program provides the Company the license to grow, manufacture, and dispense USDA organic hemp oil in Tennessee and represents the first step in moving its operations to the east coast of the United States. The Company plans on participating in this pilot program through this new, wholly-owned subsidiary. The Company also acquired land in Tennessee and has completed excavation and other cleanup activities to prepare the land for its intended use. EMT will seek to align itself with institutions of higher learning in working to develop new products and to identify and develop additional uses for its medical cannabis products. It is anticipated that EMT could generate revenues from the following activities: 1) | EMT will seek to enter into product development projects with institutions of higher learning in efforts to develop new and better strains of medical cannabis related products for dispensing as medications, nutraceuticals, cosmeceuticals, and probably dietary supplements. EMT anticipates participating in state and federal grants in conjunction with one or more universities as a means to defray part of its costs in these efforts. ---+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 2) | Private label packaging services - the Company has obtained a majority of the equipment required to engage in the business of packaging and labeling of medical cannabis oils, oil-infused products, and related items. ---+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 3) | Retail sales of medical cannabis oils, oil-infused products, and other merchandise through its web-based portal or retail dispensaries planned for that purpose. These activities are dependent in large part upon meeting FDA regulations and criteria relating to the sale and distribution of cannabis-infused products, and the Company is currently in the process of determining the status of those criteria. ---+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4) | Retail and wholesale sales of cosmeceutical and nutraceutical products and dietary supplements containing its high-quality cannabis oil extracts, subject to compliance with FDA and other regulations. ---+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 5) | Growing high quality cannabis plants and extracting oil for sale or for manufacturing of oil-infused products. ---+--------------------------------------------------------------------------------------------------------------- The Company will require additional capital to execute these plans and there can be no assurance that the Company will be successful in its plans to generate that capital. 2 Operating results for the three months ended September 30, 2017 and 2016: For the three months ended September 30, 2017, the Company generated revenues of $63,772 from operations, compared to $9,726 for the three months ended September 30, 2016, an increase of $54,046 or 556%. Revenues from 2016 were from the sales of the Company’s retail store in Colorado which opened in the third quarter of 2016. Revenues from 2017 were primarily from extraction services performed. For the three months ended September 30, 2017, costs of goods sold was $18,997, compared to $47,251 for the three months ended September 30, 2016, a decrease of $28,254, or 60%. The decrease in our costs is primarily related to the non-recognition and reversal of non-cash stock based compensation expense from a unvested restricted stock award granted to our extraction technician. In addition, salary expense for extraction technicians also decreased due to completion of an extraction services contract during the three months ended September 30, 2017. As a result of the changes in revenues and costs of goods sold discussed above, the Company’s gross profit increased from a loss of $37,525 for the three months ended September 30, 2016 to $44,775, or 70% of revenues for the three months ended September 30, 2017. For the three months ended September 30, 2017, selling, general and administrative expenses were $186,328, compared to $325,711 during the three months ended September 30, 2016, a decrease of $139,383, or 43%. The decrease in these expenses are attributable to (1) a decrease in employee compensation expenses due to higher executive compensation in prior period and the closing of our Colorado retail operation, and (2) a decrease in general administrative expenses primarily due to fewer legal activities during the current period. During the three months ended September 30, 2017, the Company incurred interest expense of $13,178, compared to $10 for the three months ended September 30, 2016. During the current period, the Company accrued $13,178 of interest expense on the notes payable to related party. There were no such liabilities existed at September 30, 2016. As a result of the changes in revenues, costs and expenses, the Company incurred a net loss of $154,218 for the three months ended September 30, 2017, compared to a net loss of $363,106 for the three months ended September 30, 2016. The future trends of all expenses are expected to be primarily driven by the Company’s ability to execute its business plans and the future outcome of its application to obtain operating licenses in other states. As the cannabis industry grows, additional expenses are anticipated to be incurred in complying with various state and federal regulatory requirements. The Company’s ability to continue to fund operating expenses will depend on its ability to raise additional capital. There can be no assurance that the Company will be successful in doing so. Operating results for the nine months ended September 30, 2017 and 2016: For the nine months ended September 30, 2017, the Company generated revenues of $344,133 from operations, compared to $235,092 for the nine months ended September 30, an increase of $109,041 or 46%. The increase in revenues is primarily attributable to the increase in processing and revenues generated from its retail store operations in Colorado. For the nine months ended September 30, 2017, costs of goods sold was $183,738, compared to $160,315 for the nine months ended September 30, 2016, an increase of $23,423, or 15%. The increase in our costs is primarily related to production based bonuses, recognition of non-cash stock based compensation expense from a restricted stock award granted to our extraction technician and costs of goods sold in our retail store in Colorado. As a result of the changes in revenues and costs of goods sold discussed above, the Company’s gross profit increased from $74,777 for the nine months ended September 30, 2016 to $160,395, or 47% of revenues for the nine months ended September 30, 2017. For the nine months ended September 30, 2017, selling, general and administrative expenses were $1,114,883, compared to $960,369 during the nine months ended September 30, 2016, an increase of $154,514, or 16%. The increase in these expenses are attributable to (1) an increase in employee compensation expenses in Canna-Cures which did not begin operations until third quarter of 2016, the hiring of additional administrative staff, stock based compensation to employee, and accrual of bonuses for current management, and (2) an increase in general administrative expenses primarily due to stock based compensation to board of directors, third party vendors and outside counsel, and increase in professional fees. 3 During the nine months ended September 30, 2017, the Company incurred interest expense of $416,311, compared to $48 for the nine months ended September 30, 2016. During the current period, the Company paid interest in the amount of $5,000 to the convertible note holder, accrued $23,961 of interest expense on the notes payable to related party, issued common stock valued at $366,400 as interest to a related party for working capital advances and as debt issuance costs related to the issuance of the convertible note payable and $20,950 as cash debt discount. There were no such liabilities existed at September 30, 2016. As a result of the changes in revenues, costs and expenses, the Company incurred a net loss of $1,373,536 for the nine months ended September 30, 2017, compared to a net loss of $928,487 for the nine months ended September 30, 2016. The future trends of all expenses are expected to be primarily driven by the Company’s ability to execute its business plans and the future outcome of its application to obtain operating licenses in other states. As the cannabis industry grows, additional expenses are anticipated to be incurred in complying with various state and federal regulatory requirements. The Company’s ability to continue to fund operating expenses will depend on its ability to raise additional capital. There can be no assurance that the Company will be successful in doing so. Liquidity and Capital Resources The Company’s cash position at September 30, 2017 decreased by $6,995 to $36,883, as compared to a balance of $43,878, as of December 31, 2016. The net decrease in cash for the nine months ended September 30, 2017 was attributable to net cash used in operating activities of $492,849, net cash used in investing activities of $6,196, offset by net cash provided by financing activities of $492,050. As of September 30, 2017, the Company had negative working capital of $759,684 compared to negative working capital of $191,435, at December 31, 2016, a decrease of $568,249, attributable primarily to issuance of notes payable to its CEO and amounts owed to related parties for working capital advances. Net cash used in operating activities of $492,849 during the nine months ended September 30, 2017, was lower compared to the prior period of $739,264, primarily due to higher net loss, offset by (i) non-cash items such as common stock issued for services and interest and amortization of debt discount and (ii) changes in operating assets and liabilities, including an increase in payable to related parties. Net cash used in investing activities of $6,196 for the nine months ended September 30, 2017 was lower compared to $35,414 for the nine months ended September 30, 2016. This is primarily due to purchases of extraction equipment in the prior period as the Company began to provide extraction services for its customer. Net cash provided by financing activities of $492,050 during the nine months ended September 30, 2017 decreased by $198,954 compared to $691,004 during the nine months ended September 30, 2016. The decrease in net cash provided by financing activities was primarily attributable to a reduction in net proceeds from the reverse acquisition. During the nine months ended September 30, 2017, the Company also issued 41,266 shares of its common stock to acquire, prepare, and cleanup a parcel of land from one of its directors. These shares are valued at $50,723. The Company also issued 144,000 shares of its common stock as costs directly related to entering into the equity purchase agreement with an investor. These shares were valued at $240,900. In addition, accrued interest on notes payable to related party of $21,117, accrued expense of $2,234 and related party advances of $130,050, totaling $153,400 was consolidated with existing notes payable to related party of $405,000, into one single note payable to related party of $558,000. During the three months ended September 30, 2017, the board of directors approved the Company to enter into a consolidated note payable agreement to consolidate notes and advances received from a related party, including accrued interests on these notes. Note Date | Note Amount | | | Accrued Interest | ---------------------------------+-------------+---------+---------+------------------+-- January 2017 | $ | 300,000 | | | $ | 16,504 ---------------------------------+-------------+---------+---------+------------------+---+-------- June 2017 | | 105,000 | | | | 2,048 ---------------------------------+-------------+---------+---------+------------------+---+-------- June 2017 | | 130,050 | | | | 2,564 ---------------------------------+-------------+---------+---------+------------------+---+-------- Total notes and accrued interest | | $ | 556,166 | ---------------------------------+-------------+---------+---------+----------------- Expenses owed to related party | | | 2,234 | ---------------------------------+-------------+---------+---------+----------------- | | | | | $ | 558,400 ---------------------------------+-------------+---------+---------+------------------+---+-------- The consolidated note payable bears interest at 8% and is due and payable on demand or first from any capital raised. The note is secured by a first lien on the assets of the Company and its subsidiaries. 4 As reported in the accompanying consolidated financial statements, for the nine months ended September 30, 2017 and 2016, the Company incurred net losses of $1,373,536 and $928,487, respectively. The Company did not produce significant revenues in the periods presented and has sustained operating losses since inception. The Company’s ability to continue as a going concern is dependent upon its ability to raise additional capital, obtain licenses to commence operations in states outside of Colorado and achieve a level of profitability. Until recently where the Company obtained working capital from convertible notes financing and equity purchase agreement with an outside investor, the Company has financed its activities principally from working capital advances from related parties and issuing notes payable to its CEO since inception. It intends to finance its future operating activities and its working capital needs largely from proceeds from the convertible notes agreement, the sale of equity securities, combined with additional funding from its CEO. The sale of equity and convertible notes financing agreements may result in dilution to stockholders and those securities may have rights senior to those of common shares. If the Company raises additional funds through the issuance of convertible notes or other debt financing, these activities or other debt could contain covenants that would restrict the Company’s operations. Any other third-party funding arrangements could require the Company to relinquish valuable rights. The Company will require additional capital beyond its currently anticipated needs. Additional capital, if available, may not be available on reasonable terms or at all. The Company has not generated significant revenue to date, and will not generate significant revenue in the foreseeable future. The Company expects to continue to incur operating losses as it proceeds with its pursuit of operating licenses in various states. The future trends of all expenses are expected to be primarily driven by the Company’s ability to execute its business plans and the future outcome of its application to obtain operating licenses in other states. As the cannabis industry grows, additional expenses are anticipated to be incurred in complying with various regulatory requirements. The Company’s ability to continue to fund operating expenses will depend on its ability to raise additional capital. There can be no assurance that the Company will be successful in doing so. Financial Condition The Company’s total assets at September 30, 2017 and December 31, 2016 were $919,621 and $684,783, respectively, an increase of $234,838. Total liabilities at September 30, 2017 and December 31, 2016 were $962,674 and $394,530, respectively, an increase of $568,144. The significant change in the Company’s financial condition is attributable to (i) issuance of note payable to a related party, (ii) increase in working capital advances from related parties, (iii) payment of accrued expenses of $43,907, and (iv) incurring deferred offering cost of $240,900. As a result of these transactions, the Company’s cash position decreased from $43,878 to $36,883 during the nine months ended September 30, 2017. Off-Balance Sheet Arrangements We have made no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors. Item 3. Quantitative and Qualitative Disclosures About Market Risk. We are a Smaller Reporting Company as defined by Rule 12b-2 of the Securities Exchange Act of 1934 and are not required to provide the information under this item. Item 4. Controls and Procedures Disclosure Controls and Procedures The Company’s Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of September 30, 2017. Based upon such evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of September 30, 2017, the Company’s disclosure controls and procedures were not effective. The controls were determined to be ineffective due to the lack of segregation of duties. In January 2017, the Company hired a part-time financial controller to assist with technical accounting issues and the preparation of the filings. However, until the Company begins generating sufficient revenues, it is unable to remediate the weakness. Despite the existence of material weaknesses, management believes the financial information presented herein is materially correct and fairly presents the financial position and operating results of the three months ended September 30, 2017, in accordance with U.S. GAAP. Changes in Internal Control Over Financial Reporting No change in the Company’s internal control over financial reporting occurred during the three months ended September 30, 2017, that materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. 5 PART II. OTHER INFORMATION Item 1. Legal Proceedings. None. Item 1A. Risk Factors The Company is a Smaller Reporting Company as defined by Rule 12b-2 of the Securities Exchange Act of 1934 and is not required to provide the information under this item. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds. During the nine months ended September 30, 2017, the Company issued 608,166 shares of its restricted common stock as follows: 1) | 10,000 shares to each director for services rendered for fiscal year 2016 and 10,000 shares for services to be rendered for fiscal year 2017, total 60,000 shares, valued at $99,000; ---+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 2) | 17,646 shares to a consultant for investors relations services, valued at $30,000; ---+----------------------------------------------------------------------------------- 3) | 50,000 shares to the Company’s SEC legal counsel for services performed, valued at $82,500; ---+-------------------------------------------------------------------------------------------- 4) | 10,000 shares to an employee for services performed, valued at $12,800; ---+------------------------------------------------------------------------ 5) | 110,000 shares to an investor and its affiliate as offering costs, valued at $184,800; ---+--------------------------------------------------------------------------------------- 6) | 50,000 shares to a director for services rendered in the convertible note and equity purchase agreement transactions, valued at $82,500; ---+----------------------------------------------------------------------------------------------------------------------------------------- 7) | 100,000 shares issued as debt issuance cost to CEO for related party advances, valued at $182,000; ---+--------------------------------------------------------------------------------------------------- 8) | 100,000 shares issued as interest expense to CEO for related party advances, valued at $158,000; ---+------------------------------------------------------------------------------------------------- 9) | 15,000 shares to a consultant for continuing services, valued at $23,400; and ---+------------------------------------------------------------------------------ 10) | 80,000 shares to a director as other considerations and to purchase and prepare assets acquired by the Company’s subsidiary, valued at $128,000. ----+------------------------------------------------------------------------------------------------------------------------------------------------- 11) | 15,520 shares to a director for expenses incurred related to land excavation and clean up, valued at $9,529. ----+------------------------------------------------------------------------------------------------------------- The shares of our common stock were issued pursuant to an exemption from registration in Section 4(a)(2) of the Securities Act of 1933. These shares of our common stock qualified for exemption under Section 4(a)(2) of the Securities Act of 1933 since the issuance of shares by us did not involve a public offering. The offering was not a “public offering” as defined in Section 4(a)(2) due to the insubstantial number of persons involved in the deal, size of the offering, manner of the offering and number of shares offered. We did not undertake an offering in which we sold a high number of shares to a high number of investors. In addition, these shareholders had necessary investment intent as required by Section 4(a)(2) since they agreed to receive share certificates bearing a legend stating that such shares are restricted pursuant to Rule 144 of the 1933 Act. This restriction ensures that these shares would not be immediately redistributed into the market and therefore not be part of a “public offering.” All shareholders are “sophisticated investors” and are business acquaintances of our officers and directors. Based on an analysis of the above factors, we believe we have met the requirements to qualify for exemption under section 4(a)(2) of the Securities Act of 1933 for this transaction. Item 3. Defaults Upon Senior Securities None. Item 4. Mine Safety Disclosures Not applicable. Item 5. Other Information. None. 6 Item 6. Exhibits Exhibits required by Item 601, Regulation S-K; Exhibit Number and Description | | Location Reference -------------------------------+---------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | (3.0) | Articles of Incorporation | | -------------------------------+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------+---------------- | | (3.1) | Articles Of Amendment And Restated Articles Of Incorporation of Acacia Diversified Holdings, Inc. dated June 9, 2015 | | See Exhibit Key -------------------------------+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------+-----------------+---------------- | | (3.2) | Restated Bylaws Of Acacia Diversified Holdings, Inc. dated June 29, 2015 | | See Exhibit Key -------------------------------+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------+-----------------+---------------- | (9.0) | Voting Proxy Agreement between Rick Pertile and Steven L. Sample | | See Exhibit Key -------------------------------+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------+---------------- | (10.1) | Consolidated Loan Agreement | | See Exhibit Key -------------------------------+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------+---------------- | (10.2) | Consolidated Promissory Note | | See Exhibit Key -------------------------------+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------+---------------- | (10.3) | Security Agreement – Acacia Diversified Holdings, Inc. | | See Exhibit Key -------------------------------+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------+---------------- | (10.4) | Security Agreement -- Marij Agriculture, Inc. | | See Exhibit Key -------------------------------+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------+---------------- | (10.5) | Security Agreement – Marij Pharmaceuticals, Inc. | | See Exhibit Key -------------------------------+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------+---------------- | (10.6) | Security Agreement – CannaCures Research & Development Center, Inc. | | See Exhibit Key -------------------------------+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------+---------------- | (14.0) | Code of Ethics | | Filed herewith -------------------------------+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------+---------------- | (21.0) | List of Subsidiaries | | See Exhibit Key -------------------------------+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------+---------------- | (31.1) | Certificate of Chief Executive Officer And Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | | Filed herewith -------------------------------+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------+---------------- | (32.1) | Certification of Chief Executive Officer And Chief Financial Officer Pursuant to 18 U.S.C. § 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | | Filed herewith -------------------------------+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------+---------------- | 101.INS | XBRL Instance Document | | -------------------------------+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------+---------------- | 101.SCH | XBRL Taxonomy Extension Schema Document | | -------------------------------+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------+---------------- | 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document | | -------------------------------+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------+---------------- | 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document | | -------------------------------+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------+---------------- | 101.LAB | XBRL Taxonomy Extension Label Linkbase Document | | -------------------------------+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------+---------------- | 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document | | -------------------------------+---------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------------------------------------------------------------------------------------------+---------------- Exhibit Key 3.1 Incorporated by reference herein from the Company’s Form 8-K filed on July 16, 2015. 3.2 Incorporated by reference herein from the Company’s Form 8-K filed on July 16, 2015. 9.0 Incorporated by reference herein from the Company’s Form 10-K filed on March 28, 2017. 10.1 Incorporated by reference herein from the Company’s Form 8-K filed on November 3, 2017. 10.2 Incorporated by reference herein from the Company’s Form 8-K filed on November 3, 2017. 10.3 Incorporated by reference herein from the Company’s Form 8-K filed on November 3, 2017. 10.4 Incorporated by reference herein from the Company’s Form 8-K filed on November 3, 2017. 10.5 Incorporated by reference herein from the Company’s Form 8-K filed on November 3, 2017. 10.6 Incorporated by reference herein from the Company’s Form 8-K filed on November 3, 2017. 21.0 Incorporated by reference herein from the Company’s Form 10-Q filed on August 7, 2017. 7 SIGNATURES Pursuant to the requirements of the Securities exchange Act of 1934, registrant has duly caused this report to be signed on its behalf by the undersigned. | Acacia Diversified Holdings, Inc. | ------------------------+-----------------------------------+-------------------------------------------------------- Date: November 13, 2017 | By: | /s/ Richard K. Pertile ------------------------+-----------------------------------+-------------------------------------------------------- | | Richard K. Pertile ------------------------+-----------------------------------+-------------------------------------------------------- | | Chief Executive Officer, Principal Executive Officer ------------------------+-----------------------------------+-------------------------------------------------------- | | Chief Financial Officer and Principal Financial Officer ------------------------+-----------------------------------+-------------------------------------------------------- 8

Acer Therapeutics Inc.

1069308

10-Q

0001654954-17-010486

Blueprint UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) ☑ | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 --+---------------------------------------------------------------------------------------- | For the Quarterly Period Ended September 30, 2017 --+---------------------------------------------------------------------------------------- or ☐ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 --+----------------------------------------------------------------------------------------- | For the Transition Period from to --+----------------------------------------------------------------------------------------- Commission File Number: 001-33004 Acer Therapeutics Inc. (Exact name of registrant as specified in its charter) Texas | 222 Third Street, Suite #2240 | 76-0333165 --------------------------------+---------------------------------+-------------------- (State or other jurisdiction of | Cambridge, Massachusetts 02142 | (I.R.S. Employer --------------------------------+---------------------------------+-------------------- Incorporation or organization) | (Address of principal executive | Identification No.) --------------------------------+---------------------------------+-------------------- | offices and zip code) | --------------------------------+---------------------------------+-------------------- (844) 902-6100 Registrant’s telephone number, including area code Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes ☑ No ☐ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). ☑ Yes ☐ No Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer”, “smaller reporting company”, and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large accelerated filer ☐ | | Accelerated filer ☐ -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+----------------------- Non-accelerated filer ☐ (Do not check if a smaller reporting company) | Smaller reporting company ☑ -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------ Emerging growth company ☐ | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------------------------------ If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☑ ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ As of November 1, 2017, there were 6,450,766 shares of the issuer’s Common Stock outstanding. ACER THERAPEUTICS INC. For the nine months ended September 30, 2017 INDEX PART I – FINANCIAL INFORMATION | Page -------------------------------+--------------------------------------------------------------------------------------------------------------------------- Item 1. | Financial Statements | 1 -------------------------------+----------------------------------------------------------------------------------------------------------------------------+--- | Condensed Consolidated Balance Sheets as of September 30, 2017 and December 31, 2016 | 1 -------------------------------+----------------------------------------------------------------------------------------------------------------------------+--- | Unaudited Condensed Consolidated Statements of Operations: For the three and nine months ended September 30, 2017 and 2016 | 2 -------------------------------+----------------------------------------------------------------------------------------------------------------------------+--- | Unaudited Condensed Consolidated Statements of Cash Flows: For the nine months ended September 30, 2017 and 2016 | 3 -------------------------------+----------------------------------------------------------------------------------------------------------------------------+--- | Notes to Unaudited Condensed Consolidated Financial Statements | 4 -------------------------------+----------------------------------------------------------------------------------------------------------------------------+--- Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations | 12 -------------------------------+----------------------------------------------------------------------------------------------------------------------------+--- Item 3. | Quantitative and Qualitative Disclosures About Market Risk | 19 -------------------------------+----------------------------------------------------------------------------------------------------------------------------+--- Item 4. | Controls and Procedures | 19 -------------------------------+----------------------------------------------------------------------------------------------------------------------------+--- PART II – OTHER INFORMATION | -------------------------------+--------------------------------------------------------------------------------------------------------------------------- Item 1. | Legal Proceedings | 20 -------------------------------+----------------------------------------------------------------------------------------------------------------------------+--- Item 1A. | Risk Factors | 20 -------------------------------+----------------------------------------------------------------------------------------------------------------------------+--- Item 6. | Exhibits | 59 -------------------------------+----------------------------------------------------------------------------------------------------------------------------+--- Signatures | | 60 -------------------------------+----------------------------------------------------------------------------------------------------------------------------+--- PART I - FINANCIAL INFORMATION Item 1. Financial Statements. ACER THERAPEUTICS INC. CONDENSED CONSOLIDATED BALANCE SHEETS | September 30, | December 31, -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+------------- | 2017 | 2016 -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+------------- Assets | (unaudited) | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+------------- Current assets: | | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+------------- Cash and cash equivalents | $8,404,332 | $1,834,018 -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+------------- Prepaid expenses | 836,756 | 540,053 -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+------------- Total current assets | 9,241,088 | 2,374,071 -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+------------- Property and equipment, net | 5,062 | 6,217 -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+------------- Other assets: | | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+------------- Goodwill | 7,647,266 | 272,315 -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+------------- In-process research and development | 118,600 | 118,600 -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+------------- Deferred financing costs | — | 1,901 -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+------------- Total assets | $17,012,016 | $2,773,104 -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+------------- Liabilities, Redeemable Preferred Stock and Stockholders’ Equity (Deficit) | | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+------------- Current liabilities: | | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+------------- Accounts payable | $539,440 | $383,411 -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+------------- Accrued expenses | 1,711,300 | 438,028 -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+------------- Total liabilities | 2,250,740 | 821,439 -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+------------- Commitments | | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+------------- Series B Convertible Redeemable Preferred stock, $0.0001 par value; none and 970,238 shares authorized, issued and outstanding at September 30, 2017 and December 31, 2016, respectively | — | 8,022,219 -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+------------- Series A Convertible Redeemable Preferred stock, $0.0001 par value; none and 638,416 shares authorized, issued and outstanding at September 30, 2017 and December 31, 2016, respectively | — | 4,114,221 -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+------------- Convertible Redeemable Preferred stock | — | 12,136,440 -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+------------- Stockholders’ equity (deficit): | | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+------------- Preferred stock, no par value; authorized 10,000,000 shares; none issued and outstanding | — | — -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+------------- Common stock, $0.01 par value; authorized 150,000,000 shares; 6,450,766 and 2,450,000 shares issued and outstanding at September 30, 2017 and December 31, 2016, respectively | 645 | 246 -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+------------- Additional paid-in capital | 36,098,222 | 1,172,200 -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+------------- Accumulated deficit | (21,337,591) | (11,357,221) -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+------------- Total stockholders’ equity (deficit) | 14,761,276 | (10,184,775) -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+------------- Total liabilities, redeemable preferred stock and stockholders’ equity (deficit) | $17,012,016 | $2,773,104 -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+------------- See notes to unaudited condensed consolidated financial statements. 1 ACER THERAPEUTICS INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2017 AND 2016 (Unaudited) | Three Months Ended September 30, | Nine Months Ended September 30, ---------------------------------------------------------------+-----------------------------------+-------------------------------- | 2017 | 2016 | 2017 | 2016 ---------------------------------------------------------------+-----------------------------------+---------------------------------+--------------+------------- Operating expenses: | | | | ---------------------------------------------------------------+-----------------------------------+---------------------------------+--------------+------------- Research and development | $2,057,421 | $1,610,822 | $6,948,816 | $3,510,118 ---------------------------------------------------------------+-----------------------------------+---------------------------------+--------------+------------- General and administrative | 1,302,401 | 274,512 | 2,792,424 | 1,054,479 ---------------------------------------------------------------+-----------------------------------+---------------------------------+--------------+------------- Loss from operations | 3,359,822 | 1,885,334 | 9,741,240 | 4,564,597 ---------------------------------------------------------------+-----------------------------------+---------------------------------+--------------+------------- Other income (expense): | | | | ---------------------------------------------------------------+-----------------------------------+---------------------------------+--------------+------------- Interest income | 2,993 | 136 | 4,819 | 174 ---------------------------------------------------------------+-----------------------------------+---------------------------------+--------------+------------- Interest expense | (120,229) | — | (242,982) | — ---------------------------------------------------------------+-----------------------------------+---------------------------------+--------------+------------- Loss on disposal of asset | (967) | — | (967) | — ---------------------------------------------------------------+-----------------------------------+---------------------------------+--------------+------------- Total other income (expense), net | (118,203) | 136 | (239,130) | 174 ---------------------------------------------------------------+-----------------------------------+---------------------------------+--------------+------------- Net loss | $(3,478,025) | $(1,885,198) | $(9,980,370) | $(4,564,423) ---------------------------------------------------------------+-----------------------------------+---------------------------------+--------------+------------- Net loss per share - basic and diluted | $(1.09) | $(0.77) | $(3.69) | $(1.86) ---------------------------------------------------------------+-----------------------------------+---------------------------------+--------------+------------- Weighted average common shares outstanding - basic and diluted | 3,199,796 | 2,450,000 | 2,702,678 | 2,450,000 ---------------------------------------------------------------+-----------------------------------+---------------------------------+--------------+------------- See notes to unaudited condensed consolidated financial statements. 2 ACER THERAPEUTICS INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2017 AND 2016 (Unaudited) | Nine Months Ended -------------------------------------------------------------------------------+------------------ | September 30, -------------------------------------------------------------------------------+------------------ | 2017 | 2016 -------------------------------------------------------------------------------+-------------------+------------- Cash flows from operating activities: | | -------------------------------------------------------------------------------+-------------------+------------- Net loss. | $(9,980,370) | $(4,564,423) -------------------------------------------------------------------------------+-------------------+------------- Adjustments to reconcile net loss to net cash used in operating activities: | | -------------------------------------------------------------------------------+-------------------+------------- Non-cash interest expense | 242,982 | — -------------------------------------------------------------------------------+-------------------+------------- Share-based compensation | 136,617 | 39,031 -------------------------------------------------------------------------------+-------------------+------------- Depreciation | 2,711 | 2,627 -------------------------------------------------------------------------------+-------------------+------------- Loss on disposal of asset | 967 | — -------------------------------------------------------------------------------+-------------------+------------- Write-off of deferred financing costs | 1,901 | 69,896 -------------------------------------------------------------------------------+-------------------+------------- Changes in operating assets and liabilities | | -------------------------------------------------------------------------------+-------------------+------------- Prepaid expenses | (291,703) | (36,902) -------------------------------------------------------------------------------+-------------------+------------- Accounts payable | 156,029 | (60,803) -------------------------------------------------------------------------------+-------------------+------------- Accrued expenses | (157,890) | (23,591) -------------------------------------------------------------------------------+-------------------+------------- Net cash used in operating activities | (9,888,756) | (4,574,165) -------------------------------------------------------------------------------+-------------------+------------- Cash flows from investing activities: | | -------------------------------------------------------------------------------+-------------------+------------- Cash acquired in Merger, net of payment in lieu of fractional shares | 1,030,123 | — -------------------------------------------------------------------------------+-------------------+------------- Purchase of property and equipment | (2,523) | (1,582) -------------------------------------------------------------------------------+-------------------+------------- Net cash provided by (used in) investing activities | 1,027,600 | (1,582) -------------------------------------------------------------------------------+-------------------+------------- Cash flows from financing activities: | | -------------------------------------------------------------------------------+-------------------+------------- Proceeds from issuance of common stock | 10,000,000 | — -------------------------------------------------------------------------------+-------------------+------------- Proceeds from issues of Preferred Series B, net | — | 7,994,834 -------------------------------------------------------------------------------+-------------------+------------- Deferred financing costs | (68,530) | — -------------------------------------------------------------------------------+-------------------+------------- Proceeds from convertible notes payable | 5,500,000 | — -------------------------------------------------------------------------------+-------------------+------------- Net cash provided by financing activities | 15,431,470 | 7,994,834 -------------------------------------------------------------------------------+-------------------+------------- Net increase in cash and cash equivalents | 6,570,314 | 3,419,087 -------------------------------------------------------------------------------+-------------------+------------- Cash and cash equivalents, beginning of period | 1,834,018 | 798,545 -------------------------------------------------------------------------------+-------------------+------------- Cash and cash equivalents, end of period | $8,404,332 | $4,217,632 -------------------------------------------------------------------------------+-------------------+------------- Supplemental non-cash financing transactions: | | -------------------------------------------------------------------------------+-------------------+------------- Accretion of issuance costs on Series A Convertible Redeemable Preferred stock | $51,943 | $11,130 -------------------------------------------------------------------------------+-------------------+------------- Accretion of issuance costs on Series B Convertible Redeemable Preferred stock | $127,780 | — -------------------------------------------------------------------------------+-------------------+------------- Conversion of Series A Convertible Redeemable Preferred stock to common stock | $4,166,164 | — -------------------------------------------------------------------------------+-------------------+------------- Conversion of Series B Convertible Redeemable Preferred stock to common stock | $8,149,995 | — -------------------------------------------------------------------------------+-------------------+------------- Conversion of convertible notes payable and accrued interest to common stock | $5,674,452 | — -------------------------------------------------------------------------------+-------------------+------------- Issuance of common stock in Merger (Note 1) | $6,978,916 | — -------------------------------------------------------------------------------+-------------------+------------- See notes to unaudited condensed consolidated financial statements. 3 ACER THERAPEUTICS INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2017 AND 2016 (Unaudited) 1. NATURE OF OPERATIONS AND BASIS OF PRESENTATION Business Acer Therapeutics Inc. (“Acer”) is a pharmaceutical company focused on the acquisition, development and commercialization of therapies for patients with serious rare and ultra-rare diseases with critical unmet medical need. Acer’s late-stage clinical pipeline includes two candidates for severe genetic disorders for which there are few or no FDA-approved treatments: EDSIVO™ (celiprolol) for vascular Ehlers-Danlos Syndrome (“vEDS”), and ACER-001 (a fully taste-masked, immediate release formulation of sodium phenylbutyrate) for urea cycle disorders (“UCD”) and Maple Syrup Urine Disease (“MSUD”). There are no FDA-approved drugs for vEDS and MSUD and limited options for UCD, which collectively impact more than 4,000 patients in the United States. Acer’s products have clinical proof-of-concept and mechanistic differentiation, and Acer intends to seek approval for them in the U.S. by using the regulatory pathway established under section 505(b)(2) of the Federal Food, Drug, and Cosmetic Act, or FFDCA, that allows an applicant to rely for approval at least in part on third-party data, which is expected to expedite the preparation, submission, and approval of a marketing application. Since its inception, Acer has devoted substantially all of its efforts to business planning, research and development, recruiting management and technical staff, acquiring operating assets and raising capital. The accompanying condensed consolidated financial statements for periods prior to August 2016 include the accounts of Acer and its wholly-owned subsidiaries, Acer Therapeutics Inc., a Delaware corporation, and Anchor Therapeutics, Inc. (“Anchor”) (collectively referred to as the “Company”). All intercompany balances and transactions are eliminated. See Merger and Reverse Stock Split section below. The Company is subject to a number of risks similar to other companies in its industry including rapid technological change, uncertainty of market acceptance of products, competition from larger companies with substitute products, availability of future financing and dependence on key personnel. Merger and Reverse Stock Split On September 19, 2017, Acer Therapeutics Inc., a Texas corporation, formerly known as Opexa Therapeutics, Inc. (the “Registrant”), completed its business combination with what was then known as “Acer Therapeutics Inc.,” a Delaware corporation (“Private Acer”), in accordance with the terms of the Agreement and Plan of Merger and Reorganization, dated as of June 30, 2017, by and among the Registrant, Opexa Merger Sub, Inc. (“Merger Sub”) and Private Acer (the “Merger Agreement”), pursuant to which Merger Sub merged with and into Private Acer, with Private Acer surviving as a wholly-owned subsidiary of the Registrant (the “Merger”). This transaction was approved by the Registrant’s shareholders at a special meeting of its shareholders on September 19, 2017 (the “Special Meeting”). Also on September 19, 2017, in connection with, and prior to the completion of, the Merger, the Registrant effected a 1-for-10.355527 reverse stock split of its then outstanding common stock (the “Reverse Split”) and immediately following the Merger, the Registrant changed its name to “Acer Therapeutics Inc.”, pursuant to amendments to its certificate of formation filed with the Texas Secretary of State on September 19, 2017. All share numbers in this report have been adjusted to reflect the Reverse Split. Following the completion of the Merger, the business conducted by the Registrant became primarily the business conducted by Private Acer, which is a pharmaceutical company that acquires, develops and intends to commercialize therapies for patients with serious rare diseases with critical unmet medical need. Under the terms of the Merger Agreement, the Registrant issued shares of its common stock to Private Acer’s stockholders, at an exchange rate of one share of common stock (after giving effect to the Reverse Split and the conversion of Private Acer’s Series A and Series B preferred stock and convertible debt) in exchange for each share of Private Acer common stock outstanding immediately prior to the Merger. The exchange rate was determined through arm’s length negotiations between the Registrant and Private Acer. The Registrant also assumed all issued and outstanding stock options under the Acer Therapeutics Inc. 2013 Stock Incentive Plan, with such stock options henceforth representing the right to purchase a number of shares of the Registrant’s common stock equal to the number of shares of Private Acer’s common stock previously represented by such stock options. 4 Immediately after the Merger, (i) there were approximately 6.5 million shares of the Registrant’s common stock outstanding; (ii) the former Private Acer stockholders, including investors in the Concurrent Financing (as defined below), owned approximately 89% of the outstanding common stock of the Registrant; and (iii) the Registrant’s shareholders immediately prior to the Merger, whose shares of the Registrant’s common stock remain outstanding after the Merger, owned approximately 11% of the outstanding common stock of the Registrant. The issuance of the shares of the Registrant’s common stock to the former stockholders of Private Acer was registered with the U.S. Securities and Exchange Commission (the “SEC”) on a Registration Statement on Form S-4 (Reg. No. 333-219358) (the “Registration Statement”). Immediately prior to the Merger, Private Acer issued and sold an aggregate of approximately $15.7 million (inclusive of the conversion of approximately $5.7 million of principal and accrued interest on outstanding convertible promissory notes issued by Private Acer) of shares of Private Acer’s common stock (the “Concurrent Financing”) to certain current stockholders of Private Acer and certain new investors at a per share price of $9.47. Accounting principles generally accepted in the United States require that a company whose security holders retain the majority voting interest in the combined business be treated as the acquirer for financial reporting purposes. Accordingly, the Merger was accounted for as a reverse acquisition whereby Private Acer was treated as the acquirer for accounting and financial reporting purposes. As such, references to the results of operations for the nine months ended September 30, 2017 include the historical results of Private Acer from January 1, 2017 through September 18, 2017 and include the consolidated results of the combined company from September 19, 2017 through September 30, 2017. The Registrant’s common stock continued to trade on a pre-split basis through the close of business on Wednesday, September 20, 2017 on The NASDAQ Capital Market under the ticker symbol “OPXA.” Commencing with the open of trading on Thursday, September 21, 2017, the post-split shares began trading on The NASDAQ Capital Market under the ticker symbol “ACER.” On September 21, 2017, the Registrant’s Series M Warrants, previously trading through the close of business on Wednesday, September 20, 2017 under the ticker symbol “OPXAW,” commenced trading on The NASDAQ Capital Market, under the ticker symbol “ACERW.” The Registrant’s common stock and Series M Warrants have new CUSIP numbers of 00444P 108 and 00444P 116, respectively. Private Acer was incorporated on December 26, 2013 as part of a reorganization whereby Acer Therapeutics, LLC was converted into a corporation organized under the laws of the state of Delaware. On March 20, 2015, Private Acer acquired Anchor, with Anchor becoming a wholly-owned subsidiary of Private Acer. On August 19, 2016, Anchor’s pepducin business reverted back to the pre-acquisition holders of Anchor’s equity. The accompanying condensed consolidated financial statements include the activities of Private Acer as of and for the respective periods presented. Basis of Presentation The accompanying condensed consolidated balance sheet as of September 30, 2017 and the condensed consolidated statements of operations and cash flows for the three and nine months ended September 30, 2017 and 2016 are unaudited and have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Regulation S-X. The unaudited condensed consolidated financial statements have been prepared on the same basis as the audited annual consolidated financial statements and reflect, in the opinion of management, all adjustments of a normal and recurring nature that are necessary for the fair presentation of the Company’s financial position as of September 30, 2017, the results of operations for the three and nine months ended September 30, 2017 and 2016, and the cash flows for the nine months ended September 30, 2017 and 2016. The results of operations for the three and nine months ended September 30, 2017 are not necessarily indicative of the results to be expected for the year ending December 31, 2017 or for any other future annual or interim period. The condensed consolidated balance sheet as of December 31, 2016 included herein was derived from the audited consolidated financial statements as of that date. These unaudited condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements included in the Registration Statement. Going Concern Uncertainty The accompanying financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The Company has experienced recurring losses since inception. The Company has relied on raising capital to finance its operations. The Company plans to raise capital through equity and/or debt financings. There is no assurance, however, that the Company will be able to raise sufficient capital to fund its operations on terms that are acceptable, or that its operations will ever be profitable. 5 There is substantial doubt about the Company’s ability to continue as a going concern within one year after the date that the accompanying financial statements are available to be issued and these financial statements do not include any adjustments relating to the recoverability of recorded asset amounts that might be necessary as a result of the above uncertainty. Based on available resources, the Company believes that its cash and cash equivalents currently on hand are sufficient to fund its anticipated operating and capital requirements through the first half of 2018. 2. SIGNIFICANT ACCOUNTING POLICIES A summary of the significant accounting policies followed by the Company in the preparation of the accompanying condensed consolidated financial statements follows: Business Combinations Assets acquired and liabilities assumed as part of a business acquisition are generally recorded at their fair value at the date of acquisition. The excess of purchase price over the fair value of assets acquired and liabilities assumed is recorded as goodwill. Determining fair value of identifiable assets, particularly intangibles, and liabilities acquired also requires management to make estimates, which are based on all available information and in some cases assumptions with respect to the timing and amount of future revenues and expenses associated with an asset. Accounting for business acquisitions may require management to make judgments and estimates as to fair value of consideration transferred. This judgment and determination may affect the amount of consideration paid that is allocable to assets and liabilities acquired in the business purchase transaction. Share-Based Compensation The Company records share-based payments at fair value. The measurement date for compensation expense related to employee awards is generally the date of the grant. The measurement date for compensation expense related to nonemployee awards is generally the date that the performance of the awards is completed and, until such time, the fair value of the awards is remeasured at the end of each reporting period. Accordingly, the ultimate expense is not fixed until such awards are vested. The fair value of awards, net of expected forfeitures, is recognized as expense in the statement of operations over the requisite service period, which is generally the vesting period. The fair value of options is calculated using the Black-Scholes option pricing model. This option valuation model requires input of assumptions including, among others, the volatility of stock price, the expected term of the option, and the risk-free interest rate. Use of Estimates The Company’s accounting principles require management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of assets and liabilities at the date of the financial statements, and reported amounts of revenues and expenses during the reporting period. Estimates having relatively higher significance include the accounting for acquisitions, stock-based compensation, and income taxes. Actual results could differ from those estimates and changes in estimates may occur. Basic and Diluted Net Loss per Common Share Basic and diluted net loss per common share is computed by dividing net loss in each period by the weighted average number of shares of common stock outstanding during such period. For the periods presented, common stock equivalents, consisting of options, convertible redeemable preferred stock, warrants and convertible notes payable, were not included in the calculation of the diluted loss per share because they were anti-dilutive. Recently Adopted Accounting Pronouncements In March 2016, the Financial Accounting Standards Board ("FASB") issued ASU No. 2016-09, Improvements to Employee Share-Based Payment Accounting , or ASU No. 2016-09, which simplifies several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities and classification of cash flows. The Company adopted ASU No. 2016-09 as of January 1, 2017. Under the new standard, all excess tax benefits and tax deficiencies are recognized as income tax expense or benefit in the statement of operations. The tax effects of exercised or vested awards are treated asdiscrete items in the reporting period in which they occur. The Company applied the modified retrospective adoption approach upon adoption of the standard, and prior periods have not been adjusted. The Company elected to recognize forfeitures related to employee share-based payments as they occur. There was no material impact on the Company’s financial statements as a result of the adoption of this guidance. Recently Issued Accounting Pronouncements Revenue from Contracts with Customers In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606), or ASU 2014-09 . Subsequently, the FASB issued ASU 2015-14, Revenue from Contracts with Customers (Topic 606) , which adjusted the effective date of ASU 2014-09; ASU No. 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net) , which amends the principal-versus-agent implementation guidance and illustrations in ASU 2014-09; ASU No. 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing, which clarifies identifying performance obligations and licensing implementation guidance and illustrations in ASU 2014-09 ; ASU No. 2016-12, Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients , which addresses implementation issues and is intended to reduce the cost and complexity of applying the new revenue standard in ASU 2014-09; and ASU No. 2017-13, Revenue Recognition (Topic 605), Revenue from Contracts with Customers (Topic 606), Leases (Topic 840), and Leases (Topic 842): Amendments to SEC Paragraphs Pursuant to the Staff Announcement at the July 20, 2017 EITF Meeting and Rescission of Prior SEC Staff Announcements and Observer Comments (SEC Update) , which codifies recent announcements by the SEC staff, or collectively, the Revenue ASUs. The Revenue ASUs provide an accounting standard for a single comprehensive model for use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance. The accounting standard is effective for interim and annual periods beginning after December 15, 2017, with an option to early adopt for interim and annual periods beginning after December 15, 2016. The guidance permits two methods of adoption: retrospectively to each prior reporting period presented (the full retrospective method), or retrospectively with the cumulative effect of initially applying the guidance recognized at the date of initial application (the modified retrospective method). The Company will adopt the new standard effective January 1, 2018 under the modified retrospective method. The Company has allocated internal resources to the implementation and is in the process of determining the impact of the Revenue ASUs on its financial statements; however, the adoption of the Revenue ASUs may have a material impact on revenue recognition, its notes to consolidated financial statements and its internal controls over financial reporting. Currently, the Company does not have sources of revenue but future arrangements may be impacted by the adoption of the Revenue ASUs noted above. 6 Other Recent Accounting Pronouncements In January 2017, the FASB issued ASU No. 2017-04, Intangibles - Goodwill and Other (Topic 350). This ASU eliminates step 2 from the goodwill impairment test by comparing the fair value of a reporting unit with the carrying amount of the reporting unit. If the carrying amount exceeds the fair value, an impairment charge for the excess is recorded. The amendments of this ASU are effective for annual or any interim goodwill impairment tests in fiscal years beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The Company is currently evaluating the impact of the adoption of this ASU on the consolidated financial statements. In May 2017, the FASB issued ASU No. 2017-09, Compensation - Stock Compensation (Topic 718): Scope of Modification Accounting , which clarifies when changes to the terms or conditions of a share-based payment award must be accounted for as modifications. The new guidance will reduce diversity in practice and result in fewer changes to the terms of an award being accounted for as modifications. Under ASU 2017-09, an entity will not apply modification accounting to a share-based payment award if the award’s fair value, vesting conditions and classification as an equity or liability instrument are the same immediately before and after the change. ASU 2017-09 will be applied prospectively to awards modified on or after the adoption date. The guidance is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2017. Early adoption is permitted. The Company is evaluating the impact of the adoption of this guidance on its financial statements, but does not expect it to have a material impact. In July 2017, FASB issued ASU No. 2017-11, Earnings Per Share (Topic 260); Distinguishing Liabilities from Equity (Topic 480); Derivatives and Hedging (Topic 815): (Part I) Accounting for Certain Financial Instruments with Down Round Features, (Part II) Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Non-controlling Interests with a Scope Exception (Update) . Part I of this Update addresses the complexity of accounting for certain financial instruments with down round features by simplifying the accounting for these instruments. This Update requires companies to disregard the down round feature when assessing whether an instrument, such as a warrant, is indexed to its own stock, for purposes of determining liability or equity classification. This will change the classification of certain warrants with down round features from a liability to equity. Also, entities must adjust their basic earnings per share (EPS) calculation for the effect of the down round provision when triggered (that is, when the exercise price of the related equity-linked financial instrument is adjusted downward because of the down round feature). That effect is treated as a dividend and as a reduction of income available to common shareholders in basic EPS. An entity will also recognize the effect of the trigger within equity. The guidance is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2017. Early adoption is permitted. The Company is evaluating the impact of the adoption of this guidance on its financial statements. Part II of this Update addresses the difficulty of navigating Topic 480, Distinguishing Liabilities from Equity , because of the existence of extensive pending content in the FASB Accounting Standards Codification. The amendments in Part II of this Update re-characterize the indefinite deferral of certain provisions of Topic 480, Distinguishing Liabilities from Equity , that previously were presented as pending content in the Codification, to a scope exception, and do not have any accounting effect. 3. PURCHASE ACCOUNTING The Merger was accounted for using the purchase method of accounting as a reverse acquisition. In a reverse acquisition, the post-acquisition net assets of the surviving combined company includes the historical cost basis of the net assets of the accounting acquirer (Private Acer) plus the fair value of the net assets of the accounting acquiree (the Registrant). Further, under the purchase method, the purchase price is allocated to the assets acquired, liabilities assumed, and identifiable intangible assets based on their estimated fair values, with the remaining excess purchase price over net assets acquired allocated to goodwill. The fair value of the consideration transferred in the Merger was $6,978,916 and was calculated as the number of shares of common stock that Private Acer issued (adjusted for the exchange ratio) in order for the Registrant’s shareholders to hold an 11% equity interest in the combined company post-acquisition, multiplied by the estimated fair value of Private Acer’s common stock on the acquisition date. The estimated fair value of Private Acer’s common stock was based on the offering price of the common stock sold in the private placement which was both completed concurrently with and conditioned upon the closing of the Merger. This price was determined to be the best indication of fair value on that date since the price was based on an arm’s length negotiation with a group consisting of both new and existing investors of Private Acer that had been advised of the pending Merger and assumed similar liquidity risk as those investors holding the majority of shares being valued as purchase consideration. The following table summarizes the Company’s determination of fair values of the assets acquired and the liabilities assumed as of the date of acquisition. Consideration - issuance of securities and cash paid for fractional shares | $7,007,069 ---------------------------------------------------------------------------+------------ Assets acquired and liabilities assumed: | ---------------------------------------------------------------------------+------------ Cash | $1,058,276 ---------------------------------------------------------------------------+------------ Other assets | 5,000 ---------------------------------------------------------------------------+------------ Accrued liabilities | (1,431,158) ---------------------------------------------------------------------------+------------ Goodwill | 7,374,951 ---------------------------------------------------------------------------+------------ Total purchase price | $7,007,069 ---------------------------------------------------------------------------+------------ The Company determined that the acquired legacy technology of the Registrant had no value as of the date of the acquisition. Goodwill represents the excess of the purchase price (consideration paid plus net liabilities assumed) of an acquired business over the fair value of the underlying net tangible and intangible assets. Goodwill includes the value of the Registrant’s standing as a public entity. None of the goodwill associated with the Merger is deductible for income tax purposes. 7 There were no changes in goodwill during the period ended September 30, 2017, after the initial purchase accounting. The Company is required to perform an annual impairment test related to goodwill which is performed in the fourth quarter of each year, or sooner if changes in circumstances suggest that the carrying value of an asset may not be recoverable. Unaudited pro forma operating results, assuming the Merger occurred as of January 1, 2016, are as follows: | Three Months Ended | Nine Months Ended ---------------------------------------+--------------------+------------------ | September 30, | September 30, ---------------------------------------+--------------------+------------------ | 2017 | 2016 | 2017 | 2016 ---------------------------------------+--------------------+-------------------+--------------+------------- Net loss | $(3,478,025) | $(1,885,198) | $(9,980,370) | $(4,564,423) ---------------------------------------+--------------------+-------------------+--------------+------------- Net loss per share - basic and diluted | $(1.09) | $(0.77) | $(3.69) | $(1.86) ---------------------------------------+--------------------+-------------------+--------------+------------- 4. PROPERTY AND EQUIPMENT Property and equipment consisted of the following at September 30, 2017 and December 31, 2016: | September 30, 2017 | December 31, 2016 -------------------------------+---------------------+------------------- Computer hardware and software | $10,706 | $10,862 -------------------------------+---------------------+------------------- Less accumulated depreciation | (5,645) | (4,645) -------------------------------+---------------------+------------------- | $5,062 | $6,217 -------------------------------+---------------------+------------------- 5. ACCRUED EXPENSES Accrued expenses consisted of the following at September 30, 2017 and December 31, 2016: | September 30, 2017 | December 31, 2016 -------------------------------+---------------------+------------------- Accrued legal | $248,710 | $21,477 -------------------------------+---------------------+------------------- Accrued pre-commercial costs | 317,567 | — -------------------------------+---------------------+------------------- Accrued consulting | 94,169 | 13,105 -------------------------------+---------------------+------------------- Accrued audit and tax | 92,437 | 39,820 -------------------------------+---------------------+------------------- Accrued license fees | 893,949 | 205,444 -------------------------------+---------------------+------------------- Accrued contract manufacturing | — | 126,700 -------------------------------+---------------------+------------------- Accrued contract research | 35,657 | 16,800 -------------------------------+---------------------+------------------- Accrued miscellaneous expenses | 28,811 | 14,682 -------------------------------+---------------------+------------------- | $1,711,300 | $438,028 -------------------------------+---------------------+------------------- 8 6. CONVERTIBLE NOTES PAYABLE On March 22, 2017, Private Acer issued senior secured convertible notes payable (the “2017 Notes”) to existing investors and a vendor in the aggregate principal amount of $3,125,000. The 2017 Notes accrued interest at 10% per annum and matured on the earlier of (i) March 22, 2018 (the “Maturity Date”) or (ii) upon a Change in Control of Private Acer, as defined therein. On May 31, 2017, Private Acer issued additional 2017 Notes to existing investors and a vendor in the aggregate principal amount of $2,375,000. The 2017 Notes were convertible into common stock upon a Qualified Financing (as defined therein), a Change in Control, or an optional conversion by the holder. Conversion upon a Qualified Financing was at a price per share equal to the price per share paid for the shares sold in the Qualified Financing less a discount of: (i) 0%, if a Qualified Financing occurred on or before June 30, 2017; (ii) 10%, if a Qualified Financing occurred after June 30, 2017 but on or before September 1, 2017; or (iii) 20%, if a Qualified Financing occurred after September 1, 2017. Conversion upon a Change in Control was at the discretion of the holder such that Private Acer would pay each holder the outstanding balance on their respective note or the note would be converted at a price per share equal to the lesser of $16.57 and the price per share of common stock paid to the holders of the common stock in such Change in Control. Conversion under an optional conversion by the holder was at a price per share of $16.57 based on the outstanding balance of the note. Upon the issuance of the 2017 Notes, Private Acer evaluated all terms of the 2017 Notes, including the Change in Control provision, to identify any embedded features that required bifurcation and recording as derivative instruments. Private Acer determined that there were no such features requiring separate accounting. In connection with the 2017 Notes, Private Acer incurred debt issuance costs of $68,530 and recorded them as a debt discount. During the nine months ended September 30, 2017, the Company recognized $242,982 of interest expense, which includes $68,530 in amortization of debt discount and $174,452 of accrued interest on the 2017 Notes. The principal of $5,500,000 and accrued interest of $174,452 on the 2017 Notes converted into 599,201 fully-paid shares of common stock at the time of the Merger described in Note 1, with no discount on the conversion. 7. COMMITMENTS License Agreements In August 2016, Private Acer signed an agreement with the Greater Paris University Hospitals AP-HP (via its Department of Clinical Research and Development) granting Private Acer exclusive worldwide rights to access and use data from a randomized controlled clinical study of celiprolol. The Company will use this pivotal clinical data to support a New Drug Application (“NDA”) regulatory filing for its lead product, celiprolol, for the treatment of vEDS. The agreement requires Private Acer to make certain upfront payments to AP-HP, as well as reimburse certain costs, and make payments upon achievement of defined milestones and payment of royalties on net sales of celiprolol over the royalty term. In April 2014, Private Acer obtained exclusive rights to intellectual property relating to ACER-001 and preclinical and clinical data, through an exclusive license agreement with Baylor College of Medicine (“BCM”). Under the terms of the agreement, as amended, Private Acer has worldwide exclusive rights to develop, manufacture, use, sell and import Licensed Products as defined in the agreement. The license agreement requires Private Acer to make certain upfront and annual payments to BCM, as well as reimburse certain legal costs, and make payments upon achievement of defined milestones and payment of royalties on net sales of any developed product over the royalty term. Litigation From time to time, the Company or its subsidiaries may become involved in litigation or proceedings relating to claims arising from the ordinary course of business. On September 27, 2017, Piper Jaffray & Co. filed a lawsuit against Private Acer, Piper Jaffray & Co. v. Acer Therapeutics Inc., Index No. 656055/2017, in the Supreme Court of the State of New York, County of New York. The complaint alleges that Private Acer breached its obligations to Piper Jaffray & Co. pursuant to an August 30, 2016 engagement letter between the parties and an April 28, 2017 addendum thereto by failing to pay Piper Jaffray & Co. (i) a fee of $1,097,207 in connection with the financing which closed on September 19, 2017 for aggregate consideration of approximately $15.7 million (including the conversion of the 2017 Notes described in Note 6) and (ii) $67,496 in reimbursement for expenses incurred by Piper Jaffray & Co. pursuant to the engagement letter. On November 10, 2017, Private Acer filed an answer and counterclaim in the lawsuit, denying Piper Jaffray & Co.’s breach of contract allegation, asserting several defenses, and bringing several counterclaims, including claims for breach of contract and breach of the duty of good faith and fair dealing. The Company has not recorded a liability as of September 30, 2017 because a potential loss is not probable or reasonably estimable given the preliminary nature of the proceedings. 9 8. STOCKHOLDERS’ EQUITY Immediately prior to the consummation of the Merger described in Note 1, (i) Private Acer’s Series A Convertible Redeemable Preferred stock and Series B Convertible Redeemable Preferred stock were converted into 638,416 and 970,238 shares of common stock, respectively, (ii) Private Acer’s 2017 Notes and accrued interest totaling $5,674,452 were converted into 599,201 shares of common stock, and (iii) 1,055,961 shares of common stock were sold for $9.47 per share generating $10,000,000 of gross proceeds. At the closing of the Merger, 736,950 shares of common stock were held by existing shareholders of the Registrant. 2013 Stock Incentive Plan Private Acer’s 2013 Stock Incentive Plan, as amended (the “2013 Plan”), which was assumed by Acer in connection with the Merger, provides for the granting of up to 165,000 shares of common stock as incentive or non-qualified stock options and/or restricted common stock to employees, officers, directors, consultants and advisers. Option awards are generally granted with an exercise price equal to the fair value of the common stock at the date of grant and have contractual terms of 10 years. A summary of option activity under the 2013 Plan for the nine months ended September 30, 2017 is as follows: | Number of Shares | Weighted Average Exercise Price | Weighted Average Remaining Contractual Term (Years) ------------------------------------------+-------------------+------------------------------------+-------------------------------------------------------- Options outstanding at December 31, 2016 | 122,000 | $2.55 | — ------------------------------------------+-------------------+------------------------------------+-------------------------------------------------------- Granted | 48,625 | 7.21 | — ------------------------------------------+-------------------+------------------------------------+-------------------------------------------------------- Exercised | — | — | — ------------------------------------------+-------------------+------------------------------------+-------------------------------------------------------- Cancelled/forfeited | (5,625) | 2.55 | — ------------------------------------------+-------------------+------------------------------------+-------------------------------------------------------- Options outstanding at September 30, 2017 | 165,000 | $3.92 | 7.54 ------------------------------------------+-------------------+------------------------------------+-------------------------------------------------------- Options exercisable at September 30, 2017 | 123,562 | $3.47 | 8.46 ------------------------------------------+-------------------+------------------------------------+-------------------------------------------------------- At September 30, 2017, there was approximately $99,600 of unrecognized compensation expense related to the share-based compensation arrangements granted under the 2013 Plan and the average remaining vesting period is 0.58 years. The weighted average grant date fair value of options granted during the nine months ended September 30, 2017 was $3.76. 2010 Stock Incentive Plan Acer’s Amended and Restated 2010 Stock Incentive Plan, as amended (the “2010 Plan”), provides for the granting of up to 470,000 shares of common stock as incentive or non-qualified stock options, stock appreciation rights, restricted stock units and/or restricted common stock to employees, officers, directors, consultants and advisers. Option awards are generally granted with an exercise price equal to the fair value of the common stock at the date of grant and have contractual terms of 10 years. All outstanding and unexercised equity awards (representing 22,061 underlying shares) under the 2010 Plan were cancelled in connection with the Merger. 10 Warrants A summary of warrant activity for the three months ended September 30, 2017 is presented below: | Number of Shares | Weighted Average Exercise Price | Weighted Average Remaining Contract Term (# years) | Intrinsic Value --------------------------------------------------+------------------+---------------------------------+----------------------------------------------------+---------------- Assumed in the Merger at September 19, 2017 | 317,630 | $123.61 | 0.54 | — --------------------------------------------------+------------------+---------------------------------+----------------------------------------------------+---------------- Outstanding and exercisable at September 30, 2017 | 317,630 | $123.61 | 0.54 | — --------------------------------------------------+------------------+---------------------------------+----------------------------------------------------+---------------- 9. NET LOSS PER SHARE Basic net loss per share is computed by dividing the net loss by the weighted-average number of common shares outstanding. Diluted net loss per share is computed similarly to basic net loss per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potential common shares had been issued and if the additional common shares were dilutive. Diluted net loss per share is the same as basic net loss per common share, since the effects of potentially dilutive securities are antidilutive. As of September 30, 2017 and 2016, the number of shares of common stock underlying potentially dilutive securities include: | September 30, ---------------------------------------+-------------- | 2017 | 2016 ---------------------------------------+---------------+-------- Convertible redeemable preferred stock | — | 638,416 ---------------------------------------+---------------+-------- Warrants | 317,630 | — ---------------------------------------+---------------+-------- Options to purchase common stock | 165,000 | 122,000 ---------------------------------------+---------------+-------- Total | 482,630 | 760,416 ---------------------------------------+---------------+-------- 10. SUBSEQUENT EVENTS On October 4, 2017, the Company’s Board of Directors granted non-qualified stock options under the 2010 Plan to purchase an aggregate of (i) 218,600 shares of the Company’s common stock to executive officers and employees and (ii) 30,000 shares of the Company’s common stock to outside non-employee directors, all at an exercise price of $15.34 per share. Stock options granted to executive officers and employees vest over a four-year period, with 25% vesting on the one-year anniversary of the grant date and the remaining 75% vesting quarterly over the remaining three years, assuming continued service, and with vesting acceleration in full immediately prior to a change in control. Stock options granted to outside non-employee directors vest either (a) in full on the one-year anniversary of the grant date, assuming continued service, for awards to continuing directors, with vesting acceleration in full immediately prior to a change in control, or (b) quarterly over a three-year period, assuming continued service, for awards to new directors, with vesting acceleration in full immediately prior to a change in control. On November 8, 2017, the Company’s Board of Directors granted a non-qualified stock option to purchase 25,000 shares of the Company’s common stock to an employee with an exercise price of $17.51, which vests over a four-year period, with 25% vesting on the one-year anniversary of the grant date and the remaining 75% vesting quarterly over the remaining three years, assuming continued service, and with vesting acceleration in full immediately prior to a change in control. 11 Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following discussion and analysis of our financial condition is as of September 30, 2017. Our results of operations and cash flows should be read in conjunction with our unaudited condensed consolidated financial statements and notes thereto included elsewhere in this report and the audited financial statements and the notes thereto included in our Form 10-K for the year ended December 31, 2016. Forward-Looking Statements This Quarterly Report on Form 10-Q contains forward-looking statements which are made pursuant to the safe harbor provisions of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Statements contained in this report, other than statements of historical fact, constitute “forward-looking statements.” The words “expects,” “believes,” “hopes,” “anticipates,” “estimates,” “may,” “could,” “intends,” “exploring,” “evaluating,” “progressing,” “proceeding” and similar expressions are intended to identify forward-looking statements. These forward-looking statements do not constitute guarantees of future performance. Investors are cautioned that statements which are not strictly historical statements, including, without limitation, statements regarding current or future financial payments, costs, returns, royalties, performance and position, plans and objectives for future operations, plans and objectives for product development, plans and objectives for present and future clinical trials and results of such trials, plans and objectives for regulatory approval, litigation, intellectual property, product development, manufacturing plans and performance, management’s initiatives and strategies, and the development of our product candidates, including EDSIVO™ (celiprolol) and ACER-001, constitute forward-looking statements. Such forward-looking statements are subject to a number of risks and uncertainties that could cause actual results to differ materially from those anticipated. These risks and uncertainties include, but are not limited to, those risks discussed in “Risk Factors,” as well as, without limitation, risks associated with: ● the strategies, prospects, plans, expectations and objectives of management for future operations of the company, including the execution of integration and restructuring plans and the anticipated timing of filings; ● the progress, scope or duration of the development of product candidates or programs; ● the benefits that may be derived from product candidates or the commercial or market opportunity in any target indication; ● ability to protect our intellectual property rights; ● our ability to maintain compliance with NASDAQ listing standards; ● our anticipated operations, financial position, costs or expenses; ● statements regarding future economic conditions or performance; ● any statements concerning proposed new products, services or developments; ● the expected benefits of and potential value created by the Merger for our shareholders; and ● statements of belief and any statement of assumptions underlying any of the foregoing. These forward-looking statements speak only as of the date made. We assume no obligation or undertaking to update any forward-looking statements to reflect any changes in expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based. You should, however, review additional disclosures we make in our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K filed with the SEC. Overview Acer is a pharmaceutical company focused on the acquisition, development and commercialization of therapies for patients with serious rare and ultra-rare diseases with critical unmet medical need. Our late-stage clinical pipeline includes two candidates for severe genetic disorders for which there are few or no FDA-approved treatments: EDSIVO™ (celiprolol) for vascular Ehlers-Danlos Syndrome (“vEDS”), and ACER-001 (a fully taste-masked, immediate release formulation of sodium phenylbutyrate) for urea cycle disorders (“UCD”) and Maple Syrup Urine Disease (“MSUD”). There are no FDA-approved drugs for vEDS and MSUD and limited options for UCD, which collectively impact more than 4,000 patients in the United States. Our products have clinical proof-of-concept and mechanistic differentiation, and we intend to seek approval for them in the U.S. by using the regulatory pathway established under section 505(b)(2) of the Federal Food, Drug, and Cosmetic Act, or FFDCA, that allows an applicant to rely for approval at least in part on third-party data, which is expected to expedite the preparation, submission, and approval of a marketing application. 12 Merger and Reverse Stock Split On September 19, 2017, Acer Therapeutics Inc., a Texas corporation, formerly known as Opexa Therapeutics, Inc. (the “Registrant”), completed its business combination with what was then known as “Acer Therapeutics Inc.,” a Delaware corporation (“Private Acer”), in accordance with the terms of the Agreement and Plan of Merger and Reorganization, dated as of June 30, 2017, by and among the Registrant, Opexa Merger Sub, Inc. (“Merger Sub”) and Private Acer (the “Merger Agreement”), pursuant to which Merger Sub merged with and into Private Acer, with Private Acer surviving as a wholly-owned subsidiary of the Registrant (the “Merger”). This transaction was approved by the Registrant’s shareholders at a special meeting of its shareholders on September 19, 2017 (the “Special Meeting”). Also on September 19, 2017, in connection with, and prior to the completion of, the Merger, the Registrant effected a 1-for-10.355527 reverse stock split of its then outstanding common stock (the “Reverse Split”) and immediately following the Merger, the Registrant changed its name to “Acer Therapeutics Inc.” pursuant to amendments to its certificate of formation filed with the Texas Secretary of State on September 19, 2017. Following the completion of the Merger, the business conducted by the Registrant became primarily the business conducted by Private Acer, which is a pharmaceutical company that acquires, develops and intends to commercialize therapies for patients with serious rare diseases with critical unmet medical need. Under the terms of the Merger Agreement, the Registrant issued shares of its common stock to Private Acer’s stockholders, at an exchange rate of one share of common stock (after giving effect to the Reverse Split and the conversion of Private Acer’s Series A and Series B preferred stock and convertible debt) in exchange for each share of Private Acer common stock outstanding immediately prior to the Merger. The exchange rate was determined through arm’s length negotiations between the Registrant and Private Acer. The Registrant also assumed all issued and outstanding stock options under the Acer Therapeutics Inc. 2013 Stock Incentive Plan, with such stock options henceforth representing the right to purchase a number of shares of the Registrant’s common stock equal to the number of shares of Private Acer’s common stock previously represented by such stock options. Immediately after the Merger: (i) there were approximately 6.5 million shares of the Registrant’s common stock outstanding; (ii) the former Private Acer stockholders, including investors in the Concurrent Financing (as defined below), owned approximately 89% of the outstanding common stock of the Registrant; and (iii) the Registrant’s shareholders immediately prior to the Merger, whose shares of the Registrant’s common stock remain outstanding after the Merger, owned approximately 11% of the outstanding common stock of the Registrant. The issuance of the shares of the Registrant’s common stock to the former stockholders of Private Acer was registered with the U.S. Securities and Exchange Commission (the “SEC”) on a Registration Statement on Form S-4 (Reg. No. 333-219358) (the “Registration Statement”). Immediately prior to the Merger, Private Acer issued and sold an aggregate of approximately $15.7 million (inclusive of the conversion of approximately $5.7 million of principal and accrued interest on outstanding convertible promissory notes issued by Private Acer) of shares of Private Acer’s common stock (the “Concurrent Financing”) to certain current stockholders of Private Acer and certain new investors at a per share price of $9.47. The Registrant’s common stock traded on a pre-split basis through the close of business on Wednesday, September 20, 2017 on The NASDAQ Capital Market under the ticker symbol “OPXA.” Commencing with the open of trading on Thursday, September 21, 2017, the post-split shares began trading on The NASDAQ Capital Market under the ticker symbol “ACER.” On September 21, 2017, the Registrant’s Series M Warrants, previously trading through the close of business on Wednesday, September 20, 2017 under the ticker symbol “OPXAW,” commenced trading on The NASDAQ Capital Market, under the ticker symbol “ACERW.” The Registrant’s common stock and Series M Warrants have new CUSIP numbers of 00444P 108 and 00444P 116, respectively. Revenue We have no products approved for commercial sale and have not generated any revenue from product sales. In the future, we may generate revenue by entering into licensing arrangements or strategic alliances. To the extent we enter into any license arrangements or strategic alliances, we expect that any revenue we generate will fluctuate from quarter-to-quarter as a result of the timing of achievement of pre-clinical, clinical, regulatory and commercialization milestones, if at all, the timing and amount of payments relating to such milestones, as well as the extent to which any products are approved and successfully commercialized. If our product candidates are not developed in a timely manner, if regulatory approval is not obtained for them, or if such product candidates are not commercialized, our ability to generate future revenue, and our results of operations and financial position, would be adversely affected. 13 Research and Development Expenses Research and development expenses consist of costs associated with the development of our product candidates. Our research and development expenses include: ● employee-related expenses, including salaries, benefits, and stock-based compensation; ● external research and development expenses incurred under arrangements with third parties, such as contract research organizations, contract manufacturing organizations, consultants, and our scientific advisors; and ● license fees. We expense research and development costs as incurred. We account for nonrefundable advance payments for goods and services that will be used in future research and development activities as expenses when the service has been performed or when the goods have been received. At any time, we are working on multiple programs, primarily within our therapeutic areas of focus. Our internal resources, employees and infrastructure are not directly tied to any one research or drug discovery project and are typically deployed across multiple projects. As such, we do not generate meaningful information regarding the costs incurred for these early stage research and drug discovery programs on a specific project basis. However, we are currently spending the vast majority of our research and development resources on our two lead development programs. Since our inception in December 2013, we have spent a total of approximately $14.2 million in research and development expenses through September 30, 2017. Of the approximately $14.2 million in research and development expenses, approximately $11.9 million is directly related to EDSIVO and approximately $2.1 million is directly related to ACER-001. Other research and development costs, such as legal and travel costs, have not been identified as directly attributable to a specific research and development project. We expect our research and development expenses to increase for the foreseeable future as we continue to conduct our ongoing regulatory activities, initiate new preclinical and clinical trials, and build upon our pipeline. The process of conducting clinical trials and pre-clinical studies necessary to obtain regulatory approval, preparing to seek regulatory approval, and preparing for commercialization in the event of regulatory approval, is costly and time consuming. We may never succeed in achieving marketing approval for any of our product candidates. Successful development of product candidates is highly uncertain and may not result in approved products. Completion dates and completion costs can vary significantly for each product candidate and are difficult to predict. We anticipate we will make determinations as to which programs to pursue and how much funding to direct to each program on an ongoing basis in response to our ability to enter into new strategic alliances with respect to each program or potential product candidate, the scientific and clinical success of each product candidate, the timing and ability to obtain regulatory approval for our product candidates (if any), and ongoing assessments as to each product candidate’s commercial potential. We will need to raise additional capital and may seek to do so through public or private equity or debt financings, government or other third-party funding, marketing and distribution arrangements and other collaborations, strategic alliances and licensing arrangements or a combination of these approaches. However, we may be unable to raise additional funds or enter into such other arrangements when needed on favorable terms or at all. Our failure to raise capital or enter into such other arrangements as and when needed would have a negative impact on our financial condition and our ability to develop our product candidates and pursue regulatory approval. General and Administrative Expenses General and administrative expenses consist primarily of professional fees for auditing, tax, legal and business consulting services. We expect that general and administrative expenses will increase in the future as we expand our operating activities. We expect to incur significant additional costs associated with being a publicly-traded company. These increases will likely include legal fees, costs associated with Sarbanes-Oxley compliance, accounting fees, and directors’ and officers’ liability insurance premiums. Other income (expense), net Other income (expense), net consists primarily of interest income and expense, and various income or expense items of a non-recurring nature. We earn interest income from interest-bearing accounts and money market funds for cash and cash equivalents. Interest expense has historically been comprised of interest and other related non-cash charges incurred under convertible notes payable with our investors. 14 Critical Accounting Polices and Estimates This management’s discussion and analysis of financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). The preparation of these financial statements requires our management to make estimates and judgments that affect the reported amounts of assets, liabilities and expenses. On an ongoing basis, we evaluate these estimates and judgments. We base our estimates on historical experience and on various assumptions that we believe to be reasonable under the circumstances. These estimates and assumptions form the basis for making judgments about the carrying values of assets and liabilities and the recording of expenses that are not readily apparent from other sources. Actual results may differ materially from these estimates. We believe that the accounting policies discussed below are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving our judgments and estimates. Business Combinations Assets acquired and liabilities assumed as part of a business acquisition are generally recorded at their fair value at the date of acquisition. The excess of purchase price over the fair value of assets acquired and liabilities assumed is recorded as goodwill. Determining fair value of identifiable assets, particularly intangibles, and liabilities acquired also requires management to make estimates, which are based on all available information and in some cases assumptions with respect to the timing and amount of future revenues and expenses associated with an asset. Accounting for business acquisitions may require management to make judgments and estimates as to fair value of consideration transferred. This judgment and determination may affect the amount of consideration paid that is allocable to assets and liabilities acquired in the business purchase transaction. Stock-Based Compensation We account for stock-based compensation expense related to stock options granted to employees and members of our board of directors under our 2013 Stock Incentive Plan, as amended, and our Amended and Restated 2010 Stock Incentive Plan, as amended, by estimating the fair value of each stock option or award on the date of grant using the Black-Scholes model. We recognize stock-based compensation expense on a straight-line basis over the vesting term. We account for stock options issued to non-employees by valuing the award using an option pricing model and remeasuring such awards to the current fair value until the awards are vested or a performance commitment has otherwise been reached. Research and Development Research and development costs are expensed as incurred and include compensation and related benefits, license fees and outside contracted research and manufacturing consultants. We often make nonrefundable advance payments for goods and services that will be used in future research and development activities. These payments are capitalized and recorded as expense in the period that we receive the goods or when the services are performed. Clinical Trial and Pre-Clinical Study Accruals We make estimates of accrued expenses as of each balance sheet date in our consolidated financial statements based on certain facts and circumstances at that time. Our accrued expenses for pre-clinical studies and clinical trials are based on estimates of costs incurred for services provided by contract research organizations (“CRO”), manufacturing organizations, and for other trial-related activities. Payments under our agreements with external service providers depend on a number of factors such as site initiation, patient screening, enrollment, delivery of reports, and other events. In accruing for these activities, we obtain information from various sources and estimate the level of effort or expense allocated to each period. Adjustments to our research and development expenses may be necessary in future periods as our estimates change. As these activities are generally material to our overall financial statements, subsequent changes in estimates may result in a material change in our accruals. 15 Results of Operations Comparison of the three months ended September 30, 2017 and 2016 The following table summarizes our results of operations for the three months ended September 30, 2017 and 2016: | Three Months Ended September 30, | | ----------------------------+----------------------------------+-------------+------------ | 2017 | 2016 | $ Change | % Change ----------------------------+----------------------------------+-------------+-------------+--------- Research and development | $2,057,421 | $1,610,822 | $446,599 | 28% ----------------------------+----------------------------------+-------------+-------------+--------- General and administrative | 1,302,401 | 274,512 | 1,027,889 | 374% ----------------------------+----------------------------------+-------------+-------------+--------- Other income (expense), net | (118,203) | 136 | (118,339) | (87014)% ----------------------------+----------------------------------+-------------+-------------+--------- Net loss | (3,478,025) | (1,885,198) | (1,592,827) | 84% ----------------------------+----------------------------------+-------------+-------------+--------- Research and Development Expenses Research and development expense was approximately $2.1 million during the three months ended September 30, 2017, as compared to $1.6 million during the three months ended September 30, 2016. This increase of approximately $447,000 was principally due to an increase in spending for clinical development and manufacturing services relating to EDSIVO. Research and development expense for the three months ended September 30, 2017 was comprised of approximately $1.9 million directly related to EDSIVO and approximately $133,000 directly related to ACER-001. Research and development expense for the three months ended September 30, 2016 was comprised of approximately $862,000 directly related to EDSIVO and approximately $748,000 directly related to ACER-001. Other research and development costs such as legal and travel costs have not been identified as directly attributable to a specific research and development project. General and Administrative Expenses General and administrative expense was approximately $1.3 million for the three months ended September 30, 2017 as compared to approximately $274,000 for the three months ended September 30, 2016. This increase of approximately $1.0 million was primarily due to an increase in legal and pre-commercial launch costs. Other Income (Expense), Net Other expense, net of approximately $118,000 during the three months ended September 30, 2017 was primarily attributable to interest expense related to the outstanding convertible promissory notes prior to conversion. Comparison of the nine months ended September 30, 2017 and 2016 The following table summarizes our results of operations for the nine months ended September 30, 2017 and 2016: | Nine Months Ended September 30, | | ----------------------------+---------------------------------+-------------+------------ | 2017 | 2016 | $ Change | % Change ----------------------------+---------------------------------+-------------+-------------+---------- Research and development | $6,948,816 | $3,510,118 | $3,438,698 | 98% ----------------------------+---------------------------------+-------------+-------------+---------- General and administrative | 2,792,424 | 1,054,479 | 1,737,945 | 165% ----------------------------+---------------------------------+-------------+-------------+---------- Other income (expense), net | (239,130) | 174 | (239,304) | (137531)% ----------------------------+---------------------------------+-------------+-------------+---------- Net loss | (9,980,370) | (4,564,423) | (5,415,947) | 119% ----------------------------+---------------------------------+-------------+-------------+---------- Research and Development Expenses Research and development expense was approximately $6.9 million for the nine months ended September 30, 2017, as compared to approximately $3.5 million for the nine months ended September 30, 2016. This increase of approximately $3.4 million was principally due to an increase in spending for clinical development and manufacturing services relating to EDSIVO and the acquisition of the clinical data license from AP-HP. Research and development expense for the nine months ended September 30, 2017 was comprised of approximately $6.5 million directly related to EDSIVO and approximately $345,000 directly related to ACER-001. Research and development expense for the nine months ended September 30, 2016 was comprised of approximately $2.3 million directly related to EDSIVO and approximately $1.2 million directly related to ACER-001. Other research and development costs such as legal and travel costs have not been identified as directly attributable to a specific research and development project. 16 General and Administrative Expenses General and administrative expense was approximately $2.8 million for the nine months ended September 30, 2017 as compared to approximately $1.1 million for the nine months ended September 30, 2016. This increase of approximately $1.7 million was primarily due to an increase in legal and pre-commercial launch costs. Other Income (Expense), Net Other expense, net of approximately $239,000 during the nine months ended September 30, 2017 was primarily attributable to interest expense related to the outstanding convertible promissory notes prior to conversion. Liquidity and Capital Resources We have never been profitable and have incurred operating losses in each year since inception. From inception to September 30, 2017, we have raised net cash proceeds of approximately $27.5 million, primarily from private placements of convertible preferred stock, common stock and debt financings. As of September 30, 2017, we had approximately $8.4 million in cash and cash equivalents. Our net loss was approximately $10.0 million for the nine months ended September 30, 2017, and approximately $6.7 million for the year ended December 31, 2016. As of September 30, 2017, we had an accumulated deficit of approximately $21.3 million. Substantially all of our operating losses resulted from expenses incurred in connection with our research and development programs and from general and administrative costs associated with our operations. The following table shows a summary of our cash flows for the nine months ended September 30, 2017 and 2016: | Nine Months Ended September 30, ------------------------------------------+-------------------------------- Net cash (used in) provided by: | 2017 | 2016 ------------------------------------------+---------------------------------+------------- Operating activities | $(9,888,756) | $(4,574,165) ------------------------------------------+---------------------------------+------------- Investing activities | 1,027,600 | (1,582) ------------------------------------------+---------------------------------+------------- Financing activities | 15,431,470 | 7,994,834 ------------------------------------------+---------------------------------+------------- Net increase in cash and cash equivalents | 6,570,314 | 3,419,087 ------------------------------------------+---------------------------------+------------- Operating Activities Net cash used in operating activities was approximately $9.9 million for the nine months ended September 30, 2017 as compared to approximately $4.6 million for the nine months ended September 30, 2016. The increase of approximately $5.3 million was principally the result of an increase in net loss due to increased research and development activities in advancing our product candidates and increased general and administrative activities. Investing Activities Net cash provided by investing activities during the nine months ended September 30, 2017 relates to cash acquired in the Merger. Financing Activities Net cash provided by financing activities during the nine months ended September 30, 2017 consisted of $10 million from the issuance of common stock and $5.5 million from the issuance of convertible notes payable (which, together with $174,452 of accrued interest, was converted into common stock). Net cash provided by financing activities during the nine months ended September 30, 2016 consisted of net proceeds from the issuance of Series B Convertible Redeemable Preferred stock. Future Capital Requirements We have not generated any revenue from product sales. We do not know when, or if, we will generate any revenue from product sales. We do not expect to generate any revenue from product sales unless and until we obtain regulatory approval for and commercialize any of our product candidates. At the same time, we expect our expenses to increase in connection with our ongoing development and manufacturing activities, particularly as we continue the research, development, manufacture and clinical trials of, and seek regulatory approval for, our product candidates. In addition, subject to obtaining regulatory approval of any of our product candidates and thereafter successfully commercialize any such product candidates, we anticipate that we will need substantial additional funding in connection with our continuing operations. 17 As of September 30, 2017, we had approximately $8.4 million in cash and cash equivalents. We expect our research and development expenses to substantially increase in connection with our ongoing activities, particularly as we advance our product candidates in or towards clinical development or potential regulatory approval. Our future capital requirements are difficult to forecast and will depend on many factors, including but not limited to: ● our ability to obtain adequate levels of financing to meet our operating plan; ● the costs associated with filing, outcome and timing of regulatory approvals; ● the terms and timing of any strategic alliance, licensing and other arrangements that we may establish; ● the cost and timing of hiring new employees to support our continued growth; ● the costs and timing of having clinical supplies of our product candidates manufactured; ● the initiation and progress of ongoing pre-clinical studies and clinical trials for our product candidates; ● the costs involved in patent filing, prosecution, and enforcement; and ● the number of programs we pursue. Our current capital resources are not sufficient to fund our planned operations for the next 12 months. We will continue to require substantial additional capital to continue our clinical development and pursuit of regulatory approval activities. Accordingly, we will need to raise substantial additional capital to continue to fund our operations. The amount and timing of our future funding requirements will depend on many factors, including the pace and results of our development, regulatory and commercialization efforts. Failure to raise capital as and when needed, on favorable terms or at all, would have a negative impact on our financial condition and our ability to develop and potentially commercialize (if approved) our product candidates. Based on available resources, we believe that our cash and cash equivalents currently on hand are sufficient to fund our anticipated operating and capital requirements through the first half of 2018. We expect to incur significant expenses and increasing operating losses for at least the next two years as we initiate and continue the clinical development of, seek regulatory approval for, and potentially commercialize (if approved) our product candidates and add personnel necessary to operate as a public company with an advanced clinical pipeline of product candidates. In addition, operating as a publicly-traded company involves the hiring of additional financial and other personnel, upgrading financial information systems, and incurring costs associated with operating as a public company. We expect that our operating losses will fluctuate significantly from quarter-to-quarter and year-to-year due to the timing of clinical development programs, efforts to achieve regulatory approval and planning for potential commercialization (if approved) of our product candidates. Until we can generate a sufficient amount of product revenue to finance our cash requirements, which would require us to obtain regulatory approval for and successfully commercialize one or more of our product candidates, we expect to finance our future cash needs primarily through the issuance of additional equity and potentially through borrowing and strategic alliances with partner companies. To the extent that we raise additional capital through the issuance of additional equity or convertible debt securities, the ownership interest of our shareholders will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect the rights of existing shareholders. Debt financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. If we raise additional funds through marketing and distribution arrangements or other collaborations, strategic alliances or licensing arrangements with third parties, we may have to relinquish valuable rights to our technologies, future revenue streams, research programs or product candidates or grant licenses on terms that may not be favorable to us. If we are unable to raise additional funds through equity or debt financings when needed, we may be required to delay, limit, reduce or terminate our product development or pursuit of regulatory approval efforts or grant rights to develop and market product candidates to third parties that we would otherwise prefer to develop and, if applicable, market ourselves. License Agreements In August 2016, Private Acer entered into an agreement with the AP-HP granting Private Acer the exclusive worldwide rights to access and use data from a multicenter, prospective, randomized, open trial related to the use of celiprolol for the treatment of vEDS. We intend to use this pivotal clinical data to support an NDA filing for EDSIVO for the treatment of vEDS. The agreement requires Private Acer to make certain upfront payments to AP-HP, reimburse certain of AP-HP’s costs, make payments upon achievement of defined milestones and pay royalties on net sales of celiprolol over the royalty term. 18 In April 2014, Private Acer obtained exclusive rights to patents and certain other intellectual property relating to ACER-001 and preclinical and clinical data, through an exclusive license agreement with Baylor College of Medicine, or BCM. Under the terms of the agreement, as amended, Private Acer has worldwide exclusive rights to develop, manufacture, use, sell and import products incorporating the licensed intellectual property. The license agreement requires us to make upfront and annual payments to BCM, reimburse certain of BCM’s legal costs, make payments upon achievement of defined milestones, and pay royalties on net sales of any developed product over the royalty term. Off-Balance Sheet Arrangements We have not entered into any off-balance sheet arrangements and do not have any holdings in variable interest entities. Item 3. Quantitative and Qualitative Disclosures About Market Risk. Not Applicable. Item 4. Controls and Procedures. Evaluation of Disclosure Controls and Procedures We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit to the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized, and reported within the time periods specified by the Securities and Exchange Commission’s rules and forms, and that information is accumulated and communicated to our management, including our principal executive officer and principal financial officer (whom we refer to in this periodic report as our Certifying Officers), as appropriate to allow timely decisions regarding required disclosure. Our management evaluated, with the participation of our Certifying Officers, the effectiveness of our disclosure controls and procedures as of September 30, 2017, pursuant to Rule 13a-15(b) under the Securities Exchange Act. Based upon that evaluation, our Certifying Officers concluded that, as of September 30, 2017, our disclosure controls and procedures were effective. Changes in Internal Control Over Financial Reporting There were no changes in our internal control over financial reporting that occurred during our most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 19 PART II - OTHER INFORMATION Item 1. Legal Proceedings. From time to time, the Company or its subsidiaries may become involved in litigation or proceedings relating to claims arising from the ordinary course of business. See Note 7 to our unaudited condensed consolidated financial statements included in this report for a description of our litigation with Piper Jaffray & Co. Item 1A. Risk Factors. Investing in our securities involves a high degree of risk. You should consider the following risk factors, as well as other information contained or incorporated by reference in this report, before deciding to invest in our securities. The following factors affect our business, our intellectual property, the industry in which we operate and our securities. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known or which we consider immaterial as of the date hereof may also have an adverse effect on our business. If any of the matters discussed in the following risk factors were to occur, our business, financial condition, results of operations, cash flows or prospects could be materially adversely affected, the market price of our securities could decline and you could lose all or part of your investment in our securities. Risks Related to Our Business and Financial Condition We have a limited operating history and have incurred significant losses since our inception and anticipate that we will continue to incur losses for the foreseeable future and may never achieve or maintain profitability. The absence of any commercial sales and our limited operating history make it difficult to assess our future viability. We are a development-stage pharmaceutical company with a limited operating history. On September 19, 2017, we completed the reverse merger, or the Merger, with Acer Therapeutics Inc., a Delaware corporation, or Private Acer, in accordance with the terms of the Agreement and Plan of Merger and Reorganization, dated as of June 30, 2017, by and among Private Acer, ourselves and Opexa Merger Sub, Inc. Also on September 19, 2017, in connection with, and prior to the completion of, the Merger, we effected a 1-for-10.355527 reverse stock split of our common stock and changed our name to “Acer Therapeutics Inc.” Pharmaceutical product development is a highly speculative undertaking and involves a substantial degree of risk. We are focused principally on repurposing and/or reformulating existing drugs for (ultra) orphan diseases with significant unmet medical need. We are not profitable and Private Acer had incurred losses in each year since its inception in 2013. We have only a limited operating history upon which you can evaluate our business and prospects. In addition, we have limited experience and have not yet demonstrated an ability to successfully overcome many of the risks and uncertainties frequently encountered by companies in new and rapidly evolving fields, particularly in the specialty pharmaceutical industry. We have not generated any revenue to date. We continue to incur significant research and development and other expenses related to our ongoing operations. Our net loss for the year ended December 31, 2016 as a private company was $6.7 million. As of September 30, 2017, we had an accumulated deficit of $21.3 million. We expect to continue to incur losses for the foreseeable future as we continue our development of, and seek marketing approvals for, our product candidates. We have devoted substantially all of our financial resources to identify, acquire, and develop our product candidates, including providing general and administrative support for our operations. To date, we have financed our operations primarily through the sale of equity securities and convertible promissory notes. The amount of our future net losses will depend, in part, on the rate of our future expenditures and our ability to obtain funding through equity or debt financings, strategic collaborations, or grants. Pharmaceutical product development is a highly speculative undertaking and involves a substantial degree of risk. We expect losses to increase as we conduct clinical trials and continue to develop our lead product candidates. We expect to invest significant funds into the research and development of our current product candidates to determine the potential to advance these product candidates to regulatory approval. If we obtain regulatory approval to market a product candidate, our future revenue will depend upon the size of any markets in which our product candidates may receive approval, and our ability to achieve sufficient market acceptance, pricing, reimbursement from third-party payors, and adequate market share for our product candidates in those markets. Even if we obtain adequate market share for our product candidates, because the potential markets in which our product candidates may ultimately receive regulatory approval could be very small, we may never become profitable despite obtaining such market share and acceptance of our products. 20 We expect to continue to incur significant expenses and increasing operating losses for the foreseeable future, and our expenses will increase substantially if and as we: ● continue the clinical development of our product candidates; ● continue efforts to discover new product candidates; ● undertake the manufacturing of our product candidates or increase volumes manufactured by third parties; ● advance our programs into larger, more expensive clinical trials; ● initiate additional pre-clinical, clinical, or other trials or studies for our product candidates; ● seek regulatory and marketing approvals and reimbursement for our product candidates; ● establish a sales, marketing and distribution infrastructure to commercialize any products for which we may obtain marketing approval and market for ourselves; ● seek to identify, assess, acquire and/or develop other product candidates; ● make milestone, royalty or other payments under third-party license agreements; ● seek to maintain, protect and expand our intellectual property portfolio; ● seek to attract and retain skilled personnel; and ● experience any delays or encounter issues with the development and potential for regulatory approval of our clinical candidates such as safety issues, clinical trial accrual delays, longer follow-up for planned studies, additional major studies or supportive studies necessary to support marketing approval. Further, the net losses we incur may fluctuate significantly from quarter to quarter and year to year, such that a period-to-period comparison of our results of operations may not be a good indication of our future performance. We currently have no source of product sales revenue and may never be profitable. We have not generated any revenues from commercial sales of any of our current product candidates, EDSIVO (for Vascular Ehlers-Danlos Syndrome, or vEDS) and ACER-001 (for Urea Cycle Disorder, or UCD, and Maple Syrup Urine Disease, or MSUD). Our ability to generate product revenue depends upon our ability to successfully commercialize these product candidates or other product candidates that we may develop, in-license or acquire in the future. Our ability to generate future product revenue from our current or future product candidates also depends on a number of additional factors, including our ability to: ● successfully complete research and clinical development of current and future product candidates; ● establish and maintain supply and manufacturing relationships with third parties, and ensure adequate and legally compliant manufacturing of product candidates; ● obtain regulatory approval from relevant regulatory authorities in jurisdictions where we intend to market our product candidates; ● launch and commercialize future product candidates for which we obtain marketing approval, if any, and if launched independently, successfully establish a sales force and marketing and distribution infrastructure; ● obtain coverage and adequate product reimbursement from third-party payors, including government payors; ● achieve market acceptance for our products, if any; ● establish, maintain and protect our intellectual property rights; and ● attract, hire and retain qualified personnel. 21 In addition, because of the numerous risks and uncertainties associated with clinical product development, including that our product candidates may not advance through development or achieve regulatory approval, we are unable to predict the timing or amount of any potential future product sales revenues. Our expenses also could increase beyond expectations if we decide to or are required by the United Stated Food and Drug Administration, or FDA, or comparable foreign regulatory authorities, to perform studies or trials in addition to those that we currently anticipate. Even if we complete the development and regulatory processes described above, we anticipate incurring significant costs associated with launching and commercializing these products. We will require substantial additional financing to obtain marketing approval of our product candidates and commercialize our product candidates, and a failure to obtain this necessary capital when needed on acceptable terms, or at all, could force us to delay, limit, reduce or terminate our product development, other operations or commercialization efforts. Since our inception, substantially all of our resources have been dedicated to the clinical development of our product candidates. As of September 30, 2017, we had an accumulated deficit of $21.3 million, cash and cash equivalents of $8.4 million and current liabilities aggregating $2.3 million. Based on available resources, we believe that our cash and cash equivalents currently on hand are sufficient to fund our anticipated operating and capital requirements through the first half of 2018. We believe that we will continue to expend substantial resources for the foreseeable future on the completion of clinical development and regulatory preparedness of our product candidates, preparations for a commercial launch of our product candidates, if approved, and development of any other current or future product candidates we may choose to further develop. These expenditures will include costs associated with research and development, conducting preclinical studies and clinical trials, obtaining marketing approvals, and manufacturing and supply as well as marketing and selling any products approved for sale. In addition, other unanticipated costs may arise. Because the outcome of any drug development process is highly uncertain, we cannot reasonably estimate the actual amounts necessary to successfully complete the development and commercialization of our current product candidates, if approved, or future product candidates, if any. Our operating plan may change as a result of factors currently unknown to us, and we may need to seek additional funds sooner than planned, through public or private equity or debt financings or other sources, such as strategic collaborations. Such financing may result in dilution to shareholders, imposition of debt covenants and repayment obligations, or other restrictions that may adversely affect our business. In addition, we may seek additional capital due to favorable market conditions or strategic considerations even if we believe we have sufficient funds for our current or future operating plans. Our future capital requirements depend on many factors, including: ● the scope, progress, results and costs of researching and developing our current product candidates, future product candidates and conducting preclinical and clinical trials; ● the cost of seeking regulatory and marketing approvals and reimbursement for our product candidates; ● the cost of commercialization activities if our current product candidates and future product candidates are approved for sale, including marketing, sales and distribution costs and preparedness of our corporate infrastructure; ● the cost of manufacturing current product candidates and future product candidates that we obtain approval for and successfully commercialize; ● our ability to establish and maintain strategic collaborations, licensing or other arrangements and the financial terms of such agreements; ● the number and characteristics of any additional product candidates we may develop or acquire; ● any product liability or other lawsuits related to our products or commenced against us; ● the expenses needed to attract and retain skilled personnel; ● the costs associated with being a public company; ● the costs involved in preparing, filing, prosecuting, maintaining, defending and enforcing our intellectual property rights, including litigation costs and the outcome of such litigation; and ● the timing, receipt and amount of sales of, or royalties on, any future approved products, if any. 22 Additional funds may not be available when we need them, on terms that are acceptable to us, or at all. If adequate funds are not available to us on a timely basis, we may be required to: ● delay, limit, reduce or terminate preclinical studies, clinical trials or other development activities for our current product candidates or future product candidates, if any; ● delay, limit, reduce or terminate our research and development activities; or ● delay, limit, reduce or terminate our establishment of sales and marketing capabilities or other activities that may be necessary to commercialize our future product candidates. Raising additional capital may cause dilution to our existing shareholders, restrict our operations or require us to relinquish rights to our technologies or product candidates. We may seek additional capital through a combination of public and private equity offerings, debt financings, strategic collaborations and alliances and licensing arrangements. To the extent that we raise additional capital through the sale of equity or convertible debt securities, the ownership interest of our shareholders will be diluted, and the terms may include liquidation or other preferences that adversely affect the rights of our shareholders. The incurrence of indebtedness would result in increased fixed payment obligations and could involve certain restrictive covenants, such as limitations on our ability to incur additional debt, limitations on our ability to acquire or license intellectual property rights and other operating restrictions that could adversely impact our ability to conduct our business. If we raise additional funds through strategic collaborations and alliances and licensing arrangements with third parties, we may have to relinquish valuable rights to our technologies or product candidates, or grant licenses on terms unfavorable to us. Our auditors have expressed doubt about our ability to continue as a going concern. In their audited financial report in respect of the 2016 fiscal year, the independent registered public accounting firm for Private Acer included in its report an emphasis-of-a-matter indicating that the recurring losses from operations of Private Acer raised a substantial doubt as to the ability of Private Acer to continue as a going concern. We subsequently received $15.5 million in connection with a financing that closed in connection with the Merger. As of September 30, 2017, we had an accumulated deficit of $21.3 million, cash and cash equivalents of $8.4 million and current liabilities aggregating $2.3 million. Based on available resources, we believe that our cash and cash equivalents currently on hand are sufficient to fund our anticipated operating and capital requirements through the first half of 2018. We expect to continue to incur losses for the foreseeable future as we continue our development of, and seek marketing approvals for, our product candidates. These matters raise substantial doubt about our ability to continue as a going concern. Because we have been issued an opinion by our independent registered public accounting firm that substantial doubt exists as to whether we can continue as a going concern, it may be more difficult for us to attract investors. Unless we are able to raise additional capital, it is possible that the opinion of our independent registered public accounting firm on our audited financial report in respect of the upcoming 2017 fiscal year or future years may include a similar going concern qualification. Funding from our ATM facility may be limited or be insufficient to fund our operations or to implement our strategy. We will need to amend and keep current our shelf registration statement and the offering prospectus relating to the ATM facility with Brinson Patrick (now a division of IFS Securities, Inc.) in order to use the program to sell shares of our common stock. The number of shares and price at which we may be able to sell shares under our ATM facility may be limited due to market conditions and other factors beyond our control. We have incurred, and expect to continue to incur, increased costs and risks as a result of being a public company. As a public company, we are required to comply with the Sarbanes-Oxley Act of 2002, or SOX, as well as rules and regulations implemented by the Securities and Exchange Commission, or SEC, and The NASDAQ Stock Market, or NASDAQ. Changes in the laws and regulations affecting public companies, including the provisions of SOX and rules adopted by the SEC and by NASDAQ, have resulted in, and will continue to result in, increased costs as we respond to their requirements. Given the risks inherent in the design and operation of internal controls over financial reporting, the effectiveness of our internal controls over financial reporting is uncertain. If our internal controls are not designed or operating effectively, we may not be able to conclude an evaluation of our internal control over financial reporting as required or we or our independent registered public accounting firm may determine that our internal control over financial reporting was not effective. We currently have a very limited workforce, and it may be difficult to adhere to appropriate internal controls over financial reporting or disclosure controls with such limited staffing. In addition, our registered public accounting firm may either disclaim an opinion as it relates to management’s assessment of the effectiveness of our internal controls or may issue an adverse opinion on the effectiveness of our internal controls over financial reporting, especially in light of the fact that we currently have a very limited workforce. Investors may lose confidence in the reliability of our financial statements, which could cause the market price of our common stock to decline and which could affect our ability to run our business as we otherwise would like to. New rules could also make it more difficult or more costly for us to obtain certain types of insurance, including directors’ and officers’ liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the coverage that is the same or similar to our current coverage. The impact of these events could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, our board committees and as executive officers. We cannot predict or estimate the total amount of the costs we may incur or the timing of such costs to comply with these rules and regulations. 23 Under the corporate governance standards of NASDAQ, a majority of our board of directors and each member of our Audit and Compensation Committees must be an independent director. If any vacancies on our Board or Audit or Compensation Committees occur that need to be filled by independent directors, we may encounter difficulty in attracting qualified persons to serve on our Board and, in particular, our Audit Committee. If we fail to attract and retain the required number of independent directors, we may be subject to SEC enforcement proceedings and delisting of our common stock from the NASDAQ Capital Market. If we fail to retain accounting and finance staff with appropriate experience, our ability to maintain the financial controls required of a public company may adversely affect our business. We currently rely on third-party accounting professionals to assist with our financial accounting and compliance obligations. We are seeking financial professionals with appropriate experience to maintain our financial control and reporting obligations as a public company. If we are unable to identify and retain such qualified and experienced personnel, our business may be adversely affected. If we fail to maintain proper and effective internal controls, our ability to produce accurate financial statements on a timely basis could be impaired. We are subject to the reporting requirements of the Exchange Act, SOX and NASDAQ rules and regulations. SOX requires, among other things, that we maintain effective disclosure controls and procedures and internal control over financial reporting. We must perform system and process evaluation and testing of our internal control over financial reporting to allow management to report on the effectiveness of our internal controls over financial reporting in our Annual Report on Form 10-K filing for that year, as required by Section 404 of SOX. We rely on third-party accounting professionals to assist with our financial accounting and compliance obligations. As a private company, Private Acer had never been required to test its internal controls within a specified period. This will require that we incur substantial professional fees and internal costs to expand our accounting and finance functions and that we expend significant management efforts. We may experience difficulty in meeting these reporting requirements in a timely manner. Although we are committed to continuing to improve our internal control processes, and although we will continue to diligently and vigorously review our internal control over financial reporting, we cannot be certain that, in the future, a material weakness or significant deficiency will not exist or otherwise be discovered. We may discover weaknesses in our system of internal financial and accounting controls and procedures that could result in a material misstatement of our financial statements. Our internal control over financial reporting will not prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud will be detected. If we are not able to comply with the requirements of Section 404 of SOX, or if we are unable to maintain proper and effective internal controls, we may not be able to produce timely and accurate financial statements. If that were to happen, the market price of our common stock could decline and we could be subject to sanctions or investigations by NASDAQ, the SEC, or other regulatory authorities. Any acquisitions that we make could disrupt our business and harm our financial condition. We expect to evaluate potential strategic acquisitions of complementary businesses, products or technologies on a global geographic footprint. We may also consider joint ventures, licensing and other collaborative projects. We may not be able to identify appropriate acquisition candidates or strategic partners, or successfully negotiate, finance or integrate acquisitions of any businesses, products or technologies. Furthermore, the integration of any acquisition and management of any collaborative project may divert our management’s time and resources from our core business and disrupt our operations. We do not have any experience with acquiring companies, or with acquiring products outside of the United States. Any cash acquisition we pursue would potentially divert the cash we have on our balance sheet from our present clinical development programs. Any stock acquisitions would dilute our shareholders’ ownership. While we from time to time evaluate potential collaborative projects and acquisitions of businesses, products and technologies, and anticipate continuing to make these evaluations, we have no present agreements with respect to any acquisitions or collaborative projects. 24 Risks Related to the Clinical Development and Marketing Approval of Our Product Candidates The marketing approval processes of the FDA and comparable foreign authorities are lengthy, time consuming and inherently unpredictable, and if we are ultimately unable to obtain marketing approval for our product candidates, our business will be substantially harmed. None of our current product candidates have gained marketing approval for sale in the United States or any other country, and we cannot guarantee that we will ever have marketable products. Our business is substantially dependent on our ability to complete the development of, obtain marketing approval for, and successfully commercialize our product candidates in a timely manner. We cannot commercialize our product candidates in the United States without first obtaining approval from the FDA to market each product candidate. Similarly, we cannot commercialize our product candidates outside of the United States without obtaining regulatory approval from comparable foreign regulatory authorities. Our product candidates could fail to receive marketing approval for many reasons, including the following: ● the FDA or comparable foreign regulatory authorities may disagree with the design or implementation of our clinical trials; ● the FDA or comparable foreign regulatory authorities may find the human subject protections for our clinical trials inadequate and place a clinical hold on an Investigational New Drug Application, or IND, at the time of its submission precluding commencement of any trials or a clinical hold on one or more clinical trials at any time during the conduct of our clinical trials; ● the FDA could determine that we cannot rely on Section 505(b)(2) of the Federal Food, Drug and Cosmetic Act, or FFDCA, for any or all of our product candidates; ● we may be unable to demonstrate to the satisfaction of the FDA or comparable foreign regulatory authorities that a product candidate is safe and effective for its proposed indication; ● the results of clinical trials may not meet the level of statistical significance required by the FDA or comparable foreign regulatory authorities for approval; ● we may be unable to demonstrate that a product candidate’s clinical and other benefits outweigh its safety risks; ● the FDA or comparable foreign regulatory authorities may disagree with our interpretation of data from preclinical studies or clinical trials; ● the FDA could determine that we have identified the wrong reference listed drug or drugs or that approval of our 505(b)(2) application for any of our product candidates is blocked by patent or non-patent exclusivity of the reference listed drug or drugs; ● the data collected from clinical trials of our product candidates may not be sufficient to support the submission of an application to obtain marketing approval in the United States or elsewhere; ● the FDA or comparable foreign regulatory authorities may find inadequate the manufacturing processes or facilities of third-party manufacturers with which we contract for clinical and commercial supplies; and ● the approval policies or regulations of the FDA or comparable foreign regulatory authorities may significantly change in a manner that would delay marketing approval. Before obtaining marketing approval for the commercial sale of any drug product for a target indication, we must demonstrate in preclinical studies and well-controlled clinical trials and, with respect to approval in the United States, to the satisfaction of the FDA, that the product is safe and effective for its intended use and that the manufacturing facilities, processes and controls are adequate to preserve the drug’s identity, strength, quality and purity. In the United States, it is necessary to submit and obtain approval of a New Drug Application, or NDA, from the FDA. An NDA must include extensive preclinical and clinical data and supporting information to establish the product safety and efficacy for each desired indication. The NDA must also include significant information regarding the chemistry, manufacturing and controls for the product. After the submission of an NDA, but before approval of the NDA, the manufacturing facilities used to manufacture a product candidate must be inspected by the FDA to ensure compliance with the applicable Current Good Manufacturing Practice, or cGMP, requirements. The FDA and the Competent Authorities of the Member States of the European Economic Area, or EEA, and comparable foreign regulatory authorities, may also inspect our clinical trial sites and audit clinical study data to ensure that our studies are properly conducted in accordance with the IND regulations, human subject protection regulations, and good clinical practice, or cGCP. 25 Obtaining approval of an NDA is a lengthy, expensive and uncertain process, and approval may not be obtained. Upon submission of an NDA, the FDA must make an initial determination that the application is sufficiently complete to accept the submission for filing. We cannot be certain that any submissions will be accepted for filing and reviewed by the FDA, or ultimately be approved. If the application is not accepted for review, the FDA may require that we conduct additional clinical studies or preclinical testing, or take other actions before it will reconsider our application. If the FDA requires additional studies or data, we would incur increased costs and delays in the marketing approval process, which may require us to expend more resources than we have available. In addition, the FDA may not consider any additional information to be complete or sufficient to support the filing or approval of the NDA. Regulatory authorities outside of the United States, such as in Europe and Japan and in emerging markets, also have requirements for approval of drugs for commercial sale with which we must comply prior to marketing in those areas. Regulatory requirements can vary widely from country to country and could delay or prevent the introduction of our product candidates. Clinical trials conducted in one country may not be accepted or the results may not be found adequate by regulatory authorities in other countries, and obtaining regulatory approval in one country does not mean that regulatory approval will be obtained in any other country. However, the failure to obtain regulatory approval in one jurisdiction could have a negative impact on our ability to obtain approval in a different jurisdiction. Approval processes vary among countries and can involve additional product candidate testing and validation and additional administrative review periods. Seeking foreign regulatory approval could require additional non-clinical studies or clinical trials, which could be costly and time consuming. Foreign regulatory approval may include all of the risks associated with obtaining FDA approval. For all of these reasons, we may not obtain foreign regulatory approvals on a timely basis, if at all. The process to develop, obtain marketing approval for, and commercialize product candidates is long, complex and costly, both inside and outside of the United States, and approval is never guaranteed. The time required to obtain approval by the FDA and comparable foreign authorities is unpredictable but typically takes many years following the commencement of clinical trials and depends upon numerous factors, including the substantial discretion of the regulatory authorities. In addition, approval policies, regulations, or the type and amount of clinical data necessary to gain approval may change during the course of a product candidate’s clinical development and may vary among jurisdictions. Even if our product candidates were to successfully obtain approval from regulatory authorities, any such approval might significantly limit the approved indications for use, including more limited patient populations, require that precautions, warnings or contraindications be included on the product labeling, including black box warnings, require expensive and time-consuming post-approval clinical studies, risk evaluation and mitigation strategies or surveillance as conditions of approval, or, through the product label, the approval may limit the claims that we may make, which may impede the successful commercialization of our product candidates. Following any approval for commercial sale of our product candidates, certain changes to the product, such as changes in manufacturing processes and additional labeling claims, as well as new safety information, may require new studies and will be subject to additional FDA notification, or review and approval. Also, marketing approval for any of our product candidates may be withdrawn. If we are unable to obtain marketing approval for our product candidates in one or more jurisdictions, or any approval contains significant limitations, our ability to market to our full target market will be reduced and our ability to realize the full market potential of our product candidates will be impaired. Furthermore, we may not be able to obtain sufficient funding or generate sufficient revenue and cash flows to continue or complete the development of any of our current or future product candidates. If we are unable to submit an application for approval under Section 505(b)(2) of the FFDCA or if we are required to generate additional data related to safety and efficacy in order to obtain approval under Section 505(b)(2), we may be unable to meet our anticipated development and commercialization timelines. Our current strategy for seeking marketing authorization in the United States for our product candidates relies primarily on Section 505(b)(2) of the FFDCA, which permits use of a marketing application, referred to as a 505(b)(2) application, where at least some of the information required for approval comes from studies not conducted by or for the applicant and for which the applicant has not obtained a right of reference or use. The FDA interprets this to mean that an applicant may rely for approval on such data as that found in published literature or the FDA’s finding of safety or effectiveness, or both, of a previously approved drug product owned by a third party. There is no assurance that the FDA would find third-party data relied upon by us in a 505(b)(2) application sufficient or adequate to support approval, and the FDA may require us to generate additional data to support the safety and efficacy of our product candidates. Consequently, we may need to conduct substantial new research and development activities beyond those we currently plan to conduct. Such additional new research and development activities would be costly and time consuming and there is no assurance that such data generated from such additional activities would be sufficient to obtain approval. 26 If the data to be relied upon in a 505(b)(2) application are related to drug products previously approved by the FDA and covered by patents that are listed in the FDA’s Orange Book, we would be required to submit with our 505(b)(2) application a Paragraph IV Certification in which we must certify that we do not infringe the listed patents or that such patents are invalid or unenforceable, and provide notice to the patent owner or the holder of the approved NDA. The patent owner or NDA holder would have 45 days from receipt of the notification of our Paragraph IV Certification to initiate a patent infringement action against us. If an infringement action is initiated, the approval of our NDA would be subject to a stay of up to 30 months or more while we defend against such a suit. Approval of our product candidates under Section 505(b)(2) may therefore be delayed until patent exclusivity expires or until we successfully challenge the applicability of those patents to our product candidates. Alternatively, we may elect to generate sufficient clinical data so that we would no longer need to rely on third-party data, which would be costly and time consuming and there would be no assurance that such data generated from such additional activities would be sufficient to obtain approval. We may not be able to obtain shortened review of our applications, and the FDA may not agree that our product candidates qualify for marketing approval. If we are required to generate additional data to support approval, we may be unable to meet anticipated or reasonable development and commercialization timelines, may be unable to generate the additional data at a reasonable cost, or at all, and may be unable to obtain marketing approval of our product candidates. If the FDA changes its interpretation of Section 505(b)(2) allowing reliance on data in a previously approved drug application owned by a third party, or there is a change in the law affecting Section 505(b)(2), this could delay or even prevent the FDA from approving any Section 505(b)(2) application that we submit. Clinical drug development involves a lengthy and expensive process with an uncertain outcome, and results of earlier studies and trials may not be predictive of future trial results. Clinical testing is expensive, and can take many years to complete, and its outcome is inherently uncertain. The FDA and comparable foreign regulatory authorities have substantial discretion in the approval process, and determining when or whether marketing approval will be obtained for our current product candidates. Even if we believe the data collected from clinical trials of our current product candidates are promising, such data may not be sufficient to support approval by the FDA or comparable foreign authorities. Our future clinical trial results may not be successful. It is impossible to predict the extent to which the clinical trial process may be affected by legislative and regulatory developments. Due to these and other factors, our current product candidates or future product candidates could take a significantly longer time to gain marketing approval than expected or may never gain marketing approval. This could delay or eliminate any potential product revenue by delaying or terminating the potential commercialization of our current product candidates. Preclinical trials must also be conducted in accordance with FDA and comparable foreign authorities’ legal requirements, regulations or guidelines, including Good Laboratory Practice, or GLP, an international standard meant to harmonize the conduct and quality of nonclinical studies and the archiving and reporting of findings. Preclinical studies including long-term toxicity studies and carcinogenicity studies in experimental animals may result in findings that may require further evaluation, which could affect the risk-benefit evaluation of clinical development, or which may even lead the regulatory agencies to delay, prohibit the initiation of or halt clinical trials or delay or deny marketing authorization applications. Failure to adhere to the applicable GLP standards or misconduct during the course of preclinical trials may invalidate the data and require one or more studies to be repeated or additional testing to be conducted. Clinical trials must also be conducted in accordance with FDA and comparable foreign authorities’ legal requirements, regulations or guidelines, including human subject protection requirements and GCP. Clinical trials are subject to further oversight by these governmental agencies and institutional review boards, or IRBs, at the medical institutions where the clinical trials are conducted. In addition, clinical trials must be conducted with supplies of our current product candidates produced under cGMP, and other requirements. Our clinical trials are conducted at multiple sites, including some sites in countries outside the United States and the European Union, which may subject us to further delays and expenses as a result of increased shipment costs, additional regulatory requirements and the engagement of foreign and non-EU clinical research organizations, as well as expose us to risks associated with clinical investigators who are unknown to the FDA or the European regulatory authorities, and with different standards of diagnosis, screening and medical care. The commencement and completion of clinical trials for our current product candidates may be delayed, suspended or terminated as a result of many factors, including but not limited to: ● the delay or refusal of regulators or IRBs to authorize us to commence a clinical trial at a prospective trial site and changes in regulatory requirements, policies and guidelines; ● the FDA or comparable foreign regulatory authorities disagreeing as to the design or implementation of our clinical trials; 27 ● failure to reach agreement on acceptable terms with prospective contract research organizations, or CROs, and clinical trial sites, the terms of which can be subject to extensive negotiation and may vary significantly among different CROs and trial sites; ● delays in patient enrollment and variability in the number and types of patients available for clinical trials; ● the inability to enroll a sufficient number of patients in trials to ensure adequate statistical power to detect statistically significant treatment effects; ● lower than anticipated retention rates of patients and volunteers in clinical trials; ● clinical sites deviating from trial protocol or dropping out of a trial; ● adding new clinical trial sites; ● negative or inconclusive results, which may require us to conduct additional preclinical or clinical trials or to abandon projects that we expect to be promising; ● safety or tolerability concerns could cause us to suspend or terminate a trial if we find that the participants are being exposed to unacceptable health risks; ● regulators or IRBs requiring that we or our investigators suspend or terminate clinical research for various reasons, including noncompliance with regulatory requirements; ● our third-party research and manufacturing contractors failing to comply with regulatory requirements or meet their contractual obligations to us in a timely manner, or at all; ● difficulty in maintaining contact with patients after treatment, resulting in incomplete data; ● delays in establishing the appropriate dosage levels; ● the quality or stability of our current product candidates falling below acceptable standards; ● the inability to produce or obtain sufficient quantities of our current product candidates to complete clinical trials; and ● exceeding budgeted costs due to difficulty in predicting accurately the costs associated with clinical trials. Patient enrollment is a significant factor in the timing of clinical trials and is affected by many factors, including the size and nature of the patient population, the proximity of patients to clinical sites, the eligibility criteria for the trial, the design of the clinical trial, competing clinical trials and clinicians’ and patients’ perceptions as to the potential advantages of the drug being studied in relation to other available therapies, including any new drugs or treatments that may be approved for the indications we are investigating. There are significant requirements imposed on us and on clinical investigators who conduct clinical trials that we sponsor. Although we are responsible for selecting qualified clinical investigators, providing them with the information they need to conduct the clinical trial properly, ensuring proper monitoring of the clinical trial, and ensuring that the clinical trial is conducted in accordance with the general investigational plan and protocols contained in the IND, we cannot ensure the clinical investigators will maintain compliance with all regulatory requirements at all times. The pharmaceutical industry has experienced cases where clinical investigators have been found to incorrectly record data, omit data, or even falsify data. We cannot ensure that the clinical investigators in our trials will not make mistakes or otherwise compromise the integrity or validity of data, any of which would have a significant negative effect on our ability to obtain marketing approval, our business, and our financial condition. We could encounter delays if a clinical trial is suspended or terminated by us, by the IRBs of the institutions in which such trial is being conducted, by the data safety monitoring board, or DSMB, for such trial, or by the FDA or comparable foreign regulatory authorities. We or such authorities may impose a suspension or termination due to a number of factors, including failure to conduct the clinical trial in accordance with regulatory requirements or our clinical protocols, inspection of the clinical trial operations or trial site by the FDA or comparable foreign regulatory authorities resulting in the imposition of a clinical hold, safety issues or adverse side effects, failure to demonstrate a benefit from using the drug, changes in governmental regulations or administrative actions or lack of adequate funding to continue the clinical trial. If we experience delays in the completion of, or termination of, any clinical trial of our current product candidates, the commercial prospects of our current product candidates will be harmed, and our ability to generate product revenues from our product candidates will be delayed. In addition, any delays in completing our clinical trials will increase our costs, slow our development and approval process and jeopardize our ability to commence product sales and generate revenues. Many of the factors that cause, or lead to, a delay in the commencement or completion of clinical trials may also ultimately lead to the denial of marketing approval of our product candidates. 28 Moreover, clinical investigators for our clinical trials may serve as scientific advisors or consultants to us from time to time and receive compensation in connection with such services. We are required to report certain financial relationships with clinical investigators to the FDA and, where applicable, take steps to minimize the potential for bias resulting from such financial relationships. The FDA will evaluate the reported information and may conclude that a financial relationship between us and a clinical investigator has created a conflict of interest or otherwise affected interpretation of the study. The FDA may therefore question the integrity of the data generated at the applicable clinical trial site, and the utility of the clinical trial itself may be jeopardized. This could result in a refusal to accept or a delay in approval of our marketing applications by the FDA and may ultimately lead to the denial of marketing approval of one or more of our product candidates. Any of these occurrences could materially adversely affect our business, financial condition, results of operations, and prospects. In addition, many of the factors that cause, or lead to, a delay in the commencement or completion of clinical trials may also ultimately lead to the denial of marketing approval of our current product candidates. Significant clinical trial delays could also allow our competitors to bring products to market before we are able to do so, shorten any periods during which we have the exclusive right to commercialize our current product candidates and impair our ability to commercialize our current product candidates, which may harm our business, financial condition, results of operations, and prospects. Clinical failure can occur at any stage of clinical development. Because the results of earlier clinical trials are not necessarily predictive of future results, any product candidate we advance through clinical trials may not have favorable results in later clinical trials or receive marketing approval. Clinical failure can occur at any stage of our clinical development. The results of preclinical studies and early clinical trials of our product candidates may not be predictive of the results of later-stage clinical trials. Product candidates in later stages of clinical trials may fail to show the desired safety and efficacy traits despite having progressed through preclinical studies and initial clinical trials. A number of companies in the pharmaceutical industry have suffered significant setbacks in advanced clinical trials due to lack of efficacy or adverse safety profiles, notwithstanding promising results in earlier trials. Clinical trials may produce negative or inconclusive results, and we may decide, or regulators may require us, to conduct additional clinical or preclinical testing. Data obtained from tests are susceptible to varying interpretations, and regulators may not interpret our data as favorably as we do, which may delay, limit or prevent marketing approval. In addition, the design of a clinical trial can determine whether our results will support approval of a product, or approval of a product for desired indications, and flaws or shortcomings in the design of a clinical trial may not become apparent until the clinical trial is well advanced. We have limited experience in designing clinical trials and may be unable to design and execute a clinical trial to support marketing approval for our desired indications. Further, clinical trials of potential products often reveal that it is not practical or feasible to continue development efforts. If one of our product candidates is found to be unsafe or lack efficacy, we will not be able to obtain marketing approval for it and our business would be harmed. For example, if the results of our clinical trials of our product candidates do not achieve pre-specified endpoints or we are unable to provide primary or secondary endpoint measurements deemed acceptable by the FDA or comparable foreign regulators or if we are unable to demonstrate an acceptable level of safety relative to the efficacy associated with our proposed indications, the prospects for approval of our product candidates would be materially and adversely affected. A number of companies in the pharmaceutical industry, including those with greater resources and experience than us, have suffered significant setbacks in Phase 2 and Phase 3 clinical trials, even after seeing promising results in earlier clinical trials. In some instances, there can be significant variability in safety and/or efficacy results between different trials of the same product candidate due to numerous factors, including differences in trial protocols and design, the size and type of the patient population, adherence to the dosing regimen and the rate of dropout among clinical trial participants. We do not know whether any clinical trials we may conduct will demonstrate consistent and/or adequate efficacy and safety to obtain marketing approval for our product candidates. As an organization, we have never completed any clinical trial before and may be unable to do so efficiently or at all for our current product candidates or any product candidate we develop. We intend to conduct clinical trials of our product candidates. The conduct of clinical trials and the submission of a successful NDA is a complicated process. As an organization, we have not completed a clinical trial before, and we have limited experience in preparing and submitting regulatory filings. Consequently, we may be unable to successfully and efficiently execute and complete necessary clinical trials in a way that leads to NDA submission and approval of our current product candidates or for any other product candidate we develop. We may require more time and incur greater costs than anticipated and may not succeed in obtaining marketing approval of the product candidates we develop. Failure to commence or complete, or delays in, our planned clinical trials would prevent us from or delay us in commercializing our current product candidates or any other product candidate we develop. 29 Marketing approval may be substantially delayed or may not be obtained for one or all of our product candidates if regulatory authorities require additional or more time-consuming studies to assess the safety and efficacy of our product candidates. We may be unable to initiate or complete development of our product candidates on schedule, if at all. The completion of the studies for our product candidates will require us to obtain substantial additional funding beyond our current resources. In addition, regulatory authorities may require additional or more time-consuming studies to assess the safety or efficacy of our product candidates than we are currently planning. We may not be able to obtain adequate funding to complete the necessary steps for approval for any or all of our product candidates. Additional delays may result if the FDA, an FDA Advisory Committee (if one is convened to review our NDA) or other regulatory authority indicates that a product candidate should not be approved or there should be restrictions on approval, such as the requirement for a Risk Evaluation and Mitigation Strategy, or REMS, to ensure safe use of the drug. Delays in marketing approval or rejections of applications for marketing approval in the United States or other markets may result from many factors, including: ● the FDA’s or comparable foreign regulatory authorities’ disagreement with the design or implementation of our clinical trials; ● regulatory requests for additional analyses, reports, data, non-clinical and preclinical studies and clinical trials; ● regulatory questions or disagreement by the FDA or comparable regulatory authorities regarding interpretations of data and results and the emergence of new information regarding our current or future product candidates or the field of research; ● unfavorable or inconclusive results of clinical trials and supportive non-clinical studies, including unfavorable results regarding safety or efficacy of our product candidates during clinical trials; ● failure to meet the level of statistical significance required for approval; ● inability to demonstrate that a product candidate’s clinical and other benefits outweigh its safety risks; ● lack of adequate funding to commence or continue our clinical trials due to unforeseen costs or other business decisions; ● regulatory authorities may find inadequate the manufacturing processes or facilities of the third-party manufacturers with which we contract for clinical and commercial supplies; ● we may have insufficient funds to pay the significant user fees required by the FDA upon the filing of an NDA; and ● the approval policies or regulations of the FDA or comparable foreign regulatory authorities may significantly change in a manner that would delay marketing approval. The lengthy and unpredictable approval process, as well as the unpredictability of future clinical trial results, may result in our failure to obtain marketing approval to market our other product candidates, which would significantly harm our business, results of operations and prospects. Our product candidates may cause undesirable adverse effects or have other properties that could delay or prevent their marketing approval, limit the commercial profile of an approved label, or result in significant negative consequences following marketing approval, if obtained. Undesirable side effects caused by our product candidates could cause us or regulatory authorities to interrupt, delay or halt clinical trials and could result in a more restrictive label or the delay or denial of marketing approval by the FDA or other comparable foreign authorities. If any of our current product candidates or any other product candidate we develop is associated with serious adverse, undesirable or unacceptable side effects, we may need to abandon such candidate’s development or limit development to certain uses or sub-populations in which such side effects are less prevalent, less severe or more acceptable from a risk-benefit perspective. Many compounds that initially showed promise in early-stage or clinical testing have later been found to cause side effects that prevented further development of the compound. Results of our trials could reveal a high and unacceptable prevalence of these or other side effects. In such an event, our trials could be suspended or terminated and the FDA or comparable foreign regulatory authorities could order us to cease further development of or deny approval of our product candidates for any or all targeted indications. The drug-related side effects could affect patient recruitment or the ability of enrolled patients to complete the trial or result in potential product liability claims. 30 If our product candidates receive marketing approval, and we or others later identify undesirable side effects caused by such products, a number of potentially significant negative consequences could result, including: ● regulatory authorities may withdraw approvals of such product; ● we may be required to recall a product or change the way such product is administered to patients; ● additional restrictions may be imposed on the marketing of the particular product or the manufacturing process for the product or any component thereof; ● regulatory authorities may require the addition of labeling statements, such as a precaution, “black box” warning or other warnings or a contraindication; ● we or our collaborators may be required to implement a REMS or create a medication guide outlining the risks of such side effect for distribution to patients; ● we or our collaborators could be sued and held liable for harm caused to patients; ● the product may become less competitive; and ● our reputation may suffer. Any of these events could prevent us from achieving or maintaining market acceptance of our product candidates, if approved, and could materially adversely affect our business, financial condition, results of operations and prospects. We are heavily dependent on the success of our product candidate. We cannot give any assurance that we will generate data for any of our product candidates sufficient to receive regulatory approval in our planned indications, which will be required before they can be commercialized. We have invested substantially all of our efforts and financial resources to identify, acquire and develop our portfolio of product candidates. Our future success is dependent on our ability to successfully further develop, obtain regulatory approval for, and commercialize one or more product candidates. We currently generate no revenue from sales of any products, and we may never be able to develop or commercialize a product candidate. We are not permitted to market or promote any of our product candidates before we receive regulatory approval from the FDA or comparable foreign regulatory authorities, and we may never receive such regulatory approval for any of our product candidates. We cannot be certain that any of our product candidates will be successful in clinical trials or receive regulatory approval. Further, our product candidates may not receive regulatory approval even if they are successful in clinical trials. If we do not receive regulatory approvals for our product candidates, we may not be able to continue our operations. We may use our financial and human resources to pursue a particular research program or product candidate and fail to capitalize on programs or product candidates that may be more profitable or for which there is a greater likelihood of success. Because we have limited financial and human resources, we may forego or delay pursuit of opportunities with some programs or product candidates or for other indications that later prove to have greater commercial potential. Our resource allocation decisions may cause us to fail to capitalize on viable commercial products or more profitable market opportunities. Our spending on current and future research and development programs and future product candidates for specific indications may not yield any commercially viable products. We may also enter into additional strategic collaboration agreements to develop and commercialize some of our programs and potential product candidates in indications with potentially large commercial markets. If we do not accurately evaluate the commercial potential or target market for a particular product candidate, we may relinquish valuable rights to that product candidate through strategic collaborations, licensing or other royalty arrangements in cases in which it would have been more advantageous for us to retain sole development and commercialization rights to such product candidate, or we may allocate internal resources to a product candidate in a therapeutic area in which it would have been more advantageous to enter into a partnering arrangement. We may find it difficult to enroll patients in our clinical trials given the limited number of patients who have the diseases for which our product candidates are being studied. Difficulty in enrolling patients could delay or prevent clinical trials of our product candidates. Identifying and qualifying patients to participate in clinical trials of our product candidates is essential to our success. The timing of our clinical trials depends in part on the rate at which we can recruit patients to participate in clinical trials of our product candidates, and we may experience delays in our clinical trials if we encounter difficulties in enrollment. 31 The eligibility criteria of our planned clinical trials may further limit the available eligible trial participants as we expect to require that patients have specific characteristics that we can measure or meet the criteria to assure their conditions are appropriate for inclusion in our clinical trials. We may not be able to identify, recruit, and enroll a sufficient number of patients to complete our clinical trials in a timely manner because of the perceived risks and benefits of the product candidate under study, the availability and efficacy of competing therapies and clinical trials, and the willingness of physicians to participate in our planned clinical trials. If patients are unwilling to participate in our clinical trials for any reason, the timeline for conducting trials and obtaining regulatory approval of our product candidates may be delayed. If we experience delays in the completion of, or termination of, any clinical trials of our product candidates, the commercial prospects of our product candidates could be harmed, and our ability to generate product revenue from any of these product candidates could be delayed or prevented. In addition, any delays in completing our clinical trials would likely increase our overall costs, impair product candidate development and jeopardize our ability to obtain regulatory approval relative to our current plans. Any of these occurrences may harm our business, financial condition, and prospects significantly. Even if we receive marketing approval for our product candidates, such approved products will be subject to ongoing obligations and continued regulatory review, which may result in significant additional expense. Additionally, our product candidates, if approved, could be subject to labeling and other restrictions, and we may be subject to penalties and legal sanctions if we fail to comply with regulatory requirements or experience unanticipated problems with our approved products. If the FDA approves any of our product candidates, the manufacturing processes, labeling, packaging, distribution, adverse event reporting, storage, advertising, promotion and recordkeeping for the product will be subject to extensive and ongoing regulatory requirements. These requirements include submissions of safety and other post-marketing information and reports, registration, as well as continued compliance with cGMP regulations and GCP for any clinical trials that we conduct post-approval. Any marketing approvals that we receive for our product candidates may also be subject to limitations on the approved indicated uses for which the product may be marketed or to conditions of approval, or contain requirements for potentially costly post-marketing testing, including Phase 4 clinical trials, and surveillance to monitor safety and efficacy. Later discovery of previously unknown problems with an approved product, including adverse events of unanticipated severity or frequency, or with manufacturing operations or processes, or failure to comply with regulatory requirements, or evidence of acts that raise questions about the integrity of data supporting the product approval, may result in, among other things: ● restrictions on the marketing or manufacturing of the product, withdrawal of the product from the market, or voluntary or mandatory product recalls; ● fines, warning letters, or holds on clinical trials; ● refusal by the FDA to approve pending applications or supplements to approved applications filed by us, or suspension or revocation of product approvals; ● product seizure or detention, or refusal to permit the import or export of products; and ● injunctions or the imposition of civil or criminal penalties. The FDA’s policies may change and additional government regulations may be enacted that could prevent, limit or delay marketing approval, manufacturing or commercialization of our product candidates. We cannot predict the likelihood, nature or extent of government regulation that may arise from future legislation or administrative action, either in the United States or abroad. If we are slow or unable to adapt to changes in existing requirements or the adoption of new requirements or policies, or we are not able to maintain regulatory compliance, we may lose any marketing approval that may have been obtained and we may not achieve or sustain profitability, which would adversely affect our business. If we fail to obtain regulatory approval in jurisdictions outside the United States, we will not be able to market our products in those jurisdictions. We intend to market our product candidates, if approved, in international markets, potentially in conjunction with collaborators. Such marketing will require separate regulatory approvals in each market and compliance with numerous and varying regulatory requirements. The approval procedures vary from country to country and may require testing in addition to what is required for a marketing application in the United States. Moreover, the time required to obtain approval may differ from that required to obtain FDA approval. In addition, in many countries outside the United States, a product candidate must be approved for reimbursement before it can be approved for sale in that country. Approval by the FDA does not ensure approval by regulatory authorities in other countries or jurisdictions, and approval by one foreign regulatory authority does not ensure approval by regulatory authorities in other foreign countries or by the FDA. The failure to obtain approval in one jurisdiction may negatively impact our ability to obtain approval in another jurisdiction. The foreign regulatory approval process may include all of the risks associated with obtaining FDA approval and additional or different risks. We may not be able to file for regulatory approvals and may not receive necessary approvals to commercialize our products in any market. 32 Agencies like the FDA and national competition regulators in European countries regulate the promotion and uses of drugs not consistent with approved product labeling requirements. If we are found to have improperly promoted our current product candidates for uses beyond those that are approved, we may become subject to significant liability. Regulatory authorities like the FDA and national competition laws in Europe strictly regulate the promotional claims that may be made about prescription products, such as EDSIVO or ACER-001, if approved. In particular, a product may not be promoted for uses that are not approved by the FDA or comparable foreign regulatory authorities as reflected in the product’s approved labeling, known as “off-label” use, nor may it be promoted prior to obtaining marketing approval. If we receive marketing approval for our product candidates for our proposed indications, physicians may nevertheless use our products for their patients in a manner that is inconsistent with the approved label if the physicians personally believe in their professional medical judgment it could be used in such manner. Although physicians may prescribe legally available drugs for off-label uses, manufacturers may not market or promote such off-label uses. In addition, the FDA requires that promotional claims not be “false or misleading” as such terms are defined in the FDA’s regulations. For example, the FDA requires substantial evidence, which generally consists of two adequate and well-controlled head-to-head clinical trials, for a company to make a claim that its product is superior to another product in terms of safety or effectiveness. Generally, unless we perform clinical trials meeting that standard comparing our product candidates to competitive products and these claims are approved in our product labeling, we will not be able promote our current product candidates as superior to other products. If we are found to have made such claims we may become subject to significant liability. In the United States, the federal government has levied large civil and criminal fines against companies for alleged improper promotion and has enjoined several companies from engaging in improper promotion. The FDA has also requested that companies enter into consent decrees or corporate integrity agreements. The FDA could also seek permanent injunctions under which specified promotional conduct is monitored, changed or curtailed. Our current and future relationships with healthcare professionals, investigators, consultants, collaborators, actual customers, potential customers and third-party payors in the United States and elsewhere may be subject, directly or indirectly, to applicable anti-kickback, fraud and abuse, false claims, physician payment transparency, health information privacy and security and other healthcare laws and regulations, which could expose us to sanctions. Healthcare providers, physicians and third-party payors in the United States and elsewhere will play a primary role in the recommendation and prescription of any drug candidates for which we obtain marketing approval. Our current and future arrangements with healthcare professionals, investigators, consultants, collaborators, actual customers, potential customers and third-party payors may expose us to broadly applicable fraud and abuse and other healthcare laws, including, without limitation, the federal Anti-Kickback Statute and the federal False Claims Act, that may constrain the business or financial arrangements and relationships through which we sell, market and distribute any drug candidates for which we obtain marketing approval. In addition, we may be subject to physician payment transparency laws and patient privacy and security regulation by the federal government and by the U.S. states and foreign jurisdictions in which we conduct our business. The applicable federal, state and foreign healthcare laws that may affect our ability to operate include the following: ● the federal Anti-Kickback Statute, which prohibits, among other things, persons from knowingly and willfully soliciting, offering, receiving or providing remuneration, directly or indirectly, in cash or in kind, to induce or reward, or in return for, either the referral of an individual for, or the purchase, lease, order or recommendation of, any good, facility, item or service, for which payment may be made, in whole or in part, under federal and state healthcare programs such as Medicare and Medicaid; ● federal civil and criminal false claims laws and civil monetary penalty laws, including the federal False Claims Act, which impose criminal and civil penalties, including civil whistleblower or qui tam actions, against individuals or entities for, among other things, knowingly presenting, or causing to be presented, to the federal government, including the Medicare and Medicaid programs, claims for payment that are false or fraudulent or making a false statement to avoid, decrease or conceal an obligation to pay money to the federal government; ● the civil monetary penalties statute, which imposes penalties against any person or entity who, among other things, is determined to have presented or caused to be presented a claim to a federal health program that the person knows or should know is for an item or service that was not provided as claimed or is false or fraudulent; ● the federal Health Insurance Portability and Accountability Act of 1996, or HIPAA, which created new federal criminal statutes that prohibit knowingly and willfully executing, or attempting to execute, a scheme to defraud any healthcare benefit program or obtain, by means of false or fraudulent pretenses, representations or promises, any of the money or property owned by, or under the custody or control of, any healthcare benefit program, regardless of the payor (e.g., public or private), knowingly and willfully embezzling or stealing from a health care benefit program, willfully obstructing a criminal investigation of a healthcare offense and knowingly and willfully falsifying, concealing or covering up by any trick or device a material fact or making any materially false statements in connection with the delivery of, or payment for, healthcare benefits, items or services relating to healthcare matters; 33 ● HIPAA, as amended by the Health Information Technology for Economic and Clinical Health Act of 2009, or HITECH, and its implementing regulations, which impose obligations on covered entities, including healthcare providers, health plans, and healthcare clearinghouses, as well as their respective business associates that create, receive, maintain or transmit individually identifiable health information for or on behalf of a covered entity, with respect to safeguarding the privacy, security and transmission of individually identifiable health information; ● the federal Open Payments program, created under Section 6002 of the Patient Protection and Affordable Care Act, or the Affordable Care Act, and its implementing regulations, which imposed annual reporting requirements for manufacturers of drugs, devices, biologicals and medical supplies for certain payments and “transfers of value” provided to physicians and teaching hospitals, as well as ownership and investment interests held by physicians and their immediate family members, where failure to submit timely, accurately and completely the required information for all covered payments, transfers of value and ownership or investment interests may result in civil monetary penalties; and ● analogous state and foreign laws, such as state anti-kickback and false claims laws, which may apply to sales or marketing arrangements and claims involving healthcare items or services reimbursed by non-governmental third-party payors, including private insurers; state laws that require pharmaceutical companies to comply with the pharmaceutical industry’s voluntary compliance guidelines and the relevant compliance guidance promulgated by the federal government or otherwise restrict payments that may be made to healthcare providers; state and foreign laws that require drug manufacturers to report information related to payments and other transfers of value to physicians and other healthcare providers or marketing expenditures; and state and foreign laws governing the privacy and security of health information in certain circumstances, many of which differ from each other in significant ways and often are not preempted by HIPAA, thus complicating compliance efforts. Further, the Affordable Care Act, among other things, amended the intent requirement of the federal Anti-Kickback Statute and certain criminal statutes governing healthcare fraud. A person or entity no longer needs to have actual knowledge of the statute or specific intent to violate it. In addition, the Affordable Care Act provided that the government may assert that a claim including items or services resulting from a violation of the federal Anti-Kickback Statute constitutes a false or fraudulent claim for purposes of the False Claims Act. Efforts to ensure that our future business arrangements with third parties will comply with applicable healthcare laws and regulations may involve substantial costs. It is possible that governmental authorities will conclude that our business practices may not comply with current or future statutes, regulations or case law involving applicable fraud and abuse or other healthcare laws. If our operations are found to be in violation of any of these laws or any other governmental regulations that may apply to it, we may be subject to significant civil, criminal and administrative penalties, including, without limitation, damages, fines, imprisonment, exclusion from participation in government healthcare programs, such as Medicare and Medicaid, and the curtailment or restructuring of our operations, which could significantly harm our business. If any of the physicians or other healthcare providers or entities with whom we expect to do business, including our current and future collaborators, if any, are found not to be in compliance with applicable laws, those persons or entities may be subject to criminal, civil or administrative sanctions, including exclusion from participation in government healthcare programs, which could also affect our business. The impact of recent healthcare reform legislation and other changes in the healthcare industry and healthcare spending on us is currently unknown, and may adversely affect our business model. In the United States and some foreign jurisdictions, legislative and regulatory changes and proposed changes regarding the healthcare system could prevent or delay marketing approval of our drug candidates, restrict or regulate post-approval activities and affect our ability to profitably sell any drug candidates for which we obtain marketing approval. Our revenue prospects could be affected by changes in healthcare spending and policy in the United States and abroad. We operate in a highly regulated industry and new laws and judicial decisions, or new interpretations of existing laws or decisions, related to healthcare availability, the method of delivery or payment for healthcare products and services could negatively impact our business, financial condition, results of operations and prospects. There is significant interest in promoting health care reform, as evidenced by the enactment in the United States of the Affordable Care Act. Among other things, the Affordable Care Act contains provisions that may reduce the profitability of drug products, including, for example, revising the methodology by which rebates owed by manufacturers for covered outpatient drugs under the Medicaid Drug Rebate Program are calculated, extending the Medicaid Drug Rebate Program to utilization of prescriptions of individuals enrolled in Medicaid managed care plans, imposing mandatory discounts for certain Medicare Part D beneficiaries, and subjecting drug manufacturers to payment of an annual fee. 34 In addition, other legislative changes have been proposed and adopted in the United States since the Affordable Care Act was enacted. On August 2, 2011, the Budget Control Act of 2011 among other things, created measures for spending reductions by Congress. A Joint Select Committee on Deficit Reduction, tasked with recommending a targeted deficit reduction of at least $1.2 trillion for the years 2013 through 2021, was unable to reach required goals, thereby triggering the legislation’s automatic reduction to several government programs. This includes aggregate reductions to Medicare payments to providers of 2% per fiscal year, which started in April 2013, and, due to subsequent legislative amendments, will remain in effect through 2024 unless additional Congressional action is taken. On January 2, 2013, the American Taxpayer Relief Act of 2012 was signed into law, which, among other things, also reduced Medicare payments to several providers, including hospitals, imaging centers and cancer treatment centers. We expect that the Affordable Care Act, as well as other healthcare reform measures that may be adopted in the future, may result in more rigorous coverage criteria and in additional downward pressure on the price that we receive for any approved product. Any reduction in reimbursement from Medicare or other government programs may result in a similar reduction in payments from private payors. The implementation of cost containment measures or other healthcare reforms may prevent us from being able to generate revenue or commercialize our drugs. It is likely that federal and state legislatures within the United States and foreign governments will continue to consider changes to existing healthcare legislation. We cannot predict the reform initiatives that may be adopted in the future or whether initiatives that have been adopted will be repealed or modified. The continuing efforts of the government, insurance companies, managed care organizations and other payors of healthcare services to contain or reduce costs of healthcare may adversely affect: ● the demand for any drug products for which we may obtain marketing approval; ● our ability to set a price that we believe is fair for our products; ● our ability to obtain coverage and reimbursement approval for a product; ● our ability to generate revenues and achieve or maintain profitability; and ● the level of taxes that we are required to pay. If we fail to comply with environmental, health and safety laws and regulations, we could become subject to fines or penalties or incur costs that could have a material adverse effect on our business, financial condition or results of operations. Our research and development activities and our third-party manufacturers’ and suppliers’ activities involve the controlled storage, use, and disposal of hazardous materials, including the components of our product candidates and other hazardous compounds. We and our manufacturers and suppliers are subject to laws and regulations governing the use, manufacture, storage, handling, and disposal of these hazardous materials. In some cases, these hazardous materials and various wastes resulting from their use are stored at our and our manufacturers’ facilities pending their use and disposal. We cannot eliminate the risk of contamination, which could cause an interruption of our commercialization efforts, research and development efforts and business operations, environmental damage resulting in costly clean-up and liabilities under applicable laws and regulations governing the use, storage, handling, and disposal of these materials and specified waste products. Although we believe that the safety procedures utilized by us and our third-party manufacturers for handling and disposing of these materials generally comply with the standards prescribed by these laws and regulations, we cannot guarantee that this is the case or eliminate the risk of accidental contamination or injury from these materials. In such an event, we may be held liable for any resulting damages and such liability could exceed our resources and state or federal or other applicable authorities may curtail our use of specified materials and/or interrupt our business operations. Furthermore, environmental laws and regulations are complex, change frequently, and have tended to become more stringent. We cannot predict the impact of such changes and cannot be certain of our future compliance. We do not currently carry biological or hazardous waste insurance coverage. Other Risks Related to Our Business Due to our limited resources and access to capital, we must decide to prioritize development of our current product candidates for certain indications and at certain doses. These decisions may prove to have been wrong and may materially adversely affect our business, financial condition, results of operations and prospects. Because we have limited resources and access to capital to fund our operations, we must decide which dosages and indications to pursue for the clinical development of our current product candidates and the amount of resources to allocate to each. Our decisions concerning the allocation of research, collaboration, management and financial resources toward dosages or therapeutic areas may not lead to the development of viable commercial products and may divert resources away from better opportunities. If we make incorrect determinations regarding the market potential of our current product candidates or misread trends in the pharmaceutical industry, our business, financial condition, results of operations and prospects could be materially adversely affected. 35 We may not be able to win government, academic institution or non-profit contracts or grants. From time to time, we may apply for contracts or grants from government agencies, non-profit entities and academic institutions. Such contracts or grants can be highly attractive because they provide capital to fund the ongoing development of our product candidates without diluting our shareholders. However, there is often significant competition for these contracts or grants. Entities offering contracts or grants may have requirements to apply for or to otherwise be eligible for certain contracts or grants that our competitors may be able to satisfy that we cannot. In addition, such entities may make arbitrary decisions as to whether to offer contracts or make grants, to whom the contracts or grants may or will be awarded and the size of the contracts or grants to each awardee. Even if we are able to satisfy the award requirements, there is no guarantee that we will be a successful awardee. Therefore, we may not be able to win any contracts or grants in a timely manner, if at all. If we fail to attract and retain key management and scientific personnel, we may be unable to successfully develop or commercialize our product candidates. Our success as a specialty pharmaceutical company depends on our continued ability to attract, retain and motivate highly qualified management and scientific and clinical personnel. The loss of the services of any of our senior management could delay or prevent obtaining marketing approval or commercialization of our product candidates. We may not be able to attract or retain qualified management and scientific personnel in the future due to the intense competition for a limited number of qualified personnel among specialty pharmaceutical businesses, and other pharmaceutical, biotechnology and other businesses. Our failure to attract, hire, integrate and retain qualified personnel could impair our ability to achieve our business objectives. If a successful product liability claim or series of claims is brought against us for uninsured liabilities or in excess of insured liabilities, we could be forced to pay substantial damage awards. The use of any of our product candidates in clinical trials, and the sale of any approved products, may expose us to product liability claims. We currently maintain product liability insurance coverage for up to $5.0 million per occurrence, up to an aggregate limit of $5.0 million. We intend to monitor the amount of coverage we maintain as the size and design of our clinical trials evolve, and if we are successful in obtaining approval to commercialize any of our product candidates, and adjust the amount of coverage we maintain accordingly. However, there is no assurance that such insurance coverage will fully protect us against some or all of the claims to which we might become subject. We might not be able to maintain adequate insurance coverage at a reasonable cost or in sufficient amounts or scope to protect us against potential losses. In the event a claim is brought against us, we might be required to pay legal and other expenses to defend the claim, as well as uncovered damages awards resulting from a claim brought successfully against us. Furthermore, whether or not we are ultimately successful in defending any such claims, we might be required to direct financial and managerial resources to such defense and adverse publicity could result, all of which could harm our business. Our employees, independent contractors, investigators, contract research organizations, consultants, collaborators and vendors may engage in misconduct or other improper activities, including noncompliance with regulatory standards and requirements and insider trading. We are exposed to the risk that our employees and other third parties may engage in fraudulent conduct or other illegal activity. Misconduct by employees and other third parties could include intentional, reckless and/or negligent conduct or disclosure of unauthorized activities to us that violate FDA regulations, including those laws requiring the reporting of true, complete and accurate information to the FDA, manufacturing standards, federal and state healthcare fraud and abuse laws and regulations, or laws that require the reporting of financial information or data accurately. In particular, sales, marketing and business arrangements in the healthcare industry are subject to extensive laws intended to prevent fraud, kickbacks, self-dealing and other abusive practices. These laws and regulations may restrict or prohibit a wide range of pricing, discounting, marketing and promotion, sales commission, customer incentive programs and other business arrangements. Activities subject to these laws also involve the improper use of information obtained in the course of clinical trials, which could result in regulatory sanctions and serious harm to our reputation. It is not always possible to identify and deter employee and other third-party misconduct, and the precautions we take to detect and prevent this activity may not be effective in controlling unknown or unmanaged risks or losses or in protecting us from governmental investigations or other actions or lawsuits stemming from a failure to be in compliance with such laws. If any such actions are instituted against us, and we are not successful in defending ourselves or asserting our rights, those actions could have a significant impact on our business, including the imposition of significant civil, criminal and administrative penalties, damages, monetary fines, disgorgement, possible exclusion from participation in Medicare, Medicaid and other federal healthcare programs, contractual damages, reputational harm, diminished profits and future earnings and curtailment or restructuring of our operations, any of which could adversely affect our ability to operate. 36 We will need to expand our organization and we may experience difficulties in managing this growth, which could disrupt our operations. As of September 30, 2017, we had four full-time employees. As our development and commercialization plans and strategies develop, we expect to need additional managerial, operational, sales, marketing, financial, legal and other resources. Our management may need to divert a disproportionate amount of our attention away from our day-to-day activities and devote a substantial amount of time to managing these growth activities. As we advance our product candidates through clinical trials, we will need to expand our development, regulatory, manufacturing, marketing and sales capabilities or contract with third parties to provide these capabilities for us. As our operations expand, we expect that we will need to manage additional relationships with such third parties, as well as additional collaborators and suppliers. We may not be able to effectively manage the expansion of our operations, which may result in weaknesses in our infrastructure, operational mistakes, loss of business opportunities, loss of employees, and reduced productivity among remaining employees. Our expected growth could require significant capital expenditures and may divert financial resources from other projects, such as the development of additional product candidates. If our management is unable to effectively manage our growth, our expenses may increase more than expected, our ability to generate and/or grow revenue could be reduced and we may not be able to implement our business strategy. Our future financial performance and our ability to commercialize product candidates and compete effectively will depend, in part, on our ability to effectively manage any future growth. Our internal computer systems, or those of our development collaborators, third-party clinical research organizations or other contractors or consultants, may fail or suffer security breaches, which could result in a material disruption of our product development programs. Despite the implementation of security measures, our internal computer systems and those of our current and any future CROs and other contractors, consultants and collaborators are vulnerable to damage from computer viruses, unauthorized access, natural disasters, terrorism, war and telecommunication and electrical failures. While we have not experienced any such material system failure, accident or security breach to date, if such an event were to occur and cause interruptions in our operations, it could result in a material disruption of our development programs and our business operations. For example, the loss of clinical trial data from completed or future clinical trials could result in delays in our marketing approval efforts and significantly increase our costs to recover or reproduce the data. Likewise, we intend to rely on third parties to manufacture our product candidates and conduct clinical trials, and similar events relating to their computer systems could also have a material adverse effect on our business. To the extent that any disruption or security breach were to result in a loss of, or damage to, our data or applications, or inappropriate disclosure of confidential or proprietary information, we could incur liability and the further development and commercialization of our product candidates could be delayed. We are involved in litigation that may be expensive and time consuming, and if resolved adversely, could harm our business, financial condition, or results of operations. As described in Note 7 to our unaudited condensed consolidated financial statements included in this report, Piper Jaffray & Co. has filed a lawsuit against Private Acer alleging breach of contract. Defending against this lawsuit may be costly and may significantly divert the time and attention of our management from our operations. There can be no assurance that a favorable outcome will be obtained. A negative outcome, whether by final judgment or an unfavorable settlement, could result in payment of significant monetary damages and could adversely affect our financial condition and results of operations. Risks Related to Commercialization of Our Product Candidates Even if we obtain the required regulatory approvals in the United States and other territories, the commercial success of our product candidates will depend on market awareness and acceptance of our product candidates. Even if we obtain marketing approval for our current product candidates or any other product candidates that we may develop or acquire in the future, the products may not gain market acceptance among physicians, key opinion leaders, healthcare payors, patients and the medical community. Market acceptance of any approved products depends on a number of factors, including: ● the timing of market introduction; ● the efficacy and safety of the product, as demonstrated in clinical trials; ● the clinical indications for which the product is approved and the label approved by regulatory authorities for use with the product, including any precautions, warnings or contraindications that may be required on the label; ● acceptance by physicians, key opinion leaders and patients of the product as a safe and effective treatment; 37 ● the cost, safety and efficacy of treatment in relation to alternative treatments; ● the availability of coverage and adequate reimbursement and pricing by third-party payors and government authorities; ● the number and clinical profile of competing products; ● the growth of drug markets in our various indications; ● relative convenience and ease of administration; ● marketing and distribution support; ● the prevalence and severity of adverse side effects; and ● the effectiveness of our sales and marketing efforts. Market acceptance is critical to our ability to generate revenue. Any product candidate, if approved and commercialized, may be accepted in only limited capacities or not at all. If any approved products are not accepted by the market to the extent that we expect, we may not be able to generate revenue and our business would suffer. If the market opportunities for our product candidates are smaller than we believe they are, then our revenues may be adversely affected and our business may suffer. The diseases that our current and future product candidates are being developed to address are rare. Our projections of both the number of people who have these diseases, as well as the subset of people with these diseases who have the potential to benefit from treatment with our product candidates, and our assumptions relating to pricing are based on estimates. Given the small number of patients who have the diseases that we are targeting, our eligible patient population and pricing estimates may differ significantly from the actual market addressable by our product candidates. Currently, most reported estimates of the prevalence of vEDS, UCD and MSUD are based on studies of small subsets of the population of specific geographic areas, which are then extrapolated to estimate the prevalence of the diseases in the broader world population. It is difficult to precisely measure the incidence or prevalence of vEDS in any population. Studies estimate the prevalence of vEDS as ranging from approximately 1 in 90,000 to 1 in 250,000. Studies indicate that MSUD affects an estimated 1 in 185,000 infants worldwide. Approximately 3,000 patients suffer from MSUD worldwide, of whom approximately 800 are located in the United States. It is estimated that vEDS, UCD and MSUD collectively impact approximately 4,900 patients in the United States. As new studies are performed the estimated prevalence of these diseases may change. The number of patients may turn out to be lower than expected. There can be no assurance that the prevalence of vEDS, UCD or MSUD in the study populations accurately reflect the prevalence of these diseases in the broader world population. If our estimates of the prevalence of vEDS, UCD or MSUD or of the number of patients who may benefit from treatment with EDSIVO or ACER-001 prove to be incorrect, the market opportunities for our product candidates may be smaller than we believe they are, our prospects for generating revenue may be adversely affected and our business may suffer. Likewise, the potentially addressable patient population for each of our product candidates may be limited or may not be amenable to treatment with our product candidates, and new patients may become increasingly difficult to identify or gain access to, which would adversely affect our business, financial condition, results of operations and prospects. We currently have limited marketing and sales experience. If we are unable to establish sales and marketing capabilities or enter into agreements with third parties to market and sell our product candidates, we may be unable to generate any revenue. We have never commercialized a product candidate, and we currently have no marketing and sales organization. To the extent our product candidates are approved for marketing, if we are unable to establish marketing and sales capabilities or enter into agreements with third parties to market and sell our product candidates, we may not be able to effectively market and sell our product candidates or generate product revenue. We have never commercialized a product candidate, and we currently do not have marketing, sales or distribution capabilities for our product candidates. In order to commercialize any of our products that receive marketing approval, we would have to build marketing, sales, distribution, managerial and other non-technical capabilities or make arrangements with third parties to perform these services, and we may not be successful in doing so. In the event of successful development of our product candidates, if we elect to build a targeted specialty sales force, such an effort would be expensive and time consuming. Any failure or delay in the development of our internal sales, marketing and distribution capabilities would adversely impact the commercialization of these products. We may choose to collaborate with third parties that have their own sales forces and established distribution systems, in lieu of or to augment any sales force and distribution systems we may create. If we are unable to enter into collaborations with third parties for the commercialization of approved products, if any, on acceptable terms or at all, or if any such collaborator does not devote sufficient resources to the commercialization of our product or otherwise fails in commercialization efforts, we may not be able to successfully commercialize our product candidates if we receive marketing approval. If we are not successful in commercializing our product candidates, either on our own or through collaborations with one or more third parties, our future revenue will be materially and adversely impacted. 38 If we fail to enter into strategic relationships or collaborations, our business, financial condition, commercialization prospects and results of operations may be materially adversely affected. Our product development programs and the potential commercialization of our current product candidates will require substantial additional cash to fund expenses. Therefore, in addition to financing the development of our product candidates through additional equity financings or through debt financings, we may decide to enter into collaborations with pharmaceutical or biopharmaceutical companies for the development and potential commercialization of our product candidates. We face significant competition in seeking appropriate collaborators. Collaborations are complex and time-consuming to negotiate and document. We may also be restricted under existing and future collaboration agreements from entering into agreements on certain terms with other potential collaborators. We may not be able to negotiate collaborations on acceptable terms, or at all. If that were to occur, we may have to curtail the development of a particular product, reduce or delay one or more of our development programs, delay our potential commercialization or reduce the scope of our sales or marketing activities, or increase our expenditures and undertake development or commercialization activities at our own expense. If we elect to increase our expenditures to fund development or commercialization activities on our own, we may need to obtain additional capital, which may not be available to us on acceptable terms or at all. If we do not have sufficient funds, we will not be able to bring our product candidates to market and generate product revenue. If we do enter into a collaboration agreement, it could be subject to the following risks, each of which may materially harm our business, commercialization prospects and financial condition: ● we may not be able to control the amount or timing of resources that the collaborator devotes to the product development program; ● the collaborator may experience financial difficulties and thus not commit sufficient financial resources to the product development program; ● we may be required to relinquish important rights such as marketing, distribution and intellectual property rights; ● a collaborator could move forward with a competing product developed either independently or in collaboration with third parties, including our competitors; or ● business combinations or significant changes in a collaborator’s business strategy may adversely affect our willingness to complete our obligations under any arrangement. Our product candidate EDSIVO has not been approved for any indication in the United States, which may result in greater research and development expenses, regulatory issues that could delay or prevent approval, or discovery of unknown or unanticipated adverse effects. EDSIVO is a repurposing of celiprolol for the treatment of vEDS. An NDA for this drug in the treatment of hypertension was filed with the FDA in 1987 but not approved. However, the drug has been approved in Europe for the treatment of hypertension since 1984. There can be no assurance that issues related to the development of this drug candidate which kept it from being approved by the FDA previously will not reoccur, which may cause significant delays or we may not be able to resolve. Regulatory approval of EDSIVO may be more expensive and take longer than for other, more well-known or extensively studied pharmaceutical product candidates due to our and regulatory agencies’ lack of experience with celiprolol. The novelty of this product candidate may lengthen the regulatory review process, require us to conduct additional studies or clinical trials, increase our development costs, lead to changes in regulatory positions and interpretations, delay or prevent approval and commercialization of our product candidates or lead to significant post-approval limitations or restrictions. There is also an increased risk that we may discover previously unknown or unanticipated adverse effects during our clinical trials and beyond. Any such events could adversely impact our business prospects, financial condition and results of operations. Coverage and reimbursement may be limited or unavailable in certain market segments for our product candidates, which could make it difficult for us to sell our products profitably. There is significant uncertainty related to third-party coverage and reimbursement of newly approved pharmaceuticals. Market acceptance and sales of any approved product candidates will depend significantly on the availability of coverage and adequate reimbursement from third-party payors and may be affected by existing and future healthcare reform measures. Patients who are prescribed treatments for their conditions and providers performing the prescribed services generally rely on third-party payors to reimburse all or part of the associated healthcare costs. Government authorities and third-party payors, such as private health insurers, health maintenance organizations, and government payors like Medicare and Medicaid, decide which drugs they will pay for and establish reimbursement levels. Increasingly, third-party payors are requiring that drug companies provide them with predetermined discounts from list prices and are challenging the prices charged for drugs and products. Coverage and reimbursement may not be available for any product that we commercialize and, even if coverage is provided, the level of reimbursement may not be satisfactory. Inadequate reimbursement levels may adversely affect the demand for, or the price of, any drug candidate for which we obtain marketing approval. 39 Reimbursement by a third-party payor may depend upon a number of factors, including the third-party payor’s determination that use of a product is, among other things: ● a covered benefit under its health plan; ● safe, effective and medically necessary; ● appropriate for the specific patient; ● cost-effective; and ● neither experimental nor investigational. Obtaining coverage and adequate reimbursement approval for a product from a government or other third-party payor is a time consuming and costly process that could require us to conduct expensive pharmacoeconomic studies and provide supporting scientific, clinical and cost-effectiveness data for the use of our products to the payor. We may not be able to provide data sufficient to gain acceptance with respect to coverage and adequate reimbursement. In addition to examining the medical necessity and cost-effectiveness of new products, coverage may be limited to specific drug products on an approved list, or formulary, which might not include all of the FDA-approved drug products for a particular indication. There may also be formulary placements that result in lower reimbursement levels and higher cost-sharing borne by patients, any of which could have an adverse effect on our revenues and profits. Moreover, a third-party payor’s decision to provide coverage for a drug product does not imply that an adequate reimbursement rate will be approved. Adequate third-party reimbursement may not be available to enable us to maintain price levels sufficient to realize an appropriate return on our investment in product development. Additionally, coverage and reimbursement for drug products can differ significantly from payor to payor. One third-party payor’s decision to cover a particular drug product does not ensure that other payors will also provide coverage for the drug product, or even if coverage is available, establish an adequate reimbursement rate. We cannot be sure that coverage or adequate reimbursement will be available for any of our product candidates. Also, we cannot be sure that reimbursement amounts will not reduce the demand for, or the price of, our products. If reimbursement is not available or is available only to limited levels, we may not be able to commercialize certain of our products. In the United States, third-party payors are increasingly attempting to contain healthcare costs by limiting both coverage and the level of reimbursement of new drugs. Third-party payors are increasingly challenging the prices charged for medical products and services, examining the medical necessity and reviewing the cost-effectiveness of drug products and medical services and questioning safety and efficacy. As a result, significant uncertainty exists as to whether and how much third-party payors will reimburse patients for their use of newly approved drugs, which in turn will put pressure on the pricing of drugs. Additionally, emphasis on managed care in the United States has increased and we expect will continue to increase the pressure on drug pricing. If third-party payors do not consider our products to be cost-effective compared to other available therapies, they may not cover the products for which we receive FDA approval or, if they do, the level of payment may not be sufficient to allow us to sell our products at a profit. The U.S. government, state legislatures and foreign governments have shown significant interest in implementing cost-containment programs to limit the growth of government-paid healthcare costs and drug prices in general, including for therapies for rare diseases. These measures include price controls, transparency requirements triggered by the introduction of new, high-cost drugs onto the market, drug re-importation, restrictions on reimbursement and requirements for substitution of generic products for branded prescription drugs. Some laws and regulations have already been enacted in these areas, and additional measures have been introduced or are under consideration at both the federal and state levels. Additionally, at the request of U.S. Senators, the Government Accountability Office is currently investigating abuses of the Orphan Drug Act, which could potentially lead to legislation or regulation that affects reimbursement for drugs with small patient populations. Other governmental funding restrictions, legislative proposals and interpretations of policy may negatively impact amounts available through reimbursement, including by restricting payment increases to hospitals and other providers through reimbursement systems. We are not able to predict whether changes will be made in the rates prescribed by governmental programs, whether other controls will be imposed on drug prices, or, if such measures do go into effect, what impact they could have on our business. However, adoption of such controls and measures, and tightening of restrictive policies in jurisdictions with existing controls and measures, could limit payments for pharmaceuticals such as our drug product candidates and could adversely affect our net revenue and results. 40 In addition, in the United States, the Affordable Care Act contains provisions that have the potential to substantially change healthcare delivery and financing, including impacting the profitability of drugs. For example, the Affordable Care Act revised the methodology by which rebates owed by manufacturers for covered outpatient drugs are calculated under the Medicaid Drug Rebate Program, extended the Medicaid Drug Rebate Program to utilization of covered drugs dispensed to individuals enrolled in Medicaid managed care organizations and subjected manufacturers to new annual fees for certain branded prescription drugs. On May 4, 2017, the House of Representatives passed the American Health Care Act, or AHCA, which contains provisions that would change the level of federal funding of state Medicaid programs and affect funding for long term care recipients, including the elderly and disabled. The Senate then moved to craft its own “repeal and replace” legislation known as the Better Care Reconciliation Act, or BCRA, with more onerous funding changes affecting the elderly and disabled. The BCRA and two other amendments failed in the Senate and it is unclear if the Senate will debate potential amendments further. However, even if a different bill or amendment passed in the Senate, reconciliation with the House’s AHCA bill would be required. Under any new legislation, we expect additional rules, regulations and interpretations to be issued that may materially affect our financial condition and operations. Even if the Affordable Care Act is not amended or repealed, the new administration could propose changes impacting implementation of the Affordable Care Act. The ultimate composition and timing of any legislation enacted under the new administration that would impact the current implementation of the Affordable Care Act remains uncertain. Given the complexity of the Affordable Care Act and the substantial requirements for regulation thereunder, the impact of the Affordable Care Act on our financial conditions and operations cannot be predicted, whether in its current form or as amended or repealed. Pricing and reimbursement methodologies vary widely from country to country. Some countries require that drug products may be marketed only after a reimbursement price has been agreed. Some countries may require the completion of additional studies that compare the cost-effectiveness of a particular product candidate to currently available therapies. For example, the European Union provides options for its member states to restrict the range of drug products for which their national health insurance systems provide reimbursement and to control the prices of medicinal products for human use. European Union member states may approve a specific price for a drug product or they may instead adopt a system of direct or indirect controls on our profitability in placing the drug product on the market. Other member states allow companies to fix their own prices for drug products, but monitor and control company profits. The downward pressure on healthcare costs in general, particularly prescription drugs, has become intense. As a result, increasingly high barriers are being erected to the entry of new products. In addition, in some countries, cross-border imports from low-priced markets exert competitive pressure that may reduce pricing within a country. Any country that has price controls or reimbursement limitations for drug products may not allow favorable reimbursement and pricing arrangements for any of our products. Coverage policies, third-party reimbursement rates and drug pricing regulation may change at any time, and there is the potential for significant movement in these areas in the foreseeable future. Even if favorable coverage and reimbursement status is attained for one or more products for which we receive marketing approval, less favorable coverage policies and reimbursement rates may be implemented in the future. We face substantial competition, which may result in others discovering, developing or commercializing products before, or more successfully, than we do. The life sciences industry is highly competitive, and we face significant competition from many pharmaceutical, biopharmaceutical and biotechnology companies that are generally developing and marketing therapeutic products. Such competition may include large pharmaceutical and biotechnology companies, specialty pharmaceutical and generic companies and medical technology companies. Our future success depends on our ability to demonstrate and maintain a competitive advantage with respect to the design, development and commercialization of our product candidates for the treatment of orphan and ultraorphan diseases for which there is a small patient population in the United States. A drug designated an orphan drug may receive up to seven years of exclusive marketing in the United States for that indication. Our objective is to design, develop and commercialize product candidates by repurposing or reformulating existing drugs for orphan diseases with significant unmet medical need. Many of our potential competitors have significantly greater financial, manufacturing, marketing, development, technical and human resources than we do. Large pharmaceutical and biotechnology companies, in particular, have extensive experience in clinical testing, obtaining regulatory approvals, recruiting patients and in manufacturing clinical products. These companies also have significantly greater research and marketing capabilities than we do and may also have products that have been approved or are in late stages of development, and have collaborative arrangements in our target markets with leading companies and research institutions. Established companies may also invest heavily to accelerate discovery and development of compounds that could make the product candidates that we develop obsolete. As a result of all of these factors, the obtaining of orphan drug designation for our product candidates is essential to our viability since our competitors may, among other things: ● have greater name and brand recognition, financial and human resources; ● develop and commercialize products that are safer, more effective, less expensive, or more convenient or easier to administer; 41 ● obtain quicker marketing approval; ● establish superior proprietary positions; ● have access to more manufacturing capacity; ● implement more effective approaches to sales and marketing; or ● form more advantageous strategic alliances. Should any of these events occur, our business, financial condition, results of operations, and prospects could be materially adversely affected. If we are not able to compete effectively against potential competitors, our business will not grow and our financial condition and operations will suffer. We believe that our ability to successfully compete will depend on our ability to obtain orphan drug designation as well as: ● our ability to design and successfully execute appropriate clinical trials; ● our ability to recruit and enroll patients for our clinical trials; ● the results of our clinical trials and the efficacy and safety of our product candidates; ● the speed at which we develop our product candidates; ● achieving and maintaining compliance with regulatory requirements applicable to our business; ● the timing and scope of regulatory approvals, including labeling; ● adequate levels of reimbursement under private and governmental health insurance plans, including Medicare and Medicaid; ● our ability to protect intellectual property rights related to our product candidates; ● our ability to commercialize and market any of our product candidates that may receive marketing approval; ● our ability to manufacture and sell commercial quantities of any approved product candidates to the market; ● acceptance of our product candidates by physicians, other healthcare providers and patients; and ● the cost of treatment in relation to alternative therapies. If our competitors are able to obtain orphan drug exclusivity for their products that are the same drug as our product candidates, we may not be able to have competing products approved by the applicable regulatory authority for a significant period of time. We expect to seek orphan drug designation from the FDA and the European Medicines Agency, or the EMA, for EDSIVO and ACER-001, and there can be no assurance that we will be successful. If we are unable to secure orphan status in either Europe or the United States, it may have a material negative effect on our business. Generally, if a product with an orphan drug designation subsequently receives the first marketing approval for the indication for which it has such designation, that product is entitled to a period of marketing exclusivity, which precludes the applicable regulatory authority from approving another marketing application for the same drug for the same indication for that time period. The applicable period is seven years in the United States and ten years in the European Union. The exclusivity period in the European Union can be reduced to six years if the product no longer meets the criteria for orphan drug designation or if its commercialization is sufficiently profitable so that market exclusivity is no longer justified. Orphan drug exclusivity may be lost if the FDA or the EMA determines that the request for designation was materially defective or if the manufacturer is unable to ensure sufficient quantity of the product to meet the needs of patients with the rare disease or condition. Obtaining orphan drug exclusivity for EDSIVO and ACER-001 may be important to the product candidate’s success. Even if we obtain orphan drug exclusivity for EDSIVO for vEDS and ACER-001 for UCD and MSUD, we may not be able to maintain it. For example, if a competitive product that treats the same disease as our product candidate is shown to be clinically superior to our product candidate, any orphan drug exclusivity we have obtained will not block the approval of such competitive product and we may effectively lose what had previously been orphan drug exclusivity. Orphan drug exclusivity for EDSIVO or ACER-001 also will not bar the FDA from approving another celiprolol drug product or a sodium phenylbutyrate, or NaPB product, for another indication. In the United States, reforms to the Orphan Drug Act, if enacted, could also materially affect our ability to maintain orphan drug exclusivity for EDSIVO for vEDS and ACER-001 for UCD and MSUD. 42 Price controls may be imposed in foreign markets, which may adversely affect our future profitability. In some countries, particularly member states of the European Union, the pricing of prescription drugs is subject to governmental control. In these countries, pricing negotiations with governmental authorities can take considerable time after receipt of marketing approval for a product. In addition, there can be considerable pressure by governments and other stakeholders on prices and reimbursement levels, including as part of cost containment measures. Political, economic and regulatory developments may further complicate pricing negotiations, and pricing negotiations may continue after reimbursement has been obtained. Reference pricing used by various European Union member states and parallel distribution, or arbitrage between low-priced and high-priced member states, can further reduce prices. In some countries, we may be required to conduct a clinical trial or other studies that compare the cost-effectiveness of our product candidates to other available therapies in order to obtain or maintain reimbursement or pricing approval. Publication of discounts by third-party payors or authorities may lead to further pressure on the prices or reimbursement levels within the country of publication and other countries. If reimbursement of our products is unavailable or limited in scope or amount, or if pricing is set at unsatisfactory levels, our business could be adversely affected. Rapid technological change could make our products obsolete. Pharmaceutical technologies have undergone rapid and significant change, and we expect that they will continue to do so. As a result, there is significant risk that our product candidates may be rendered obsolete or uneconomical by new discoveries before we recover any expenses incurred in connection with their development. If our product candidates are rendered obsolete by advancements in pharmaceutical technologies, our prospects will suffer. Government controls and health care reform measures could adversely affect our business. The business and financial condition of pharmaceutical and biotechnology companies are affected by the efforts of governmental and third-party payors to contain or reduce the costs of health care. In the United States and in foreign jurisdictions, there have been, and we expect that there will continue to be, a number of legislative and regulatory proposals aimed at changing the health care system. For example, in some foreign countries, particularly in Europe, the pricing of prescription pharmaceuticals is subject to governmental control. In these countries, pricing negotiations with governmental authorities can take considerable time after the receipt of marketing approval for a product candidate. To obtain reimbursement or pricing approval in some countries, we may be required to conduct additional clinical trials that compare the cost-effectiveness of any product candidate to other available therapies. If reimbursement of any product candidate is unavailable or limited in scope or amount in a particular country, or if pricing is set at unsatisfactory levels, we may be unable to achieve or sustain profitability in such country. In the United States, the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, or MMA, changed the way Medicare covers and pays for pharmaceutical products. The legislation established Medicare Part D, which expanded Medicare coverage for outpatient prescription drug purchases by the elderly but provided authority for limiting the number of drugs that will be covered in any therapeutic class. The MMA also introduced a new reimbursement methodology based on average sales prices for physician-administered drugs. Any negotiated prices for any product candidate covered by a Part D prescription drug plan will likely be lower than the prices that might otherwise be obtained outside of the Medicare Part D prescription drug plan. Moreover, while Medicare Part D applies only to drug benefits for Medicare beneficiaries, private payors often follow Medicare coverage policy and payment limitations in setting their own payment rates. Any reduction in payment under Medicare Part D may result in a similar reduction in payments from non-governmental payors. The United States and several other jurisdictions are considering, or have already enacted, a number of legislative and regulatory proposals to change the healthcare system in ways that could affect our ability to sell any product candidate. Among policy-makers and payors in the United States and elsewhere, there is significant interest in promoting changes in healthcare systems with the stated goals of containing healthcare costs, improving quality and/or expanding access to healthcare. In the United States, the pharmaceutical industry has been a particular focus of these efforts and has been significantly affected by major legislative initiatives. There have been, and likely will continue to be, legislative and regulatory proposals at the federal and state levels directed at broadening the availability of healthcare and containing or lowering the cost of healthcare. We cannot predict the initiatives that may be adopted in the future. The continuing efforts of the government, insurance companies, managed care organizations and other payors of healthcare services to contain or reduce costs of healthcare may adversely affect: the demand for any product candidate; the ability to set a price that we believe is fair for any product candidate; our ability to generate revenues and achieve or maintain profitability; the level of taxes that we are required to pay; and the availability of capital. 43 Risks Related to Third Parties We rely on third-party suppliers and other third parties for production of our product candidates and our dependence on these third parties may impair the advancement of our research and development programs and the development of our product candidates. We do not currently own or operate manufacturing facilities for clinical or commercial production of our product candidates. We lacks the resources and the capability to manufacture any of our product candidates on a clinical or commercial scale. Instead, we rely on, and expect to continue to rely on, third parties for the supply of raw materials and manufacture of drug supplies necessary to conduct our preclinical studies and clinical trials. Our reliance on third parties may expose us to more risk than if we were to manufacture our current product candidates or other products ourselves. Delays in production by third parties could delay our clinical trials or have an adverse impact on any commercial activities. In addition, the fact that we are dependent on third parties for the manufacture of and formulation of our product candidates means that we are subject to the risk that the products may have manufacturing defects that we have limited ability to prevent or control. Although we oversee these activities to ensure compliance with our quality standards, budgets and timelines, we have had and will continue to have less control over the manufacturing of our product candidates than potentially would be the case if we were to manufacture our product candidates. Further, the third parties we deal with could have staffing difficulties, might undergo changes in priorities or may become financially distressed, which would adversely affect the manufacturing and production of our product candidates. In addition, a third party could be acquired by, or enter into an exclusive arrangement with, one of our competitors, which would adversely affect our ability to access the formulations we require. The facilities used by our current contract manufacturers and any future manufacturers to manufacture our product candidates must be inspected by the FDA after we submit our NDA. We do not control the manufacturing process of, and are completely dependent on, our contract manufacturers for compliance with the regulatory requirements, known as cGMPs, for manufacture of both active drug substances and finished drug products. If our contract manufacturers cannot successfully manufacture material that conforms to our specifications and the strict regulatory requirements of the FDA or others, the FDA may refuse to approve our NDA. If the FDA or a comparable foreign regulatory authority does not approve our NDA because of concerns about the manufacture of our product candidates or if significant manufacturing issues arise in the future, we may need to find alternative manufacturing facilities, which would significantly impact our ability to develop our product candidates, to obtain marketing approval of our NDA or to continue to market our product candidates, if approved. Although we are ultimately responsible for ensuring compliance with these regulatory requirements, we do not have day-to-day control over a contract manufacturing organization, or CMO, or other third-party manufacturer’s compliance with applicable laws and regulations, including cGMPs and other laws and regulations, such as those related to environmental health and safety matters. Any failure to achieve and maintain compliance with these laws, regulations and standards could subject us to the risk that we may have to suspend the manufacturing of our product candidates or that obtained approvals could be revoked, which would adversely affect our business and reputation. In addition, third-party contractors, such as our CMOs, may elect not to continue to work with us due to factors beyond our control. They may also refuse to work with us because of their own financial difficulties, business priorities or other reasons, at a time that is costly or otherwise inconvenient for us. If we were unable to find adequate replacement or another acceptable solution in time, our clinical trials could be delayed or our commercial activities could be harmed. Problems with the quality of the work of third parties, may lead us to seek to terminate our working relationships and use alternative service providers. However, making this change may be costly and may delay clinical trials. In addition, it may be very challenging, and in some cases impossible, to find replacement service providers that can develop and manufacture our drug candidates in an acceptable manner and at an acceptable cost and on a timely basis. The sale of products containing any defects or any delays in the supply of necessary services could adversely affect our business, financial condition, results of operations, and prospects. Growth in the costs and expenses of components or raw materials may also adversely affect our business, financial condition, results of operations, and prospects. Supply sources could be interrupted from time to time and, if interrupted, supplies may not be resumed (whether in part or in whole) within a reasonable timeframe and at an acceptable cost or at all. 44 We plan to rely on third parties to conduct clinical trials for our product candidates. If these third parties do not successfully carry out their contractual duties or meet expected deadlines, it may cause delays in commencing and completing clinical trials of our product candidates or we may be unable to obtain marketing approval for or commercialize our product candidates. Clinical trials must meet applicable FDA and foreign regulatory requirements. We do not have the ability to independently conduct Phase 2 or Phase 3 clinical trials for any of our product candidates. We expect to rely on third parties, such as CROs, medical institutions, clinical investigators and contract laboratories, to conduct all of our clinical trials of our product candidates; however, we remain responsible for ensuring that each of our clinical trials is conducted in accordance with our investigational plan and protocol. Moreover, the FDA and other foreign regulatory authorities require us to comply with IND and human subject protection regulations and current good clinical practice standards, commonly referred to as GCPs, for conducting, monitoring, recording, and reporting the results of clinical trials to ensure that the data and results are scientifically credible and accurate and that the trial subjects are adequately informed of the potential risks of participating in clinical trials. Our reliance on third parties does not relieve us of these responsibilities and requirements. Regulatory authorities enforce these GCPs through periodic inspections of trial sponsors, principal investigators and trial sites. If we or any of our third-party contractors fail to comply with applicable GCPs, the clinical data generated in our clinical trials may be deemed unreliable and the FDA or comparable foreign regulatory authorities may require us to perform additional clinical trials before approving our marketing applications. There is no assurance that upon inspection by a given regulatory authority, such regulatory authority will determine that any of our clinical trials comply with GCPs. Our failure to comply with these regulations may require us to repeat clinical trials, which would delay the marketing approval process. There are significant requirements imposed on us and on clinical investigators who conduct clinical trials that we sponsor. Although we are responsible for selecting qualified CROs or clinical investigators, providing them with the information they need to conduct the clinical trials properly, ensuring proper monitoring of the clinical trials, and ensuring that the clinical trials are conducted in accordance with the general investigational plan and protocols contained in the IND, we cannot ensure that the CROs or clinical investigators will maintain compliance with all regulatory requirements at all times. The pharmaceutical industry has experienced cases where clinical investigators have been found to incorrectly record data, omit data, or even falsify data. We cannot ensure that the CROs or clinical investigators in our trials will not make mistakes or otherwise compromise the integrity or validity of data, any of which would have a significant negative effect on our ability to obtain marketing approval, our business, and our financial condition. We or the third parties we rely on may encounter problems in clinical trials that may cause us or the FDA or foreign regulatory agencies to delay, suspend or terminate our clinical trials at any phase. These problems could include the possibility that we may not be able to manufacture sufficient quantities of materials for use in our clinical trials, conduct clinical trials at our preferred sites, enroll a sufficient number of patients for our clinical trials at one or more sites, or begin or successfully complete clinical trials in a timely fashion, if at all. Furthermore, we, the FDA or foreign regulatory agencies may suspend clinical trials of our product candidates at any time if we or they believe the subjects participating in the trials are being exposed to unacceptable health risks, whether as a result of adverse events occurring in our trials or otherwise, or if we or they find deficiencies in the clinical trial process or conduct of the investigation. The FDA and foreign regulatory agencies could also require additional clinical trials before or after granting of marketing approval for any products, which would result in increased costs and significant delays in the development and commercialization of such products and could result in the withdrawal of such products from the market after obtaining marketing approval. Our failure to adequately demonstrate the safety and efficacy of a product candidate in clinical development could delay or prevent obtaining marketing approval of the product candidate and, after obtaining marketing approval, data from post-approval studies could result in the product being withdrawn from the market, either of which would likely have a material adverse effect on our business. We may be unable to realize the potential benefits of any collaboration. Even if we are successful in entering into a collaboration with respect to the development and/or commercialization of one or more product candidates, there is no guarantee that the collaboration will be successful. Collaborations may pose a number of risks, including: ● collaborators often have significant discretion in determining the efforts and resources that they will apply to the collaboration, and may not commit sufficient resources to the development, marketing or commercialization of the product or products that are subject to the collaboration; 45 ● collaborators may not perform their obligations as expected; ● any such collaboration may significantly limit our share of potential future profits from the associated program, and may require us to relinquish potentially valuable rights to our current product candidates, potential products or proprietary technologies or grant licenses on terms that are not favorable to us; ● collaborators may cease to devote resources to the development or commercialization of our product candidates if the collaborators view our product candidates as competitive with their own products or product candidates; ● disagreements with collaborators, including disagreements over proprietary rights, contract interpretation or the course of development, might cause delays or termination of the development or commercialization of product candidates, and might result in legal proceedings, which would be time consuming, distracting and expensive; ● collaborators may be impacted by changes in their strategic focus or available funding, or business combinations involving them, which could cause them to divert resources away from the collaboration; ● collaborators may infringe the intellectual property rights of third parties, which may expose us to litigation and potential liability; ● the collaborations may not result in us achieving revenues to justify such transactions; and ● collaborations may be terminated and, if terminated, may result in a need for us to raise additional capital to pursue further development or commercialization of the applicable product candidate. As a result, a collaboration may not result in the successful development or commercialization of our product candidates. We enter into various contracts in the normal course of our business in which we indemnify the other party to the contract. In the event we have to perform under these indemnification provisions, it could have a material adverse effect on our business, financial condition and results of operations. In the normal course of business, we periodically enter into academic, commercial, service, collaboration, licensing, consulting and other agreements that contain indemnification provisions. With respect to our academic and other research agreements, we typically indemnify the institution and related parties from losses arising from claims relating to the products, processes or services made, used, sold or performed pursuant to the agreements for which we have secured licenses, and from claims arising from our or our sublicensees’ exercise of rights under the agreement. Should our obligation under an indemnification provision exceed applicable insurance coverage or if we were denied insurance coverage, our business, financial condition and results of operations could be adversely affected. Similarly, if we are relying on a collaborator to indemnify us and the collaborator is denied insurance coverage or the indemnification obligation exceeds the applicable insurance coverage, and if the collaborator does not have other assets available to indemnify us, our business, financial condition and results of operations could be adversely affected. If our contractors fail to comply with continuing regulations, we or they may be subject to enforcement action that could adversely affect us. If any of our contractors fail to comply with the requirements of the FDA and other applicable U.S. or foreign governmental or regulatory authorities or previously unknown problems with our products, manufacturers or manufacturing processes are discovered, we or the contractor could be subject to administrative or judicially imposed sanctions, including: restrictions on the products, the manufacturers or manufacturing processes we use, warning letters, civil or criminal penalties, fines, injunctions, product seizures or detentions, import bans, voluntary or mandatory product recalls and publicity requirements, suspension or withdrawal of regulatory approvals, total or partial suspension of production, and refusal to approve pending applications for marketing approval of new products to approved applications. 46 Risks Related to Our Intellectual Property Our proprietary rights may not adequately protect our technologies and product candidates. Our commercial success will depend in part on our ability to obtain additional patents and protect our existing patent position as well as our ability to maintain adequate protection of other intellectual property for our technologies, product candidates, and any future products in the United States and other countries. If we do not adequately protect our intellectual property, competitors may be able to use our technologies and erode or negate any competitive advantage we may have, which could harm our business and ability to achieve profitability. The laws of some foreign countries do not protect our proprietary rights to the same extent or in the same manner as U.S. laws, and we may encounter significant problems in protecting and defending our proprietary rights in these countries. We will be able to protect our proprietary rights from unauthorized use by third parties only to the extent that our proprietary technologies, product candidates and any future products are covered by valid and enforceable patents or are effectively maintained as trade secrets. We apply for patents covering both our technologies and product candidates, as we deem appropriate. However, we may fail to apply for patents on important technologies or product candidates in a timely fashion, or at all. Our existing patents and any future patents we obtain may not be sufficiently broad to prevent others from practicing our technologies or from developing competing products and technologies. We cannot be certain that our patent applications will be approved or that any patents issued will adequately protect our intellectual property. While we are responsible for and have control over the filing and prosecuting of patent applications and maintaining patents which cover making, using or selling EDSIVO and ACER-001, we may lose such rights if we decide to allow any licensed patent to lapse. If we fail to appropriately prosecute and maintain patent protection for any of our product candidates, our ability to develop and commercialize those product candidates may be adversely affected and we may not be able to prevent competitors from making, using and selling competing products. Moreover, the patent positions of pharmaceutical companies are highly uncertain and involve complex legal and factual questions for which important legal principles are evolving and remain unresolved. As a result, the validity and enforceability of patents cannot be predicted with certainty. In addition, we do not know whether: ● we or our licensors were the first to make the inventions covered by each of our issued patents and pending patent applications; ● we or our licensors were the first to file patent applications for these inventions; ● any of the patents that cover our product candidates will be eligible to be listed in the FDA’s compendium of “Approved Drug Products with Therapeutic Equivalence Evaluation,” sometimes referred to as the FDA’s Orange Book; ● others will independently develop similar or alternative technologies or duplicate any of our technologies; ● any of our or our licensors’ pending patent applications will result in issued patents; ● any of our or our licensors’ patents will be valid or enforceable; ● any patents issued to us or our licensors and collaborators will provide us with any competitive advantages, or will be challenged by third parties; ● we will develop additional proprietary technologies that are patentable; ● the U.S. government will exercise any of its statutory rights to our intellectual property that was developed with government funding; or ● our business may infringe the patents or other proprietary rights of others. 47 The actual protection afforded by a patent varies based on products or processes, from country to country and depends upon many factors, including the type of patent, the scope of its coverage, the availability of regulatory related extensions, the availability of legal remedies in a particular country, the validity and enforceability of the patents and our financial ability to enforce our patents and other intellectual property. Our ability to maintain and solidify our proprietary position for our products will depend on our success in obtaining effective claims and enforcing those claims once granted. Our issued patents and those that may issue in the future, or those licensed to us, may be challenged, narrowed, invalidated or circumvented, and the rights granted under any issued patents may not provide us with proprietary protection or competitive advantages against competitors with similar products. Due to the extensive amount of time required for the development, testing and regulatory review of a potential product, it is possible that, before any of our product candidates can be commercialized, any related patent may expire or remain in force for only a short period following commercialization, thereby reducing any advantage of the patent. We may also rely on trade secrets to protect some of our technology, especially where we do not believe patent protection is appropriate or obtainable. However, trade secrets are difficult to maintain. While we use reasonable efforts to protect our trade secrets, we or any of our collaborators’ employees, consultants, contractors or scientific and other advisors may unintentionally or willfully disclose our proprietary information to competitors and we may not have adequate remedies in respect of that disclosure. Enforcement of claims that a third party has illegally obtained and is using trade secrets is expensive, time consuming and uncertain. In addition, foreign courts are sometimes less willing than U.S. courts to protect trade secrets. If our competitors independently develop equivalent knowledge, methods and know-how, we would not be able to assert our trade secrets against them and our business could be harmed. We are a party to license agreements under which we license intellectual property and receive commercialization rights relating to EDSIVO and ACER-001. If we fail to comply with obligations in such agreements or otherwise experience disruptions to our business relationships with our licensors, we could lose license rights that are important to our business; any termination of such agreements would adversely affect our business. In April 2014, we entered into an agreement with Baylor College of Medicine pursuant to which we obtained an exclusive, worldwide license to develop and commercialize NaPB for treatment of MSUD. In August 2016, we entered into an agreement with Assistance Publique—Hôpitaux de Paris, Hôpital Européen Georges Pompidou, or AP-HP, pursuant to which we obtained an exclusive worldwide right to access and use data from the Ong trial, which we intend to use to support an NDA filing for EDSIVO for the treatment of vEDS. Under each license agreement, we are subject to commercialization and development diligence obligations, royalty payments and other obligations. If we fail to comply with any of these obligations or otherwise breach any of these license agreements, the licensor may have the right to terminate the license in whole or in part or to terminate the exclusive nature of the license. The loss of the licenses granted to us under our agreements with these licensors or the rights provided therein would prevent us from developing, manufacturing or marketing products covered by the license or subject to supply commitments, and could materially harm our business, financial condition, results of operations and prospects. We may not be able to protect our intellectual property rights throughout the world. Filing, prosecuting and defending patents on product candidates in all countries throughout the world would be prohibitively expensive, and our intellectual property rights in some countries outside the United States can be less extensive than those in the United States. In addition, the laws of some foreign countries do not protect intellectual property rights to the same extent as federal and state laws in the United States. For example, many foreign countries have compulsory licensing laws under which a patent owner must grant licenses to third parties. Consequently, we may not be able to prevent third parties from practicing our inventions in all countries outside the United States, or from selling or importing products made using our inventions in and into the United States or other jurisdictions. Competitors may use our technologies in jurisdictions where we have not obtained patent protection to develop their own products and further, may export otherwise infringing products to territories where we have patent protection, but enforcement rights are not as strong as those in the United States. These products may compete with our product candidates in jurisdictions where we do not have any issued patents and our patent claims or other intellectual rights may not be effective or sufficient to prevent them from so competing. Many companies have encountered significant problems in protecting and defending intellectual property rights in foreign jurisdictions. The legal systems of certain countries do not favor the enforcement of patents and other intellectual property protection, which could make it difficult for us to stop the infringement of our patents generally. Proceedings to enforce our patent rights in foreign jurisdictions could result in substantial costs and divert our efforts and attention from other aspects of our business, could put our patents at risk of being invalidated or interpreted narrowly and our patent applications at risk of not issuing and could provoke third parties to assert claims against us. We may not prevail in any lawsuits that we initiate and the damages or other remedies awarded, if any, may not be commercially meaningful. Accordingly, our efforts to enforce our intellectual property rights around the world may be inadequate to obtain a significant commercial advantage from the intellectual property that we develop or license. 48 If we do not obtain patent term extension in the United States under the Hatch-Waxman Act and in foreign countries under similar legislation, thereby potentially extending the term of marketing exclusivity for our product candidates, our business may be materially harmed. Depending on the timing, duration and specifics of FDA marketing approval of our product candidates, if any, one of the U.S. patents covering each of such approved product(s) or the use thereof may be eligible for up to five years of patent term restoration under the Hatch-Waxman Act. The Hatch-Waxman Act allows a maximum of one patent to be extended per FDA-approved product. Patent term extension also may be available in certain foreign countries upon regulatory approval of our product candidates. Nevertheless, we may not be granted patent term extension either in the United States or in any foreign country because of, for example, failing to apply within applicable deadlines, failing to apply prior to expiration of relevant patents or otherwise failing to satisfy applicable requirements. Moreover, the term of extension, as well as the scope of patent protection during any such extension, afforded by the governmental authority could be less than we request. If we are unable to obtain patent term extension or restoration, or the term of any such extension is less than we or our collaborators request, the period during which we will have the right to exclusively market our product will be shortened and our competitors may obtain approval of competing products following our patent expiration, and our revenue could be reduced, possibly materially. We may not identify relevant patents or may incorrectly interpret the relevance, scope or expiration of a patent, which may adversely affect our ability to develop and market our product candidates. We cannot guarantee that any of our patent searches or analyses, including but not limited to the identification of relevant patents, the scope of patent claims or the expiration of relevant patents, are complete or thorough, nor can we be certain that we have identified each and every patent and pending application in the United States and abroad that is relevant to or necessary for the commercialization of our product candidates in any jurisdiction. The scope of a patent claim is determined by an interpretation of the law, the written disclosure in a patent and the patent’s prosecution history. Our interpretation of the relevance or the scope of a patent or a pending application may be incorrect, which may negatively impact our ability to market our product candidates. We may incorrectly determine that our product candidates are not covered by a third-party patent. Many patents may cover a marketed product, including but not limited to patents covering the composition, methods of use, formulations, production processes and purification processes of or for the product. The identification of all patents and their expiration dates relevant to the production and sale of a therapeutic product is extraordinarily complex and requires sophisticated legal knowledge in the relevant jurisdiction. It may be impossible to identify all patents in all jurisdictions relevant to a marketed product. Our determination of the expiration date of any patent in the United States or abroad that we consider relevant may be incorrect, which may negatively impact our ability to develop and market our product candidates. Obtaining and maintaining our patent protection depends on compliance with various procedural, documentary, fee payment and other requirements imposed by governmental patent agencies, and our patent protection could be reduced or eliminated for non-compliance with these requirements. The United States Patent and Trademark Office, or USPTO, and various foreign governmental patent agencies require compliance with a number of procedural, documentary, fee payment and other similar provisions during the patent prosecution process. Periodic maintenance fees, renewal fees, annuity fees and various other governmental fees on any issued patent and/or pending patent applications are due to be paid to the USPTO and foreign patent agencies in several stages over the lifetime of a patent or patent application. We employ an outside firm and rely on our outside counsel to pay these fees. While an inadvertent lapse may sometimes be cured by payment of a late fee or by other means in accordance with the applicable rules, there are many situations in which noncompliance can result in abandonment or lapse of the patent or patent application, resulting in partial or complete loss of patent rights in the relevant jurisdiction. If we fail to maintain the patents and patent applications directed to our product candidates, our competitors might be able to enter the market earlier than should otherwise have been the case, which would have a material adverse effect on our business. 49 The patent protection for our product candidates may expire before we are able to maximize their commercial value, which may subject us to increased competition and reduce or eliminate our opportunity to generate product revenue. The patents for our product candidates have varying expiration dates and, if these patents expire, we may be subject to increased competition and we may not be able to recover our development costs or market any of our approved products profitably. In some of the larger potential market territories, such as the United States and Europe, patent term extension or restoration may be available to compensate for time taken during aspects of the product’s development and regulatory review. However, we cannot be certain that such an extension will be granted, or if granted, what the applicable time period or the scope of patent protection afforded during any extension period will be. In addition, even though some regulatory authorities may provide some other exclusivity for a product under their own laws and regulations, we may not be able to qualify the product or obtain the exclusive time period. If we are unable to obtain patent term extension/restoration or some other exclusivity, we could be subject to increased competition and our opportunity to establish or maintain product revenue could be substantially reduced or eliminated. Furthermore, we may not have sufficient time to recover our development costs prior to the expiration of our U.S. and foreign patents. We may become involved in lawsuits to protect our patents or other intellectual property rights, which could be expensive, time-consuming and ultimately unsuccessful. Competitors may infringe our patents or other intellectual property rights. To counter infringement or unauthorized use, we may be required to file infringement claims, directly or through our licensors, which can be expensive and time consuming. In addition, in an infringement proceeding, a court may decide that a patent of our licensor is not valid or is unenforceable, or may refuse to stop the other party from using the technology at issue on the grounds that our patents do not cover the technology in question. An adverse result in any litigation or defense proceedings could put one or more of the patents we license at risk of being invalidated or interpreted narrowly and could put our licensors’ patent applications at risk of not issuing. Interference proceedings brought by the USPTO may be necessary to determine the priority of inventions with respect to our patents or the patents of our licensors. An unfavorable outcome could require us to cease using the technology or to attempt to license rights to it from the prevailing party. Our business could be harmed if a prevailing party does not offer us a license on terms that are acceptable to us. Litigation or interference proceedings may fail and, even if successful, may result in substantial costs and distraction of our management and other employees. We may not be able to prevent, alone or with our licensors, misappropriation of our proprietary rights, particularly in countries where the laws may not protect those rights as fully as in the United States. Furthermore, because of the substantial amount of discovery required in connection with intellectual property litigation, there is a risk that some of our confidential and proprietary information could be compromised by disclosure during this type of litigation. In addition, there could be public announcements of the results of hearings, motions or other interim proceedings or developments. If securities analysts or investors perceive these results to be negative, it could have a substantial adverse effect on the price of our common stock. Third-party claims of intellectual property infringement or misappropriation may adversely affect our business and could prevent us from developing or commercializing our product candidates. Our commercial success depends in part on us not infringing the patents and proprietary rights of third parties. There is a substantial amount of litigation, both within and outside the United States, involving patent and other intellectual property rights in the biotechnology and pharmaceutical industries, including patent infringement lawsuits, interferences, oppositions, ex-parte review and inter partes reexamination and post-grant review proceedings before the USPTO and corresponding foreign patent offices. Numerous U.S. and foreign issued patents and pending patent applications owned by third parties exist in the fields in which we are developing and may develop our product candidates. As the biotechnology and pharmaceutical industries expand and more patents are issued, the risk increases that our product candidates may be subject to claims of infringement of the patent rights of third parties. If a third party claims that we infringe on their products or technology, we could face a number of issues, including: ● infringement and other intellectual property claims which, with or without merit, can be expensive and time-consuming to litigate and can divert management’s attention from our core business; ● substantial damages for past infringement, which we may have to pay if a court decides that our product infringes on a competitor’s patent; ● a court prohibiting us from selling or licensing our product unless the patent holder licenses the patent to us, which the collaborator would not be required to do; ● if a license is available from a patent holder, we may have to pay substantial royalties or grant cross licenses to our patents; and ● redesigning our processes so they do not infringe, which may not be possible or could require substantial funds and time. 50 Third parties may assert that we are employing their proprietary technology without authorization. There may be third-party patents or patent applications with claims to materials, formulations, methods of manufacture or methods for treatment related to the use or manufacture of our product candidates that we failed to identify. For example, applications filed before November 29, 2000 and certain applications filed after that date that will not be filed outside the United States remain confidential until issued as patents. Except for the preceding exceptions, patent applications in the United States and elsewhere are generally published only after a waiting period of approximately 18 months after the earliest filing. Therefore, patent applications covering our product candidates could have been filed by others without the knowledge of us or our licensors. Additionally, pending patent applications which have been published can, subject to certain limitations, be later amended in a manner that could cover our product candidates or the use or manufacture of our product candidates. We may also face a claim of misappropriation if a third party believes that we inappropriately obtained and used trade secrets of such third party. If we are found to have misappropriated a third party’s trade secrets, we may be prevented from further using such trade secrets, limiting our ability to develop our product candidates, and we may be required to pay damages. If any third-party patents were held by a court of competent jurisdiction to cover aspects of our materials, formulations, methods of manufacture or methods for treatment, the holders of any such patents would be able to block our ability to develop and commercialize the applicable product candidate until such patent expired or unless we obtain a license. These licenses may not be available on acceptable terms, if at all. Even if we were able to obtain a license, the rights may be nonexclusive, which could result in our competitors gaining access to the same intellectual property. Ultimately, we could be prevented from commercializing a product, or be forced to cease some aspect of our business operations, if, as a result of actual or threatened patent infringement claims, we are unable to enter into licenses on acceptable terms. In addition, during the course of any patent or other intellectual property litigation, there could be public announcements of the results of hearings, rulings on motions, and other interim proceedings in the litigation. If securities analysts or investors regard these announcements as negative, the perceived value of our product candidates, programs, or intellectual property could be diminished. Accordingly, the market price of our common stock may decline. Parties making claims against us may obtain injunctive or other equitable relief, which could effectively block our ability to further develop and commercialize one or more of our product candidates. Defending against claims of patent infringement or misappropriation of trade secrets could be costly and time-consuming, regardless of the outcome. Thus, even if we were to ultimately prevail, or to settle at an early stage, such litigation could burden us with substantial unanticipated costs. In addition, litigation or threatened litigation could result in significant demands on the time and attention of our management team, distracting them from the pursuit of other company business. In the event of a successful claim of infringement against us, we may have to pay substantial damages, including treble damages and attorneys’ fees for willful infringement, pay royalties, redesign our infringing products or obtain one or more licenses from third parties, which may be impossible or require substantial time and monetary expenditure. In addition, the uncertainties associated with litigation could have a material adverse effect on our ability to raise the funds necessary to continue our clinical trials, continue our research programs, license necessary technology from third parties, or enter into development collaborations that would help us bring our product candidates to market. Changes in U.S. patent law could diminish the value of patents in general, thereby impairing our ability to protect our product candidates. As is the case with other pharmaceutical companies, our success is heavily dependent on intellectual property, particularly on obtaining and enforcing patents and patent rights. Obtaining and enforcing patents and patent rights in the specialty pharmaceutical industry involves both technological and legal complexity, and therefore, is costly, time-consuming and inherently uncertain. In addition, the United States has recently enacted and is currently implementing wide-ranging patent reform legislation. Further, several recent U.S. Supreme Court rulings have either narrowed the scope of patent protection available in certain circumstances or weakened the rights of patent owners in certain situations. In addition to increasing uncertainty with regard to our ability to obtain patents in the future, this combination of events has created uncertainty with respect to the value of patents and patent rights, once obtained. For our U.S. patent applications containing a claim not entitled to priority before March 16, 2013, there is a greater level of uncertainty in the patent law. In September 2011, the Leahy-Smith America Invents Act, or the America Invents Act, or AIA, was signed into law. The AIA includes a number of significant changes to U.S. patent law, including provisions that affect the way patent applications will be prosecuted, reviewed after issuance, and may also affect patent litigation. The USPTO is currently developing regulations and procedures to govern administration of the AIA, and many of the substantive changes to patent law associated with the AIA. It is not clear what other, if any, impact the AIA will have on the operation of our business. Moreover, the AIA and its implementation could increase the uncertainties and costs surrounding the prosecution of patent applications and the enforcement or defense of patent rights, all of which could have a material adverse effect on our business and financial condition. 51 An important change introduced by the AIA is that, as of March 16, 2013, the United States transitioned to a “first-inventor-to-file” system for deciding which party should be granted a patent when two or more patent applications are filed by different parties claiming the same invention. A third party that files a patent application in the USPTO after that date but before a licensor or us could therefore be awarded a patent covering an invention of ours even if said licensor or we had made the invention before it was made by the third party. This will require us to be cognizant going forward of the time from invention to filing of a patent application. Furthermore, our ability to obtain and maintain valid and enforceable patent rights depends on whether the differences between the licensor’s or our technology and the prior art allow our technology to be patentable over the prior art. Since patent applications in the United States and most other countries are confidential for a period of time after filing, we cannot be certain that a licensor or we were the first to either (a) file any patent application related to our product candidates or (b) invent any of the inventions claimed in our patents or patent applications. Among some of the other changes introduced by the AIA are changes that limit where a patentee may file a patent infringement suit and providing opportunities for third parties to challenge any issued patent in the USPTO. This applies to all U.S. patents, even those issued before March 16, 2013. Because of a lower evidentiary standard in USPTO proceedings compared to the evidentiary standard in United States federal court necessary to invalidate a patent claim, a third party could potentially provide evidence in a USPTO proceeding sufficient for the USPTO to hold a claim invalid as unpatentable even though the same evidence may be insufficient to invalidate the claim if first presented in a district court action. Accordingly, a third party may attempt to use the USPTO procedures to invalidate patent rights that would not have been invalidated if first challenged by the third party as a defendant in a district court action. Depending on decisions by the U.S. Congress, the federal courts, and the USPTO, the laws and regulations governing patents could change in unpredictable ways that would weaken our ability to obtain new patents or to enforce our existing patents and patents that we might obtain in the future. Because of the expense and uncertainty of litigation, we may not be in a position to enforce our intellectual property rights against third parties. Because of the expense and uncertainty of litigation, we may conclude that even if a third party is infringing our patents or the patents of our licensors or other intellectual property rights, the risk-adjusted cost of bringing and enforcing such a claim or action may be too high or not in the best interest of us or our shareholders. In such cases, we may decide that the more prudent course of action is to simply monitor the situation or initiate or seek some other non-litigious action or solution. Intellectual property rights do not address all potential threats to our competitive advantage. The degree of future protection afforded by our intellectual property rights is uncertain because intellectual property rights have limitations, and may not adequately protect our business, or permit us to maintain our competitive advantage. The following examples are illustrative: ● Others may be able to make products that are similar to our product candidates but that are not covered by the claims of the patents that we license from others or may license or own in the future. ● Others may independently develop similar or alternative technologies or otherwise circumvent any of our technologies without infringing our intellectual property rights. ● Any of our collaborators might not have been the first to conceive and reduce to practice the inventions covered by the patents or patent applications that we license or will, in the future, own or license. ● Any of our collaborators might not have been the first to file patent applications covering certain of the patents or patent applications that we license or will, in the future, license. ● Issued patents that have been licensed to us may not provide us with any competitive advantage, or may be held invalid or unenforceable, as a result of legal challenges by our competitors. ● Our competitors might conduct research and development activities in countries where we do not have license rights, or in countries where research and development safe harbor laws exist, and then use the information learned from such activities to develop competitive products for sale in our major commercial markets. ● Ownership of patents or patent applications licensed to us may be challenged by third parties. ● The patents of third parties or pending or future applications of third parties, if issued, may have an adverse effect on our business. 52 Confidentiality agreements with employees, consultants and others may not adequately prevent disclosure of trade secrets and protect other proprietary information. We consider proprietary trade secrets and/or confidential know-how and unpatented know-how to be important to our business. We may rely on trade secrets and/or confidential know-how to protect our technology, especially where patent protection is believed by us to be of limited value. However, trade secrets and/or confidential know-how can be difficult to maintain as confidential. To protect this type of information against disclosure or appropriation by competitors, our policy is to require our employees, consultants, contractors and advisors to enter into confidentiality agreements with us. However, current or former employees, consultants, contractors and advisers may unintentionally or willfully disclose our confidential information to competitors, and confidentiality agreements may not provide an adequate remedy in the event of unauthorized disclosure of confidential information. Enforcing a claim that a third party obtained illegally and is using trade secrets and/or confidential know-how is expensive, time consuming and unpredictable. The enforceability of confidentiality agreements may vary from jurisdiction to jurisdiction. Failure to obtain or maintain trade secrets and/or confidential know-how trade protection could adversely affect our competitive position. Moreover, our competitors may independently develop substantially equivalent proprietary information and may even apply for patent protection in respect of the same. If successful in obtaining such patent protection, our competitors could limit our use of our trade secrets and/or confidential know-how. We may need to license certain intellectual property from third parties, and such licenses may not be available or may not be available on commercially reasonable terms. A third party may hold intellectual property, including patent rights that are important or necessary to the development or commercialization of our product candidates. It may be necessary for us to use the patented or proprietary technology of third parties to commercialize our product candidates, in which case we would be required to obtain a license from these third parties. Such a license may not be available on commercially reasonable terms or at all, which could materially harm our business. We may be subject to claims that our employees, consultants or independent contractors have wrongfully used or disclosed confidential information of third parties. We have received confidential and proprietary information from third parties. In addition, we employ individuals who were previously employed at other biotechnology or pharmaceutical companies. We may be subject to claims that we or our employees, consultants or independent contractors have inadvertently or otherwise improperly used or disclosed confidential information of these third parties or our employees’ former employers. Further, we may be subject to ownership disputes in the future arising, for example, from conflicting obligations of consultants or others who are involved in developing our product candidates. We may also be subject to claims that former employees, consultants, independent contractors, collaborators or other third parties have an ownership interest in our patents or other intellectual property. Litigation may be necessary to defend against these and other claims challenging our right to and use of confidential and proprietary information. If we fail in defending any such claims, in addition to paying monetary damages, we may lose our rights therein. Such an outcome could have a material adverse effect on our business. Even if we are successful in defending against these claims, litigation could result in substantial cost and be a distraction to our management and employees. We may be subject to claims challenging the inventorship or ownership of our patents and other intellectual property. We may also be subject to claims that former employees, collaborators or other third parties have an ownership interest in our patents and other intellectual property. We may be subject to ownership disputes in the future arising, for example, from conflicting obligations of consultants or others who are involved in developing our product candidates. Litigation may be necessary to defend against these and other claims challenging inventorship or ownership. If we fail in defending any such claims, in addition to paying monetary damages, we may lose valuable intellectual property rights, such as exclusive ownership of, or right to use, valuable intellectual property. Such an outcome could have a material adverse effect on our business. Even if we are successful in defending against such claims, litigation could result in substantial costs and be a distraction to management and other employees. 53 Our reliance on third parties requires us to share our trade secrets, which increases the possibility that a competitor will discover them or that our trade secrets will be misappropriated or disclosed. Because we rely on third parties to assist with research and development and to manufacture our product candidates, we must, at times, share trade secrets with them. We seek to protect our proprietary technology in part by entering into confidentiality agreements and, if applicable, material transfer agreements, consulting agreements or other similar agreements with our advisors, employees, third-party contractors and consultants prior to beginning research or disclosing proprietary information. These agreements typically limit the rights of the third parties to use or disclose our confidential information, including our trade secrets. Despite the contractual provisions employed when working with third parties, the need to share trade secrets and other confidential information increases the risk that such trade secrets become known by our competitors, are inadvertently incorporated into the technology of others, or are disclosed or used in violation of these agreements. Given that our proprietary position is based, in part, on our know-how and trade secrets, a competitor’s discovery of our trade secrets or other unauthorized use or disclosure would impair our competitive position and may have a material adverse effect on our business. In addition, these agreements typically restrict the ability of our advisors, employees, third-party contractors and consultants to publish data potentially relating to our trade secrets, although our agreements may contain certain limited publication rights. For example, any academic institution that we may collaborate with in the future will usually expect to be granted rights to publish data arising out of such collaboration, provided that we are notified in advance and given the opportunity to delay publication for a limited time period in order for us to secure patent protection of intellectual property rights arising from the collaboration, in addition to the opportunity to remove confidential or trade secret information from any such publication. In the future we may also conduct joint research and development programs that may require us to share trade secrets under the terms of our research and development or similar agreements. Despite our efforts to protect our trade secrets, our competitors may discover our trade secrets, either through breach of our agreements with third parties, independent development or publication of information by any of our third-party collaborators. A competitor’s discovery of our trade secrets would impair our competitive position and have an adverse impact on our business. If our trademarks and trade names are not adequately protected, then we may not be able to build name recognition in our markets of interest and our business may be adversely affected. If our trademarks and trade names are not adequately protected, then we may not be able to build name recognition in our markets of interest and our business may be adversely affected. Our unregistered trademarks or trade names may be challenged, infringed, circumvented or declared generic or determined to be infringing on other marks. We may not be able to protect our rights to these trademarks and trade names, which we need to build name recognition among potential collaborators or customers in our markets of interest. At times, competitors may adopt trade names or trademarks similar to ours, thereby impeding our ability to build brand identity and possibly leading to market confusion. In addition, there could be potential trade name or trademark infringement claims brought by owners of other registered trademarks or trademarks that incorporate variations of our unregistered trademarks or trade names. Over the long term, if we are unable to successfully register our trademarks and trade names and establish name recognition based on our trademarks and trade names, then we may not be able to compete effectively and our business may be adversely affected. Our efforts to enforce or protect our proprietary rights related to trademarks, trade secrets, domain names, copyrights or other intellectual property may be ineffective and could result in substantial costs and diversion of resources and could adversely impact our financial condition or results of operations. Risks Related to Our Securities There is currently a limited market for our securities, and any trading market that exists in our securities may be highly illiquid and may not reflect the underlying value of our net assets or business prospects. Although our common stock is traded on the NASDAQ Capital Market, there is currently a limited market for our securities and there can be no assurance that an active market will ever develop. Investors are cautioned not to rely on the possibility that an active trading market may develop. Our stock may be delisted from NASDAQ, which could affect our market price and liquidity. We are required to meet certain qualitative and financial tests (including a minimum bid price for our common stock of $1.00 per share and a minimum shareholders’ equity of $2.5 million), as well as certain corporate governance standards, to maintain the listing of our common stock on the NASDAQ Capital Market. While we are exercising diligent efforts to maintain the listing of our common stock and warrants on NASDAQ, there can be no assurance that we will be able to do so, and our securities could be delisted. 54 Our share price is volatile, and you may not be able to resell your shares at a profit or at all. The market price of our common stock could be subject to significant fluctuations. The market prices for securities of pharmaceutical and biotechnology companies, and early-stage drug discovery and development companies like ours in particular, have historically been highly volatile and may continue to be highly volatile in the future. The following factors, in addition to other risk factors described in this section, may have a significant impact on the market price of our common stock: ● announcements of significant changes in our business or operations; ● the development status of any of our drug candidates, such as EDSIVO or ACER-001, including clinical study results and determinations by regulatory authorities with respect thereto; ● the initiation, termination or reduction in the scope of any collaboration arrangements or any disputes or developments regarding such collaborations; ● our inability to obtain additional funding; ● announcements of technological innovations, new commercial products or other material events by our competitors or by us; ● disputes or other developments concerning our proprietary rights; ● changes in, or failure to meet, securities analysts’ or investors’ expectations of our financial performance; ● additions or departures of key personnel; ● discussions of our business, products, financial performance, prospects or stock price by the financial and scientific press and online investor communities; ● public concern as to, and legislative action with respect to, the pricing and availability of prescription drugs or the safety of drugs and drug delivery techniques; ● regulatory developments in the United States and in foreign countries; or ● dilutive effects of sales of shares of common stock by us or our shareholders, and sales of common stock acquired upon exercise or conversion by the holders of warrants, options or convertible notes. Broad market and industry factors, as well as economic and political factors, also may materially adversely affect the market price of our common stock. We may be or become the target of securities litigation, which is costly and time-consuming to defend. In the past, following periods of market volatility in the price of a company’s securities or the reporting of unfavorable news, security holders have often instituted class action litigation. This risk is especially relevant for us because pharmaceutical companies have experienced significant stock price volatility in recent years. If we become involved in this type of litigation, regardless of the outcome, we could incur substantial legal costs and our management’s attention could be diverted from the operation of our business, causing our business to suffer. Our “blank check” preferred stock could be issued to prevent a business combination not desired by management or our majority shareholders. Our charter authorizes the issuance of “blank check” preferred stock with such designations, rights and preferences as may be determined by our board of directors without shareholder approval. Our preferred stock could be utilized as a method of discouraging, delaying, or preventing a change in control and as a method of preventing shareholders from receiving a premium for their shares in connection with a change of control. Future sales of our securities could cause dilution, and the sale of such securities, or the perception that such sales may occur, could cause the price of our stock to fall. Sales of additional shares of our common stock, as well as securities convertible into or exercisable for common stock, could result in substantial dilution to our shareholders and cause the market price of our common stock to decline. An aggregate of 6,450,766 shares of common stock were outstanding as of September 30, 2017. As of such date, another (i) 165,000 shares of common stock were issuable upon exercise of outstanding options and (ii) 317,630 shares of common stock were issuable upon the exercise of outstanding warrants. A substantial majority of the outstanding shares of our common stock and warrants (as well as a substantial majority of the shares of common stock issuable upon exercise of outstanding options and warrants) are freely tradable without restriction or further registration under the Securities Act of 1933. 55 We may sell additional shares of common stock, as well as securities convertible into or exercisable for common stock, in subsequent public or private offerings. We may also issue additional shares of common stock, as well as securities convertible into or exercisable for common stock, to finance future acquisitions. We will need to raise additional capital in order to initiate or complete additional development activities for EDSIVO in vEDS and for ACER-001 in UCD and MSUD, or to pursue additional disease indications for our product candidates, and this may require us to issue a substantial amount of securities (including common stock as well as securities convertible into or exercisable for common stock). There can be no assurance that our capital raising efforts will be able to attract the capital needed to execute on our business plan and sustain our operations. Moreover, we cannot predict the size of future issuances of our common stock, as well as securities convertible into or exercisable for common stock, or the effect, if any, that future issuances and sales of our securities will have on the market price of our common stock. Sales of substantial amounts of our common stock, as well as securities convertible into or exercisable for common stock, including shares issued in connection with an acquisition or securing funds to complete any clinical trial plans, or the perception that such sales could occur, may result in substantial dilution and may adversely affect prevailing market prices for our common stock. We presently do not intend to pay cash dividends on our common stock. We currently anticipates that no cash dividends will be paid on the common stock in the foreseeable future. While our dividend policy will be based on the operating results and capital needs of the business, it is anticipated that all earnings, if any, will be retained to finance the future expansion of our business. Our shareholders may experience substantial dilution in the value of their investment if we issue additional shares of our capital stock. Our charter allows us to issue up to 150,000,000 shares of common stock and to issue and designate the rights of, without shareholder approval, up to 10,000,000 shares of preferred stock. In order to raise additional capital, we may in the future offer additional shares of our common stock or other securities convertible into or exchangeable for our common stock at prices that may not be the same as the price per share paid by other investors, and dilution to our shareholders could result. We may sell shares or other securities in any other offering at a price per share that is less than the price per share paid by investors, and investors purchasing shares or other securities in the future could have rights superior to existing shareholders. The price per share at which we sell additional shares of our common stock, or securities convertible or exchangeable into common stock, in future transactions may be higher or lower than the price per share paid by other investors. We may issue debt and equity securities or securities convertible into equity securities, any of which may be senior to our common stock as to distributions and in liquidation, which could negatively affect the value of our common stock. In the future, we may attempt to increase our capital resources by entering into debt or debt-like financing that is unsecured or secured by up to all of our assets, or by issuing additional debt or equity securities, which could include issuances of secured or unsecured commercial paper, medium-term notes, senior notes, subordinated notes, guarantees, preferred stock, hybrid securities, or securities convertible into or exchangeable for equity securities. In the event of our liquidation, our lenders and holders of our debt and preferred securities would receive distributions of available assets before distributions to the holders of our common stock. Because our decision to incur debt and issue securities in future offerings may be influenced by market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings or debt financings. Further, market conditions could require us to accept less favorable terms for the issuance of our securities in the future. Our management has significant flexibility in using the current available cash. In addition to general corporate purposes (including working capital, research and development, business development and operational purposes), we currently intend to use our available cash to continue the development of our drug candidates, such as EDSIVO and ACER-001. Depending on future developments and circumstances, we may use some of our available cash for other purposes which may have the potential to decrease our cash runway. Notwithstanding our current intentions regarding use of our available cash, our management will have significant flexibility with respect to such use. The actual amounts and timing of expenditures will vary significantly depending on a number of factors, including the amount and timing of cash used in our operations and our research and development efforts. Management’s failure to use these funds effectively would have an adverse effect on the value of our common stock and could make it more difficult and costly to raise funds in the future. An active trading market may never develop for our Series M warrants, which may limit the ability to resell the warrants. There is no established trading market for the Series M warrants we issued in April 2015. While the warrants have been listed for trading on NASDAQ under the symbol “ACERW,” there can be no assurance that that a market will develop for the warrants. Even if a market for the warrants does develop, the price of the warrants may fluctuate and liquidity may be limited. If a market for the warrants does not develop, then holders of the warrants may be unable to resell the warrants or be able to sell them only at an unfavorable price. Future trading prices of the warrants will depend on many factors, including our operating performance and financial condition, our ability to continue the effectiveness of the registration statement covering the warrants and the common stock issuable upon exercise of the warrants, the interest of securities dealers in making a market and the market for similar securities. 56 The market price of our common stock may not exceed the exercise price of the Series M warrants. The Series M warrants issued in April 2015 will expire on April 9, 2018. The warrants entitle the holders to purchase shares of common stock at an exercise price of $124.27 per share through their expiration. There can be no assurance that the market price of our common stock will exceed the exercise price of the warrants at any time prior to their expiration. Any warrants not exercised by their expiration date will expire worthless and we will be under no further obligation to the warrant holder. The Series M warrants may be redeemed on short notice. This may have an adverse impact on their price. We may redeem the Series M warrants for $0.83 per warrant if the closing price of our common stock has equaled or exceeded $207.11 per share, subject to adjustment, for 10 consecutive trading days. If we give notice of redemption, holders will be forced to sell or exercise their warrants or accept the redemption price. The notice of redemption could come at a time when it is not advisable or possible to exercise the warrants. As a result, holders would be unable to benefit from owning the warrants being redeemed. Because the Merger resulted in an ownership change under Section 382 of the Internal Revenue Code, our pre-Merger net operating loss carryforwards and certain other tax attributes will be subject to limitation or elimination. The net operating loss carryforwards and certain other tax attributes of Private Acer may also be subject to limitations as a result of ownership changes. If a corporation undergoes an “ownership change” within the meaning of Section 382 of the Internal Revenue Code, or Section 382, the corporation’s net operating loss carryforwards and certain other tax attributes arising from before the ownership change are subject to limitations on use after the ownership change. In general, an ownership change occurs if there is a cumulative change in the corporation’s equity ownership by certain shareholders that exceeds fifty percentage points by value over a rolling three-year period. Similar rules may apply under state tax laws. The Merger resulted in an ownership change for us and, accordingly, our net operating loss carryforwards and certain other tax attributes will now be subject to limitation and possibly elimination. It is possible that Private Acer’s net operating loss carryforwards and certain other tax attributes may also be subject to limitation as a result of prior shifts in equity ownership and/or the Merger. Additional ownership changes in the future could result in additional limitations on our and Private Acer’s net operating loss carryforwards and certain other tax attributes. Consequently, even if we achieve profitability, we may not be able to utilize a material portion of our or Private Acer’s net operating loss carryforwards and certain other tax attributes, which could have a material adverse effect on cash flow and results of operations. Because the ownership of our common stock is highly concentrated, it may prevent shareholders from influencing significant corporate decisions and may result in conflicts of interest that could cause our stock price to decline. Our executive officers and directors and their affiliates beneficially own or control approximately 63% of the outstanding shares of our common stock. Accordingly, these executive officers, directors and their affiliates, acting as a group, will have substantial influence over the outcome of corporate actions requiring shareholder approval, including the election of directors, any merger, consolidation or sale of all or substantially all of our assets or any other significant corporate transactions. These shareholders may also delay or prevent a change of control of our company, even if such a change of control would benefit our other shareholders. The significant concentration of stock ownership may adversely affect the trading price of our common stock due to investors’ perception that conflicts of interest may exist or arise. If equity research analysts do not publish research or reports, or publish unfavorable research or reports, about our company, our business or our market, our stock price and trading volume could decline. The trading market for the our common stock will be influenced by the research and reports that equity research analysts publish about us and our business. Equity research analysts may elect not to provide research coverage of our common stock, and such lack of research coverage may adversely affect the market price of our common stock. In the event we do have equity research analyst coverage, we will not have any control over the analysts or the content and opinions included in their reports. The price of our common stock could decline if one or more equity research analysts downgrade our stock or issue other unfavorable commentary or research. If one or more equity research analysts ceases coverage of our company or fails to publish reports on us regularly, demand for our common stock could decrease, which in turn could cause our stock price or trading volume to decline. 57 Anti-takeover provisions in our organizational documents and Texas law might discourage or delay acquisition attempts for our company that you might consider favorable. Our certificate of formation and bylaws contain provisions that may delay or prevent an acquisition or change in control of our company. Among other things, these provisions: ● authorize the board of directors to issue without shareholder approval blank-check preferred stock that, if issued, could operate as a “poison pill” to dilute the stock ownership of a potential hostile acquirer to prevent an acquisition that is not approved by the board of directors; ● establish advance notice requirements for shareholder nominations of directors and for shareholder proposals that can be acted on at shareholder meetings; and ● limit who may call shareholder meetings. Further, as a Texas corporation, we are also subject to provisions of Texas law, which may impair a takeover attempt that the our shareholders may find beneficial. These anti-takeover provisions and other provisions under Texas law could discourage, delay or prevent a transaction involving a change in control of our company, including actions that our shareholders may deem advantageous, or negatively affect the trading price of our common stock. These provisions could also discourage proxy contests and make it more difficult for you and other shareholders to elect directors of your choosing and to cause the us to take other corporate actions you desire. We may experience adverse consequences because of required indemnification of officers and directors. Provisions of our certificate of formation and bylaws provide that we will indemnify any director and officer as to liabilities incurred in their capacity as a director or officer and on those terms and conditions set forth therein to the fullest extent of Texas law. Further, we may purchase and maintain insurance on behalf of any such persons whether or not we would have the power to indemnify such person against the liability insured against. The foregoing could result in substantial expenditures by us and prevent any recovery from our officers, directors, agents and employees for losses incurred by us as a result of their actions. 58 Item 6. Exhibits Exhibit No. | Description --------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 3.1 | Restated Certificate of Formation (incorporated by reference to Exhibit 3.1 to Acer’s Current Report on Form 8-K filed on July 26, 2012). --------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 3.2 | Certificate of Designation of Preferences, Rights and Limitations of Series A Convertible Preferred Stock (incorporated by reference to Exhibit 4.2 to Acer’s Current Report on Form 8-K filed on July 26, 2012). --------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 3.3 | Certificate of Amendment of the Restated Certificate of Formation (incorporated by reference to Exhibit 3.1 to Acer’s Current Report on Form 8-K filed on December 14, 2012). --------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 3.4 | Certificate of Amendment to the Restated Certificate of Formation (incorporated by reference to Exhibit 3.1 to Acer’s Quarterly Report on Form 10-Q filed on November 10, 2015). --------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 3.5 | Certificate of Amendment to the Restated Certificate of Formation (incorporated by reference to Exhibit 3.1 to Acer’s Current Report on Form 8-K filed on September 28, 2015). --------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 3.6 | Certificate of Amendment to the Restated Certificate of Formation (incorporated by reference to Exhibit 3.1 of Acer’s Current Report on Form 8-K filed on September 20, 2017). --------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 3.7 | Certificate of Amendment to the Restated Certificate of Formation (incorporated by reference to Exhibit 3.2 of Acer’s Current Report on Form 8-K filed on September 20, 2017). --------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 4.1* | Specimen common stock certificate. --------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 10.1+ | Acer Therapeutics Inc. Amended and Restated 2010 Stock Incentive Plan (incorporated by reference to Appendix A to Acer’s Definitive Proxy Statement on Schedule 14A filed on April 11, 2016).** --------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 10.2+ | Amendment No. 1 to the Acer Therapeutics Inc. Amended and Restated 2010 Stock Incentive Plan (incorporated by reference to Exhibit 10.35 to Acer’s Registration Statement on Form S-4, as amended, (File No. 333-219358) filed on July 19, 2017).** --------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 10.3+ | Acer Therapeutics Inc. 2013 Stock Incentive Plan, as amended (incorporated by reference to Exhibit 10.3 of Acer’s Current Report on Form 8-K filed on September 20, 2017). --------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 31.1* | Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. --------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 31.2* | Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. --------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 32.1* | Certification of Principal Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. --------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 32.2* | Certification of Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. --------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 101* | Financial statements from the Quarterly Report on Form 10-Q of Acer for the period ended September 30, 2017, formatted in Extensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets; (ii) Consolidated Statements of Operations; (iii) Consolidated Statements of Changes in Stockholders’ Equity; (iv) Consolidated Statements of Cash Flows; and (v) Notes to Consolidated Financial Statements. --------------+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ _______________ * Filed herewith. + Management contract or compensatory plans or arrangements. ** Note that the name of this plan has been amended to reflect the current name of the Registrant. 59 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. | ACER THERAPEUTICS INC. | ------------------------+------------------------+------------------------------------------------------------------------ Date: November 13, 2017 | By: | /s/ Harry Palmin ------------------------+------------------------+------------------------------------------------------------------------ | | Harry Palmin ------------------------+------------------------+------------------------------------------------------------------------ | | Chief Financial Officer (Principal Financial and Accounting Officer) ------------------------+------------------------+------------------------------------------------------------------------ 60

AeroGrow International, Inc.

1316644

10-Q

0001185185-17-002337

UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 FORM 10-Q (MARK ONE) | -----------+---------------------------------------------------------------------------------------- ☒ | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 -----------+---------------------------------------------------------------------------------------- | For the quarterly period ended September 30, 2017 -----------+---------------------------------------------------------------------------------------- OR ---------- ☐ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT -----------+---------------------------------------------------------------------------------------- | For the transition period from ______________ to ______________ -----------+---------------------------------------------------------------------------------------- Commission File No. 001-33531 AEROGROW INTERNATIONAL, INC. (Exact Name of Registrant as specified in its charter) NEVADA | 46-0510685 ---------------------------------------------------------------+------------------------------------- (State or other jurisdiction of incorporation or organization) | (IRS Employer Identification Number) ---------------------------------------------------------------+------------------------------------- 6075 Longbow Drive, Suite 200, Boulder, Colorado | 80301 -------------------------------------------------+----------- (Address of principal executive offices) | (Zip Code) -------------------------------------------------+----------- (303) 444-7755 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No ☐ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. Large accelerated filer ☐ | Accelerated filer ☐ ----------------------------------------------------------------------+---------------------------- Non-accelerated filer o (Do not check if smaller reporting company) | Smaller reporting company ☒ ----------------------------------------------------------------------+---------------------------- Emerging growth company ☐ | ----------------------------------------------------------------------+---------------------------- Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒ Number of shares of issuer's common stock outstanding as of November 6, 2017: 34,328,036 AeroGrow International, Inc. TABLE OF CONTENTS FORM 10-Q REPORT September 30, 2017 PART I Financial Information | -------------------------------+----------------------------------------------------------------------------------------------------- Item 1. | Financial Statements | 3 -------------------------------+------------------------------------------------------------------------------------------------------+--- | Condensed Balance Sheets as of September 30, 2017 (Unaudited) and March 31, 2017 | 3 -------------------------------+------------------------------------------------------------------------------------------------------+--- | Condensed Statements of Operations for the Three and Six Months Ended September 30, 2017 (Unaudited) | 4 -------------------------------+------------------------------------------------------------------------------------------------------+--- | Condensed Statements of Cash Flows for the Six Months Ended September 30, 2017 (Unaudited) | 5 -------------------------------+------------------------------------------------------------------------------------------------------+--- | Notes to the Condensed Financial Statements (Unaudited) | 7 -------------------------------+------------------------------------------------------------------------------------------------------+--- Item 2. | Management's Discussion and Analysis of Financial Condition and Results of Operations | 17 -------------------------------+------------------------------------------------------------------------------------------------------+--- Item 3. | Quantitative and Qualitative Disclosures About Market Risk | 29 -------------------------------+------------------------------------------------------------------------------------------------------+--- Item 4. | Controls and Procedures | 30 -------------------------------+------------------------------------------------------------------------------------------------------+--- PART II Other Information | -------------------------------+----------------------------------------------------------------------------------------------------- Item 1. | Legal Proceedings | 31 -------------------------------+------------------------------------------------------------------------------------------------------+--- Item 1A. | Risk Factors | 31 -------------------------------+------------------------------------------------------------------------------------------------------+--- Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | 31 -------------------------------+------------------------------------------------------------------------------------------------------+--- Item 3. | Defaults Upon Senior Securities | 31 -------------------------------+------------------------------------------------------------------------------------------------------+--- Item 4. | Mine Safety Disclosures | 31 -------------------------------+------------------------------------------------------------------------------------------------------+--- Item 5. | Other Information | 31 -------------------------------+------------------------------------------------------------------------------------------------------+--- Item 6. | Exhibits | 32 -------------------------------+------------------------------------------------------------------------------------------------------+--- Signatures | 33 -------------------------------+----------------------------------------------------------------------------------------------------- PART I - FINANCIAL INFORMATION Item 1. Condensed Financial Statements AEROGROW INTERNATIONAL, INC. CONDENSED BALANCE SHEETS | September 30, 2017 | | | March 31, 2017 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+-- (in thousands, except share and per share data) | (Unaudited) | | | (Derived from Audited Statements) | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+-- ASSETS | | | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+-- Current assets | | | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+-- Cash | $ | 1,420 | | | $ | 8,804 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+---+----------+-- Restricted cash | | 15 | | | | 15 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+---+----------+-- Accounts receivable, net of allowance for doubtful accounts of $58 and $20 at September 30, 2017 and March 31, 2017, respectively | | 5,838 | | | | 2,484 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+---+----------+-- Other receivables | | 111 | | | | 258 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+---+----------+-- Inventory, net | | 8,381 | | | | 2,921 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+---+----------+-- Prepaid expenses and other | | 1,494 | | | | 511 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+---+----------+-- Total current assets | | 17,259 | | | | 14,993 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+---+----------+-- Property and equipment and intangible assets, net of accumulated depreciation of $4,219 and $4,020 at September 30, 2017 and March 31, 2017, respectively | | 313 | | | | 415 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+---+----------+-- Other assets | | | | | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+---+----------+-- Deposits | | 110 | | | | 106 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+---+----------+-- Total assets | $ | 17,682 | | | $ | 15,514 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+---+----------+-- LIABILITIES AND STOCKHOLDERS' EQUITY | | | | | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+---+----------+-- Current liabilities | | | | | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+---+----------+-- Accounts payable | $ | 2,954 | | | $ | 1,853 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+---+----------+-- Accrued expenses | | 2,181 | | | | 1,520 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+---+----------+-- Customer deposits | | 60 | | | | 106 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+---+----------+-- Debt associated with sale of intellectual property | | 98 | | | | 117 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+---+----------+-- Total current liabilities | | 5,293 | | | | 3,596 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+---+----------+-- Long term liabilities | | | | | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+---+----------+-- Capital lease liability | | 15 | | | | 19 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+---+----------+-- Total liabilities | | 5,308 | | | | 3,615 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+---+----------+-- Commitments and contingencies | | | | | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+---+----------+-- Stockholders' equity | | | | | | | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+---+----------+-- Common stock, $.001 par value, 750,000,000 shares authorized, 34,328,036 and 33,477,287, shares issued and outstanding at September 30, 2017 and March 31, 2017, respectively | | 34 | | | | 33 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+---+----------+-- Additional paid-in capital | | 140,817 | | | | 138,757 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+---+----------+-- Stock dividend to be distributed for Scotts Miracle-Gro transactions | | - | | | | 2,595 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+---+----------+-- Accumulated deficit | | (128,477 | ) | | | (129,486 | ) ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+---+----------+-- Total stockholders' equity | | 12,374 | | | | 11,899 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+---+----------+-- Total liabilities and stockholders' equity | $ | 17,682 | | | $ | 15,514 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+----------+---+-----------------------------------+---+----------+-- See accompanying notes to the condensed financial statements. 3 AEROGROW INTERNATIONAL, INC. CONDENSED STATEMENTS OF OPERATIONS (Unaudited) | Three Months ended September 30, | | | Six Months ended September 30, | ------------------------------------------------------------------------------------+----------------------------------+--------+---+--------------------------------+-- (in thousands, except per share data) | 2017 | | | 2016 | | | 2017 | | 2016 | ------------------------------------------------------------------------------------+----------------------------------+--------+---+--------------------------------+---+--------+------+---+--------+-- Net revenue | $ | 5,741 | | | $ | 2,242 | | $ | 8,204 | | $ | 4,398 | ------------------------------------------------------------------------------------+----------------------------------+--------+---+--------------------------------+---+--------+------+---+--------+---+---+--------+-- Cost of revenue | | 4,079 | | | | 1,551 | | | 5,720 | | | 2,863 | ------------------------------------------------------------------------------------+----------------------------------+--------+---+--------------------------------+---+--------+------+---+--------+---+---+--------+-- Gross profit | | 1,662 | | | | 691 | | | 2,484 | | | 1,535 | ------------------------------------------------------------------------------------+----------------------------------+--------+---+--------------------------------+---+--------+------+---+--------+---+---+--------+-- Operating expenses | | | | | | | | | | | | | ------------------------------------------------------------------------------------+----------------------------------+--------+---+--------------------------------+---+--------+------+---+--------+---+---+--------+-- Research and development | | 141 | | | | 114 | | | 233 | | | 211 | ------------------------------------------------------------------------------------+----------------------------------+--------+---+--------------------------------+---+--------+------+---+--------+---+---+--------+-- Sales and marketing | | 1,012 | | | | 729 | | | 1,844 | | | 1,549 | ------------------------------------------------------------------------------------+----------------------------------+--------+---+--------------------------------+---+--------+------+---+--------+---+---+--------+-- General and administrative | | 638 | | | | 475 | | | 1,265 | | | 1,055 | ------------------------------------------------------------------------------------+----------------------------------+--------+---+--------------------------------+---+--------+------+---+--------+---+---+--------+-- Total operating expenses | | 1,791 | | | | 1,318 | | | 3,342 | | | 2,815 | ------------------------------------------------------------------------------------+----------------------------------+--------+---+--------------------------------+---+--------+------+---+--------+---+---+--------+-- (Loss) from operations | | (129 | ) | | | (627 | ) | | (858 | ) | | (1,280 | ) ------------------------------------------------------------------------------------+----------------------------------+--------+---+--------------------------------+---+--------+------+---+--------+---+---+--------+-- Other income (expense), net | | | | | | | | | | | | | ------------------------------------------------------------------------------------+----------------------------------+--------+---+--------------------------------+---+--------+------+---+--------+---+---+--------+-- Fair value changes in derivative warrant liability | | - | | | | (458 | ) | | - | | | (903 | ) ------------------------------------------------------------------------------------+----------------------------------+--------+---+--------------------------------+---+--------+------+---+--------+---+---+--------+-- Interest expense – related party | | - | | | | (27 | ) | | (1 | ) | | (31 | ) ------------------------------------------------------------------------------------+----------------------------------+--------+---+--------------------------------+---+--------+------+---+--------+---+---+--------+-- Other income (expense) | | 8 | | | | (16 | ) | | 48 | | | (41 | ) ------------------------------------------------------------------------------------+----------------------------------+--------+---+--------------------------------+---+--------+------+---+--------+---+---+--------+-- Total other income (expense), net | | 8 | | | | (501 | ) | | 47 | | | (975 | ) ------------------------------------------------------------------------------------+----------------------------------+--------+---+--------------------------------+---+--------+------+---+--------+---+---+--------+-- Net loss | $ | (121 | ) | | $ | (1,128 | ) | $ | (811 | ) | $ | (2,255 | ) ------------------------------------------------------------------------------------+----------------------------------+--------+---+--------------------------------+---+--------+------+---+--------+---+---+--------+-- Change in fair value of stock to be distributed for Scotts Miracle-Gro transactions | | (47 | ) | | | (317 | ) | | 534 | | | (767 | ) ------------------------------------------------------------------------------------+----------------------------------+--------+---+--------------------------------+---+--------+------+---+--------+---+---+--------+-- Net loss attributable to common stockholders | $ | (168 | ) | | $ | (1,445 | ) | $ | (277 | ) | $ | (3,022 | ) ------------------------------------------------------------------------------------+----------------------------------+--------+---+--------------------------------+---+--------+------+---+--------+---+---+--------+-- Net loss per share, basic and diluted | $ | (0.00 | ) | | $ | (0.17 | ) | $ | (0.01 | ) | $ | (0.37 | ) ------------------------------------------------------------------------------------+----------------------------------+--------+---+--------------------------------+---+--------+------+---+--------+---+---+--------+-- Weighted average number of common shares outstanding, basic and diluted | | 34,041 | | | | 8,576 | | | 33,761 | | | 8,138 | ------------------------------------------------------------------------------------+----------------------------------+--------+---+--------------------------------+---+--------+------+---+--------+---+---+--------+-- See accompanying notes to the condensed financial statements. 4 AEROGROW INTERNATIONAL, INC. CONDENSED STATEMENTS OF CASH FLOWS (Unaudited) | Six months ended September 30, | ---------------------------------------------------------------------+--------------------------------+------- | 2017 | | | 2016 | ---------------------------------------------------------------------+--------------------------------+--------+---+------+-- (in thousands) | | | | | ---------------------------------------------------------------------+--------------------------------+--------+---+------+-- Cash flows from operating activities: | | | | | ---------------------------------------------------------------------+--------------------------------+--------+---+------+-- Net (loss) | $ | (811 | ) | | $ | (2,255 | ) ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- Adjustments to reconcile net (loss) to cash used by operations: | | | | | | | ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- Issuance of common stock and options under equity compensation plans | | - | | | | 92 | ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- Depreciation and amortization expense | | 180 | | | | 185 | ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- Bad debt (recovery) expense | | 39 | | | | 3 | ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- Inventory allowance | | (76 | ) | | | - | ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- Fair value remeasurement of derivative warrant liability | | - | | | | 903 | ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- Accretion of debt associated with sale of intellectual property | | (19 | ) | | | (22 | ) ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- Loss on write-off of assets | | 19 | | | | - | ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- SMG intellectual property royalty and branding license | | - | | | | 217 | ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- Change in operating assets and liabilities: | | | | | | | ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- (Increase) in accounts receivable | | (3,393 | ) | | | (201 | ) ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- Decrease in other receivable | | 147 | | | | 147 | ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- (Increase) in inventory | | (5,384 | ) | | | (2,361 | ) ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- (Increase) in prepaid expense and other | | (983 | ) | | | (752 | ) ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- (Increase) decrease in deposits | | (4 | ) | | | 50 | ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- Increase in accounts payable | | 2,387 | | | | 1,589 | ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- Increase (decrease) in accrued expenses | | 661 | | | | (114 | ) ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- Increase in accrued interest-related party | | - | | | | 13 | ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- (Decrease) in customer deposits | | (46 | ) | | | (157 | ) ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- Net cash used by operating activities | $ | (7,283 | ) | | $ | (2,663 | ) ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- Cash flows from investing activities: | | | | | | | ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- Purchases of equipment | | (97 | ) | | | (88 | ) ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- Net cash (used) by investing activities | $ | (97 | ) | | $ | (88 | ) ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- Cash flows from financing activities: | | | | | | | ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- Proceeds from notes payable-related party | | - | | | | 2,750 | ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- Repayment of notes payable-related party | | - | | | | (1,000 | ) ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- Repayment of capital lease | | (4 | ) | | | (1 | ) ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- Net cash (used) provided by financing activities | $ | (4 | ) | | $ | 1,749 | ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- Net (decrease) in cash | | (7,384 | ) | | | (1,002 | ) ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- Cash, cash equivalents and restricted cash, beginning of period | | 8,819 | | | | 1,416 | ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- Cash, cash equivalents and restricted cash, end of period | $ | 1,435 | | | $ | 414 | ---------------------------------------------------------------------+--------------------------------+--------+---+------+---+--------+-- See supplemental disclosures below and the accompanying notes to the condensed financial statements. 5 Continued from previous page | Six months ended September 30, (in thousands) | ------------------------------------------------------------------------------------------------------------------------+-----------------------------------------------+------ | 2017 | | 2016 | ------------------------------------------------------------------------------------------------------------------------+-----------------------------------------------+-------+------+-- Cash paid during the year for: | | | | ------------------------------------------------------------------------------------------------------------------------+-----------------------------------------------+-------+------+-- Interest | $ | - | | $ | 18 | ------------------------------------------------------------------------------------------------------------------------+-----------------------------------------------+-------+------+---+-------+-- Income taxes | $ | - | | $ | - | ------------------------------------------------------------------------------------------------------------------------+-----------------------------------------------+-------+------+---+-------+-- Supplemental disclosure of non-cash investing and financing activities: | | | | | | ------------------------------------------------------------------------------------------------------------------------+-----------------------------------------------+-------+------+---+-------+-- Property and equipment acquired through capital lease | $ | - | | $ | 22 | ------------------------------------------------------------------------------------------------------------------------+-----------------------------------------------+-------+------+---+-------+-- Decrease in liability due to issuance of stock to SMG on notes payable – related party | $ | - | | $ | 297 | ------------------------------------------------------------------------------------------------------------------------+-----------------------------------------------+-------+------+---+-------+-- Fair value of common stock issued for payment of interest on notes payable-related party | | - | | | 480 | ------------------------------------------------------------------------------------------------------------------------+-----------------------------------------------+-------+------+---+-------+-- Change in fair value of common stock issued for payment of interest on notes payable-related party at issuance | | - | | | 183 | ------------------------------------------------------------------------------------------------------------------------+-----------------------------------------------+-------+------+---+-------+-- Change in fair value of SMG intellectual property royalty, branding license and interest on notes payable-related party | $ | 485 | | $ | (946 | ) ------------------------------------------------------------------------------------------------------------------------+-----------------------------------------------+-------+------+---+-------+-- Change in fair value of stock dividends for common stock issued on convertible preferred stock | | - | | | 530 | ------------------------------------------------------------------------------------------------------------------------+-----------------------------------------------+-------+------+---+-------+-- Change in fair value of stock dividends accrued on convertible preferred stock | $ | 49 | | $ | (534 | ) ------------------------------------------------------------------------------------------------------------------------+-----------------------------------------------+-------+------+---+-------+-- Decrease in liability due to issuance of stock to SMG for intellectual property and branding license | $ | 1,286 | | $ | 1,006 | ------------------------------------------------------------------------------------------------------------------------+-----------------------------------------------+-------+------+---+-------+-- 6 AEROGROW INTERNATIONAL, INC. NOTES TO THE CONDENSED FINANCIAL STATEMENTS (Unaudited) 1. Description of the Business AeroGrow International, Inc. (collectively, the "Company," "AeroGrow," "we," "our," or "us") was formed as a Nevada corporation on March 25, 2002. The Company's principal business is developing, marketing, and distributing advanced indoor aeroponic garden systems designed and priced to appeal to the consumer gardening, cooking and small indoor appliance markets worldwide. The Company manufactures, distributes and markets nine different models of its AeroGarden systems in multiple colors, as well as over 40 varieties of seed pod kits and a full line of accessory products through multiple channels, including retail distribution via online retail outlets and brick-and-mortar storefronts, catalogue and direct-to-consumer sales primarily in the United States and Canada, as well as selected countries in Europe. 2. Basis of Presentation, Liquidity and Summary of Significant Accounting Policies Basis of Presentation The unaudited interim financial statements of the Company included herein have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission ("SEC") for interim reporting including the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. These condensed statements do not include all disclosures required by accounting principles generally accepted in the United States of America ("U.S. GAAP") for annual audited financial statements and should be read in conjunction with the Company's audited financial statements and related notes included in the Company's Annual Report on Form 10-K for the year ended March 31, 2017, as filed with the SEC on June 26, 2017. In the opinion of management, the accompanying unaudited interim financial statements reflect all adjustments, including recurring adjustments, necessary to present fairly the financial position of the Company at September 30, 2017, the results of operations for the three and six months ended September 30, 2017 and 2016, and the cash flows for the six months ended September 30, 2017 and 2016. The results of operations for the three and six months ended September 30, 2017 are not necessarily indicative of the expected results of operations for the full year or any future period. In this regard, the Company's business is highly seasonal, with approximately 65.7% of revenues in the fiscal year ended March 31, 2017 ("Fiscal 2017") occurring in the four consecutive calendar months from October through January. Furthermore, during the six-month period ended September 30, 2017, the Company has further expanded its distribution channels and invested in necessary overhead in anticipation of the peak sales season. The balance sheet as of March 31, 2017 is derived from the Company's audited financial statements. Liquidity Sources of funding to meet prospective cash requirements include the Company's existing cash balances, cash flow from operations, and borrowings under the Company's debt arrangements. We may need to seek additional debt or equity capital, however, to address the seasonal nature of our working capital needs, increase the scale of our business and provide a cash reserve against contingencies. There can be no assurance we will be able to raise this additional capital. See Note 10 for subsequent events. On September 13, 2017, the Company entered into a Term Loan Agreement in the principal amount of up to $2.0 million with a wholly owned subsidiary of The Scotts Miracle-Gro Company (collectively with its subsidiary, "SMG" or "Scotts Miracle-Gro"). See Note 3 "Notes Payable, Long Term Debt and Current Portion – Long Term Debt" below. Significant Accounting Policies Use of Estimates The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. It is reasonably possible that a change in the Company's estimates could occur in the near term as additional or new information becomes available. 7 Net Income (Loss) per Share of Common Stock The Company computes net income (loss) per share of common stock in accordance with Accounting Standards Codification ("ASC") 260. ASC 260 requires companies to present basic and diluted earnings per share ("EPS"). Basic EPS is measured as the income or loss available to common stockholders divided by the weighted average shares of common stock outstanding for the period. Diluted EPS is similar to basic EPS, but presents the dilutive effect on a per share basis of common stock equivalents (e.g., convertible securities, options, and warrants) as if such securities had been converted at the beginning of the periods presented. Potential shares of common stock that have an anti-dilutive effect (i.e., those that increase income per share or decrease loss per share) are excluded from the calculation of diluted EPS. Securities are not included in the computation of EPS because to do so would have been anti-dilutive were employee stock options to purchase 175,000 shares and warrants to purchase 2,000 shares of common stock for the period ended September 30, 2017 and employee stock options to purchase 656,000 shares and warrants to purchase 3,093,000 shares for the three months ended September 30, 2016. Concentrations of Risk ASC 825-10-50-20 requires disclosure of significant concentrations of credit risk regardless of the degree of such risk. Cash: The Company maintains cash depository accounts with financial institutions. The amount on deposit with several financial institutions exceeded the $250,000 federally insured limit as of September 30, 2017. The Company has not historically incurred any losses related to these deposits. The financial institutions are highly rated, financially sound and the risk of loss is minimal. Customers and Accounts Receivable: For the three months ended September 30, 2017, the Company had four customers, Bed, Bath & Beyond, Amazon.ca, Macy's and Kohl's, which represented 25.8%, 22.5%, 12.5% and 11.0% of net revenue, respectively. For the three months ended September 30, 2016, the Company had three customers, Amazon.com, Sur La Table and Ace Hardware, which represented 33.3%, 20.1% and 16.8% of the Company's net revenue, respectively. For the six months ended September 30, 2017, the Company had three customers, Bed, Bath & Beyond, Amazon.ca and Amazon.com, which represented 18.1%, 17.5% and 12.0% of the Company's net revenue. For the six months ended September 30, 2016, the Company had had one customer, Amazon.com that represented 34.6% of the Company's net revenue. As of September 30, 2017, the Company had four customers, Bed, Bath & Beyond, Amazon.ca, Macy's and Kohl's that represented 29.3%, 26.3%, 12.3% and 11.2%, respectively, of the Company's outstanding accounts receivable. As of March 31, 2017, the Company had three customers, Amazon.com, Amazon.uk and Amazon.ca, which represented 33.9%, 14.3% and 11.0%, respectively, of outstanding accounts receivable. The Company believes that all receivables from these customers are collectible. Suppliers: For the three months ended September 30, 2017, the Company purchased $7.6 million of inventories and other inventory-related items from two suppliers, as we increase inventory levels for the holiday season. For the three months ended September 30, 2016, the Company purchased $3.6 million of inventories and other inventory-related items from four suppliers. For the six months ended September 30, 2017, the Company purchased $8.8 million of inventories and other inventory-related items from one supplier. For the six months ended September 30, 2016, the Company purchased $4.1 million of inventories and other inventory-related items from one supplier. The purchase of inventories and other inventory-related items is dependent on timing of purchases for our highly seasonal business and payment terms with our suppliers. The Company's primary contract manufacturers are located in China. As a result, the Company may be subject to political, currency, regulatory, transportation/shipping, and weather/natural disaster risks. Although the Company believes alternate sources of manufacturing could be obtained, the risk of an interruption in product sourcing could have an adverse impact on operations. Fair Value of Financial Instruments The Company follows the guidance in ASC 820, Fair Value Measurements and Disclosures ("ASC 820"), as it relates to the fair value of its financial assets and liabilities. ASC 820 provides for a standard definition of fair value to be used in new and existing pronouncements. This guidance requires disclosure of fair value information about certain financial instruments (insurance contracts, real estate, goodwill and taxes are excluded) for which it is practicable to estimate such values, whether or not these instruments are included in the balance sheet at fair value. The fair values presented for certain financial instruments are estimates which, in many cases, may differ significantly from the amounts that could be realized upon immediate liquidation. 8 Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (i.e., exit price) in an orderly transaction between market participants. ASC 820 also provides a hierarchy for determining fair value, which emphasizes the use of observable market data whenever available. The three broad levels defined by the hierarchy are as follows, with the highest priority given to Level 1 as these are the most reliable, and the lowest priority given to Level 3. Level 1 – Quoted prices in active markets for identical assets. Level 2 – Quoted prices for similar assets in active markets, quoted prices for identical or similar assets in markets that are not active, or other inputs that are observable or can be corroborated by observable market data, including model-derived valuations. Level 3 – Unobservable inputs that are supported by little or no market activity. The carrying value of financial instruments including cash, receivables, accounts payable and accrued expenses, approximates their fair value at September 30, 2017 and March 31, 2017 due to the relatively short-term nature of these instruments. The Company's intellectual property liability carrying value was determined by Level 3 inputs. As discussed below in Notes 3 and 4, each of these liabilities was incurred in conjunction with the Company's strategic alliance with Scotts Miracle-Gro. As of September 30, 2017 and March 31, 2017, the fair value of the Company's note payable and sale of intellectual property liability were estimated using the discounted cash flow method, which is based on expected future cash flows, discounted to present value using a discount rate of 15%. As of September 30, 2017, the Company did not have any financial assets or liabilities that were measured at fair value on a recurring basis subsequent to initial recognition, except for the derivative warrant liability. Accounts Receivable and Allowance for Doubtful Accounts The Company sells its products to retailers and directly to consumers. Direct-to-consumer transactions are primarily paid by credit card. Retailer sales terms vary by customer, but generally range from net 30 days to net 60 days. Accounts receivable are reported at net realizable value and net of the allowance for doubtful accounts. The Company uses the allowance method to account for uncollectible accounts receivable. The Company's allowance estimate is based on a review of the current status of trade accounts receivable, which resulted in an allowance of $58,000 and $20,000 at September 30, 2017 and March 31, 2017, respectively. Other Receivables In conjunction with the Company's processing of credit card transactions for its direct-to-consumer sales activities and as security with respect to the Company's performance for credit card refunds and charge backs, the Company is required to maintain a cash reserve with Litle and Company, the Company's credit card processor. This reserve is equal to 5% of the credit card sales processed during the previous six months. As of September 30, 2017 and March 31, 2017, the balance in this reserve account was $111,000 and $258,000, respectively. Advertising and Production Costs The Company expenses all production costs related to advertising, including print, television, and radio advertisements when the advertisement has been broadcast or otherwise distributed. In contrast, the Company records media and marketing costs related to its direct-to-consumer advertisements, inclusive of related postage and printing costs incurred in conjunction with mailings of direct-response catalogues, and related direct-response advertising costs, in accordance with ASC 340-20 Capitalized Advertising Costs . As prescribed by ASC 340-20-25, direct-to-consumer advertising costs incurred are reported as assets and should be amortized over the estimated period of the benefits, based on the proportion of current period revenue from the advertisement to probable future revenue. As the Company has continued to expand its retail distribution channel, the Company has expanded its advertising to include online gateway and portal advertising, as well as placement in third party catalogues. Advertising expense for the three and six months ended September 30, 2017 and 2016 were as follows: | Three Months Ended September 30, (in thousands) | | Six Months Ended September 30, (in thousands) | --------------------------+-------------------------------------------------+-----+-----------------------------------------------+-- | 2017 | | 2016 | | | 2017 | | 2016 --------------------------+-------------------------------------------------+-----+-----------------------------------------------+---+-----+------+---+----- Direct-to-consumer | $ | 50 | | $ | 36 | | $ | 121 | $ | 115 --------------------------+-------------------------------------------------+-----+-----------------------------------------------+---+-----+------+---+------+---+---- Retail | | 115 | | | 107 | | | 301 | | 302 --------------------------+-------------------------------------------------+-----+-----------------------------------------------+---+-----+------+---+------+---+---- Other | | 9 | | | 7 | | | 19 | | 15 --------------------------+-------------------------------------------------+-----+-----------------------------------------------+---+-----+------+---+------+---+---- Total advertising expense | $ | 174 | | $ | 150 | | $ | 441 | $ | 432 --------------------------+-------------------------------------------------+-----+-----------------------------------------------+---+-----+------+---+------+---+---- 9 As of September 30, 2017 and March 31, 2017, the Company deferred $1,000 and $24,000, respectively, related to such media and advertising costs, including the catalogue cost described above. The costs are included in the prepaid expenses and other line of the condensed balance sheets. Inventory Inventories are valued at the lower of cost, determined on the basis of standard costing, which approximates the first-in, first-out method, or net realizable value. When the Company is the manufacturer, raw materials, labor, and manufacturing overhead are included in inventory costs. The Company records raw materials at delivered cost. Standard labor and manufacturing overhead costs are applied to the finished goods based on normal production capacity as prescribed under ASC 330 Inventory Pricing . A majority of the Company's products are manufactured overseas and are recorded at standard cost which includes product costs for purchased and manufactured products, and freight and transportation costs for inbound freight from manufacturers. Inventory values at September 30, 2017 and March 31, 2017 were as follows: | September 30, | | March 31, | ---------------+---------------------+-------+---------------------+-- | 2017 (in thousands) | | 2017 (in thousands) | ---------------+---------------------+-------+---------------------+-- Finished goods | $ | 7,413 | | $ | 2,274 ---------------+---------------------+-------+---------------------+---+------ Raw materials | | 968 | | | 647 ---------------+---------------------+-------+---------------------+---+------ | $ | 8,381 | | $ | 2,921 ---------------+---------------------+-------+---------------------+---+------ The Company determines an inventory obsolescence reserve based on management's historical experience and establishes reserves against inventory according to the age of the product. As of September 30, 2017 and March 31, 2017, the Company had reserved $286,000 and $362,000 for inventory obsolescence, respectively. The inventory values are shown net of these reserves. Revenue Recognition The Company recognizes revenue from product sales, net of estimated returns, when persuasive evidence of a sale exists, including the following; (i) a product is shipped under an agreement with a customer; (ii) the risk of loss and title has passed to the customer; (iii) the fee is fixed or determinable; and (iv) collection of the resulting receivable is reasonably assured. The Company records estimated reductions to revenue for customer and distributor programs and incentive offerings, including promotions, rebates, and other volume-based incentives. Certain incentive programs require the Company to estimate the number of customers who will actually redeem the incentive based on historical industry experience. As of September 30, 2017 and March 31, 2017, the Company had accrued $634,000 and $304,000, respectively, as an estimate for the foregoing deductions and allowances within the "accrued expenses" line of the balance sheets. Warranty and Return Reserves The Company records warranty liabilities at the time of sale for the estimated costs that may be incurred under its basic warranty program. The specific warranty terms and conditions vary depending upon the product sold, but generally include technical support, repair parts, and labor for periods up to one year. Factors that affect the Company's warranty liability include the number of installed units currently under warranty, historical and anticipated rates of warranty claims on those units, and cost per claim to satisfy the Company's warranty obligation. Based upon the foregoing, the Company has recorded a provision for potential future warranty costs of $116,000 and $125,000 as of September 30, 2017 and March 31, 2017, respectively. The Company reserves for known and potential returns from customers and associated refunds or credits related to such returns based upon historical experience. In certain cases, retailer customers are provided a fixed allowance, usually in the 1% to 2% range, to cover returned goods and this allowance is deducted from payments made to us by such customers. As of September 30, 2017 and March 31, 2017, the Company has recorded a reserve for customer returns of $183,000 and $175,000, respectively. Segments of an Enterprise and Related Information GAAP utilizes a management approach based on allocating resources and assessing performance as the source of the Company's reportable segments. GAAP also requires disclosures about products and services, geographic areas and major customers. At present, the Company operates in two segments, Direct-to-Consumer and Retail Sales. 10 Recently Issued Accounting Pronouncements In November 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2016-18, "Statement of Cash Flows." The new guidance will require that the statement of cash flows explain the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. Therefore, amounts generally described as restricted cash and restricted cash equivalents are required to be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. The new guidance is effective for interim and annual periods beginning after December 15, 2017 and early adoption is permitted. The amendment should be adopted retrospectively. The Company early adopted this new guidance in the first quarter of fiscal year 2018 and the adoption did not have a material impact on our financial statements. In March 2016, the FASB issued ASU 2016-09, "Improvements to Employee Share-Based Compensation Accounting," which requires excess tax benefits to be recorded on the income statement as opposed to additional paid-in-capital, and treated as an operating activity on the statement of cash flows. ASU 2016-09 also allows companies to make an accounting policy election to either estimate the number of awards that are expected to vest (current U.S. GAAP) or account for forfeitures when they occur. ASU 2016-09 further requires cash paid by an employer when directly withholding shares for tax-withholding purposes to be classified as a financing activity on the statement of cash flows. Due to the Company's valuation allowance on its deferred tax assets, no income tax benefit is recognized as a result of the adoption of ASU 2016-09. There is no change to retained earnings with respect to excess tax benefits, as this is not applicable to the Company. The treatment of forfeitures has not changed as we are electing to continue our current process of estimating the number of forfeitures. We have elected to present the cash flow statement on a prospective transition method and no prior periods have been adjusted. In February 2016, the FASB issued ASU 2016-02, "Leases." The new standard establishes a right-of-use (ROU) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. The adoption of this ASU is expected to result in all operating leases being capitalized and a current and long-term liability recorded in the Company's financial statements. In August 2015, the FASB issued ASU 2015-14 to defer the effective date by one year of previously issued ASU 2014-09, "Revenue from Contracts with Customers," which amended revenue recognition guidance to clarify the principles for recognizing revenue from contracts with customers. The guidance requires an entity to recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which an entity expects to be entitled in exchange for those goods or services. The guidance also requires expanded disclosures relating to the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. Additionally, qualitative and quantitative disclosures are required about customer contracts, significant judgments and changes in judgments, and assets recognized from the costs to obtain or fulfill a contract. This accounting guidance is effective for the Company beginning in the first quarter of fiscal year 2019 using one of two prescribed retrospective methods. Early adoption is permitted but not before annual periods beginning after December 15, 2016. We anticipate we will adopt the full retrospective transition method and are currently evaluating the impact of adoption of this ASU on our consolidated financial statements and disclosures. In July 2015, the FASB issued ASU 2015-11, "Simplifying the Measurement of Inventory." Under this ASU, inventory will be measured at the "lower of cost and net realizable value" and alternatives that currently exist for "market value" will be eliminated. The ASU defines net realizable value as the "estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation." No other changes were made to the current guidance on inventory measurement. ASU 2015-11 is effective for interim and annual periods beginning after December 15, 2016. Early application is permitted and should be applied prospectively. Management early adopted ASU 2015-11 and noted no material impact on the Company's financial position or results of operations. In August 2014, the FASB issued ASU 2014-15, "Presentation of Financial Statements – Going Concern: Disclosures of Uncertainties about an Entity's Ability to Continue as a Going Concern," which requires management to evaluate whether there are conditions and events that raise substantial doubt about the entity's ability to continue as a going concern within one year after the financial statements are issued. This ASU is effective for annual periods ending after December 15, 2016 and interim periods within annual periods beginning after December 15, 2016. The adoption of this ASU did not have a material impact on the Company's financial statements. 11 3. Notes Payable, Long Term Debt and Current Portion – Long Term Debt For a detailed discussion on our previously outstanding Notes Payable, Long Term Debt and Current Portion – Long Term Debt, refer to the Company's Annual Report on Form 10-K for the year ended March 31, 2017, as filed with the SEC on June 26, 2017. The following are the changes to our Notes Payable, Long Term Debt and Current Portion – Long Term Debt for the periods presented. As of September 30, 2017 and March 31, 2017, the outstanding balance of the Company's notes payable and debt, including accrued interest, is as follows: | September 30, 2017 (in thousands) | | March 31, 2017 (in thousands) | -----------------------------------------------------+-----------------------------------+----+-------------------------------+-- Sale of intellectual property liability (see Note 4) | | 98 | | | 117 -----------------------------------------------------+-----------------------------------+----+-------------------------------+---+---- Total debt | | 98 | | | 117 -----------------------------------------------------+-----------------------------------+----+-------------------------------+---+---- Less current portion – long term debt | | 98 | | | 117 -----------------------------------------------------+-----------------------------------+----+-------------------------------+---+---- Long term debt | $ | - | | $ | - -----------------------------------------------------+-----------------------------------+----+-------------------------------+---+---- Scotts Miracle-Gro Term Loan On September 13, 2017, AeroGrow entered into a Term Loan Agreement in the principal amount of up to $2.0 million with Scotts Miracle-Gro ("SMG Term Loan"). The proceeds will be made available as needed in increments of $500,000 not to exceed $2.0 million with a due date of March 30, 2018. The funding provides general working capital and is being used for the purpose of acquiring inventory to support anticipated growth as the Company expands its retail and its direct-to-consumer sales channels. The Term Loan Agreement is secured by a lien on the assets of the Company and interest is charged at the stated rate of 10% per annum, but will be paid quarterly in arrears in cash at the end of each September, December and March. The Term Loan may be prepaid from time to time, in whole or in part, in an amount greater than or equal to $250,000, without penalty or premium. Amounts repaid or prepaid in respect of the Term Loan may not be reborrowed. The Term Loan Agreement was filed as an exhibit to a Current Report on Form 8-K filed with the SEC on September 26, 2017. As of September 30, 2017, the Company had not borrowed any funds under the Term Loan. Liability Associated with Scotts Miracle-Gro Transaction On April 22, 2013, the Company and Scotts Miracle-Gro agreed to enter an Intellectual Property Sale Agreement, a Technology License Agreement, a Brand License Agreement, and a Supply Chain Services Agreement. The Intellectual Property Sale Agreement and the Technology License constitute an agreement of sales of future revenues. Because the Company received cash from Scotts Miracle-Gro and agreed to pay for a defined period a specified percentage of revenue, and because the Company has significant involvement in the generation of its revenue, the excess paid over net book value is classified as debt and is being amortized under the effective interest method. As of September 30, 2017 and March 31, 2017, a liability of $98,000 and $117,000, respectively, was recorded on the balance sheets for the Intellectual Property Sale Agreement. As of September 30, 2017 and March 31, 2017, the accrued liability for shares to be distributed at $1.51 per share: (i) the Technology Licensing Agreement was at $0 and $935,000, respectively; (ii) the Brand License Agreement at $0 and $1.6 million, respectively. Accrued liabilities for the Technology Licensing Agreement and Brand License Agreement were recorded as a stock dividend to be distributed at period end, based on a value of $1.51 per share. However, the Scotts Miracle-Gro and the Company settled their respective obligations under the Technology Licensing Agreement and Brand License Agreement in August 2017 and no further liabilities will be accrued that require shares to be distributed or a periodic fair value calculation to occur. 12 4. Scotts Miracle-Gro Transactions – Convertible Preferred Stock, Warrants and Other Transactions Series B Convertible Preferred Stock and Related Transactions On April 22, 2013, the Company entered into a Securities Purchase Agreement with SMG Growing Media, Inc., a wholly owned subsidiary of Scotts Miracle-Gro (NYSE: "SMG"), a worldwide marketer of branded consumer lawn and garden products. Pursuant to the Securities Purchase Agreement, Scotts Miracle-Gro acquired 2,649,007 shares of the Company's Series B Convertible Preferred Stock, par value $0.001 per share (the "Series B Preferred Stock") and (ii) a warrant to purchase shares of the Company's common stock (the "Warrant," as described in greater detail below) for an aggregate purchase price of $4.0 million. The Securities Purchase Agreement, Certificates of Designations for the Series B Preferred Stock, Form of Warrant, Indemnification Agreement, Investor's Rights Agreement and Voting Agreement have been filed as exhibits to a Current Report on Form 8-K that was filed with the SEC on April 23, 2013. After deducting offering expenses, including commissions and expenses paid to the Company's advisor, net cash proceeds totaled to $3.8 million. The Company used $950,000 of the net proceeds to repay "in full" (with concessions) the Promissory Note due to a former supplier. The Company used the remaining net proceeds for working capital and general corporate purposes. On November 29, 2016 Scotts Miracle-Gro fully exercised the Warrant and upon exercise of the Warrant the Series B Preferred Stock converted into shares of common stock. The Series B Preferred Stock was convertible into 2,649,007 shares of common stock ($4.0 million divided by a conversion price of $1.51 per share). The Series B Preferred Stock bore a cumulative annual dividend of 8.0%, payable in shares of the Company's common stock at a conversion price of $1.51 per share (subject to customary anti-dilution rights, as described in the Series B Preferred Stock Certificates of Designations). The Series B Preferred Stock did not have a liquidation preference and was entitled to vote on an "as-converted" basis with the common stock. The stock dividend accrued from day to day and was payable in shares of our common stock within thirty days after the end of each fiscal year end. The stock dividend was recorded at the fair market value of our common stock at the end of each quarter in the equity section of the balance sheet. The corresponding charge was recorded below net income to arrive at net income available to common shareholders. The Series B Preferred Stock automatically converted into the Company's common stock: (i) upon the affirmative election of the holders of at least a majority of the then outstanding shares of the Series B Preferred Stock voting together as a single class on an as-if-converted to common stock basis; or (ii) if, at the date of exercise in whole or in part of the Warrant, the holder (or holders) of the Series B Preferred Stock own 50.1% of the issued and then-outstanding common stock of the Company, giving effect to the issuance of shares of common stock in connection with the conversion of the Series B Preferred Stock and such exercise of the Warrant. By its terms, the Series B Preferred Stock automatically converted into the Company's common stock on November 29, 2016, when Scotts Miracle-Gro exercised the Warrant. In addition, all shares related to this agreement were settled in the issuance in August 2017 and no accrual remains as of September 30, 2017 for the stock dividend. Upon demand by Scotts Miracle-Gro, the Company must use its best efforts to file a Registration Statement on Form S-3, or, if the Company is not eligible for Form S-3, on Form S-1 (collectively, the "Registration Statement"), covering the shares of the Company's common stock issued upon conversion/exercise of the Preferred Stock and the Warrant, within 120 calendar days after receipt of Scotts Miracle-Gro's demand for registration and shall use its best efforts to cause the Registration Statement to become effective as soon as possible thereafter. The foregoing description of the Securities Purchase Agreement, the Certificates of Designations for the Series B Convertible Preferred Stock, the Warrant, and the resulting transaction is only a summary, does not purport to be complete, and is qualified in its entirety by reference to the full text of the applicable documents, each of which was included as an exhibit to the Company's Current Report on Form 8-K, as filed with the SEC on April 23, 2013. The warrant on the Series B Convertible Preferred Stock was accounted for as a liability at its estimated fair value. The derivative warrant liability was re-measured to fair value, on a recurring basis, at the end of each reporting period until it was exercised. The Company accounted for the warrant as a liability and measured the value of the warrant using the Monte Carlo simulation model as of the end of each quarterly reporting period until the warrant was exercised. As of September 30, 2017 and March 31, 2017, the warrant had been exercised, and the fair value of the warrant was $0. On November 29, 2016, Scotts Miracle-Gro fully exercised its warrant to purchase 80% of the Company's outstanding stock, when the derivative warrant liability was extinguished and the Convertible Preferred Stock was converted to common stock. As stated above, all shares related to this agreement were settled in the issuance in August 2017 and no accrual for the 8.0% stock dividend remains as of September 30, 2017. In conjunction with the private offering described above, the Company and Scotts Miracle-Gro also agreed to enter an Intellectual Property Sale Agreement, a Technology License Agreement, a Brand License Agreement, and a Supply Chain Services Agreement. The Intellectual Property Sale Agreement and the Technology License constitute an agreement of sales of future revenues. For more details regarding these agreements, please refer to Note 3 "Scotts Miracle-Gro Transactions" to the financial statements included in the Company's Annual Report on Form 10-K, as filed with the SEC on June 26, 2017. See also Note 3 for the Term Loan with Scotts Miracle-Gro. 13 5. Equity Compensation Plans For the three and six months ended September 30, 2017 and September 30, 2016, the Company did not grant options to purchase shares of common stock under the Company's 2005 Equity Compensation Plan (the "2005 Plan") and no new options will be granted under this plan until a new plan is adopted. During the three and six months ended September 30, 2017 and September 30, 2016, no options to purchase shares of common stock were cancelled or expired and no shares of common stock were issued upon exercise of outstanding stock options under the 2005 Plan. As of September 30, 2017, the Company had no unvested outstanding options to purchase shares of the Company's common stock. Information regarding all stock options outstanding under the 2005 Plan as of September 30, 2017 is as follows: | | OPTIONS OUTSTANDING AND EXERCISABLE ---------------+------+------------------------------------ Exercise price | | Options (in thousands) | | Weighted-average Remaining Contractual Life (years) | Weighted-average Exercise Price | Aggregate Intrinsic Value (in thousands) | ---------------+------+-------------------------------------+-----+-----------------------------------------------------+---------------------------------+------------------------------------------+----- $ | 1.10 | | 50 | | 0.50 | $ | 1.10 | | ---------------+------+-------------------------------------+-----+-----------------------------------------------------+---------------------------------+------------------------------------------+------+---+--- $ | 1.55 | | 11 | | 2.88 | $ | 1.55 | | ---------------+------+-------------------------------------+-----+-----------------------------------------------------+---------------------------------+------------------------------------------+------+---+--- $ | 2.20 | | 21 | | 1.04 | $ | 2.20 | | ---------------+------+-------------------------------------+-----+-----------------------------------------------------+---------------------------------+------------------------------------------+------+---+--- $ | 5.31 | | 93 | | 1.85 | $ | 5.31 | | ---------------+------+-------------------------------------+-----+-----------------------------------------------------+---------------------------------+------------------------------------------+------+---+--- | | | 175 | | 1.44 | $ | 3.50 | $ | 93 ---------------+------+-------------------------------------+-----+-----------------------------------------------------+---------------------------------+------------------------------------------+------+---+--- The aggregate intrinsic value in the preceding table represents the difference between the Company's closing stock price and the exercise price of each in-the-money option on the last trading day of the period presented, which was September 29, 2017. 6. Income Taxes The Company follows the guidance in ASC 740, Accounting for Uncertainty in Income Taxes ("ASC 740") which clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements. This interpretation defines the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. Deferred income taxes are recognized for the tax consequences in future years of differences between the tax basis of assets and liabilities and their financial reporting amounts at the end of each period, based on enacted laws and statutory rates applicable to the periods in which the differences are expected to affect taxable income. Amounts payable to taxing authorities are recorded as income tax liability. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is established against such assets where management is unable to conclude more likely than not that such asset will be realized. As of September 30, 2017 and March 31, 2017, the Company recognized a valuation allowance equal to 100% of the net deferred tax asset balance and the Company has no unrecognized tax benefits related to uncertain tax positions. 7. Related Party Transactions See Note 6 "Related Party Transactions" of Form 10-K for the year ended March 31, 2017, as filed with the SEC on June 26, 2017 for a detailed discussion of related party transactions. On September 13, 2017, AeroGrow entered into a Term Loan Agreement in the principal amount of up to $2.0 million with Scotts Miracle-Gro. Interest is charged at the stated rate of 10% per annum and will be paid quarterly in arrears, in cash at the end of each September, December and March. See Note 3 "Notes Payable, Long Term Debt and Current Portion – Long Term Debt" above. 14 8. Stockholders' Equity A summary of the Company's common stock warrant activity for the period from April 1, 2017 through September 30, 2017 is presented below: | Warrants Outstanding (in thousands) | | | Weighted Average Exercise Price | | | Aggregate Intrinsic Value (in thousands) --------------------------------+-------------------------------------+------+---+---------------------------------+---+------+----------------------------------------- Outstanding, April 1, 2017 | | 396 | | | $ | 6.97 | | $ | 2 --------------------------------+-------------------------------------+------+---+---------------------------------+---+------+------------------------------------------+---+-- Granted | | - | | | | - | | | --------------------------------+-------------------------------------+------+---+---------------------------------+---+------+------------------------------------------+---+-- Exercised | | - | | | | - | | | --------------------------------+-------------------------------------+------+---+---------------------------------+---+------+------------------------------------------+---+-- Expired | | (394 | ) | | | 7.00 | | | --------------------------------+-------------------------------------+------+---+---------------------------------+---+------+------------------------------------------+---+-- Outstanding, September 30, 2017 | | 2 | | | $ | 2.10 | | $ | 1 --------------------------------+-------------------------------------+------+---+---------------------------------+---+------+------------------------------------------+---+-- As of September 30, 2017, the Company had the following outstanding warrants to purchase shares of its common stock: | | Weighted Average | ------------------------------------+---+------------------+-- Warrants Outstanding (in thousands) | | Exercise Price | | | Remaining Life (Years) ------------------------------------+---+------------------+---+------+----------------------- | 2 | | $ | 2.10 | | 1.02 ------------------------------------+---+------------------+---+------+------------------------+----- | 2 | | $ | 2.10 | | 1.02 ------------------------------------+---+------------------+---+------+------------------------+----- Preferred Stock and Preferred Stock Warrants As discussed in Note 4 above, the Series B Preferred Stock was converted into 2,649,007 shares of common stock ($4.0 million divided by a conversion price of $1.51 per share) on November 29, 2016, concurrently with Scotts Miracle-Gro's exercise of its Warrant. The Series B Convertible Preferred Stock bore a cumulative annual dividend of 8.0%, payable in shares of the Company's common stock at a conversion price of $1.51 per share (subject to customary anti-dilution rights, as described in the Series B Convertible Preferred Stock Certificates of Designations). All shares related to this agreement were settled in the issuance in August 2017 and no accrual remains as of September 30, 2017 for the stock dividend. For additional details regarding the initial issuance of the Series B Convertible Preferred Stock and Warrant in March 2013 and the November 2016 conversation/exercise of the Series B Preferred Stock and Warrant, see "Note 4 – Scotts Miracle-Gro Transaction" above. 9. Segment Information The Company has determined that its reportable segments are those that are based on its method of internal reporting and the perspective of the chief operating decision maker. The company has two reportable segments, Retail Sales and Direct-to-Consumers. The Company evaluates performance based on the primary financial measure of contribution margin ("segment profit"). Segment profit reflects the income or loss from operations before corporate expenses, non-operating income, net interest expense, and income taxes. The Company does not have any individually identified assets regarding specific segments as all processes to manufacture products are not different based on segment. | Three Months Ended September 30, 2017 | --------------------------+---------------------------------------+----- (in thousands) | Direct-to-consumer | | | Retail | | | Corporate/Other | | Consolidated | --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+-- Net sales | $ | 911 | | | $ | 4,830 | | $ | - | | $ | 5,741 | --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Cost of revenue | | 602 | | | | 3,477 | | | - | | | 4,079 | --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Gross profit | | 309 | | | | 1,353 | | | - | | | 1,662 | --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Gross profit percentage | | 33.9 | % | | | 28.0 | % | | - | | | 28.9 | % --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Sales and marketing (1) | | 3 | | | | 181 | | | 89 | | | 273 | --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Segment profit | | 306 | | | | 1,172 | | | (89 | ) | | 1,389 | --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Segment profit percentage | | 33.6 | % | | | 24.3 | % | | - | | | 24.2 | % --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- (1) Sales and marketing includes advertising, trade shows, media production and promotional products and other as discussed in the sales and marketing section of the MD&A. 15 | Three Months Ended September 30, 2016 | --------------------------+---------------------------------------+----- (in thousands) | Direct-to-consumer | | | Retail | | | Corporate/Other | | Consolidated | --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+-- Net sales | $ | 825 | | | $ | 1,417 | | $ | - | | $ | 2,242 | --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Cost of revenue | | 545 | | | | 1,006 | | | - | | | 1,551 | --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Gross profit | | 280 | | | | 411 | | | - | | | 691 | --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Gross profit percentage | | 33.9 | % | | | 29.0 | % | | - | | | 30.8 | % --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Sales and marketing (1) | | 3 | | | | 156 | | | 66 | | | 225 | --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Segment profit | | 277 | | | | 255 | | | (66 | ) | | 466 | --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Segment profit percentage | | 33.6 | % | | | 18.0 | % | | - | | | 20.8 | % --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- (1) Sales and marketing includes advertising, trade shows, media production and promotional products and other as discussed in the sales and marketing section of the MD&A. | Six Months Ended September 30, 2017 | --------------------------+-------------------------------------+------ (in thousands) | Direct-to-consumer | | | Retail | | | Corporate/Other | | Consolidated | --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+-- Net sales | $ | 2,336 | | | $ | 5,868 | | $ | - | | $ | 8,204 | --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Cost of revenue | | 1,538 | | | | 4,182 | | | - | | | 5,720 | --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Gross profit | | 798 | | | | 1,686 | | | - | | | 2,484 | --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Gross profit percentage | | 34.2 | % | | | 28.7 | % | | - | | | 30.3 | % --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Sales and marketing (1) | | 23 | | | | 430 | | | 158 | | | 611 | --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Segment profit | | 775 | | | | 1,256 | | | (158 | ) | | 1,873 | --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Segment profit percentage | | 33.2 | % | | | 21.4 | % | | - | | | 22.8 | % --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- (1) Sales and marketing includes advertising, trade shows, media production and promotional products and other as discussed in the sales and marketing section of the MD&A. | Six Months Ended September 30, 2016 | --------------------------+-------------------------------------+------ (in thousands) | Direct-to-consumer | | | Retail | | | Corporate/Other | | Consolidated | --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+-- Net sales | $ | 1,967 | | | $ | 2,431 | | $ | - | | $ | 4,398 | --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Cost of revenue | | 1,243 | | | | 1,620 | | | - | | | 2,863 | --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Gross profit | | 724 | | | | 811 | | | - | | | 1,535 | --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Gross profit percentage | | 36.8 | % | | | 33.4 | % | | - | | | 34.9 | % --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Sales and marketing (1) | | 22 | | | | 426 | | | 121 | | | 569 | --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Segment profit | | 702 | | | | 385 | | | (121 | ) | | 966 | --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Segment profit percentage | | 35.7 | % | | | 15.8 | % | | - | | | 22.0 | % --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- (1) Sales and marketing includes advertising, trade shows, media production and promotional products and other as discussed in the sales and marketing section of the MD&A. 10. Subsequent Events As disclosed in Note 3 above, the proceeds under the SMG Term Loan are made available in increments of at least $500,000 with a due date of March 30, 2018. As of November 6, 2017, the Company had borrowed an aggregate of $1.0 million in principal under the SMG Term Loan. 16 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations The discussion contained herein is for the three and six months ended September 30, 2017 and September 30, 2016. The following discussion should be read in conjunction with the financial statements of AeroGrow International, Inc. (the "Company," "AeroGrow," "we," "our," or "us") and the notes to the financial statements included elsewhere in this Quarterly Report on Form 10-Q for the period ended September 30, 2017 (this "Quarterly Report"). The following discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), including statements that include words such as "anticipates," "expects," "intends," "plans," "believes," "may," "will," or similar expressions that are intended to identify forward-looking statements. In addition, any statements that refer to expectations, projections, or other characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements. Such statements include, but are not limited to, statements regarding our intent, belief, or current expectations regarding our strategies, plans, and objectives, our product release schedules, our ability to design, develop, manufacture, and market products, the ability of our products to achieve or maintain commercial acceptance, our ability to obtain financing and/or generate cash flow sufficient to fund our future operations, and our ability to continue as a going concern. Such statements are not guarantees of future performance and are subject to risks, uncertainties, and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors. Factors that could cause or contribute to the differences are discussed in this Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations and in Item 1A. "Risk Factors" of our Annual Report on Form 10-K for the year ended March 31, 2017. Except as required by applicable law or regulation, we undertake no obligation to revise or update any forward-looking statements contained in this Quarterly Report. The information contained in this Quarterly Report is not a complete description of our business or the risks associated with an investment in our common stock. Each reader should carefully review and consider the various disclosures we made in this Quarterly Report and in our other filings with the U.S. Securities and Exchange Commission ("SEC"). Overview AeroGrow International, Inc. was formed as a Nevada corporation on March 25, 2002. The Company's principal business is developing, marketing, and distributing advanced indoor aeroponic garden systems designed and priced to appeal to the consumer gardening, cooking and small indoor appliance markets worldwide. The Company's principal activities from its formation through March 2006, consisted of product research and development, market research, business planning, and raising the capital necessary to fund these activities. In December 2005, the Company commenced initial production of its AeroGarden system and, in March 2006, began shipping these systems to retail and catalogue customers. The Company manufactures, distributes and markets nine different models of its AeroGarden systems in multiple colors, as well as over 40 varieties of seed pod kits and a full line of accessory products through multiple channels including retail distribution, catalogue and direct-to-consumer sales primarily in the United States and Canada, as well as selected countries in Europe. In April 2013, we entered into a Securities Purchase Agreement and strategic alliance with a wholly owned subsidiary of The Scotts Miracle-Gro Company (collectively with its subsidiary, "Scotts Miracle-Gro"). Pursuant to the Securities Purchase Agreement, we issued (i) 2.6 million shares of Series B Convertible Preferred Stock, par value $0.001 per share (the "Series B Preferred Stock); and (ii) a warrant to purchase shares of our common stock for an aggregate purchase price of $4.0 million. In addition, as part of the strategic alliance, we entered into several other agreements with Scotts Miracle-Gro, including: (i) an Intellectual Property Sale Agreement; (ii) a Technology Licensing Agreement; (iii) a Brand License Agreement; and (iv) a Supply Chain Management Agreement. Pursuant to the Intellectual Property Agreement, we agreed to sell all intellectual property associated with our hydroponic products (the "Hydroponic IP"), other than the AeroGrow and AeroGarden trademarks, free and clear of all encumbrances, to Scotts Miracle-Gro for $500,000. Scotts Miracle-Gro has the right to use the AeroGrow and AeroGarden trademarks in connection with the sale of products incorporating the Hydroponic IP. In addition to the working capital infusion of approximately $4.5 million from the Securities Purchase Agreement and Intellectual Property Sale Agreement, as amended, the strategic alliance allows us to use the globally recognized and highly trusted Miracle-Gro brand name. We believe that the strategic alliance also gives Scotts Miracle-Gro an entry into the burgeoning indoor gardening market, while providing AeroGrow a broad base of support in marketing, distribution, supply chain logistics, R&D, and sourcing. We used our strategic alliance with Scotts Miracle-Gro to re-establish our presence in the retail and international sales channels. On September 13, 2017, the Company entered into a Term Loan Agreement in the principal amount of up to $2.0 million with Scotts Miracle-Gro. The proceeds will be made available as needed in increments of $500,000 not to exceed $2.0 million with a due date of March 30, 2018. The Term Loan Agreement is secured by a lien on the assets of the Company. Interest will be charged at the stated rate of 10% per annum and will be paid, in cash, quarterly in arrears at the end of each September, December and March. The funding provides general working capital and is being used for the purpose of acquiring inventory to support anticipated growth as the Company expands its retail and its direct-to-consumer sales channels. See Note 3 "Notes Payable, Long Term Debt and Current Portion – Long Term Debt" to our condensed financial statements. 17 Results of Operations Three Months Ended September 30, 2017 and September 30, 2016 Summary Overview For the three months ended September 30, 2017, total revenue was $5.7 million, an increase of 156.1%, or $3.5 million, relative to the same period in the prior year. The increase was primarily due to nearly $2.0 million of in-store retail channel sales with our newly acquired retail accounts, including Bed Bath and Beyond, Macy's and Kohl's. Additionally, we also experienced increased sales at Amazon.ca and other online retailers. This is consistent with our current strategy to build through online retailers while refocusing on in-store tests marketing primarily in the housewares channel that may lead to company-wide roll-outs. We anticipate that quarterly sales results during the first six months of our fiscal year (April-September), may continue to be inconsistent as the Company tests various retail channel strategies in an effort to optimize sales and profitability throughout the year, as well as the impact of load-in timing before the holiday season. Additionally, sales in our direct-to-consumer channel also increased 10.4%, or $86,000, primarily due to growing enthusiasm about new gardens, continued momentum from our general advertising and marketing campaign, and an increase in our user-base. We believe that we benefit from more visibility from our increased presence on Amazon platforms and other select online retail distribution channels. For the three months ended September 30, 2017, total dollar sales of AeroGarden units increased by 302.8% from the prior year period due to earlier load-in of large AeroGarden orders to retailers in the current period, in advance of the peak holiday season. Sales in the prior year period did not have comparable retail load-in sales for items that will be carried in-store during the holiday season. Seed pod kit and accessory sales increased by 67.3% over prior year period as our established base of AeroGardeners continues to grow. AeroGarden sales net of allowances represented 78.1% of total revenue, as compared to 66.5% in the prior year period. This percentage increase, on a product line basis, was attributable to sales to expanded and newly acquired retail accounts including many retail sales due to earlier load-in product sales prior to the holiday season. Seed pod kit and accessory sales decreased as a percent of the total to 21.8% from 33.5% due to the increased sales of AeroGarden this quarter. However, as noted above the total dollar sales increased $505,000. The Company continues to spend advertising dollars in order to strategically build market awareness and enhance initiatives implemented in the prior year. For Fiscal 2018, we intend to expand consumer awareness of the AeroGrow brand and product line. During the three months ended September 30, 2017, we spent $174,000 in advertising expenditures, a $24,000 or 15.8% year-over-year increase compared to the same period ended September 30, 2016. This was primarily due to an increase in our retail marketing campaigns and expanded email programs. The advertising expenditures were divided as follows: · | Direct-to-consumer advertising increased $14,000 from $36,000 to $50,000 during the three months ended September 30, 2017, primarily reflecting a reallocation of spending from pay-per-click and digital display advertising campaigns to retail spending. Efficiency, as measured by dollars of direct-to-consumer sales generated per dollar of related advertising expense continued to be strong, although the ratio decreased 19.5% to $18.35 for the three months ended September 30, 2017, as compared to $22.81 for the same period in Fiscal 2017 as spending increased due to increases in pay-per-click programs. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | Retail advertising increased $8,000 from $107,000 to $115,000 for the three months ended September 30, 2017 and September 30, 2016, respectively. The Company continues to invest in driving product awareness through: (i) platforms made available by our retailers; (ii) various promotional programs to increase product awareness with our housewares channel of retail accounts, including catalogs and email campaigns; and (iii) web-based advertising programs (e.g. including retail catalogues, website banner ads, email blasts, targeted search campaigns, etc.). --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Our gross profit for the three months ended September 30, 2017 was 28.9%, down from 30.8% in the prior year period due to increased sales into the retail channel, which requires much higher return allowances, particularly for load-in sales, and traditionally carries lower margins. In aggregate, our total operating expenses increased 35.9% or $473,000 year-over-year, principally as a result of aligning our growth Company initiatives in support of anticipated future growth. Gross spending fluctuated in the following areas: · | A $248,000 increase in personnel expenses, due to a small increase in headcount and other changes to our compensation program to align with our growth initiatives; --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | A $78,000 increase in general market research, new product samples, public relations and new product programs such as illustration and language translations for international product distribution; --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | A $29,000 increase in travel as we conducted face-to-face meetings with potential domestic and European customers and manufacturers in China; and --+-------------------------------------------------------------------------------------------------------------------------------------------------- · | A $24,000 increase in advertising expenditures described above including Amazon Prime Day deals; --+------------------------------------------------------------------------------------------------- 18 As a result of efforts to prepare for growth and timing of load-in orders, our operating loss improved to $129,000 for the three months ended September 30, 2017, as compared to an operating loss of $627,000 in the prior year period. Other income and expense for the three months ended September 30, 2017 totaled to a net other income of $8,000, as compared to net other expense of $502,000 in the prior year period. In the prior year, net other expense is primarily attributable to non-cash expenses relating to the fair value revaluation of the warrant held by Scotts Miracle-Gro. The net loss for the three months ended September 30, 2017 decreased to $121,000, as compared to a $1.1 million net loss in the prior year. The decline in net loss is due to higher overall sales, which are a result newly acquired retail accounts and earlier pre-holiday load-in sales to retailers, decreased operating expenses as a percentage of revenue and no fair value changes associated with the Scotts Miracle-Gro warrant liability as the warrant was fully exercised offset by decreases in margins. The following table sets forth, as a percentage of sales, our financial results for the three months ended September 30, 2017 and the three months ended September 30, 2016: | Three Months Ended September 30, | ---------------------------+----------------------------------+------ | 2017 | | | 2016 ---------------------------+----------------------------------+-------+----+----- Net revenue | | | | ---------------------------+----------------------------------+-------+----+----- Direct-to-consumer | | 15.8 | % | | 36.8 | % ---------------------------+----------------------------------+-------+----+------+-------+--- Retail | | 82.7 | % | | 61.6 | % ---------------------------+----------------------------------+-------+----+------+-------+--- International | | 1.5 | % | | 1.6 | % ---------------------------+----------------------------------+-------+----+------+-------+--- Total net revenue | | 100.0 | % | | 100.0 | % ---------------------------+----------------------------------+-------+----+------+-------+--- Cost of revenue | | 71.1 | % | | 69.2 | % ---------------------------+----------------------------------+-------+----+------+-------+--- Gross profit | | 28.9 | % | | 30.8 | % ---------------------------+----------------------------------+-------+----+------+-------+--- Operating expenses | | | | | | ---------------------------+----------------------------------+-------+----+------+-------+--- Research and development | | 2.5 | % | | 5.1 | % ---------------------------+----------------------------------+-------+----+------+-------+--- Sales and marketing | | 17.6 | % | | 32.5 | % ---------------------------+----------------------------------+-------+----+------+-------+--- General and administrative | | 11.1 | % | | 21.2 | % ---------------------------+----------------------------------+-------+----+------+-------+--- Total operating expenses | | 31.2 | % | | 58.8 | % ---------------------------+----------------------------------+-------+----+------+-------+--- Loss from operations | | (2.3 | )% | | (28.0 | )% ---------------------------+----------------------------------+-------+----+------+-------+--- Revenue For the three months ended September 30, 2017, revenue totaled $5.7 million, a year-over-year increase of 156.1% or $3.5 million, from the three months ended September 30, 2016. | Three Months Ended September 30, (in thousands) | -------------------+-------------------------------------------------+------ Net Revenue | 2017 | | 2016 | -------------------+-------------------------------------------------+-------+------+-- Direct-to-consumer | $ | 911 | | $ | 825 -------------------+-------------------------------------------------+-------+------+---+------ Retail | | 4,746 | | | 1,381 -------------------+-------------------------------------------------+-------+------+---+------ International | | 84 | | | 36 -------------------+-------------------------------------------------+-------+------+---+------ Total | $ | 5,741 | | $ | 2,242 -------------------+-------------------------------------------------+-------+------+---+------ Direct-to-consumer sales for the three months ended September 30, 2017 totaled $911,000, up $86,000 or 10.4%, from the prior year period. The increase in sales to direct-to-consumer channels was caused by increased visibility and continued momentum from our general advertising and marketing campaign, including our increased presence on select online retail distribution channels. Sales to retailer customers for the three months ended September 30, 2017 totaled $4.7 million, up $3.4 million from the prior-year period, principally reflecting load-in sales to newly acquired brick-and-mortar stores in advance of the peak holiday season, as well as growth in the existing Amazon.ca account. International sales totaled $84,000 in comparison to sales testing in Europe in the prior year of $36,000 as we continue to understand the trends that impact the international market and expand our international presence. 19 Our products consist of AeroGardens, and seed pod kits and accessories. A summary of the sales of these two product categories for the three months ended September 30, 2017 and September 30, 2016 is as follows: | Three Months Ended September 30, (in thousands) | ------------------------------+-------------------------------------------------+------- | 2017 | | | 2016 | ------------------------------+-------------------------------------------------+--------+----+------+-- Product Revenue | | | | | ------------------------------+-------------------------------------------------+--------+----+------+-- AeroGardens | $ | 6,626 | | | $ | 1,645 | ------------------------------+-------------------------------------------------+--------+----+------+---+-------+--- Seed pod kits and accessories | | 1,255 | | | | 750 | ------------------------------+-------------------------------------------------+--------+----+------+---+-------+--- Other | | (2,140 | ) | | | (153 | ) ------------------------------+-------------------------------------------------+--------+----+------+---+-------+--- Total | $ | 5,741 | | | $ | 2,242 | ------------------------------+-------------------------------------------------+--------+----+------+---+-------+--- % of Total Revenue | | | | | | | ------------------------------+-------------------------------------------------+--------+----+------+---+-------+--- AeroGardens | | 115.4 | % | | | 73.4 | % ------------------------------+-------------------------------------------------+--------+----+------+---+-------+--- Seed pod kits and accessories | | 21.8 | % | | | 33.5 | % ------------------------------+-------------------------------------------------+--------+----+------+---+-------+--- Other | | (37.2 | )% | | | (6.9 | )% ------------------------------+-------------------------------------------------+--------+----+------+---+-------+--- Total | | 100.0 | % | | | 100.0 | % ------------------------------+-------------------------------------------------+--------+----+------+---+-------+--- AeroGarden sales increased $5.0 million, or 302.8%, from the prior year period, reflecting in: (i) increased retail channel sales as we sold into brick-and-mortar stores in advance of the peak holiday season and expanded upon tests that were successful in the prior year; and (ii) increased sales of AeroGardens in our Direct-to-Consumer channel as our advertising campaigns from the prior year continued to inform buyers about our products. The increase in seed pod kit and accessory sales, from $750,000 to $1.3 million, principally reflects the overall increase in our established base of AeroGardens. For the three months ended September 30, 2017, sales of seed pod kits and accessories represented 21.8% of total revenue, as compared to 33.5% in the prior year period, which is a result of the increase in AeroGarden retail sales to expanded accounts in the current year. Other revenue, which is comprised primarily of grow club revenue, shipping revenue, accruals and deductions, decreased as a percent of the total to (37.2)% from (6.9)% in the prior year period due to lower shipping revenue as a percentage of sales and significantly higher deductions for sales allowances and future discounts for in-store retail accounts. Cost of Revenue Cost of revenue for the three months ended September 30, 2017 totaled $4.1 million, an increase of $2.5 million from the three months ended September 30, 2016, due to increased revenue. Cost of revenue includes product costs for purchased and manufactured products, freight costs for inbound freight from manufacturers, costs related to warehousing and the shipping of products to customers, credit card processing fees for direct sales, and duties and customs applicable to imported products. As a percent of total revenue, cost of revenue represented 71.1% of revenue as compared to 69.2% for the quarter ended September 30, 2016. The increase in costs as a percent of revenue reflected our change in customer mix to a higher percentage of retail sales at brick-and-mortar locations, which traditionally generate lower margins. Gross Profit Our gross profit varies based upon the factors affecting net revenue and cost of revenue (as discussed above), as well as the mix of our revenue that comes from the retail, direct-to-consumer, and international channels. In a direct-to-consumer sale, we recognize as revenue the full consumer purchase price for the product. In retail and international sales, by comparison, we recognize as revenue the wholesale price for the product which we charge to the retailer or international distributor. Media costs associated with direct sales are included in sales and marketing expenses. As a result, retail and international sales generally have lower gross margins than direct-to-consumer sales. The gross profit for the quarter ended September 30, 2017 was 28.9% as compared to 30.8% for the quarter ended September 30, 2016. The decrease in our gross profit is due primarily to changes in customer and product mix, particularly the introduction of AeroGarden products into new brick-and-mortar stores which carry higher return allowances. Additionally, we experienced higher costs during the current quarter for, one-time fees related to establishing new retail customers and additional shipping costs for international and direct-to-consumer channels. Research and Development Research and development costs for the quarter ended September 30, 2017 totaled $141,000, an increase of $27,000 from the quarter ended September 30, 2016. The increase reflects approximately $40,000 for increases in employee salaries and wages for newly hired employees assisting in new product development and bonus accruals partially offset by $8,000 of consulting fee reimbursements and decreases in new product certification and testing. 20 Sales and Marketing Sales and marketing costs for the three months ended September 30, 2017 totaled $1.0 million, as compared to $729,000 for the three months ended September 30, 2016, an increase of 38.8%, or $283,000. Sales and marketing costs include all costs associated with the marketing, sales, operations, customer support, and sales order processing for our products, and consisted of the following: | Three Months Ended September 30, (in thousands) | ------------------------------------------+-------------------------------------------------+------ | 2017 | | 2016 | ------------------------------------------+-------------------------------------------------+-------+------+-- Advertising | $ | 174 | | $ | 150 | ------------------------------------------+-------------------------------------------------+-------+------+---+-----+-- Personnel | | 548 | | | 470 | ------------------------------------------+-------------------------------------------------+-------+------+---+-----+-- Sales commissions | | 47 | | | (11 | ) ------------------------------------------+-------------------------------------------------+-------+------+---+-----+-- Trade shows | | - | | | 1 | ------------------------------------------+-------------------------------------------------+-------+------+---+-----+-- Market research | | 48 | | | - | ------------------------------------------+-------------------------------------------------+-------+------+---+-----+-- Travel | | 41 | | | 21 | ------------------------------------------+-------------------------------------------------+-------+------+---+-----+-- Media production and promotional products | | 8 | | | 6 | ------------------------------------------+-------------------------------------------------+-------+------+---+-----+-- Quality control and processing fees | | 55 | | | 24 | ------------------------------------------+-------------------------------------------------+-------+------+---+-----+-- Other | | 91 | | | 68 | ------------------------------------------+-------------------------------------------------+-------+------+---+-----+-- | $ | 1,012 | | $ | 729 | ------------------------------------------+-------------------------------------------------+-------+------+---+-----+-- Advertising expense is principally comprised of the costs of development, production, printing, and postage for our catalogue mailing and web media costs for search and affiliate web marketing programs, and developing and employing other forms of advertising. Each of these are key components of our integrated marketing strategy because they help build awareness of, and consumer demand for, our products, in addition to generating direct-to-consumer sales. Advertising expense totaled $174,000 for the quarter ended September 30, 2017, a year-over-year increase of 15.8%, or $24,000, due to our increase in participation in various promotional programs and our general marketing and advertising campaigns along with our web-based advertising programs. Sales and marketing personnel costs include salaries, payroll taxes, employee benefits and other payroll costs for our sales, operations, customer service, graphics and marketing departments. For the three months ended September 30, 2017, personnel costs for sales and marketing were $548,000, up $78,000 or 16.5% from the three months ended September 30, 2016. The increase reflected an increase in headcount necessary to support our sales to retailers. Personnel expenses include all related payroll including departmental incentive programs, including salaries, bonuses and employee benefits. Other marketing expenses increased year-over-year principally because of additional travel, social media, market research programs, retailer marketing programs, third party sales tax software and new products that were initiated during the current year quarter. General and Administrative General and administrative costs for the three months ended September 30, 2017 totaled $638,000, as compared to $475,000 for the three months ended September 30, 2016, an increase of 34.2%, or $163,000. The increase is attributable to increases in: (i) payroll-related expenses, including departmental incentive programs, salaries, bonuses and employee benefits; (ii) web hosting, electronic data processing, network consulting fees for software troubleshooting; and (iii) estimates for the allowance for bad debt. Operating Loss Our operating loss for the three months ended September 30, 2017 was $129,000, an improvement of $497,000 from the operating loss of $627,000 for the three months ended September 30, 2016. The decreased loss reflected higher sales in both our retail and direct-to-consumer channels, as well as an overall proportional decrease in operating expenses (as a percentage of revenue), as discussed in greater detail above. Net Loss For the three months ended September 30, 2017, we recorded a net loss of $121,000 as compared to a net loss of $1.1 million for the three months ended September 30, 2016. Segment Results We report our segment information in the same way that management assesses the business and makes decision regarding the allocations of resources in accordance with the Segment Reporting Topic of the Financial Accounting Standards Board Accounting Standards Codification (ASC). We have two reportable segments. Retail and Direct-to-Consumer. Factors considered in determining our Reportable Segments include the nature of the business activities, the reports provided to the Company's chief operating decision maker (CODM) for operating and administrative activities, available information and information that is presented to our Board of Directors. 21 The Company's CODM has been identified as the Chief Executive Officer because he has final authority over the performance assessment and resource allocation decisions. The CODM regularly receives discrete financial information about each Reportable Segment. The CODM uses all such information for performance assessment and resource allocation decisions. The CODM evaluates the performance of and allocates resources based upon the contribution margins of each segment. As a result, we divide our business into two reportable segments: Direct-to-Consumer and Retail. This division of reportable segments is consistent with how the segments report to and are managed by the chief operating decision maker of the Company. The Company evaluates performance based on the primary financial measure of contribution margin ("segment profit"). Segment profit reflects the income or loss from operations before corporate expenses, non-operating income, net interest expense, and income taxes. | Three Months Ended September 30, 2017 | --------------------------+---------------------------------------+----- (in thousands) | Direct-to-consumer | | | Retail | | | Corporate/Other | | Consolidated | --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+-- Net sales | $ | 911 | | | $ | 4,830 | | $ | - | | $ | 5,741 | --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Cost of revenue | | 602 | | | | 3,477 | | | - | | | 4,079 | --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Gross profit | | 309 | | | | 1,353 | | | - | | | 1,662 | --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Gross profit percentage | | 33.9 | % | | | 28.0 | % | | - | | | 28.9 | % --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Sales and marketing (1) | | 3 | | | | 181 | | | 89 | | | 273 | --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Segment profit | | 306 | | | | 1,172 | | | (89 | ) | | 1,389 | --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Segment profit percentage | | 33.6 | % | | | 24.3 | % | | - | | | 24.2 | % --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- (1) Sales and marketing includes advertising, trade shows, media production and promotional products and other as discussed in the sales and marketing section of the MD&A. | Three Months Ended September 30, 2016 | --------------------------+---------------------------------------+----- (in thousands) | Direct-to-consumer | | | Retail | | | Corporate/Other | | Consolidated | --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+-- Net sales | $ | 825 | | | $ | 1,417 | | $ | - | | $ | 2,242 | --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Cost of revenue | | 545 | | | | 1,006 | | | - | | | 1,551 | --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Gross profit | | 280 | | | | 411 | | | - | | | 691 | --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Gross profit percentage | | 33.9 | % | | | 29.0 | % | | - | | | 30.8 | % --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Sales and marketing (1) | | 3 | | | | 156 | | | 66 | | | 225 | --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Segment profit | | 277 | | | | 255 | | | (66 | ) | | 466 | --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Segment profit percentage | | 33.6 | % | | | 18.0 | % | | - | | | 20.8 | % --------------------------+---------------------------------------+------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- (1) Sales and marketing includes advertising, trade shows, media production and promotional products and other as discussed in the sales and marketing section of the MD&A. Six Months Ended September 30, 2017 and September 30, 2016 Summary Overview For the six months ended September 30, 2017, total revenue of $8.2 million was up 86.5%, or $3.8 million, relative to the same period in the prior year. The increase was primarily due to growth of sales at all Amazon accounts and other online retailers, nearly $2.0 million of in-store retail channel sales to new customers, continued sales into the retail housewares channel and growing interest in our new AeroGardens that were first introduced in the prior year. The increase is the result of our strategy to use our platform with online retailers to generate focused and successful in-store tests, primarily in the housewares channel. We anticipate that quarterly sales results during the first six months of our fiscal year (April-September), may be variable as we test various retail channel strategies in an effort to optimize sales and profitability throughout the year, particularly due to retailers purchasing load-in products in advance of the peak holiday season. Sales in our direct-to-consumer channels increased, by 18.8%, or $369,000, primarily due to more visibility and continued momentum from our general advertising and marketing campaign, increased user-base including our increased presence on Amazon accounts and other select online retail distribution channels. Sales to international distributors increased by 43.8% to $146,000 in the six months ended September 30, 2017, relative to the same period in the prior year, primarily due to our expanded distribution in certain international markets such as Amazon.uk, France, Germany, Spain and Italy. For the six months ended September 30, 2017, total dollar sales of AeroGarden units increased by 176.7% from the prior year period and seed pod kit and accessory sales increased by 36.2% over prior year period. AeroGarden sales net of allowances represented 74.6% of total revenue, as compared to 65.2% in the prior year period. This percentage increase, on a product line basis, was attributable to existing and new customers purchasing AeroGardens and expansion and introduction of AeroGardens into newly acquired retail accounts including significantly earlier load-in retail sales prior to the holiday season. Seed pod kit and accessory sales decreased as a percent of the total to 25.4% from 34.8% in the prior year period as a result of as a result of the higher AeroGarden sales as we approach our peak selling season. However, as noted above, the total dollar sales increased by $553,000. 22 During the six months ended September 30, 2017, we spent $441,000 in advertising expenditures, a year-over-year increase of $9,000, or 2.0%, compared to the same period ended September 30, 2016. This increase was to support our retail sales channels. These expenditures were divided as follows: · | Direct-to-consumer advertising increased $5,000 to $121,000 during the six months ended September 30, 2017, primarily reflecting reallocation of specific pay-per-click advertising geared toward the direct-to-consumer customer base and direct advertising campaigns. Efficiency, as measured by dollars of direct-to-consumer sales per dollar of related advertising expense increased to $19.40 for the six months ended September 30, 2017, as compared to $17.05 for the same period in Fiscal 2017. --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | Retail advertising decreased to $301,000 from $302,000 for the six months ended September 30, 2017 and September 30, 2016, respectively, as we invested in: (i) platforms made available by our retailers; (ii) various promotional programs to increase product awareness with our retail housewares channel, including catalogues and email campaigns; and (iii) web-based advertising programs (e.g. inclusion in retail catalogues, website banner ads, email blasts, targeted search campaigns, etc.). --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ Our gross profit for the six months ended September 30, 2017, was 30.3%, down from 34.9% in the prior year period. The decrease in the gross profit percentage is due to increased sales, which traditionally have lower margins and are impacted by allowances for estimated returns, particularly on higher product load-in sales in advance of the peak selling season. In aggregate, our total operating expenses increased 18.7%, or $527,000, year-over-year, principally to support new product introductions and anticipated growth. Gross spending fluctuated in the following areas: · | A $311,000 increase in personnel expenses, due to a small increase in headcount and other changes to our compensation program to align with our growth initiatives; --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | A $115,000 increase in general market research, new product samples, public relations and new product programs such as illustration and language translations for international product distribution; and --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | A $25,000 increase in travel to manufacturers in China and potential domestic and European customers. --+------------------------------------------------------------------------------------------------------ Our operating loss was $858,000 for the six months ended September 30, 2017, as compared to an operating loss of $1.3 million in the prior year period, primarily due to earlier load-in product sales to retailers prior to the holiday season. Our operating loss decreased $422,000 to $858,000 for the six months ended September 30, 2017, from $1.3 million in the prior year period, primarily as a result of increased product load-in sales to new retail accounts, partially offset by lower margins on these accounts and increases in general spending for new products and market expansion. The first six months of the year are our seasonally slowest sales period. Other income and expense for the six months ended September 30, 2017 totaled to a net other income of $47,000, as compared to net other expense of $975,000 in the prior year period. The current year other income is attributable to interest income, other income from consulting related revenue, and foreign exchange gains. In the prior year, net other expense was primarily attributable to non-cash expenses relating to the fair value revaluation of the warrant held by Scotts Miracle-Gro. The net loss for the six months ended September 30, 2017 was $811,000, as compared to the $2.3 million loss in the prior year. The decreased net loss is due to no fair value changes associated with the Scotts Miracle-Gro warrant liability as the warrant was fully exercised and higher overall sales, which includes several sales to newly acquired retail accounts in advance of the peak holiday season, partially offset by sales into the lower margin retail channel and an increase in salaries and wages. 23 The following table sets forth, as a percentage of sales, our financial results for the six months ended September 30, 2017, and the six months ended September 30, 2016: | Six Months Ended September 30, | ---------------------------+--------------------------------+------ | 2017 | | | 2016 ---------------------------+--------------------------------+-------+----+----- Net revenue | | | | ---------------------------+--------------------------------+-------+----+----- Direct-to-consumer | | 28.5 | % | | 44.7 | % ---------------------------+--------------------------------+-------+----+------+-------+--- Retail | | 69.7 | % | | 53.0 | % ---------------------------+--------------------------------+-------+----+------+-------+--- International | | 1.8 | % | | 2.3 | % ---------------------------+--------------------------------+-------+----+------+-------+--- Total net revenue | | 100.0 | % | | 100.0 | % ---------------------------+--------------------------------+-------+----+------+-------+--- Cost of revenue | | 69.7 | % | | 65.1 | % ---------------------------+--------------------------------+-------+----+------+-------+--- Gross profit | | 30.3 | % | | 34.9 | % ---------------------------+--------------------------------+-------+----+------+-------+--- Operating expenses | | | | | | ---------------------------+--------------------------------+-------+----+------+-------+--- Research and development | | 2.8 | % | | 4.8 | % ---------------------------+--------------------------------+-------+----+------+-------+--- Sales and marketing | | 22.5 | % | | 35.2 | % ---------------------------+--------------------------------+-------+----+------+-------+--- General and administrative | | 15.4 | % | | 24.0 | % ---------------------------+--------------------------------+-------+----+------+-------+--- Total operating expenses | | 40.7 | % | | 64.0 | % ---------------------------+--------------------------------+-------+----+------+-------+--- Loss from operations | | (10.4 | )% | | (29.1 | )% ---------------------------+--------------------------------+-------+----+------+-------+--- Revenue For the six months ended September 30, 2017, revenue totaled $8.2 million, a year-over-year increase of 86.5% or $3.8 million, from the six months ended September 30, 2016. | Six Months Ended September 30, (in thousands) | -------------------+-----------------------------------------------+------ Net Revenue | 2017 | | 2016 | -------------------+-----------------------------------------------+-------+------+-- Direct-to-consumer | $ | 2,336 | | $ | 1,967 -------------------+-----------------------------------------------+-------+------+---+------ Retail | | 5,722 | | | 2,329 -------------------+-----------------------------------------------+-------+------+---+------ International | | 146 | | | 102 -------------------+-----------------------------------------------+-------+------+---+------ Total | $ | 8,204 | | $ | 4,398 -------------------+-----------------------------------------------+-------+------+---+------ Direct-to-consumer sales for the six months ended September 30, 2017, totaled $2.3 million, up $369,000 or 18.8%, from the prior year period. The increase in sales to direct-to-consumer channels was caused by pricing strategies to drive direct-to-consumer sales during our non-peak season, and continued cumulative momentum from our general brand awareness campaigns. Sales to retailer customers for the six months ended September 30, 2017, totaled $5.7 million, up $3.4 million, or 145.7%, from the prior-year period, principally reflecting earlier load-in sales to newly acquired and expanded retail accounts, including more brick-and-mortar retailers, in our housewares outlets, and increased online sales to the existing Amazon accounts. We also tested our products in several retail stores during the period in anticipation of the continued retail expansion throughout the year. International sales for the six months ended September 30, 2017, totaled $146,000, an increase of $44,000, primarily due to expansion of sales testing in Europe and as we continue to understand the trends that impact the international market. 24 Our products consist of AeroGardens, and seed pod kits and accessories. A summary of the sales of these two product categories for the six months ended September 30, 2017 and September 30, 2016 is as follows: | Six Months Ended September 30, | ------------------------------+--------------------------------+------- | 2017 | | | 2016 | ------------------------------+--------------------------------+--------+----+----------------+-- Product Revenue | (in thousands) | | | (in thousands) | ------------------------------+--------------------------------+--------+----+----------------+-- AeroGardens | $ | 8,278 | | | $ | 2,992 | ------------------------------+--------------------------------+--------+----+----------------+---+-------+--- Seed pod kits and accessories | | 2,084 | | | | 1,531 | ------------------------------+--------------------------------+--------+----+----------------+---+-------+--- Other | | (2,158 | ) | | | (125 | ) ------------------------------+--------------------------------+--------+----+----------------+---+-------+--- Total | $ | 8,204 | | | $ | 4,398 | ------------------------------+--------------------------------+--------+----+----------------+---+-------+--- % of Total Revenue | | | | | | | ------------------------------+--------------------------------+--------+----+----------------+---+-------+--- AeroGardens | | 100.9 | % | | | 68.0 | % ------------------------------+--------------------------------+--------+----+----------------+---+-------+--- Seed pod kits and accessories | | 25.4 | % | | | 34.8 | % ------------------------------+--------------------------------+--------+----+----------------+---+-------+--- Other | | (26.3 | )% | | | (2.8 | )% ------------------------------+--------------------------------+--------+----+----------------+---+-------+--- Total | | 100.0 | % | | | 100.0 | % ------------------------------+--------------------------------+--------+----+----------------+---+-------+--- AeroGarden sales increased $5.3 million, or 176.7%, from the prior year period, reflecting increased retail channel sales and increased sales of AeroGardens in our direct-to-consumer channel. The increase in seed pod kit and accessory sales, which increased by $553,000, or 36.2%, principally reflects the increase in our established base of AeroGardens. For the six months ended September 30, 2017, sales of seed pod kits and accessories represented 25.4% of total revenue, as compared to 34.8% in the prior year period. The percentage decrease is due to increased sales of AeroGardens. Other revenue, which is comprised primarily of grow club revenue, shipping revenue, accruals and deductions, increased as a percent of the total to (26.3)% from (2.8)% in the prior year period due to higher deductions and accruals for sales allowances and future discounts for in-store new retail accounts and lower shipping revenue as a percentage of sales. Cost of Revenue Cost of revenue for the six months ended September 30, 2017 totaled $5.7 million, an increase of $2.9 million, from the six months ended September 30, 2016, due to increased revenues. Cost of revenue includes product costs for purchased and manufactured products, freight costs for inbound freight from manufacturers, costs related to warehousing and the shipping of products to customers, credit card processing fees for direct sales, and duties and customs applicable to imported products. As a percent of total revenue, cost of revenue represented 69.7% of revenue as compared to 65.1% for the prior year period. Gross Profit Our gross profit varies based upon the factors affecting net revenue and cost of revenue as discussed above, as well as the mix of our revenue that comes from the retail, direct-to-consumer, and international channels. In a direct-to-consumer sale, we recognize as revenue the full consumer purchase price for the product. In retail and international sales, by comparison, we recognize as revenue the wholesale price for the product which we charge to the retailer or international distributor. Media costs associated with direct sales are included in sales and marketing expenses. As a result, retail and international sales generally have lower gross profits than direct-to-consumer sales. The gross profit for the six months ended September 30, 2017, was 30.3% as compared to 34.9% for the six months ended September 30, 2016. The decrease in our gross profit percentage was primarily attributable to the increased percentage of sales to new brick-and-mortar retail accounts with lower margins, changes in customer and product mix and increased pricing pressure in our direct-to-consumer channel. Research and Development Research and development costs for the six months ended September 30, 2017, totaled $233,000, an increase of 8.4%, or $18,000, from the six months ended September 30, 2016. The increase reflects increases in Research and Development employee headcount and prototype development and shipping expenses, offset by decreases in new product certification and testing and $60,000 of consulting fee reimbursements. 25 Sales and Marketing Sales and marketing costs for the six months ended September 30, 2017, totaled $1.8 million, as compared to $1.5 million for the six months ended September 30, 2016, an increase of 18.2%, or $283,000. Sales and marketing costs include all costs associated with the marketing, sales, operations, customer support, and sales order processing for our products, and consisted of the following: | Six Months Ended September 30, (in thousands) | ------------------------------------------+-----------------------------------------------+------ | 2017 | | 2016 | ------------------------------------------+-----------------------------------------------+-------+------+-- Advertising | $ | 441 | | $ | 432 | ------------------------------------------+-----------------------------------------------+-------+------+---+-------+-- Personnel | | 977 | | | 866 | ------------------------------------------+-----------------------------------------------+-------+------+---+-------+-- Sales commissions | | 30 | | | (7 | ) ------------------------------------------+-----------------------------------------------+-------+------+---+-------+-- Trade shows | | 1 | | | 1 | ------------------------------------------+-----------------------------------------------+-------+------+---+-------+-- Market research | | 55 | | | 1 | ------------------------------------------+-----------------------------------------------+-------+------+---+-------+-- Travel | | 86 | | | 72 | ------------------------------------------+-----------------------------------------------+-------+------+---+-------+-- Media production and promotional products | | 11 | | | 13 | ------------------------------------------+-----------------------------------------------+-------+------+---+-------+-- Quality control and processing fees | | 85 | | | 47 | ------------------------------------------+-----------------------------------------------+-------+------+---+-------+-- Other | | 158 | | | 124 | ------------------------------------------+-----------------------------------------------+-------+------+---+-------+-- | $ | 1,844 | | $ | 1,549 | ------------------------------------------+-----------------------------------------------+-------+------+---+-------+-- Advertising expense totaled $441,000 for the six months ended September 30, 2017, a year-over-year increase of 2.0%, or $9,000, primarily due to conservative spending on promotional programs within our retail channel, while maintaining catalogues, email campaigns, and web-based advertising programs for our houseware customers. Sales and marketing personnel costs include salaries, payroll taxes, employee benefits and other payroll costs for our sales, operations, customer service, graphics and marketing departments. For the six months ended September 30, 2017, personnel costs for sales and marketing were $977,000, up from $866,000 for the six months ended September 30, 2016, an increase of 12.8%. The increase reflected increased headcount necessary to drive what we anticipate will be increased sales to retailers and through our direct-to-consumer channel beginning in the fall of 2017. Personnel expenses include all related payroll including departmental incentive programs, including salaries, bonuses and employee benefits. Other marketing expenses increased year-over-year because of increases in a variety of spending categories, including additional travel, social media, market research programs, retailer marketing programs, third party sales tax software and new products that were initiated during the current year quarter. General and Administrative General and administrative costs for the six months ended September 30, 2017, totaled $1.3 million, as compared to $1.1 million for the six months ended September 30, 2016, an increase of 21.7%, or $225,000. The increase is attributable to increase in: (i) payroll-related expenses, including departmental incentive programs, salaries, bonuses and employee benefits; (ii) web hosting, electronic data processing, network consulting fees for software troubleshooting; and (iii) estimates for the allowance for bad debt. Operating Loss Our operating loss for the six months ended September 30, 2017, was $858,000, a decrease of $422,000 from the operating loss of $1.3 million for the six months ended September 30, 2016. The decreased operating loss was attributable to increased sales in both the retail distribution and direct-to consumer channels. Net Loss The net loss for the six months ended September 30, 2017 was $811,000, as compared to $2.2 million net loss in the prior–year period as discussed above. Segment Results We report our segment information in the same way that management assesses the business and makes decision regarding the allocations of resources in accordance with the Segment Reporting Topic of the Financial Accounting Standards Board Accounting Standards Codification (ASC). We have two reportable segments. Retail and Direct-to-Consumer. Factors considered in determining our Reportable Segments include the nature of the business activities, the reports provided to the Company's chief operating decision maker (CODM) for operating and administrative activities, available information and information that is presented to our Board of Directors. 26 The Company's CODM has been identified as the Chief Executive Officer because he has final authority over the performance assessment and resource allocation decisions. The CODM regularly receives discrete financial information about each Reportable Segment. The CODM uses all such information for performance assessment and resource allocation decisions. The CODM evaluates the performance of and allocates resources based upon the contribution margins of each segment. As a result, we divide our business into two reportable segments: Direct-to-Consumer and Retail. This division of reportable segments is consistent with how the segments report to and are managed by the chief operating decision maker of the Company. The Company evaluates performance based on the primary financial measure of contribution margin ("segment profit"). Segment profit reflects the income or loss from operations before corporate expenses, non-operating income, net interest expense, and income taxes. | Six Months Ended September 30, 2017 | --------------------------+-------------------------------------+------ (in thousands) | Direct-to-consumer | | | Retail | | | Corporate/Other | | Consolidated | --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+-- Net sales | $ | 2,336 | | | $ | 5,868 | | $ | - | | $ | 8,204 | --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Cost of revenue | | 1,538 | | | | 4,182 | | | - | | | 5,720 | --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Gross profit | | 798 | | | | 1,686 | | | - | | | 2,484 | --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Gross profit percentage | | 34.2 | % | | | 28.7 | % | | - | | | 30.3 | % --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Sales and marketing (1) | | 23 | | | | 430 | | | 158 | | | 611 | --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Segment profit | | 775 | | | | 1,256 | | | (158 | ) | | 1,873 | --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Segment profit percentage | | 33.2 | % | | | 21.4 | % | | - | | | 22.8 | % --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- (1) Sales and marketing includes advertising, trade shows, media production and promotional products and other as discussed in the sales and marketing section. | Six Months Ended September 30, 2016 | --------------------------+-------------------------------------+------ (in thousands) | Direct-to-consumer | | | Retail | | | Corporate/Other | | Consolidated | --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+-- Net sales | $ | 1,967 | | | $ | 2,431 | | $ | - | | $ | 4,398 | --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Cost of revenue | | 1,243 | | | | 1,620 | | | - | | | 2,863 | --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Gross profit | | 724 | | | | 811 | | | - | | | 1,535 | --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Gross profit percentage | | 36.8 | % | | | 33.4 | % | | - | | | 34.9 | % --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Sales and marketing (1) | | 22 | | | | 426 | | | 121 | | | 569 | --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Segment profit | | 702 | | | | 385 | | | (121 | ) | | 966 | --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- Segment profit percentage | | 35.7 | % | | | 15.8 | % | | - | | | 22.0 | % --------------------------+-------------------------------------+-------+---+--------+---+-------+-----------------+---+--------------+---+---+-------+-- (1) Sales and marketing includes advertising, trade shows, media production and promotional products and other as discussed in the sales and marketing section. Liquidity and Capital Resources After adjusting the net loss for non-cash items and changes in operating assets and liabilities, the net cash used by operating activities totaled $7.3 million for the six months ended September 30, 2017, as compared to cash used of $2.7 million in the prior year period. Non-cash items, comprising depreciation, amortization, bad debt (recoveries) allowances, change in fair value of the Scotts Miracle-Gro warrant liability and non-cash compensation expense, totaled to a net gain of $142,000 for the six months ended September 30, 2017, as compared to a net gain of $1.4 million in the prior year period. The decrease principally reflected non-cash charges arising from the change in fair value on the warrant liability in the prior year, depreciation and non-cash compensation expenses. Changes in current assets used net cash of $9.6 million during the six months ended September 30, 2017, principally from increases in inventory and in accounts receivable as timing of load-in orders increased and as we ramp up for our peak sales season, which historically begins in the third fiscal quarter. As of September 30, 2017, the total inventory balance was $8.4 million, representing approximately 171 days of sales activity, and 189 days of sales activity, at the average daily rate of product cost expensed during the twelve months and three months ended September 30, 2017, respectively. The days in inventory calculation based on the three months of sales activity can vary greatly due to the seasonality of our sales, which are at their highest level during our quarter ended December 31. The twelve months' days in inventory calculation is based on the twelve months of sales activity and is less impacted by the seasonality of our sales. 27 Current operating liabilities increased $3.0 million during the six months ended September 30, 2017, principally because of an increase in accounts payable. Accounts payable as of September 30, 2017, totaled $3.0 million, representing approximately 39 days of daily expense activity, and 46 days of daily expense activity, at the average daily rate of expenses incurred during the twelve months and three months ended September 30, 2017, respectively. Net investment activity used $97,000 of cash in the current year period, principally because of the purchases of equipment as we change our supply manufacturers and introduce new products. Net financing activity used net cash of $4,000 during the six months ended September 30, 2017, principally due the payments on the capital lease. Cash As of September 30, 2017, we had a cash balance of $1.4 million, of which $15,000 was restricted as collateral for various corporate obligations. This compares to a cash balance of $8.8 million as of March 31, 2017, of which $15,000 was restricted. The decrease in cash is primarily attributable to the purchase of inventory in the current quarter to meet peak season sales demand, in particular to satisfy the current period load-in sales with new and expanded brick-and-mortar retail customers. Borrowing Agreements As of September 30, 2017 and March 31, 2017, we have no outstanding long-term debt, however, we have entered into a Term Loan Agreement in the principal amount of up to $2.0 million with Scotts Miracle-Gro. Cash Requirements We generally require cash to: · | fund our operations and working capital requirements, --+------------------------------------------------------ · | develop and execute our product development and market introduction plans, --+--------------------------------------------------------------------------- · | execute our sales and marketing plans, --+--------------------------------------- · | fund research and development efforts, and --+------------------------------------------- · | pay debt obligations as they come due. --+--------------------------------------- At this time, we do not expect to enter into additional capital leases to finance major purchases. In addition, we do not currently have any binding commitments with third parties to obtain any material amount of equity or debt financing other than the financing arrangements described in this report. Assessment of Future Liquidity and Results of Operations Liquidity To assess our ability to fund ongoing operating requirements, we developed assumptions regarding operating cash flow. Critical sources of funding, and key assumptions and areas of uncertainty include: · | our cash of $1.4 million ($15,000 of which is restricted as collateral for our various corporate obligations) as of September 30, 2017; --+---------------------------------------------------------------------------------------------------------------------------------------- · | our cash of $2.1 million ($15,000 of which is restricted as collateral for our various corporate obligations) as of November 8, 2017; --+-------------------------------------------------------------------------------------------------------------------------------------- · | continued support of, and extensions of credit by, our suppliers and lenders, including, but not limited to, the Term Loan of up to $2.0 million from Scotts Miracle-Gro, of which we had borrowed zero and $1.0 million in principal amount as of September 30, 2017 and November 6, 2017, respectively; --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- · | our historical pattern of increased sales between September and March, and lower sales volume from April through August; --+------------------------------------------------------------------------------------------------------------------------- · | the level of spending necessary to support our planned initiatives; and --+------------------------------------------------------------------------ · | our sales to consumers, retailers, and international distributors, and the resulting cash flow from operations, which will depend in great measure on the success of our direct-to-consumer sales initiatives, and the acceptance of the product at our various retail distribution customers. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 28 On September 13, 2017, the Company entered into a Term Loan Agreement in the principal amount of up to $2.0 million with Scotts Miracle-Gro. The proceeds will be made available as needed in increments of $500,000 not to exceed $2.0 million with a due date of March 30, 2018. The Term Loan Agreement is secured by a lien on the assets of the Company and interest is charged at the stated rate of 10% per annum to be paid quarterly in arrears in cash, at the end of each September, December and March. The funding will provide general working capital and is being used for the purpose of acquiring inventory to support anticipated growth as the Company expands its retail and its direct-to-consumer sales channels. We have borrowed $1.0 million as of November 6, 2017 and will continue to borrow against the $2.0 million loan in order to purchase inventory during our peak selling season. See Note 3 "Notes Payable, Long Term Debt and Current Portion – Long Term Debt" to our condensed financial statements. Based on these facts and assumptions, we believe our existing cash and cash equivalents, along with the Term Loan Agreement and the cash generated by our anticipated results from operations, will be sufficient to meet our needs for the next twelve months. Results of Operations There are several factors that could affect our future results of operations. These factors include, but are not limited to, the following: · | the effectiveness of our consumer marketing efforts in generating both direct-to-consumer sales, and sales to consumers by our retailer customers, --+--------------------------------------------------------------------------------------------------------------------------------------------------- · | uncertainty regarding the impact of macroeconomic conditions on consumer spending, --+----------------------------------------------------------------------------------- · | uncertainty regarding the capital markets and our access to sufficient capital to support our current and projected scale of operations, --+----------------------------------------------------------------------------------------------------------------------------------------- · | the seasonality of our business, in which we have historically experienced higher sales volume during the fall and winter months (September through March), --+------------------------------------------------------------------------------------------------------------------------------------------------------------ · | a continued, uninterrupted supply of product from our third-party manufacturing suppliers in China, and --+-------------------------------------------------------------------------------------------------------- · | the success of the Scotts Miracle-Gro relationship. --+---------------------------------------------------- Off-Balance Sheet Arrangements Other than our headquarter facility lease commitment incurred in the normal course of business, we do not have any off-balance sheet financing arrangements or liabilities, guarantee contracts, retained or contingent interest in transferred assets, and have not entered into any contracts for financial derivative such as futures, swaps, and options. Item 3. Quantitative and Qualitative Disclosures About Market Risk Interest Rate Risk Our interest income is most sensitive to fluctuations in the general level of U.S. interest rates. As such, changes in U.S. interest rates affect the interest earned on our cash, cash equivalents, and short-term investments, and the value of those investments. Due to the short-term nature of our cash equivalents and investments, we have concluded that a change in interest rates does not pose a material market risk to us with respect to our interest income. Our debt carries fixed interest rates and therefore changes in the general level of market interest rates will not impact our interest expense during the terms of our existing debt arrangements. Foreign Currency Exchange Risk We transact business primarily in U.S. currency. Although we purchase our products in U.S. dollars, the prices charged by our suppliers in Asia are predicated upon their cost for components, labor and overhead. Therefore, changes in the valuation of the U.S. dollar in relation to the Chinese currencies may cause our manufacturers to raise prices of our products which could reduce our profit margins. In future periods, it is possible that we could be exposed to fluctuations in foreign currency exchange rates on accounts receivable from sales and net monetary assets denominated in foreign currencies and liabilities. To date, however, virtually all of our transactions have been denominated in U.S. dollars. 29 Item 4. Controls and Procedures (a) Evaluation of Disclosure Controls and Procedures Disclosure controls and procedures are designed to ensure that information required to be disclosed in the reports filed or submitted by the Company under the Securities Exchange Act of 1934 (the "Exchange Act"), is recorded, processed, summarized, and reported, within the time periods specified in the rules and forms of the SEC. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in the reports filed under the Exchange Act is accumulated and communicated to the Company's management, including its principal executive and financial officer, as appropriate, to allow timely decisions regarding required disclosure. The Company carried out an evaluation, under the supervision and with the participation of its management, including its principal executive officer and principal financial officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures as of the end of the period covered by this report. Based upon and as of the date of that evaluation, the Company's principal executive officer and financial officer concluded that the Company's disclosure controls and procedures are effective to ensure that information required to be disclosed in the reports the Company files and submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. (b) Changes in Internal Controls There were no changes in the Company's internal controls or in other factors that could have significantly affected those controls during the three months ended September 30, 2017. 30 PART II - OTHER INFORMATION Item 1. Legal Proceedings None. Item 1A. Risk Factors Our operations and financial results are subject to various risks and uncertainties that could adversely affect our business, results of operations, financial condition, future results, and the trading price of our common stock. In addition to the other information set forth in this Quarterly Report, you should also carefully consider the factors described in "Part I. Item 1A. Risk Factors" of our Annual Report on Form 10-K for the year ended March 31, 2017, which could materially affect our business, results of operations, financial condition, future results, and the trading price of our common stock. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds None. Item 3. Defaults Upon Senior Securities None. Item 4. Mine Safety Disclosures Not applicable. Item 5. Other Information None. 31 Item 6. Exhibits Exhibit Number | Description -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3.1 | Articles of Incorporation of the Company (incorporated by reference to Exhibit 3.1 of our Current Report on Form 8-K/A-2, filed November 16, 2006) -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3.2 | Certificate of Amendment to Articles of Incorporation, dated June 25, 2002 (incorporated by reference to Exhibit 3.2 of our Current Report on Form 8-K/A-2, filed November 16, 2006) -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3.3 | Certificate of Amendment to Articles of Incorporation, dated November 3, 2002 (incorporated by reference to Exhibit 3.3 of our Current Report on Form 8-K/A-2, filed November 16, 2006) -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3.4 | Certificate of Change to Articles of Incorporation, dated January 31, 2005 (incorporated by reference to Exhibit 3.4 of our Current Report on Form 8-K/A-2, filed November 16, 2006) -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3.5 | Certificate of Amendment to Articles of Incorporation, dated July 27, 2005 (incorporated by reference to Exhibit 3.5 of our Current Report on Form 8-K/A-2, filed November 16, 2006) -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3.6 | Certificate of Amendment to Articles of Incorporation, dated February 24, 2006 (incorporated by reference to Exhibit 3.6 of our Current Report on Form 8-K/A-2, filed November 16, 2006) -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3.7 | Certificate of Amendment to Articles of Incorporation, certified May 3, 2010 (incorporated by reference to Exhibit 3.7 of our Quarterly Report on Form 10-Q, filed August 12, 2010) -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3.8 | Certificate of Amendment to Articles of Incorporation, dated May 1, 2012 (incorporated by reference to Exhibit 3.8 of our Quarterly Report on Form 10-Q, filed August 10, 2012) -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3.9 | Amended and Restated Bylaws of the Registrant (incorporated by reference to Exhibit 3.1 of our Current Report on Form 8-K, filed September 26, 2008) -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3.10 | Amendment to Bylaws (incorporated by reference to Exhibit 3.9 of our Annual Report on Form 10-K for the fiscal year ended March 31, 2009, filed July 6, 2009) -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3.11 | Amendment No. 2 to Bylaws (incorporated by reference to Exhibit 3.1 of our Current Report on Form 8-K, filed April 23, 2013) -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3.12 | Certificate of Designations of Series A Convertible Preferred Stock (incorporated by reference to Exhibit 3.7 of our Annual Report on Form 10-K for the fiscal year ended March 31, 2009, filed July 6, 2009) -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3.13 | Certificate of Amendment to Series A Convertible Preferred Stock Certificate of Designations, certified June 21, 2010 (incorporated by reference to Exhibit 3.11 of our Quarterly Report on Form 10-Q for the quarter year ended June 30, 2010, filed August 12, 2010) -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3.14 | Amendment Number 2 to Series A Convertible Preferred Stock Certificate of Designations, as filed with the Nevada Secretary of State on April 6, 2012 (incorporated by reference to Exhibit 3.12 to our Current Report on Form 8-K, filed April 16, 2012) -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3.15 | Certificates of Designation of Series B Convertible Preferred Stock (incorporated by reference to Exhibit 3.2 of our Current Report on Form 8-K filed April 23, 2013) -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.1 | Form of Certificate of Common Stock of Registrant (incorporated by reference to Exhibit 4.1 of our Current Report on Form 8-K, filed September 5, 2007) -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.2 | Form of Warrant Agreement, dated April 22, 2013 (incorporated by reference to Exhibit 10.2 of our Current Report on Form 8-K filed April 23, 2013) -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.3 | First Amendment to Warrant Agreement (incorporated by reference to Exhibit 10.6 of our Quarterly Report on Form 10-Q filed November 9, 2015) -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.4 | Second Amendment to Warrant Agreement dated July 15, 2016 (incorporated by reference to Exhibit 10.6 of our Current Report on Form 8-K, filed July 21, 2016) -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.5 | Investor Rights Agreement by and between the Company and SMG Growing Media, Inc., dated April 22, 2013 (incorporated by reference to Exhibit 4.1 of our Current Report on Form 8-K filed April 23, 2013) -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.6 | Voting Agreement, dated April 22, 2013 (incorporated by reference to Exhibit 4.2 of our Current Report on Form 8-K filed April 23, 2013) -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 4.7 | Waiver Agreement dated July 15, 2016 (incorporated by reference to Exhibit 10.7 of our Current Report on Form 8-K, filed July 21, 2016) -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.1* | Third Amendment to the Technology License Agreement -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.1* | Certifications of the Chief Executive Officer Under Section 302 of the Sarbanes-Oxley Act. -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.2* | Certifications of the Chief Financial Officer Under Section 302 of the Sarbanes-Oxley Act. -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 32.1* | Certifications of the Chief Executive Officer Under Section 906 of the Sarbanes-Oxley Act. -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 32.2* | Certifications of the Chief Financial Officer Under Section 906 of the Sarbanes-Oxley Act. -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.INS* | XBRL Instance Document -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.SCH* | XBRL Taxonomy Extension Schema Document -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.CAL* | XBRL Taxonomy Extension Calculation Linkbase Document -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.DEF* | XBRL Taxonomy Extension Definition Linkbase Document -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.LAB* | XBRL Taxonomy Extension Label Linkbase Document -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.PRE* | XBRL Taxonomy Extension Presentation Linkbase Document -------------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- * Filed herewith. ------------------ 32 SIGNATURES In accordance with the requirements of the Securities Exchange Act of 1934 the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. | AeroGrow International, Inc. -------------------------+-------------------------------------------------------------------------------------- Date: November 13, 2017 | /s/ J. Michael Wolfe -------------------------+-------------------------------------------------------------------------------------- | By: J. Michael Wolfe -------------------------+-------------------------------------------------------------------------------------- | Its: President and Chief Executive Officer (Principal Executive Officer) and Director -------------------------+-------------------------------------------------------------------------------------- Date: November 13, 2017 | /s/Grey H. Gibbs -------------------------+-------------------------------------------------------------------------------------- | By: Grey H. Gibbs -------------------------+-------------------------------------------------------------------------------------- | Its: Senior Vice President Finance and Accounting (Principal Accounting Officer) -------------------------+-------------------------------------------------------------------------------------- 33

Aerpio Pharmaceuticals, Inc.

1422142

10-Q

0001564590-17-023441

arpo-10q_20170930.htm UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 FORM 10-Q (Mark One) ☒ | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 --+---------------------------------------------------------------------------------------- For the quarterly period ended September 30, 2017 OR ☐ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 --+----------------------------------------------------------------------------------------- For the transition period from ______________ to ______________ Commission File Number: 000-53057 Aerpio Pharmaceuticals, Inc. (Exact Name of Registrant as Specified in its Charter) Delaware | EIN 61-1547850 ---------------------------------------------------------------+------------------------------------ (State or other jurisdiction of incorporation or organization) | (I.R.S. EmployerIdentification No.) ---------------------------------------------------------------+------------------------------------ 9987 Carver Road Cincinnati, OH | 45242 ---------------------------------------------------------------+------------------------------------ (Address of principal executive offices) | (Zip Code) ---------------------------------------------------------------+------------------------------------ Registrant’s telephone number, including area code: (513) 985-1920 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No☐ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No ☐ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large accelerated filer | ☐ | Accelerated filer | ☐ ----------------------------------+------------------------------------------------+-------------------------+-- Non-accelerated filer | ☐ (Do not check if a small reporting company) | Small reporting company | ☒ ----------------------------------+------------------------------------------------+-------------------------+-- Emerging growth ☒ company | ----------------------------------+----------------------------------------------- If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☒ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒ As of November 13, 2017, the registrant had 27,070,038 shares of common stock, $0.0001 par value per share, outstanding. CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS This Quarterly Report on Form 10-Q contains express or implied forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act that are based on our management’s belief and assumptions and on information currently available to our management. Although we believe that the expectations reflected in these forward-looking statements are reasonable, these statements relate to future events or our future operational or financial performance, and involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by these forward-looking statements. Forward-looking statements in this Quarterly Report on Form 10-Q include, but are not limited to, statements about: • | the initiation, timing, progress and results of our research and development programs and future preclinical and clinical studies; --+----------------------------------------------------------------------------------------------------------------------------------- • | our ability to advance any product candidates into, and successfully complete, clinical studies and obtain regulatory approval for them; --+----------------------------------------------------------------------------------------------------------------------------------------- • | the timing or likelihood of regulatory filings and approvals; --+-------------------------------------------------------------- • | the commercialization, marketing and manufacturing of our product candidates, if approved; --+------------------------------------------------------------------------------------------- • | the pricing and reimbursement of our product candidates, if approved; --+---------------------------------------------------------------------- • | the rate and degree of market acceptance and clinical utility of any products for which we receive marketing approval; --+----------------------------------------------------------------------------------------------------------------------- • | the implementation of our strategic plans for our business, product candidates and technology; --+----------------------------------------------------------------------------------------------- • | the scope of protection we are able to establish and maintain for intellectual property rights covering our product candidates and technology; --+----------------------------------------------------------------------------------------------------------------------------------------------- • | our expectations related to the use of proceeds from private placement offering, and estimates of our expenses, future revenues, capital requirements and our needs for additional financing; --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | our ability to maintain and establish collaborations; --+------------------------------------------------------ • | our financial performance; --+--------------------------- • | developments relating to our competitors and our industry, including the impact of government regulation; and --+-------------------------------------------------------------------------------------------------------------- • | other risks and uncertainties, including those listed under the caption “Risk Factors.” --+---------------------------------------------------------------------------------------- In some cases, forward-looking statements can be identified by terminology such as “may,” “should,” “expects,” “intends,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” “continue” or the negative of these terms or other comparable terminology. These statements are only predictions. You should not place undue reliance on forward-looking statements because they involve known and unknown risks, uncertainties and other factors, which are, in some cases, beyond our control and which could materially affect results. Factors that may cause actual results to differ materially from current expectations include, among other things, those listed under the section entitled “Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q. If one or more of these risks or uncertainties occur, or if our underlying assumptions prove to be incorrect, actual events or results may vary significantly from those implied or projected by the forward-looking statements. No forward-looking statement is a guarantee of future performance. You should read this Quarterly Report on Form 10-Q and the documents that we reference in Quarterly Report on Form 10-Q and have filed with the Securities and Exchange Commission as exhibits hereto completely and with the understanding that our actual future results may be materially different from any future results expressed or implied by these forward-looking statements. The forward-looking statements in this Quarterly Report on Form 10-Q represent our views as of the date of this Report. We anticipate that subsequent events and developments will cause our views to change. However, while we may elect to update these forward-looking statements at some point in the future, we have no current intention of doing so except to the extent required by applicable law. You should therefore not rely on these forward-looking statements as representing our views as of any date subsequent to the date of this Report. Table of Contents | | Page -----------+---------------------------------------------------------------------------------------+----- PART I. | FINANCIAL INFORMATION | 2 -----------+---------------------------------------------------------------------------------------+----- Item 1. | Financial Statements (Unaudited) | 2 -----------+---------------------------------------------------------------------------------------+----- | Condensed Consolidated Balance Sheets | 2 -----------+---------------------------------------------------------------------------------------+----- | Condensed Consolidated Statements of Operations and Comprehensive Loss | 3 -----------+---------------------------------------------------------------------------------------+----- | Condensed Consolidated Statements of Stockholders Equity (Deficit) | 4 -----------+---------------------------------------------------------------------------------------+----- | Condensed Consolidated Statements of Cash Flows | 5 -----------+---------------------------------------------------------------------------------------+----- | Notes to Unaudited Condensed Consolidated Financial Statements | 6 -----------+---------------------------------------------------------------------------------------+----- Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations | 20 -----------+---------------------------------------------------------------------------------------+----- Item 3. | Quantitative and Qualitative Disclosures About Market Risk | 30 -----------+---------------------------------------------------------------------------------------+----- Item 4. | Controls and Procedures | 30 -----------+---------------------------------------------------------------------------------------+----- PART II. | OTHER INFORMATION | 31 -----------+---------------------------------------------------------------------------------------+----- Item 1. | Legal Proceedings | 31 -----------+---------------------------------------------------------------------------------------+----- Item 1A. | Risk Factors | 31 -----------+---------------------------------------------------------------------------------------+----- Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | 57 -----------+---------------------------------------------------------------------------------------+----- Item 3. | Defaults Upon Senior Securities | 57 -----------+---------------------------------------------------------------------------------------+----- Item 4. | Mine Safety Disclosures | 57 -----------+---------------------------------------------------------------------------------------+----- Item 5. | Other Information | 57 -----------+---------------------------------------------------------------------------------------+----- Item 6. | Exhibits | 58 -----------+---------------------------------------------------------------------------------------+----- Signatures | 59 -----------+-------------------------------------------------------------------------------------- i PART I—FINANCI AL INFORMATION Item 1. Financial Statements. AERPIO PHARMACEUTICALS, INC. Condensed Consolidated Balance Sheets | September 30, | | | December 31, | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+--------------+---+--------------+---- | 2017 | | | 2016 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+--------------+---+--------------+---- | (unaudited) | | | | | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+--------------+---+--------------+-----+------------ Assets | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+--------------+---+--------------+-----+-------------+-- Current assets: | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+--------------+---+--------------+-----+-------------+-- Cash and cash equivalents | $ | 24,828,910 | | | $ | 1,609,694 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+--------------+---+--------------+-----+-------------+-- Short-term investments | | 50,000 | | | | 50,000 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+--------------+---+--------------+-----+-------------+-- Accounts receivable | | 39,246 | | | | 4,157 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+--------------+---+--------------+-----+-------------+-- Prepaid research and development contracts | | 323,814 | | | | 353,434 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+--------------+---+--------------+-----+-------------+-- Other current assets | | 621,807 | | | | 209,038 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+--------------+---+--------------+-----+-------------+-- Total current assets | | 25,863,777 | | | | 2,226,323 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+--------------+---+--------------+-----+-------------+-- Furniture and equipment, net | | 116,873 | | | | 149,595 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+--------------+---+--------------+-----+-------------+-- Deposits | | 20,960 | | | | 20,960 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+--------------+---+--------------+-----+-------------+-- Total assets | $ | 26,001,610 | | | $ | 2,396,878 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+--------------+---+--------------+-----+-------------+-- Liabilities, redeemable convertible preferred stock, and stockholders´ equity (deficit) | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+--------------+---+--------------+-----+-------------+-- Current liabilities: | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+--------------+---+--------------+-----+-------------+-- Accounts payable and accrued expenses | $ | 2,586,233 | | | $ | 2,470,970 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+--------------+---+--------------+-----+-------------+-- Convertible notes | | — | | | | 12,386,647 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+--------------+---+--------------+-----+-------------+-- Total current liabilities | | 2,586,233 | | | | 14,857,617 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+--------------+---+--------------+-----+-------------+-- Commitments and contingencies (Note 11) | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+--------------+---+--------------+-----+-------------+-- Redeemable convertible preferred stock (all classes) | | — | | | | 73,757,890 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+--------------+---+--------------+-----+-------------+-- Stockholders’ equity (deficit): | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+--------------+---+--------------+-----+-------------+-- Common stock, $0.0001 par value per share; 300,000,000 and 17,440,436 shares authorized and 27,070,038 and 1,240,925 shares issued and outstanding at September 30, 2017 and December 31, 2016, respectively. | | 2,707 | | | 124 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+--------------+---+--------------+-----+------------ Additional paid-in capital | | 125,740,297 | | | | — | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+--------------+---+--------------+-----+-------------+-- Accumulated deficit | | (102,327,627 | ) | | | (86,218,753 | ) --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+--------------+---+--------------+-----+-------------+-- Total stockholders’ equity (deficit) | | 23,415,377 | | | | (86,218,629 | ) --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+--------------+---+--------------+-----+-------------+-- Total liabilities, redeemable convertible preferred stock, and stockholders’ equity (deficit) | $ | 26,001,610 | | | $ | 2,396,878 | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+--------------+---+--------------+-----+-------------+-- The accompanying notes are an integral part of these condensed consolidated financial statements. 2 AERPIO PHARMACEUTICALS, INC. Condensed Consolidated Statements of Operations and Comprehensive Loss | Three months ended September 30, | | | Nine months ended September 30, | -------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+-- | 2017 | | | 2016 | | | 2017 | | 2016 | -------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+-------------+-- Operating expenses: | (unaudited) | | | (unaudited) | -------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+-- Research and development | $ | 2,942,170 | | | $ | 3,481,261 | | $ | 8,366,869 | | $ | 9,374,383 | -------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+-------------+---+---+-------------+-- General and administrative | | 1,814,068 | | | | 1,264,054 | | | 6,732,816 | | | 3,953,808 | -------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+-------------+---+---+-------------+-- Total operating expenses | | 4,756,238 | | | | 4,745,315 | | | 15,099,685 | | | 13,328,191 | -------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+-------------+---+---+-------------+-- Loss from operations | | (4,756,238 | ) | | | (4,745,315 | ) | | (15,099,685 | ) | | (13,328,191 | ) -------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+-------------+---+---+-------------+-- Grant income | | 46,824 | | | | 26,561 | | | 93,720 | | | 116,185 | -------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+-------------+---+---+-------------+-- Interest income (expense), net | | 59,847 | | | | (166,847 | ) | | (159,612 | ) | | (254,552 | ) -------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+-------------+---+---+-------------+-- Other income, net | | — | | | | — | | | — | | | 997 | -------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+-------------+---+---+-------------+-- Total other income (expense) | | 106,671 | | | | (140,286 | ) | | (65,892 | ) | | (137,370 | ) -------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+-------------+---+---+-------------+-- Net and comprehensive loss | $ | (4,649,567 | ) | | $ | (4,885,601 | ) | $ | (15,165,577 | ) | $ | (13,465,561 | ) -------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+-------------+---+---+-------------+-- Reconciliation of net loss attributable to common stockholders: | | | | | | | | | | | | | -------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+-------------+---+---+-------------+-- Net and comprehensive loss | $ | (4,649,567 | ) | | $ | (4,885,601 | ) | $ | (15,165,577 | ) | $ | (13,465,561 | ) -------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+-------------+---+---+-------------+-- Extinguishment of preferred stock | | — | | | | — | | | — | | | 224,224 | -------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+-------------+---+---+-------------+-- Accretion of redeemable convertible preferred stock to redemption value | | — | | | | (1,054,657 | ) | | (943,297 | ) | | (3,098,149 | ) -------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+-------------+---+---+-------------+-- Net loss attributable to common stockholders | $ | (4,649,567 | ) | | $ | (5,940,258 | ) | $ | (16,108,874 | ) | $ | (16,339,486 | ) -------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+-------------+---+---+-------------+-- Net loss per share attributable to common stockholders, basic and diluted | $ | (0.17 | ) | | $ | (6.69 | ) | $ | (0.81 | ) | $ | (20.01 | ) -------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+-------------+---+---+-------------+-- Weighted average number of common shares used in computing net loss per share attributable to common stockholders, basic and diluted | | 26,926,673 | | | | 888,094 | | | 19,889,984 | | | 816,395 | -------------------------------------------------------------------------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+-------------+---+---+-------------+-- The accompanying notes are an integral part of these condensed consolidated financial statements. 3 AERPIO PHARMACEUTICALS, INC. Condensed Consolidated Statements of Stockholders Equity (Deficit) For the Nine Months Ended September 30, 2017 ------------------------------------------------------------------------------ | | | | | | | | | Stockholders’ Equity (Deficit) | -------------------------------------------------------------------------------+------------------------------------------------------+-------------+---+--------------+-------+---+-------------+--------+--------------------------------+----------- | Redeemable Convertible Preferred Stock (all classes) | | | Common Stock | | | | | | | | | | | -------------------------------------------------------------------------------+------------------------------------------------------+-------------+---+--------------+-------+---+-------------+--------+--------------------------------+------------+---+----------------------------+-------+---+-------------------- | Shares | | | | Total | | | Shares | | Par Value | | Additional Paid-In Capital | | | Accumulated Deficit | | | Total -------------------------------------------------------------------------------+------------------------------------------------------+-------------+---+--------------+-------+---+-------------+--------+--------------------------------+------------+---+----------------------------+-------+---+---------------------+---+-------------+------ Balance at December 31, 2016 | | 14,015,016 | | | | $ | 73,757,890 | | | 1,240,925 | | $ | 124 | | | | — | | $ | (86,218,753 | ) | $ | (86,218,629 | ) -------------------------------------------------------------------------------+------------------------------------------------------+-------------+---+--------------+-------+---+-------------+--------+--------------------------------+------------+---+----------------------------+-------+---+---------------------+---+-------------+-------+---+--------------+---+---+-------------+-- Adjustment of redeemable convertible preferred stock to redemption value | | — | | | | | 943,297 | | | — | | | — | | | | — | | | (943,297 | ) | | (943,297 | ) -------------------------------------------------------------------------------+------------------------------------------------------+-------------+---+--------------+-------+---+-------------+--------+--------------------------------+------------+---+----------------------------+-------+---+---------------------+---+-------------+-------+---+--------------+---+---+-------------+-- Conversion of redeemable convertible preferred stock | | (14,015,016 | ) | | | | (74,701,187 | ) | | 14,015,016 | | | 1,402 | | | | 74,699,785 | | | — | | | 74,701,187 | -------------------------------------------------------------------------------+------------------------------------------------------+-------------+---+--------------+-------+---+-------------+--------+--------------------------------+------------+---+----------------------------+-------+---+---------------------+---+-------------+-------+---+--------------+---+---+-------------+-- Conversion of convertible notes and accrued interest | | — | | | | | — | | | 2,744,059 | | | 274 | | | | 13,447,660 | | | — | | | 13,447,934 | -------------------------------------------------------------------------------+------------------------------------------------------+-------------+---+--------------+-------+---+-------------+--------+--------------------------------+------------+---+----------------------------+-------+---+---------------------+---+-------------+-------+---+--------------+---+---+-------------+-- Share exchange in connection with Merger | | — | | | | | — | | | 1,000,000 | | | 100 | | | | (100 | ) | | — | | | — | -------------------------------------------------------------------------------+------------------------------------------------------+-------------+---+--------------+-------+---+-------------+--------+--------------------------------+------------+---+----------------------------+-------+---+---------------------+---+-------------+-------+---+--------------+---+---+-------------+-- Issuance of common stock, net of issuance costs of $3,084,385 | | — | | | | | — | | | 8,049,555 | | | 805 | | | | 37,162,585 | | | — | | | 37,163,390 | -------------------------------------------------------------------------------+------------------------------------------------------+-------------+---+--------------+-------+---+-------------+--------+--------------------------------+------------+---+----------------------------+-------+---+---------------------+---+-------------+-------+---+--------------+---+---+-------------+-- Issuance of common stock upon exercise of stock options | | — | | | | | — | | | 25,729 | | | 3 | | | | 36,098 | | | — | | | 36,101 | -------------------------------------------------------------------------------+------------------------------------------------------+-------------+---+--------------+-------+---+-------------+--------+--------------------------------+------------+---+----------------------------+-------+---+---------------------+---+-------------+-------+---+--------------+---+---+-------------+-- Forfeiture of restricted stock | | — | | | | | — | | | (5,246 | ) | | (1 | ) | | | 1 | | | — | | | — | -------------------------------------------------------------------------------+------------------------------------------------------+-------------+---+--------------+-------+---+-------------+--------+--------------------------------+------------+---+----------------------------+-------+---+---------------------+---+-------------+-------+---+--------------+---+---+-------------+-- Share-based compensation expense | | — | | | | | — | | | — | | | — | | | | 394,268 | | | — | | | 394,268 | -------------------------------------------------------------------------------+------------------------------------------------------+-------------+---+--------------+-------+---+-------------+--------+--------------------------------+------------+---+----------------------------+-------+---+---------------------+---+-------------+-------+---+--------------+---+---+-------------+-- Net and comprehensive loss | | — | | | | | — | | | — | | | — | | | | — | | | (15,165,577 | ) | | (15,165,577 | ) -------------------------------------------------------------------------------+------------------------------------------------------+-------------+---+--------------+-------+---+-------------+--------+--------------------------------+------------+---+----------------------------+-------+---+---------------------+---+-------------+-------+---+--------------+---+---+-------------+-- Balance at September 30, 2017 | | — | | | | | — | | | 27,070,038 | | $ | 2,707 | | | $ | 125,740,297 | | $ | (102,327,627 | ) | $ | 23,415,377 | -------------------------------------------------------------------------------+------------------------------------------------------+-------------+---+--------------+-------+---+-------------+--------+--------------------------------+------------+---+----------------------------+-------+---+---------------------+---+-------------+-------+---+--------------+---+---+-------------+-- The accompanying notes are an integral part of these condensed consolidated financial statements. 4 AERPIO PHARMACEUTICALS, INC. Condensed Consolidated Statements of Cash Flows | Nine months ended September 30, | ----------------------------------------------------------------------------------------------+---------------------------------+------------ | 2017 | | | 2016 | ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+-- Operating activities: | (unaudited) | ----------------------------------------------------------------------------------------------+---------------------------------+------------ Net and comprehensive loss | $ | (15,165,577 | ) | | $ | (13,465,561 | ) ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Adjustments to reconcile net and comprehensive loss to net cash used in operating activities: | | | | | | | ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Depreciation | | 39,269 | | | | 53,244 | ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Stock-based compensation | | 394,268 | | | | 358,263 | ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Amortization of debt issuance costs | | 75,561 | | | | 118,554 | ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Interest expense related to convertible note conversion | | 204,929 | | | | 257,998 | ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Changes in operating assets and liabilities: | | | | | | | ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Accounts receivable | | (35,089 | ) | | | 109,399 | ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Prepaid expenses and current other assets | | (383,149 | ) | | | 59,838 | ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Accounts payable and other current liabilities | | 598,706 | | | | (168,018 | ) ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Net cash used in operating activities | | (14,271,082 | ) | | | (12,676,283 | ) ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Investing activities: | | | | | | | ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Purchase of furniture and equipment | | (6,547 | ) | | | (113,297 | ) ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Net cash used in investing activities | | (6,547 | ) | | | (113,297 | ) ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Financing activities: | | | | | | | ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Proceeds from exercise of stock options | | 36,101 | | | | 18,969 | ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Proceeds from issuances of convertible notes | | 297,354 | | | | 9,073,062 | ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Cash paid for debt issuance costs | | — | | | | (138,312 | ) ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Proceeds from sale of common stock | | 40,247,775 | | | | — | ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Cash paid in connection with the sale of common stock | | (3,084,385 | ) | | | — | ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Net cash provided by financing activities | | 37,496,845 | | | | 8,953,719 | ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Net increase (decrease) in cash and cash equivalents | | 23,219,216 | | | | (3,835,861 | ) ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Cash and cash equivalents at beginning of year | | 1,609,694 | | | | 5,144,211 | ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Cash and cash equivalents, nine months ended | $ | 24,828,910 | | | $ | 1,308,350 | ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Non-cash financing activities | | | | | | | ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Conversion of redeemable convertible preferred stock into common stock | $ | 74,701,187 | | | $ | — | ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Conversion of convertible notes and accrued interest into common stock | | 13,447,934 | | | | — | ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Accretion of redeemable convertible preferred stock to redemption value | | 943,297 | | | | 3,098,149 | ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Extinguishment of redeemable convertible preferred stock | | — | | | | (224,224 | ) ----------------------------------------------------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- The accompanying notes are an integral part of these condensed consolidated financial statements. 5 NOTES TO CONDENSED CONSOLID ATED FINANCIAL STATEMENTS (UNAUDITED) 1. Nature of Organization and Operations Aerpio Pharmaceuticals, Inc. (the “Company”) was incorporated as Zeta Acquisition Corp. II (“Zeta”) in the State of Delaware on November 16, 2007. Prior to the Merger, (as defined below), Zeta was a “shell company” (as defined in Rule 12b-2 of the Securities Exchange Act of 1934, as amended). On March 3, 2017, the Company’s Board of Directors, and on March 10, 2017, the Company’s pre-Merger (as defined below) stockholders, approved an amended and restated certificate of incorporation, which, among other things, increased authorized capital stock from 100,000,000 shares of common stock, par value $0.0001 per share, and 10,000,000 shares of preferred stock, par value $0.0001 per share, to 300,000,000 shares of common stock, par value $0.0001 per share, and 10,000,000 shares of preferred stock, par value $0.0001 per share. On March 15, 2017, Zeta changed its name to Aerpio Pharmaceuticals, Inc. and its wholly-owned subsidiary, Aerpio Acquisition Corp., a corporation formed in the State of Delaware on March 3, 2017, merged with and into Aerpio Therapeutics, Inc., (“Aerpio”), (the “Merger”), a corporation incorporated on November 17, 2011 in the State of Delaware. Pursuant to the Merger, Aerpio remained as the surviving corporation and became the Company’s wholly-owned subsidiary. At the effective time of the Merger, the shares of the Aerpio’s (i) common stock issued and outstanding immediately prior to the closing of the Merger (including restricted common stock, whether vested or unvested, issued under the Aerpio’s 2011 Equity Incentive Plan), and (ii) redeemable convertible preferred stock issued and outstanding immediately prior to the closing of the Merger, were converted into shares of the Company’s common stock. In addition, immediately prior to the Merger, the outstanding amounts under certain senior secured convertible notes issued by Aerpio to its pre-Merger noteholders were converted into shares of Aerpio’s preferred stock, which were then converted to shares of Aerpio’s common stock and subsequently were converted into shares of the Company’s common stock, together with the other shares of the Aerpio’s common stock described above. In addition, pursuant to the Merger Agreement options to purchase shares of the Aerpio’s common stock issued and outstanding immediately prior to the closing of the Merger were assumed and converted into options to purchase shares of the Company’s common stock. All the outstanding capital stock of Aerpio was converted into shares of the Company’s common stock on a 2.3336572:1 basis. As a result of the Merger, the Company acquired the business of Aerpio and will continue the existing business operations of Aerpio as a public reporting company under the name Aerpio Pharmaceuticals, Inc. Immediately after the Merger, on March 15, 2017, Aerpio converted into a Delaware limited liability company (the “Conversion”). Immediately following the Conversion, the pre-Merger stockholders of Zeta surrendered for cancellation 4,000,000 of the 5,000,000 shares of the outstanding common stock of Zeta, (the “Share Cancellation”). Following the Share Cancellation, on March 15, 2017, the Company closed a private placement offering (the “Offering”) of 8,049,555 shares of the Company’s common stock, at a purchase price of $5.00 per share, for net proceeds of $37.2 million and the issuance of warrants with a term of three years, to purchase 317,562 shares of the Company’s common stock at an exercise price of $5.00 per share. The Merger was treated as a recapitalization and reverse acquisition for financial reporting purposes. The Company is the legal acquirer of Aerpio in the transaction. However, Aerpio is considered the acquiring company for accounting purposes since (i) former Aerpio stockholders own in excess of 50% of the combined enterprise on a fully diluted basis immediately following the Merger and Offering, and (ii) all members of the Company’s executive management and Board of Directors are from Aerpio. In accordance with “reverse merger” or “reverse acquisition” accounting treatment, the unaudited condensed consolidated interim financial statements for the period ended September 30, 2017 include the accounts of the Company and its wholly owned subsidiary, Aerpio Therapeutics, LLC. The comparative historical financial statements for periods ended prior to the date of the Merger are the historical financial statements of Aerpio. Consequently, the assets and liabilities and the historical operations that are reflected in these condensed consolidated financial statements of the Company are those of Aerpio, which were recorded at their historical cost basis. Unless otherwise indicated, all share and per share figures reflect the exchange of each 2.3336572 shares of Aerpio capital stock, convertible notes and share based awards, then outstanding, for 1 share of the Company’s common stock at the effective time of the Merger. The Company is a biopharmaceutical company focused on advancing first-in-class treatments for ocular disease. The Company’s lead product candidate, AKB-9778, a small molecule activator of the Tie2 pathway, is being developed for the treatment of diabetic retinopathy (“DR”). Tie2 signaling is essential for regulating blood vessel development and the stability of mature vessels. The Company has completed a Phase 2a clinical trial in diabetic macular edema (“DME”), a swelling of the retina that is a common cause of vision loss in patients with DR and during the second quarter of 2017, initiated a twelve month, double blind Phase 2b clinical trial in patients with DR who have not developed more serious complications such as DME or proliferative diabetic retinopathy. 6 In addition, the Company has two pipeline programs. AKB-4924 is a drug candidate for the treatment of inflammatory bowel disease and ARP-1536, humanized monoclonal antibody is a drug candidate for ocular disease. Humanized antibodi es are antibodies from non-human species whose protein sequences have been modified to increase their similarity to antibodies produced naturally in humans. The Company completed a Phase 1a clinical trial in healthy volunteers for AKB-4924 and APR-1536 is currently in preclinical development. Further development on the pipeline programs is subject to receiving additional funding, which the Company may seek through collaborations with potential strategic and commercial partners. The Company’s operations to date have been limited to organizing and staffing the Company, business planning, raising capital, acquiring and developing its technology, identifying potential product candidates, and undertaking preclinical and clinical studies. The Company has not generated any revenues to date, nor is there any assurance of any future revenues. The Company’s product candidates are subject to long development cycles, and there is no assurance the Company will be able to successfully develop, obtain regulatory approval for, or market its product candidates. The Company is subject to a number of risks similar to other life science companies in the current stage of its life cycle, including, but not limited to, the need to obtain adequate additional funding, possible failure of preclinical testing or clinical trials, the need to obtain marketing approval for its product candidates, competitors developing new technological innovations, the need to successfully commercialize and gain market acceptance of any of the Company’s products that are approved, and protection of proprietary technology. If the Company does not successfully commercialize any of its products or mitigate any of these other risks, it will be unable to generate revenue or achieve profitability. 2. Summary of Significant Accounting Policies Basis of Presentation The unaudited condensed consolidated financial statements have been prepared in accordance with U.S. Securities and Exchange Commission (SEC) regulations and include all of the information and disclosures required by U.S. generally accepted accounting principles ("U.S. GAAP" or "GAAP") for interim financial reporting, and, in the opinion of management include all adjustments necessary for a fair presentation of the results of operations, financial position and cash flows for each period presented. All adjustments are of a normal and recurring nature. These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements of Aerpio Therapeutics Inc. for the year ended December 31, 2016, included in the Company’s Registration Statement on Form S-1 filed with the SEC. The results of operations for the interim periods are not necessarily indicative of results of operations for a full year. The Company’s condensed consolidated financial statements are stated in U.S. Dollars. Segment Information Operating segments are defined as components of an enterprise about which separate discrete information is available for evaluation by the chief operating decision maker, or decision-making group, in deciding how to allocate resources and in assessing performance. The Company views its operations and manages its business in one operating segment, which is the business of developing and commercializing proprietary therapeutics. All the assets and operations of the Company’s sole operating segment are located in the U.S. Use of Estimates The preparation of condensed consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues, if applicable, and expenses during the reporting period. Actual results may differ from those estimates. Management considers many factors in selecting appropriate financial accounting policies and controls and in developing the estimates and assumptions that are used in the preparation of these condensed consolidated financial statements. Management must apply significant judgment in this process. In addition, other factors may affect estimates, including expected business and operational changes, sensitivity and volatility associated with the assumptions used in developing estimates, and whether historical trends are expected to be representative of future trends. The estimation process often may yield a range of potentially reasonable estimates of the ultimate future outcomes, and management must select an amount that falls within that range of reasonable estimates. Estimates are used in the following areas, among others: fair value of the Company’s common stock and other equity instruments, accrued expenses, and income taxes. 7 Historically, the Company utilized various valuation methodologies in accorda nce with the framework of the American Institute of Certified Public Accountants Technical Practice Aid, Valuation of Privately-Held Company Equity Securities Issued as Compensation , to estimate the fair value of its common stock. Each valuation methodolog y includes estimates and assumptions that require the Company’s judgment. These estimates and assumptions include a number of objective and subjective factors, including external market conditions, the prices at which the Company sold shares of redeemable convertible preferred stock, the superior rights and preferences of securities senior to the Company’s common stock at the time, and, at December 31, 2016, a probability analysis of various liquidity events under differing scenarios, including both a poten tial public trading scenario and potential sale scenario. Significant changes to the key assumptions used in the valuations could result in different fair values of common stock and other equity instruments at each valuation date. The Company utilizes significant estimates and assumptions in determining the fair value of its common stock and other equity instruments. The Company granted stock options at exercise prices not less than the fair value of its common stock, as determined by the Board of Directors contemporaneously at the date such grants were made. The Board of Directors has historically determined the estimated fair value of the Company’s common stock based on a number of objective and subjective factors, including external market conditions affecting the biotechnology industry sector and the prices at which the Company sold shares of common and preferred stock, the superior rights and preferences of securities senior to the Company’s common stock at the time, and, for periods prior to the Offering, the likelihood of achieving a liquidity event, such as a public offering or sale of the Company. The Company’s results can also be affected by economic, political, legislative, regulatory, and legal actions. Economic conditions, such as recessionary trends, inflation, interest and monetary exchange rates, government fiscal policies, and changes in the prices of research studies, can have a significant effect on operations. While the Company maintains reserves for anticipated liabilities and carries various levels of insurance, the Company could be affected by civil, criminal, regulatory or administrative actions, claims, or proceedings. Cash and Cash Equivalents Cash and cash equivalents consist of all cash on hand, deposits, and funds invested in short-term investments with remaining maturities of three months or less at the time of purchase. The Company may maintain balances with its banks in excess of federally insured limits. Short-Term Investments Time deposits with remaining maturities of greater than three months but less than one year at the time of purchase are classified as short-term investments in the accompanying condensed consolidated balance sheets. Grant Income Grant income is recognized as earned based on contract work performed. Research and Development Costs incurred in connection with research and development activities are expensed as incurred. Research and development expense consists of (i) employee-related expenses, including salaries, benefits, travel, and stock-based compensation expense; (ii) external research and development expenses incurred under arrangements with third parties, such as contract research organizations and consultants; (iii) the cost of acquiring, developing, and manufacturing clinical study materials; (iv) facilities and other expenses, which include direct and allocated expenses for rent and maintenance of facilities and laboratory and other supplies; and (v) costs associated with preclinical activities and regulatory operations. The Company enters into consulting, research, and other agreements with commercial firms, researchers, universities, and others for the provision of goods and services. Under such agreements, the Company may pay for services on a monthly, quarterly, project, or other basis. Such arrangements are generally cancellable upon reasonable notice and payment of costs incurred. Costs are considered incurred based on an evaluation of the progress to completion of specific tasks under each contract using information and data provided to the Company by its clinical sites and vendors. These costs consist of direct and indirect costs associated with specific projects, as well as fees paid to various entities that perform certain research on behalf of the Company. Patents Costs incurred in connection with the application for and issuances of patents are expensed as incurred. 8 Income Taxes Income taxes are recorded in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (ASC) Topic 740, Income Taxes , which provides for deferred taxes using an asset and liability approach. The Company recognizes deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the condensed consolidated financial statements or tax returns. Deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities and for loss and credit carryforwards using enacted tax rates anticipated to be in effect for the year in which the differences are expected to reverse. Valuation allowances are provided, if, based upon the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. The Company accounts for uncertain tax positions in accordance with the provisions of ASC 740. When uncertain tax positions exist, the Company recognizes the tax benefit of tax positions to the extent that some or all of the benefit will more likely than not be realized. The determination as to whether the tax benefit will more likely than not be realized is based upon the technical merits of the tax position, as well as consideration of the available facts and circumstances. As of September 30, 2017, and December 31, 2016, the Company does not have any significant uncertain tax positions. If incurred, the Company would classify interest and penalties on uncertain tax positions as income tax expense. Net Loss per Share Attributable to Common Stockholders The Company’s basic net loss per share attributable to common stockholders is calculated by dividing the net loss attributable to common stockholders by the weighted average number of shares of common stock outstanding for the period. The diluted net loss per share attributable to common stockholders is computed by adjusting the weighted average shares outstanding for the dilutive effect of common stock equivalents outstanding for the period, determined using the treasury stock method. For purposes of this calculation, redeemable convertible preferred stock, convertible notes payable, stock options to purchase common stock, warrants, and unvested restricted stock awards are considered to be common stock equivalents but have been excluded from the calculation of diluted net loss per share attributable to common stockholders as their effect is anti-dilutive for all periods presented. Therefore, basic and diluted net loss per share attributable to common stockholders were the same for all periods presented. For all periods presented, all share and per share amounts have been retrospectively adjusted to reflect the exchange of each 2.3336572 shares of Aerpio capital stock and share based awards then outstanding, for 1 share of the Company’s common stock at the effective time of the Merger. Stock-Based Compensation The Company accounts for its stock-based compensation awards in accordance with FASB ASC Topic 718, Compensation – Stock Compensation . ASC 718 requires all stock-based payments to employees, including grants of employee stock options and restricted stock, to be recognized in the condensed consolidated statements of operations and comprehensive loss based on their fair values. All the Company’s stock-based awards are subject only to service-based vesting conditions. The Company estimates the fair value of its stock-based awards using the Black-Scholes option pricing model, which requires the input of subjective assumptions, including (a) the expected stock price volatility, (b) the calculation of expected term of the award, (c) the risk-free interest rate, and (d) expected dividends. The fair value of restricted stock awards is determined based on the Company’s estimated common stock value. Due to the lack of a public market for the trading of the Company’s common stock and a lack of company-specific historical and implied volatility data, the Company has based its estimate of expected volatility on the historical volatility of a group of similar companies that are publicly traded. The computation of expected volatility is based on the historical volatility of a representative group of companies with similar characteristics to the Company, including stage of product development and life science industry focus. The Company believes the group selected has sufficient similar economic and industry characteristics and includes companies that are most representative of the Company. The Company uses the simplified method as prescribed by the SEC Staff Accounting Bulletin No. 107, Share-Based Payment , to calculate the expected term, as it does not have sufficient historical exercise data to provide a reasonable basis upon which to estimate the expected term for options granted to employees, and utilizes the contractual term for options granted to non-employees. The expected term is applied to the stock option grant group as a whole, as the Company does not expect substantially different exercise or post-vesting termination behavior among its employee population. The risk-free interest rate is based on a treasury instrument whose term is consistent with the expected life of the stock options. 9 Compensation expense related to awards to employees is calculated on a straight-line basis by recognizing the grant date fair value over the associated service period of the award, which is generally the vesting term. Awards to non-em ployees are adjusted through share-based compensation expense as the award vests to reflect the current fair value of such awards and are expensed using an accelerated attribution model . Fair Value of Financial Instruments The Company’s financial instruments consist of cash equivalents, short-term investments, accounts receivable, and accounts payable. The Company values cash equivalents using quoted market prices. The valuation technique used to measure the fair value of short-term investments was based on observable market data. The fair value of accounts receivable and accounts payable approximate the carrying value because of their short-term nature. The Company is required to disclose information on all assets and liabilities reported at fair value that enables an assessment of the inputs used in determining the reported fair values. FASB ASC Topic 820, Fair Value Measurements and Disclosures , establishes a hierarchy of inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the asset or liability based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the Company’s assumptions about the inputs that market participants would use in pricing the asset or liability and are developed based on the best information available in the circumstances. The fair value hierarchy applies only to the valuation inputs used in determining the reported fair value of the investments and is not a measure of the investment credit quality. The three levels of the fair value hierarchy are described below: • | Level 1 – Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access at the measurement date --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Level 2 – Valuations based on quoted prices for similar assets or liabilities in markets that are not active or for which all significant inputs are observable, either directly or indirectly --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Level 3 – Valuations that require inputs that reflect the Company’s own assumptions that are both significant to the fair value measurement and unobservable --+------------------------------------------------------------------------------------------------------------------------------------------------------------- To the extent that a valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. Accordingly, the degree of judgment exercised by the Company in determining fair value is greatest for instruments categorized in Level 3. A financial instrument’s level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement. There were no transfers within the fair value hierarchy in the nine months ended September 30, 2017 or September 30, 2016. The assets of the Company measured at fair value on a recurring basis as of September 30, 2017 and December 31, 2016 are summarized below: | Fair Value Measurements Using | --------------------------+-------------------------------+----------- | Level 1 | | Level 2 | | | Level 3 | | Total --------------------------+-------------------------------+------------+---------+---+--------+---------+---+------ September 30, 2017 | | | | | | | | | | --------------------------+-------------------------------+------------+---------+---+--------+---------+---+-------+---+----------- Assets: | | | | | | | | | | --------------------------+-------------------------------+------------+---------+---+--------+---------+---+-------+---+----------- Cash and cash equivalents | $ | 24,828,910 | | $ | — | | $ | — | $ | 24,828,910 --------------------------+-------------------------------+------------+---------+---+--------+---------+---+-------+---+----------- Short-term investments | | — | | | 50,000 | | | — | | 50,000 --------------------------+-------------------------------+------------+---------+---+--------+---------+---+-------+---+----------- Total assets | $ | 24,828,910 | | $ | 50,000 | | $ | — | $ | 24,878,910 --------------------------+-------------------------------+------------+---------+---+--------+---------+---+-------+---+----------- December 31, 2016 | | | | | | | | | | --------------------------+-------------------------------+------------+---------+---+--------+---------+---+-------+---+----------- Assets: | | | | | | | | | | --------------------------+-------------------------------+------------+---------+---+--------+---------+---+-------+---+----------- Cash and cash equivalents | $ | 1,609,694 | | $ | — | | $ | — | $ | 1,609,694 --------------------------+-------------------------------+------------+---------+---+--------+---------+---+-------+---+----------- Short-term investments | | — | | | 50,000 | | | — | | 50,000 --------------------------+-------------------------------+------------+---------+---+--------+---------+---+-------+---+----------- Total assets | $ | 1,609,694 | | $ | 50,000 | | $ | — | $ | 1,659,694 --------------------------+-------------------------------+------------+---------+---+--------+---------+---+-------+---+----------- 10 Concentrations of Credit Risk and Off-Balance Sheet Risk Cash and cash equivalents and short-term investments are the only financial instruments that potentially subject the Company to concentrations of credit risk. At September 30, 2017 and December 31, 2016, all the Company’s cash was deposited in accounts at two principal financial institutions. The Company maintains its cash and cash equivalents and short-term investments with a high-quality, accredited financial institution and, accordingly, such funds are subject to minimal credit risk. The Company has no significant off-balance sheet concentrations of credit risk, such as foreign currency exchange contracts, option contracts, or other hedging arrangements. Comprehensive Loss Comprehensive loss is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources, if any. Comprehensive loss equaled net loss for all periods presented. Furniture and Equipment Furniture and equipment is stated at cost, less accumulated depreciation. Furniture and equipment is depreciated using the straight-line method over the estimated useful lives of the assets, generally three to seven years. Such costs are periodically reviewed for recoverability when impairment indicators are present. Such indicators include, among other factors, operating losses, unused capacity, market value declines, and technological obsolescence. Recorded values of asset groups of furniture and equipment that are not expected to be recovered through undiscounted future net cash flows are written down to current fair value, which generally is determined from estimated discounted future net cash flows (assets held for use) or net realizable value (assets held for sale). Research and Development Costs Research and development costs are expensed as incurred. Recent Accounting Pronouncements From time to time, new accounting pronouncements are issued by the FASB or other standard setting bodies and adopted by the Company as of the specified effective date. Unless otherwise discussed, the Company believes the impact of recently issued standards that are not yet effective will not have a material impact on its consolidated financial position or results of operations upon adoption. In March 2016, the FASB issued ASU 2016-09, “Improvements to Employee Share-Based Payment Accounting.” This ASU is intended to simplify accounting for share-based payments and requires that excess tax benefits for share-based payments be recorded as a reduction of income tax expense and reflected within operating cash flows rather than being recorded within equity and reflected within financing cash flows. The ASU also provides an option for companies to recognize forfeitures as they occur rather than estimating the number of awards expected to be forfeited. The Company adopted this ASU on January 1, 2017 and has applied the new guidance related to excess tax benefits on a prospective basis. The Company also elected to account for forfeitures of share-based payments as they occur. The effect of adoption was not material to the condensed consolidated financial statements. In February 2016, the FASB issued ASU 2016-02, Leases . This ASU will require lessees to recognize almost all leases on the balance sheet as a right-of-use asset and a lease liability. For statement of operations purposes, the FASB retained a dual model, requiring leases to be classified as finance leases or operating leases. This update is effective for interim and annual periods beginning after December 15, 2018, with early adoption permitted. The Company is currently assessing the effect that adoption of the new standard will have on its condensed consolidated financial statements. In August 2016, the FASB issued ASU No. 2016-15, Classification of Certain Cash Receipts and Cash Payments (a consensus of the Emerging Issues Task Force). The amendments in ASU 2016-15 address eight specific cash flow issues and apply to all entities that are required to present a statement of cash flows under FASB Accounting Standards Codification (FASB ASC) 230, Statement of Cash Flows. The amendments in ASU 2016-15 are effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted, including adoption during an interim period. The Company has not yet adopted this ASU and is currently evaluating the effect that adoption of this new standard will have on its condensed consolidated financial statements. 11 3. Related-Party Arrangements Aerpio was initially capitalized in December 2011 in a spinout transaction from Akebia Therapeutics, Inc. (Akebia) to enable more rapid development of its compounds. In connection with the spinout of Aerpio from Akebia, the companies entered into shared services agreements. Under the terms of the shared services agreements, Akebia and Aerpio obtained from and provided to each other certain services, as outlined below. These agreements expired on December 31, 2016. Below is a summary of the activities included in the statements of operations and comprehensive loss: | | Three Months Ended September 30, | | Nine Months Ended September 30, | -------------------------------+----------------------------------------------------+----------------------------------+---+---------------------------------+-- Activity | Condensed Consolidated Financial Statement Caption | 2017 | | 2016 | | | 2017 | | 2016 -------------------------------+----------------------------------------------------+----------------------------------+---+---------------------------------+---+---+------+---+----- Akebia related employee costs | Research and development operating expenses | $ | — | | $ | — | | $ | — | $ | 12,923 -------------------------------+----------------------------------------------------+----------------------------------+---+---------------------------------+---+---+------+---+------+---+------- Facility-related reimbursement | Other income (expense), net | | — | | | — | | | — | | 997 -------------------------------+----------------------------------------------------+----------------------------------+---+---------------------------------+---+---+------+---+------+---+------- 4. Accounts Payable and Accrued Expenses Accounts payable and accrued expenses are as follows: | September 30, | | December 31, | --------------------------------------------+---------------+-----------+--------------+-- | 2017 | | 2016 | --------------------------------------------+---------------+-----------+--------------+-- Accounts payable | $ | 855,423 | | $ | 1,135,608 --------------------------------------------+---------------+-----------+--------------+---+---------- Professional fees | | 355,099 | | | 200,468 --------------------------------------------+---------------+-----------+--------------+---+---------- Accrued bonus | | 470,362 | | | — --------------------------------------------+---------------+-----------+--------------+---+---------- Accrued interest | | — | | | 483,442 --------------------------------------------+---------------+-----------+--------------+---+---------- Accrued vacation | | 103,300 | | | 52,835 --------------------------------------------+---------------+-----------+--------------+---+---------- Accrued project costs | | 749,183 | | | 541,158 --------------------------------------------+---------------+-----------+--------------+---+---------- Other | | 52,866 | | | 57,459 --------------------------------------------+---------------+-----------+--------------+---+---------- Total accounts payable and accrued expenses | $ | 2,586,233 | | $ | 2,470,970 --------------------------------------------+---------------+-----------+--------------+---+---------- 5. Notes Payable to Investors In March 2016, Aerpio entered into a senior secured convertible note financing (the “Convertible Notes” or the “Convertible Note Financing”) totaling approximately $9,000,000, with certain preferred investors of Aerpio. All preferred investors were invited to participate in the Convertible Notes Financing. At September 30, 2017 and December 31, 2016, the unamortized debt issuance costs related to Convertible Note financings was $0 and $75,561, respectively. In connection with the Convertible Note Financing, Aerpio’s Articles of Incorporation were amended such that any Aerpio preferred stockholder that did not participate in the Convertible Note Financing would have their respective shares of Aerpio preferred stock automatically converted into Aerpio common stock using a 3-to-1 conversion ratio and such preferred stockholders would lose the right to representation on the Aerpio Board of Directors and other preferred rights. The Convertible Note Financing had two separate closings of approximately $4,500,000 each on April 14, 2016 and July 15, 2016. Certain Aerpio preferred stockholders chose not to participate in the Convertible Note Financing and their respective Aerpio preferred stock was converted into shares of Aerpio common stock in April 2016 in accordance with the terms of the Articles of Incorporation. Aerpio treated this as an extinguishment of its preferred stock. The Convertible Notes accrued interest at 8% per annum, compounded annually. The Company incurred $138,312 of costs in association with the issuance of the Convertible Notes that were amortized over the expected life of the Convertible Notes, from the date of execution through October 31, 2016. The Convertible Notes were also subject to mandatory prepayment upon the occurrence of certain events, such as a liquidation, dissolution, or the sale of Aerpio. In addition, and prior to maturity, the Convertible Notes were automatically convertible into shares of Aerpio capital stock upon the occurrence of a sale of Aerpio’s capital stock in a single transaction resulting in gross proceeds to Aerpio of $30,000,000 (hereinafter referred to as an “Investor Sale”). The type and class of Aerpio capital stock of to be issued to the holder of each Convertible Note upon conversion would have been identical to the type and class of Aerpio capital stock issued in the Investor Sale. The holder of each Convertible Note was entitled to a number of shares of Aerpio capital determined by dividing (i) the outstanding principal amount of the Convertible Note plus any unpaid accrued interest by (ii) an amount equal to the price per share of Aerpio capital stock paid by the purchasers of such shares in connection with the Investor Sale. The Convertible Notes were secured by a first priority perfected security interest in all of the Aerpio’s assets. 12 In October 2016 and February 2017, Aerpio executed an additional senior secured Convertible Note financings (the “Additional Convertible Notes” or the “Additional Convertible Note Financings”) totaling approximately $3,500,000 and $300,000 respectively, with certain preferred investors of Aerpio. The terms of the Additional Convertible Notes are identical to the Con vertible Notes and are treated as extensions of the original Convertible Note Financing. The Company incurred $125,935 of costs associated with these transactions, which were amortized to the maturity date of March 31, 2017. In connection with the Additio nal Convertible Note Financings, the Convertible Notes were amended and their respective maturity dates were extended from October 31, 2016 to March 31, 2017. The amendments are accounted for as a modification for accounting purposes. In connection with the Merger (Note 1) the Convertible Notes and accrued interest were converted into the Company’s common stock. 6. Common Stock As of September 30, 2017 and December 31, 2016, the Company had 300,000,000 and 17,440,436 shares, respectively, of authorized common stock with par value of $0.0001 per share. On March 15, 2017, in connection with the Merger, (Note 1) all the outstanding redeemable convertible preferred stock, was converted into 14,015,016 shares of the Company’s common stock and the Convertible Notes, both principal and accrued interest, were converted into 2,744,059 shares of the Company’s common stock. The common stock has the following characteristics. Voting The holders of common stock are entitled to one vote for each share of common stock held at all meetings of stockholders and written actions in lieu of meetings. Dividends The holders of common stock are entitled to receive dividends, if and when declared by the Board of Directors. Since the Company’s inception, no dividends have been declared or paid to the holders of common stock. Liquidation In the event of any voluntary or involuntary liquidation, dissolution, or winding-up of the Company, the holders of common stock are entitled to share ratably in the Company’s assets. Lock-up Agreements and Other Restrictions In connection with the Merger, each of the Company’s executive officers, directors, stockholders holding substantially all of the shares of common stock issued in exchange for shares held in Aerpio immediately prior to the Merger, certain other stockholders, and certain key employees, (the “Restricted Holders”), holding at the closing date of the Merger (the “Closing Date”) an aggregate of approximately 18.9 million shares of common stock, entered into lock-up agreements,(the “Lock-Up Agreements”), whereby they are restricted for a period of nine months after the Merger, or the Restricted Period, from certain sales or dispositions (including pledge) of all (or 80% in the case of the holders of 915,000 shares) of the Company’s common stock held by (or issuable to) them, (such restrictions together referred to as the “Lock-Up”). The foregoing restrictions will not apply to the resale of shares of common stock by any Restricted Holder in any registered secondary offering of equity securities by the Company (and, if such offering is underwritten, with the written consent of the lead or managing underwriter), or to certain other transfers customarily excepted. In addition, each Restricted Holder and any stockholders holding or beneficially owning 1% or more of our common stock after giving effect to the Merger, agreed, for a period of 12 months following the Closing Date, that it will not, directly or indirectly, effect or agree to effect any short sale (as defined in Rule 200 under Regulation SHO of the Securities Exchange Act of 1934 (“the Exchange Act”), whether or not against the box, establish any “put equivalent position” (as defined in Rule 16a-1(h) under the Exchange Act) with respect to the common stock, borrow or pre-borrow any shares of common stock, or grant any other right (including, without limitation, any put or call option) with respect to the common stock or with respect to any security that includes, relates to or derives any significant part of its value from the common stock or otherwise seek to hedge its position in the common stock. 13 Anti-dilution protection Investors in the Offering have anti-dilution protection with respect to the shares of the Company’s common stock sold in the Offering such that if within six (6) months after the initial closing of the Offering the Company issues additional shares of common stock or common stock equivalents (subject to certain exceptions), for consideration per share less than the Offering Price, or the Lower Price, each such investor will be entitled to receive from the Company additional shares of common stock in an amount such that, when added to the number of shares of common stock initially purchased by such investor and still held of record and beneficially owned by such investor at the time of the dilutive issuance, or the Held Shares, will equal the number of shares of common stock that such investor’s Offering subscription amount for the Held Shares would have purchased at the Lower Price. Either (i) holders of a majority of the then-held Held Shares or (ii) a representative of the holders of the then-held Held Shares, which representative shall be appointed by three (3) investors who then hold the largest number of Held Shares, may waive the anti-dilution rights of all Offering investors with respect to a particular issuance by the Company. These anti-dilution rights were determined not to be a freestanding financial instrument and did not meet the definition of a derivative. At September 30, 2017, the anti-dilution rights were expired and the Company did not issue any additional shares of common stock or common stock equivalents during the nine-month period ended September 30, 2017. Warrants to Purchase Common Stock At September 30, 2017, the Company had warrants outstanding for the purchase of 317,562 shares of the Company’s common stock at an exercise price of $5.00 per share. The warrants have a three-year term and expire on March 15, 2020. The Warrants were issued in connection with the Offering. At the expiration date of the warrant, if the fair value of the Company’s common stock exceeds the exercise price, the warrant will be automatically exercised and the exercise price will be fulfilled through the net share settlement provisions. The number of shares and the exercise price shall be adjusted for standard ant-dilution events such as stock splits, combinations, reorganizations, or issue shares as part of a stock dividend. Upon a change of control, the warrant holder will have the right to receive securities, cash or other properties it would have been entitled to receive had the warrant been exercised. The Warrants are equity classified instruments and do not contain contingent exercise provisions, or other features, that would preclude the Company from concluding that the Warrants are indexed solely to the Company’s stock. 7. Preferred Stock At September 30, 2017, the Company had 10,000,000 shares of preferred stock, par value $0.0001 per share, in authorized capital. No preferred stock was issued and outstanding at September 30, 2017. In connection with the Merger (Note 1), all the Aerpio redeemable convertible preferred stock issued and outstanding prior to the Merger was converted into shares of the Company’s common stock. At December 31, 2016, Aerpio’s redeemable convertible preferred stock consisted of the following: • | Series A redeemable convertible preferred stock: 1,326,147 shares authorized and 1,239,338 shares issued and outstanding; --+-------------------------------------------------------------------------------------------------------------------------- • | Series A1 redeemable convertible preferred stock: 8,368,247 shares authorized and 8,289,663 shares issued and outstanding; and --+------------------------------------------------------------------------------------------------------------------------------- • | Series A2 redeemable convertible preferred stock: 4,660,573 shares authorized and 4,486,015 shares issued and outstanding. --+--------------------------------------------------------------------------------------------------------------------------- All share and per share amounts are on an as converted basis to reflect the effect of the Merger. The rights, preferences, and privileges of the redeemable convertible preferred stock issued and outstanding prior to the Merger were as follows: Voting The holders of redeemable convertible preferred stock were entitled to the number of votes equal to the number of whole shares of Aerpio common stock into which the shares of redeemable convertible preferred stock were convertible. Except as provided by law or otherwise, the holders of redeemable convertible preferred stock voted together with the holders of Aerpio common stock as a single class. Certain significant actions required approval by at least 50% of the holders of redeemable convertible preferred stock voting as a single class on an as converted basis. Such significant actions include significant asset transfers, acquisitions, liquidation, amendments to the certificate of incorporation, new indebtedness, repurchase of common stock, changes in the authorized numbers of directors constituting the Board of Directors, and the declaration of dividends. 14 The holders of shares of redeemable convertible preferred stock were entitled to elect six members of Aerpio’s Board of Directors, which was subject to reductio n to not less than four directors under certain circumstances. The holders of Aerpio common stock (including any holders of all shares of redeemable convertible preferred stock on an as converted basis) were entitled to elect two members of Aerpio’s Board of Directors, which was subject to reduction to one director under certain circumstances. Dividends Dividends were payable, if permitted by law, in accordance with redeemable convertible preferred stock terms or when and if declared by Aerpio Board of Directors. Prior to the issuance of Series A2 Preferred Stock, dividends on Series A Preferred Stock and Series A1 Preferred Stock were cumulative and accrued daily at a rate of 6% per annum whether or not declared. As part of the Series A2 Preferred Stock issuance, the dividend provisions for Series A Preferred Stock and Series A1 Preferred Stock were retrospectively amended to be noncumulative with the cumulative provision to begin after the Series A2 Preferred Stock issuance date at a rate of 6% per annum. This amendment did not significantly affect the nature of the Series A Preferred Stock and Series A1 Preferred Stock or their fair value. Accordingly, the amendment was treated as a modification for accounting purposes. Liquidation In the event of any voluntary or involuntary liquidation, dissolution, or winding-up of Aerpio, or upon the occurrence of a Deemed Liquidation Event, as defined, at the election of more than 50% of the holders of Series A2 Preferred Stock and Series A1 Preferred Stock, those holders were entitled to be paid, in preference to the holders of Series A Preferred Stock and Aerpio common stock, out of the assets of Aerpio available for distribution at $4.90 per share for Series A2 Preferred Stock and $3.97 per share for Series A1 Preferred Stock, plus any accrued but unpaid dividends. After the holders of Series A1 Preferred Stock and Series A2 Preferred Stock are satisfied, the holders of Series A Preferred Stock were paid at $4.27 per share, plus any accrued but unpaid dividends before any payment was made to the holders of Aerpio’s common stock. In the event the assets of Aerpio available for distribution to stockholders were insufficient to pay the full amount to which the holder was entitled, the holders of Series A2 Preferred Stock and Series A1 Preferred Stock would share ratably any assets available for distribution in proportion to their relative original investment amounts. Any remaining assets of Aerpio would be distributed ratably among the holders of Series A Preferred Stock based upon aggregate applicable dividends accrued on Series A Preferred Stock not previously paid. After the payment of all preferential amounts required to be paid to the holders of redeemable convertible preferred stock, the remaining assets available for distribution would be distributed among the holders of redeemable convertible preferred stock and Aerpio common stock based on the pro rata number of shares held by each holder, treating such securities as if they had been converted to Aerpio common stock immediately prior to such dissolution, liquidation, or winding-up of Aerpio. Conversion Each share of redeemable convertible preferred stock was convertible at the option of the holder, at any time and from time to time, into fully paid and non-assessable shares of Aerpio common stock. The initial conversion ratio was one share of redeemable convertible preferred stock for one share of Aerpio’s common stock. The applicable conversion rate was subject to adjustments upon the occurrence of certain events. Each share of redeemable convertible preferred stock was automatically convertible into fully paid and non-assessable shares of Aerpio common stock at the then-applicable conversion ratio, as defined, upon either: (i) the closing of the sale of shares of Aerpio’s common stock to the public in an underwritten public offering at a price of $14.70 resulting in at least $40,000,000 of gross proceeds, or (ii) the date and time, or the occurrence of an event, specified by vote or written consent of the holders of more than 50% of the then outstanding shares of redeemable convertible preferred stock on an as-converted basis. 15 Aerpio evaluated each series of its redeemable convertible preferred stock and determined that each individual series is considered an equity host under ASC Topic 815, Derivatives and Hedging. In making this determination, Aerpio’s analysis followed the whole instrument approach, which compares an individual feature against the entire redeemable convertible preferred stock instrument that includes that feature. Aerpio’s analysis was based on a consideration of the economic characteristics and risks of each series of redeemable convertible preferred stock. More specifically, Aerpio evaluated all the stated and implied substantive terms and features, including: (i) whether the redeemable convertible preferred stock included redemption features, (ii) how and when any redemption features could be exercised, (iii) whether the holders of redeemable convertible preferred stock were entitled to div idends, (iv) the voting rights of the redeemable convertible preferred stock, and (v) the existence and nature of any conversion rights. Aerpio concluded that as the redeemable convertible preferred stock represents an equity host, the conversion feature i ncluded in all series of redeemable convertible preferred stock is clearly and closely related to the associated host instrument. Accordingly, the conversion feature of all series of redeemable convertible preferred stock was not considered an embedded der ivative that required bifurcation. Aerpio accounted for potentially beneficial conversion features under ASC Topic 470-20, Debt with Conversion and Other Options. At the time of each of the issuances of redeemable convertible preferred stock, Aerpio’s common stock into which each series of the redeemable convertible preferred stock was convertible had an estimated fair value less than the effective conversion prices of the redeemable convertible preferred stock. Therefore, there was no beneficial conversion element on the respective commitment dates. In March 2016, in connection with the Convertible Note Financing described more fully in Note 5, Aerpio’s Articles of Incorporation were amended such that any preferred stockholder that did not participate in the Convertible Note Financing would have their respective shares of redeemable convertible preferred stock automatically converted into Aerpio common stock using a 3-to-1 conversion ratio and such preferred stockholders would lose the right to representation on Aerpio’s Board of Directors and other preferred rights. The amendment did not represent an increase in value to the preferred stockholders and was treated as a modification to the redeemable convertible preferred stock for accounting purposes. Certain shares of redeemable convertible preferred stock held by preferred stockholders that elected to not participate in the Convertible Note Financing were converted to shares in Aerpio’s common stock. Redemption The redeemable convertible preferred stock was redeemable on or after July 31, 2017, upon a request by more than 50% of the holders of redeemable convertible preferred stock then outstanding, payable in three annual installments commencing not more than 60 days following receipt by notice at a price equal to the greater of (i) the applicable original purchase price and dividends accrued but unpaid (Applicable Accrued Value), which is equal to its liquidation preference, or (ii) the redeemable convertible preferred stock fair value per share. Due to this redemption option, the redeemable convertible preferred stock was recorded in the mezzanine equity and subject to subsequent measurement under the guidance provided under ASC 480-10-S99. In accordance with that guidance, Aerpio elected to recognize changes in redemption value immediately as they occur through adjustments to the carrying amounts of the instruments at the end of each reporting period. As of December 31, 2016, the redemption values of all series of redeemable convertible preferred stock were equal to their respective Applicable Accrued Value. The fair values of redeemable convertible preferred stock were based upon a hybrid of the probability-weighted expected returns method and an option pricing model (OPM), which is a nonrecurring Level 3 fair value measurement within the fair value hierarchy. Under this hybrid model, share value is based on the probability weighted value of Aerpio in a potential public trading scenario, in which the redeemable convertible preferred stock converted to Aerpio common stock, and a second scenario in which equity value is allocated using the OPM. For the public trading scenario, Aerpio used the guideline public company method under the market approach. 8. Stock-Based Compensation Pursuant to the Merger (Note 1), the Company assumed each option to purchase Aerpio common stock that remained outstanding under the Aerpio Therapeutics, Inc. 2011 Equity Incentive Plan (the “2011 Plan”), whether vested or unvested, and converted it into an option to purchase such number of shares of the Company’s common stock equal to the number of shares of Aerpio common stock subject to the option immediately prior to the Merger, divided by the applicable Merger exchange rate of 2.3336572, with any fraction rounded down to the nearest whole number. The exercise price per share of each assumed option is equal to the exercise price of the Aerpio option prior to the assumption, multiplied by the applicable Merger exchange rate of 2.3336572, rounded up to the nearest whole cent. The terms of the 2011 Plan continue to govern the options covering an aggregate of 898,962 and 927,592 shares of the Company’s common stock at September 30, 2017 and December 31, 2016 respectively, subject to awards assumed by the Company, except that all references in the 2011 Plan to Aerpio, will now be the Company. In addition, each unvested share of Aerpio restricted common stock issued under the 2011 Plan that was outstanding immediately prior to the effective time of the Merger, was converted by virtue of the Merger into restricted common stock of the Company, equal to the number of shares of Aerpio common stock subject to the unvested shares of Aerpio restricted common stock immediately prior to the Merger divided by the applicable Merger exchange rate of 2.3336572, with any fraction rounded down to the nearest whole number. 16 In March 2017, the Company’s Board of Directors adopted, and the stockholders approved, the 2017 Stock Option and Incentive Plan (the “2017 Plan”), that became effective in April 2017. The 2017 Plan provides for the issuance of incentive awards up to 4,60 0,000 shares of common stock to officers, employees, consultants and directors, less the number of shares subject to issued and outstanding awards under the 2011 Plan that were assumed in the Merger. The 2017 Plan also provides that the number of shares r eserved for issuance thereunder will be increased annually on the first day of each year beginning in 2018 by four percent (4%) of the shares of our common stock outstanding on the last day of the immediately preceding year or such smaller increase as dete rmined by our B o ard of D irectors. No awards were granted under the 2017 Plan as of September 30, 2017. Stock Options The options granted generally vest over 48 months. For employees with less than one year’s service, options vest in installments of 25% at the one-year anniversary and thereafter in 36 equal monthly installments beginning in the 13th month after the initial Vesting Commencement Date (as defined), subject to the employee’s continuous service with the Company. Options granted to other employees vest in 48 equal monthly installments after the initial Vesting Commencement Date, subject to the employee’s continuous service with the Company. The options generally expire ten years after the date of grant. The fair value of the options at the date of grant is recognized as an expense over the requisite service period. No option awards were granted in the nine months ended September 30, 2017 and one option award was granted for 50,228 shares in the nine months ended September 30, 2016. The following table summarizes the stock option activity during the nine-months ended September 30, 2017: | Shares | | | Weighted Average Exercise Price | | | Weighted Average Remaining Contractual Term (in Years) | | Aggregate Intrinsic Value ----------------------------------------+--------+---------+---+---------------------------------+---+------+--------------------------------------------------------+------+-------------------------- Outstanding, January 1, 2017 | | 927,592 | | | $ | 1.70 | | | 7.48 | | $ | 1,030,217 ----------------------------------------+--------+---------+---+---------------------------------+---+------+--------------------------------------------------------+------+---------------------------+---+-----------+---------- Granted | | — | | | | — | | | | | | ----------------------------------------+--------+---------+---+---------------------------------+---+------+--------------------------------------------------------+------+---------------------------+---+-----------+---------- Exercised | | (25,729 | ) | | | 1.40 | | | | | | ----------------------------------------+--------+---------+---+---------------------------------+---+------+--------------------------------------------------------+------+---------------------------+---+-----------+---------- Expired/cancelled | | (2,901 | ) | | | 2.11 | | | | | | ----------------------------------------+--------+---------+---+---------------------------------+---+------+--------------------------------------------------------+------+---------------------------+---+-----------+---------- Outstanding, September 30, 2017 | | 898,962 | | | $ | 1.70 | | 6.61 | | $ | 3,862,412 | ----------------------------------------+--------+---------+---+---------------------------------+---+------+--------------------------------------------------------+------+---------------------------+---+-----------+---------- Expected to vest, September 30, 2017 | | 188,925 | | | $ | 1.78 | | 7.77 | | $ | 797,234 | ----------------------------------------+--------+---------+---+---------------------------------+---+------+--------------------------------------------------------+------+---------------------------+---+-----------+---------- Options exercisable, September 30, 2017 | | 710,037 | | | $ | 1.68 | | | 6.30 | | $ | 3,065,178 ----------------------------------------+--------+---------+---+---------------------------------+---+------+--------------------------------------------------------+------+---------------------------+---+-----------+---------- Aggregate intrinsic value represents the estimated fair value of the Company’s common stock at the end of the period in excess of the weighted average exercise price multiplied by the number of options outstanding or exercisable. Compensation expense for stock options was $53,814 and $39,100 for the three months ended September 30, 2017 and 2016, respectively and $173,888 and $124,141 for the nine months ended September 30, 2017 and 2016 respectively. As of September 30, 2017, there was $201,221 of unrecognized compensation cost related to stock options, which is expected to be recognized over a weighted average period of 2.0 years. Restricted Stock Shares of restricted stock generally have similar vesting terms as stock options. A summary of the Company’s restricted stock activity and related information during the nine months ended September 30, 2017 is as follows: | Shares | | | Weighted Average Grant Date Fair Value | ------------------------------+--------+----------+---+----------------------------------------+-- Nonvested, January 1, 2017 | | 241,096 | | | $ | 1.91 ------------------------------+--------+----------+---+----------------------------------------+---+----- Granted | | — | | | | — ------------------------------+--------+----------+---+----------------------------------------+---+----- Vested | | (106,015 | ) | | | 1.77 ------------------------------+--------+----------+---+----------------------------------------+---+----- Forfeited | | (5,246 | ) | | | 2.20 ------------------------------+--------+----------+---+----------------------------------------+---+----- Nonvested, September 30, 2017 | | 129,835 | | | $ | 1.99 ------------------------------+--------+----------+---+----------------------------------------+---+----- The Company recognized compensation expense for restricted stock of $73,545 and $74,398 for the three months ended September 30, 2017 and 2016, respectively, and $220,380 and 234,122 for the nine months ended September 30, 2017 and 2016 respectively. As of September 30, 2017, there was $248,517 of unrecognized compensation cost related to these restricted stock grants, which is expected to be recognized over a weighted average period of 1.2 years. 17 Compensation Expense Summary The Company has recognized the following compensation cost related to employee and non-employee stock-based compensation activity: | Three Months Ended September 30, | | Nine Months Ended September 30, | ---------------------------+----------------------------------+---------+---------------------------------+-- | 2017 | | 2016 | | | 2017 | | 2016 ---------------------------+----------------------------------+---------+---------------------------------+---+---------+------+---+-------- Research and development | $ | 88,443 | | $ | 71,752 | | $ | 276,778 | $ | 228,429 ---------------------------+----------------------------------+---------+---------------------------------+---+---------+------+---+---------+---+-------- General and administrative | | 38,916 | | | 41,746 | | | 117,490 | | 129,834 ---------------------------+----------------------------------+---------+---------------------------------+---+---------+------+---+---------+---+-------- Total | $ | 127,359 | | $ | 113,498 | | $ | 394,268 | $ | 358,263 ---------------------------+----------------------------------+---------+---------------------------------+---+---------+------+---+---------+---+-------- The Company uses the Black-Scholes option pricing model to determine the estimated fair value for stock-based awards. There were no options granted in the nine months ended September 30,2017. Option pricing models require the input of various subjective assumptions, including the option’s expected life, expected dividend yield, price volatility and risk-free interest rate of the underlying stock. Accordingly, the weighted-average fair value of the options granted during the three and nine months ended September 30, 2016 was $1.22. The calculation was based on the following assumptions. | Three Months Ended | Nine Months Ended | ------------------------+--------------------+--------------------+------- | September 30, 2016 | September 30, 2016 | ------------------------+--------------------+--------------------+------- Expected term (years) | n/a | | 6.00 ------------------------+--------------------+--------------------+------- Risk-free interest rate | n/a | | 1.39% ------------------------+--------------------+--------------------+------- Expected volatility | n/a | | 78.00% ------------------------+--------------------+--------------------+------- Expected dividend yield | n/a | | 0.00% ------------------------+--------------------+--------------------+------- 9. Income Taxes The Company did not record a current or deferred income tax expense or benefit for the nine months ended September 30, 2017 and 2016, due to the Company’s net losses and increases in its deferred tax asset valuation allowance. 10. Net Loss per Share Attributable to Common Stockholders The following table sets forth the computation of the Company’s basic and diluted net loss per share attributable to common stockholders for the periods presented: | Three Months Ended September 30, | | | Nine Months Ended September 30, | ---------------------------------------------------------------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+-- | 2017 | | | 2016 | | | 2017 | | 2016 | ---------------------------------------------------------------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+-------------+-- Net and comprehensive loss | $ | (4,649,567 | ) | | $ | (4,885,601 | ) | $ | (15,165,577 | ) | $ | (13,465,561 | ) ---------------------------------------------------------------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+-------------+---+---+-------------+-- Extinguishment of preferred stock | | — | | | | — | | | — | | | 224,224 | ---------------------------------------------------------------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+-------------+---+---+-------------+-- Accretion of redeemable convertible preferred stock to redemption value | | — | | | | (1,054,657 | ) | | (943,297 | ) | | (3,098,149 | ) ---------------------------------------------------------------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+-------------+---+---+-------------+-- Net loss attributable to common stockholders | $ | (4,649,567 | ) | | $ | (5,940,258 | ) | $ | (16,108,874 | ) | $ | (16,339,486 | ) ---------------------------------------------------------------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+-------------+---+---+-------------+-- Net loss per share attributable to common stockholders, basic and diluted | $ | (0.17 | ) | | $ | (6.69 | ) | $ | (0.81 | ) | $ | (20.01 | ) ---------------------------------------------------------------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+-------------+---+---+-------------+-- Weighted average common shares used in computing net loss per share attributable to common stockholders, basic and diluted | | 26,926,673 | | | | 888,094 | | | 19,889,984 | | | 816,395 | ---------------------------------------------------------------------------------------------------------------------------------+----------------------------------+------------+---+---------------------------------+---+------------+------+---+-------------+---+---+-------------+-- 18 The following weighted average common stock equivalents were excluded from the calculation of diluted net loss per share attributable to common stockholders for the periods presented because including them would have had an anti-dilutive effect: | Three and Nine Months Ended September 30, | -------------------------------------------+-------------------------------------------+-------- | 2017 | | 2016 -------------------------------------------+-------------------------------------------+---------+----- Convertible preferred stock (if converted) | | — | | 14,141,112 -------------------------------------------+-------------------------------------------+---------+------+----------- Notes and accrued interest (if converted) | | — | | 1,904,034 -------------------------------------------+-------------------------------------------+---------+------+----------- Options to purchase common stock | | 898,962 | | 927,592 -------------------------------------------+-------------------------------------------+---------+------+----------- Unvested restricted stock | | 129,835 | | 292,183 -------------------------------------------+-------------------------------------------+---------+------+----------- Warrants to purchase common stock | | 317,562 | | — -------------------------------------------+-------------------------------------------+---------+------+----------- 11. Commitments and Contingencies The Company is a party to a lease covering 7,580 square feet of space in Cincinnati, Ohio that expires in June 2018. Total rent expense for all operating leases was $53,071 and $54,320 for the three months ended September 30, 2017 and 2016, respectively and $155,513 and $162,424 the nine months ended September 30, 2017 and 2016, respectively. The lease agreement contains free rent, escalating rent payments and reimbursement for tenant improvements that amounted to $0 and $46,390 in the three and nine months ended September 30, 2016, respectively. No such lease incentives were recognized in 2017. Rent expense is recorded on the straight-line basis over the initial term with the differences between rent expense and rent payments recorded as deferred rent. As of September 30, 2017, the Company had deferred rent of $44,566, which is included in accrued expenses in the accompanying condensed consolidated balance sheet. As of September 30, 2017, non-cancelable future minimum lease payments under the existing operating lease were $79,357. As of September 30, 2017, future payments related to operating leases activities are presented in the table below. | 2017 | | 2018 | | | 2019 and Thereafter | | Total -----------------+------+--------+------+---+--------+---------------------+---+------ Operating leases | $ | 26,379 | | $ | 52,978 | | $ | — | $ | 79,357 -----------------+------+--------+------+---+--------+---------------------+---+-------+---+------- The Company contracts with various organizations to conduct research and development activities, including clinical trial organizations to manage clinical trial activities. The scope of the services under these research and development contracts can be modified and the contracts cancelled by the Company upon written notice. In the event of a cancellation, the Company would only be liable for the cost and expenses incurred to date. 12. Employee Stock Purchase Plan In March 2017, the Board of Directors adopted and the stockholders approved, the Employee Stock Purchase Plan (the “ESPP”), that became effective in April 2017. The ESPP provides for the issuance of up to 300,000 shares of the Company’s common stock for the purchases made under the ESPP. The ESPP also provides that the number of shares reserved for issuance thereunder will be increased annually on the first day of each year beginning in 2018 by one percent (1%) of the shares of the Company’s common stock outstanding on the last day of the immediately preceding year or such smaller increase as determined by the Company’s Board of Directors. The Board of Directors has not yet determined the timing for the offering periods under the ESPP. 19 Item 2. Management’s Discussion and Analysis of Financial Co ndition and Results of Operations. The following discussion of the financial condition and results of operations of Aerpio Pharmaceuticals, Inc. should be read in conjunction with the financial statements and the notes to those statements included in this Quarterly Report on Form 10Q for the period ended September 30, 2017. Some of the information contained in this discussion and analysis including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risk, uncertainties and assumptions. You should read the “Risk Factors” section of this Quarterly Report on Form 10Q for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis. Operating Overview We are a biopharmaceutical company focused on advancing first-in-class treatments for ocular disease. Our lead product candidate, AKB-9778, a small molecule activator of the Tie-2 pathway, is being developed for the treatment of diabetic retinopathy (“DR”). Tie-2 signaling is essential for regulating blood vessel development and the stability of mature vessels. We completed a Phase 2a clinical trial in diabetic macular edema (“DME”), a swelling of the retina that is a common cause of vision loss in patients with DR. In June 2017, we initiated a twelve month, double blind Phase 2b clinical trial, which we refer to as TIME-2b, in patients with DR who have not developed more serious complications such as DME or proliferative diabetic retinopathy. The TIME-2b study is a double-masked, placebo-controlled multi-center trial that will enroll 150 patients randomized 1:1:1 to receive either AKB-9778 15 mg subcutaneously once daily, AKB-9778 15 mg twice daily or placebo for a 12-month period. The primary endpoint of the TIME-2b study is the percentage of patients who improve by at least 2 steps in DR Severity Score, or DRSS in the study eye. We recently completed a single-center study of the safety and efficacy of AKB-9778 with concomitant PRN anti-vascular endothelial growth factor (“anti-VEGF”) therapy in patients with retinal vein occlusion and a history of persistent macular edema on anti-VEGF monotherapy. We believe the results from this study suggest that activation of Tie-2 by AKB-9778 may be beneficial in patients with chronic retinal vein occlusion. However, these results are considered exploratory, given that this was an open-label, non-controlled study without a placebo or active control arm. In addition, we have two pipeline programs. AKB-4924 is a drug candidate for the treatment of inflammatory bowel disease and ARP-1536, humanized monoclonal antibody is a drug candidate for ocular disease. Humanized antibodies are antibodies from non-human species whose protein sequences have been modified to increase their similarity to antibodies produced naturally in humans. We completed a Phase 1a clinical trial in healthy volunteers for AKB-4924 and APR-1536 is currently in preclinical development. Further development on the pipeline programs is subject to receiving additional funding, which we may seek through collaborations with potential strategic and commercial partners. Our operations to date have been limited to organizing and staffing our company, business planning, raising capital, acquiring and developing our technology, identifying potential product candidates, and undertaking preclinical and clinical studies. We have not generated any revenues to date, nor is there any assurance of future revenues. Our product candidates are subject to long development cycles, and there is no assurance we will be able to successfully develop, obtain regulatory approval for, or market our product candidates. As of September 30, 2017, we had an accumulated deficit of $102.3 million and anticipate incurring additional losses for the next several years. Our primary source of liquidity to date has been through the private placement offering of our common stock (the “Offering”) in March 2017 and the historical sales of redeemable convertible preferred stock, common stock and proceeds from convertible debt. The aggregate net proceeds from the Offering in March 2017 was $37.2 million. In 2016, we raised a total of $12.5 million through the issuance of secured convertible notes. In 2017, we raised a total of $0.3 million through the issuance of secured convertible notes. In 2014, we raised a total of $22.0 million ($21.8 million net of offering costs) through the issuance of redeemable convertible preferred stock. We will need to raise additional funds to further advance our clinical research programs, commence additional clinical trials, and commercialize our products, if approved. While we continue to pursue financing alternatives, which may include equity financing, business development arrangements, licensing arrangements and business combination transactions, financing may not be available to us in the necessary time frame, in the amounts that we need, on terms that are acceptable to us or at all. If we are unable to raise the necessary funds when needed or reduce spending on currently planned activities, we may not be able to continue the development of our product candidates or we could be required to delay, scale back, or eliminate some or all of our development programs and other operations and will materially harm our business and consolidated financial position. 20 We expect to continue to incur significant expens es and increasing operating losses for the foreseeable future. We expect our expenses will increase substantially in connection with our ongoing activities, as we: • | continue our research and development efforts, primarily in connection with our ongoing TIME-2b clinical trial; --+---------------------------------------------------------------------------------------------------------------- • | add personnel to support our clinical development program; and --+--------------------------------------------------------------- • | operate as a public company. --+----------------------------- We are subject to a number of risks similar to other life science companies in the current stage of our life cycle, including, but not limited to, the need to obtain adequate additional funding, possible failure of preclinical testing or clinical trials, competitors developing new technological innovations, and protection of proprietary technology. If we do not successfully mitigate any of these risks, we will be unable to generate revenue or achieve profitability. The condensed consolidated accompanying financial statements have been prepared assuming our Company will continue as a going concern, which contemplates the realization of assets and payments of liabilities in the ordinary course of business. We had cash and cash equivalents and short-term investments of $24.8 million at September 30, 2017. We believe our existing cash and cash equivalents and short-term investments, will be sufficient to fund currently planned operations into the first quarter of fiscal year 2019. Basis of Presentation The unaudited interim condensed consolidated financial statements of the Company for the three months ended September 30, 2017 and 2016, and the nine months ended September 30, 2017 and 2016 contained herein, include a summary of our significant accounting policies and should be read in conjunction with the discussion below. Other Recent Developments Listing on the OTCQB Market Shares of our common stock were approved for trading and began trading on August 8, 2017 on the OTCQB marketplace under the symbol “ARPO.” Merger On March 15, 2017, our wholly-owned subsidiary, Aerpio Acquisition Corp., a corporation formed in the State of Delaware, or the Acquisition Sub, merged with and into Aerpio Therapeutics, Inc., (“Aerpio”) a corporation incorporated on November 17, 2011 under the laws of the State of Delaware. Pursuant to this transaction, or the Merger, Aerpio was the surviving corporation and became our wholly-owned subsidiary. We changed our name from Zeta Acquisition Corp II to Aerpio Pharmaceuticals, Inc. All the outstanding stock of Aerpio was converted into shares of our common stock. At the effective time of the Merger, the legal existence of Acquisition Sub ceased and each 2.3336572 shares of Aerpio common and preferred stock that was issued and outstanding immediately prior to the effective time of the Merger, including share based awards, whether vested or unvested issued under the Aerpio Therapeutics, Inc. 2011 Equity Incentive Plan (the “2011 Plan”), was automatically exchanged for one share of our common stock. In addition, immediately prior to the Merger, the outstanding amounts under certain senior secured convertible notes issued by Aerpio to its pre-Merger noteholders were converted into Aerpio common stock, which were converted in the Merger into shares of our common stock at the same ratio. We issued an aggregate of 18,000,000 shares of our common stock upon such exchange of the outstanding shares of Aerpio common stock. In addition, at the effective time of the Merger, we assumed Aerpio’s 2011 Equity Incentive Plan. At the effective time of the Merger, we assumed the outstanding options under the 2011 Plan and converted them into options to purchase 927,592 shares of our common stock. As a result of the Merger, we acquired the business of Aerpio and will continue the existing business operations of Aerpio as a public reporting company under the name Aerpio Pharmaceuticals, Inc. Immediately after the Merger, Aerpio was converted into a Delaware limited liability company (the “Conversion”). The Merger was treated as a recapitalization and reverse acquisition for financial reporting purposes. We are the legal acquirer of Aerpio in the transaction. However, Aerpio is considered the acquiring company for accounting purposes since (i) former Aerpio stockholders own in excess of 50% of the combined enterprise on a fully diluted basis immediately following the Merger and Offering, and (ii) all members of the Company’s executive management and Board of Directors are from Aerpio. In accordance with the “reverse merger” or “reverse acquisition” accounting treatment, the unaudited condensed consolidated interim financial statements for the period ended September 30, 2017 include the accounts of the Company and its wholly owned subsidiary, Aerpio Therapeutics, LLC. The comparative historical financial statements for periods ended prior to the date of the Merger are the historical financial statements of Aerpio. 21 The following discussion highlights Aerpio’s results of operations and the principal factors that have affected our financial condition as well as our liquidity and capital resources for the periods described, and provides information that m anagement believes is relevant for an assessment and understanding of the unaudited condensed consolidated statements of financial condition and results of operations presented herein. The following discussion and analysis are based on the Company’s unaudi ted condensed consolidated financial statements contained in this Quarterly Report on Form 10-Q, which we have prepared in accordance with United States generally accepted accounting principles. You should read the discussion and analysis together with suc h condensed consolidated financial statements and the related notes thereto. Share Cancellation Following the Merger and Conversion, and immediately prior to the closing of the Offering, an aggregate of 4,000,000 of the 5,000,000 shares of our common stock that were held by the pre-Merger stockholders of Zeta Acquisition Corp. II were surrendered for cancellation (the “Share Cancellation”). Offering Following the Merger, the Conversion and the Share Cancellation, we sold to accredited investors $40.2 million of our shares of common stock, or 8,049,555 shares, at a price of $5.00 per share, (net proceeds of $37.2 million after deducting placement agent fees and expenses of the offering). In connection with the Offering, we issued warrants to purchase 317,562 shares of our common stock at $5.00 per share to the placement agents for the Offering. The warrants are exercisable for three years. The Offering closed on March 15, 2017. Components of Statements of Operations and Comprehensive Loss Operating Expenses Research and Development. Research and development expenses consist primarily of compensation and related costs for personnel, including stock-based compensation, employee benefits and travel. These costs also consist of third-party service providers for our potential product development activities, third-party consulting services, laboratory supplies, research materials, medical equipment, computer equipment, and related depreciation and amortization. We expense research and development expenses as incurred. As we continue to invest in basic research and clinical development of our product candidates, we expect research and development expenses to increase in absolute dollars. General and Administrative. Our general and administrative expenses consist primarily of compensation and related costs for personnel, including stock-based compensation, employee benefits and travel, for our finance, human resources and other administrative personnel. In addition, general and administrative expenses include third-party consulting, legal, patent, audit, accounting services, and facilities costs. We expect general and administrative expenses to increase in absolute dollars following the consummation of the Merger due to additional legal, accounting, insurance, investor relations and other costs associated with being a public company, as well as other costs associated with growing our business. Interest Income (Expense), Net Interest income consists primarily of interest income received on our cash and cash equivalents. Interest expense consists primarily of interest and amortization of debt issuance costs related to our secured convertible promissory notes issued in 2016 and 2017. The secured convertible notes have converted into shares of our common stock in connection with the Merger and Offering. Grant Income Grant income is recognized as earned based on contract work performed. 22 Results of Operations The following tables set forth our results of operations for the periods presented: | Three Months Ended September 30, | | | Nine Months Ended September 30, | -------------------------------+----------------------------------+------------+---+---------------------------------------+-- | 2017 | | | 2016 | | | 2017 | | 2016 | -------------------------------+----------------------------------+------------+---+---------------------------------------+---+------------+------+---+-------------+-- Operating expenses: | | | | | | | | | | | | | -------------------------------+----------------------------------+------------+---+---------------------------------------+---+------------+------+---+-------------+---+---+-------------+-- Research and development | $ | 2,942,170 | | | $ | 3,481,261 | | $ | 8,366,869 | | $ | 9,374,383 | -------------------------------+----------------------------------+------------+---+---------------------------------------+---+------------+------+---+-------------+---+---+-------------+-- General and administrative | | 1,814,068 | | | | 1,264,054 | | | 6,732,816 | | | 3,953,808 | -------------------------------+----------------------------------+------------+---+---------------------------------------+---+------------+------+---+-------------+---+---+-------------+-- Total operating expenses | | 4,756,238 | | | | 4,745,315 | | | 15,099,685 | | | 13,328,191 | -------------------------------+----------------------------------+------------+---+---------------------------------------+---+------------+------+---+-------------+---+---+-------------+-- Loss from operations | | (4,756,238 | ) | | | (4,745,315 | ) | | (15,099,685 | ) | | (13,328,191 | ) -------------------------------+----------------------------------+------------+---+---------------------------------------+---+------------+------+---+-------------+---+---+-------------+-- Grant income | | 46,824 | | | | 26,561 | | | 93,720 | | | 116,185 | -------------------------------+----------------------------------+------------+---+---------------------------------------+---+------------+------+---+-------------+---+---+-------------+-- Interest income (expense), net | | 59,847 | | | | (166,847 | ) | | (159,612 | ) | | (254,552 | ) -------------------------------+----------------------------------+------------+---+---------------------------------------+---+------------+------+---+-------------+---+---+-------------+-- Other income, net | | — | | | | — | | | — | | | 997 | -------------------------------+----------------------------------+------------+---+---------------------------------------+---+------------+------+---+-------------+---+---+-------------+-- Total other income (expense) | | 106,671 | | | | (140,286 | ) | | (65,892 | ) | | (137,370 | ) -------------------------------+----------------------------------+------------+---+---------------------------------------+---+------------+------+---+-------------+---+---+-------------+-- Net and comprehensive loss | $ | (4,649,567 | ) | | $ | (4,885,601 | ) | $ | (15,165,577 | ) | $ | (13,465,561 | ) -------------------------------+----------------------------------+------------+---+---------------------------------------+---+------------+------+---+-------------+---+---+-------------+-- Comparison of the Three Months Ended September 30, 2017 and 2016 Operating Expenses | Three Months Ended September 30, | ---------------------------+----------------------------------+---------- | 2017 | | 2016 | ---------------------------+----------------------------------+-----------+------+-- Operating expenses: | | | | | ---------------------------+----------------------------------+-----------+------+---+---------- Research and development | $ | 2,942,170 | | $ | 3,481,261 ---------------------------+----------------------------------+-----------+------+---+---------- General and administrative | | 1,814,068 | | | 1,264,054 ---------------------------+----------------------------------+-----------+------+---+---------- Total operating expenses | $ | 4,756,238 | | $ | 4,745,315 ---------------------------+----------------------------------+-----------+------+---+---------- Research and Development Research and development expenses for the three months ended September 30, 2017 decreased approximately $0.5 million or 15%, compared to the three months ended September 30, 2016. This decrease was the result of decreased spending on our pipeline programs -AKB 4924 and ARP 1536, partially offset by an increase in spending on our lead program AKB-9778. The $0.4 million increase in spending in our lead program, AKB-9778, for the three months ended September 30, 2017 from the corresponding period in 2016 is primarily attributed to the cost of drug product, associated with our double-blind Phase 2 DR clinical trial initiated in the second quarter of 2017, partially offset by a decrease in pre-clinical and Phase 1 clinical trial expenses incurred in the prior period. The $0.9 million decrease in spending on our pipeline programs, for the three months ended September 30, 2017 from the corresponding period in 2016 is primarily due to our decision to focus on the lead program while pursuing alternative strategies to fund further development activities for one or both the pipeline programs. Healthy volunteers were enrolled in the AKB-4924 Phase 1a clinical trial and cell line development expenses were incurred on ARP-1536 during the 2016 period. General and Administrative. General and administrative expenses in the three months ended September 30, 2017, increased $0.6 million, or 44%, compared to the three months ended September 30, 2016. This increase was primarily attributable to personnel and related expenses, including costs to recruit additional resources as well as professional services, including legal, accounting, insurance and other professional service expenses associated with the Merger, related transactions and operating as a public company. 23 Other Income (Expense) net | Three Months Ended September 30, | ----------------------------------+----------------------------------+-------- | 2017 | | 2016 | ----------------------------------+----------------------------------+---------+------+-- Other income (expense): | | | | | | ----------------------------------+----------------------------------+---------+------+---+----------+-- Grant income | $ | 46,824 | | $ | 26,561 | ----------------------------------+----------------------------------+---------+------+---+----------+-- Interest income (expense), net | | 59,847 | | | (166,847 | ) ----------------------------------+----------------------------------+---------+------+---+----------+-- Total other income (expense), net | $ | 106,671 | | $ | (140,286 | ) ----------------------------------+----------------------------------+---------+------+---+----------+-- Grant income Grant income is recognized as earned based on contract work performed. Grant income amounts can vary greatly from period to period depending on the funding and needs of the party for whom we perform the requested services. Interest income (expense), net Interest income in the three months ended September 30, 2017 reflects interest earned during the period on cash balances invested in short term money market instruments. The net proceeds received in the Offering on March 15, 2017, less cash used in operations, were available for investment. The interest expense in the corresponding three-month period in 2016, was primarily related to the senior secured convertible notes issued in April 2016, offset in part by a small amount of interest income earned on invested cash balances. We completed three note financings in fiscal 2016 totaling an aggregate principal amount of approximately $12.5 million and one note financing in the first quarter of fiscal 2017, totaling an aggregate principal amount of approximately $0.3 million. The financings were funded in four tranches’, beginning with one in April 2016 for $4.5 million, one in July 2016 for $4.5 million, one in October 2016 for $3.5 million and one in January 2017 for $0.3 million. The notes accrued interest at the rate of eight percent (8%) per annum, compounded annually. The principal and accrued interest on the secured convertible notes was converted into common stock on March 15, 2017, in connection with the Merger. Comparison of the Nine Months Ended September 30, 2017 and 2016 Operating Expenses | Nine Months Ended September 30, | ---------------------------+---------------------------------+----------- | 2017 | | 2016 | ---------------------------+---------------------------------+------------+------+-- Operating expenses: | | | | | ---------------------------+---------------------------------+------------+------+---+----------- Research and development | $ | 8,366,869 | | $ | 9,374,383 ---------------------------+---------------------------------+------------+------+---+----------- General and administrative | | 6,732,816 | | | 3,953,808 ---------------------------+---------------------------------+------------+------+---+----------- Total operating expenses | $ | 15,099,685 | | $ | 13,328,191 ---------------------------+---------------------------------+------------+------+---+----------- Research and Development Research and development expenses for the nine months ended September 30, 2017 decreased approximately $1.0 million, or 11%, compared to the nine months ended September 30, 2016. This decrease was the result of decreased spending on our pipeline programs AKB 4924 and ARP 1536, partially offset by an increase in spending on our lead program AKB-9778, currently in Phase 2b development. The approximate $1.0 million increase in spending on our lead program, AKB-9778, for the nine months ended September 30, 2017 from the corresponding period in 2016 is primarily attributed to the cost of drug product for our double-blind Phase 2 DR clinical trial initiated during the second quarter of 2017, partially offset by a decrease in pre-clinical and Phase 1 clinical trial expenses incurred in the prior period. The approximate $2.0 million decrease in spending on our pipeline programs, for the nine months ended September 30, 2017 from the corresponding period in 2016 is primarily due to our decision to focus on the lead program while pursuing alternative strategies to fund further development activities for one or both the pipeline programs. During the nine months ended September 30, 2016, healthy volunteers were enrolled in the AKB-4924 Phase 1a clinical trial and cell line development expenses were incurred on ARP-1536. 24 General and Administrative General and administrative expenses in the nine months ended September 30, 2017, increased $2.8 million, or 70%, compared to the nine months ended September 30, 2016. This increase was primarily attributable to personnel and related expenses, including costs to recruit additional resources as well as professional services including, legal, accounting, insurance and other professional service expenses associated with the Merger, related transactions and operating as a public company. Other expense, net | Nine Months Ended September 30, | -------------------------+---------------------------------+--------- | 2017 | | | 2016 | -------------------------+---------------------------------+----------+---+------+-- Other (expense) income: | | | | | | | -------------------------+---------------------------------+----------+---+------+---+----------+-- Grant income | $ | 93,720 | | | $ | 116,185 | -------------------------+---------------------------------+----------+---+------+---+----------+-- Interest expense, net | | (159,612 | ) | | | (254,552 | ) -------------------------+---------------------------------+----------+---+------+---+----------+-- Other income, net | | — | | | | 997 | -------------------------+---------------------------------+----------+---+------+---+----------+-- Total other expense, net | $ | (65,892 | ) | | $ | (137,370 | ) -------------------------+---------------------------------+----------+---+------+---+----------+-- Grant income Grant income is recognized as earned based on contract work performed. Grant income amounts can vary greatly from period to period depending on the funding and needs of the party for whom we perform the requested services. Interest expense, net Interest expense in the nine months ended September 30, 2017, was primarily related to the senior secured convertible notes issued in 2016 and 2017, offset by interest income earned during the period on cash balances invested in short term money market instruments. The net proceeds received in the Offering on March 15, 2017, less cash used in operations during the period, were available for investment. The interest expense in the corresponding nine-month period in 2016, was primarily related to the senior secured convertible notes issued in April 2016, offset in part by a small amount of interest income earned on invested cash balances. We completed three note financings in fiscal 2016 totaling an aggregate principal amount of approximately $12.5 million and one note financing in the first quarter of fiscal 2017, totaling an aggregate principal amount of approximately $0.3 million. The convertible note financings were funded in four tranches’, beginning with one in April 2016 for $4.5 million, one in July 2016 for $4.5 million, one in October 2016 for $3.5 million and one in January 2017 for $0.3 million. The notes had interest at the rate of eight percent (8%) per annum, compounded annually. The principal and accrued interest on the secured convertible notes was converted into common stock on March 15, 2017, in connection with the Merger. Other income Other income represents amounts received from Akebia for services rendered under the shared services agreements. The agreements expired in 2016. Liquidity and Capital Resources Since inception, we have incurred significant net losses and negative cash flows from operations. For the three months ended September 30, 2017 and 2016, we had net losses of $4.6 million and $4.9 million, respectively. At September 30, 2017 and December 31, 2016, we had an accumulated deficit of $102.3 million and $86.2 million, respectively. At September 30, 2017, we had cash and cash equivalents and short-term investments of $24.8 million. To date, we have financed our operations principally through the Offering, private placements of our redeemable convertible preferred stock, common stock and issuances of secured convertible promissory notes. Based on our current plans, we expect that our existing cash and cash equivalents, will enable us to conduct our planned operations into the first quarter of fiscal 2019. 25 We could potentially use our available financial resources sooner than we currently expect, and we may incur additional indebte dness to meet future operation liquidity . We continuously evaluate our needs for additional capital and consider opportunities on an ongoing basis, including capital from many different sources including equity capital, strategic alliances, business develo pment debt, collaborations and business combinations. Adequate additional funding may not be available to us on acceptable terms or at all. In addition, although we anticipate being able to obtain additional financing through non-dilutive means, we may be unable to do so. Our failure to raise capital as and when needed could have significant negative consequences for our business, financial condition and results of operations. Our future capital requirements and the adequacy of available funds will depend on many factors, including those set forth in the section titled “Risk Factors.” The following table summarizes our cash flows for the periods presented: | Nine Months Ended September 30, | -----------------------------------------------------+---------------------------------+------------ | 2017 | | | 2016 | -----------------------------------------------------+---------------------------------+-------------+---+------+-- Net cash used in operating activities | $ | (14,271,082 | ) | | $ | (12,676,283 | ) -----------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Net cash used in investing activities | | (6,547 | ) | | | (113,297 | ) -----------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Net cash provided by financing activities | | 37,496,845 | | | | 8,953,719 | -----------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Net increase (decrease) in cash and cash equivalents | $ | 23,219,216 | | | $ | (3,835,861 | ) -----------------------------------------------------+---------------------------------+-------------+---+------+---+-------------+-- Operating Activities We have historically experienced negative cash outflows as we developed AKB-9778, ARP-1536 and AKB-4924. Our net cash used in operating activities primarily results from our net loss adjusted for non-cash expenses and changes in working capital components. Our primary uses of cash from operating activities are amounts due to contract research organizations for the conduct of our clinical programs and employee-related expenditures for research and development, and general and administrative activities. Our cash flows from operating activities will continue to be affected principally by increased spending to advance of our product candidates in the clinic, personnel to support those activities and other operating and general administrative activities. For the nine months ended September 30, 2017, operating activities used approximately $14.3 million in cash, primarily as a result of our net loss of approximately $15.2 million, offset by approximately $0.7 million in non-cash charges that consisted primarily of stock compensation expense, non-cash interest expense, amortization of debt issuance costs and depreciation expense and approximately $0.2 million from changes in working capital. For the nine months ended September 30, 2016, operating activities used approximately $12.7 million in cash, primarily as a result of our net loss of $13.5 million, offset by approximately $0.8 million of non-cash charges of stock compensation expense, non-cash interest expense, amortization of debt issuance costs and depreciation expense. Investing Activities Cash used in investing activities for both nine month periods ended September 30, 2017 and 2016 was due to capital expenditures to support our operations. In addition, in the nine months ended September 30, 2016, we acquired approximately $0.1 million of laboratory equipment to support internal drug development capabilities. Financing Activities During the nine months ended September 30, 2017, we received net proceeds of $37.5 million from the sale of common stock at $5.00 per share, issued in the Offering and $0.3 million in January from an extension to the Aerpio senior secured convertible notes. During the nine months ended September 30, 2016, we received $8.9 million from the issuance of and an extension to the Aerpio senior secured convertible notes. On March 31, 2016, Aerpio entered into a senior secured convertible note financing with certain preferred stock investors of Aerpio. The secured convertible notes accrued interest at 8% per annum, compounded annually. Each of the secured convertible notes were also subject to mandatory prepayment and were also convertible into preferred stock of Aerpio upon the occurrence of certain events, as described in the Note Agreements. We received proceeds from the first tranche in April 2016 and subsequent tranches in July 2016, October 2016 and January 2017. The outstanding principal and accrued interest under the secured convertible notes was converted into shares of Aerpio common stock immediately prior to the effective time of the Merger, and exchanged for shares of our common stock pursuant to the Merger. 26 Contractual Obligations and Commitments There have been no material changes outside the ordinary course of business during the period covered by this Report from the contractual obligations and commitments as of December 31, 2016 described in our Current Report on Form 8-K filed on March 17, 2017. Off-Balance Sheet Arrangements As of September 30, 2017 and 2016, we did not have any off-balance sheet arrangements as defined by applicable SEC regulations. Critical Accounting Policies and Estimates Our condensed consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles or GAAP. The preparation of these condensed consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, expenses and related disclosures. We evaluate our estimates and assumptions on an ongoing basis. Our estimates are based on historical experience and various other assumptions that we believe to be reasonable under the circumstances. Our actual results could differ from these estimates. We believe that the assumptions and estimates have the greatest potential impact on our condensed consolidated financial statements. Therefore, we consider these to be our critical accounting policies and estimates. For further information on all our significant accounting policies, see the notes to our financial statements. Prepaid and Accrued Research and Development Expenses As part of the process of preparing our condensed consolidated financial statements, we are required to estimate our prepaid and accrued research and development expenses. This process involves reviewing open contracts and purchase orders, communicating with our personnel to identify services that have been performed on our behalf and estimating the level of service performed and the associated cost incurred for the service when we have not yet been invoiced or otherwise notified of the actual cost. The majority of our service providers invoice us monthly in arrears for services performed. We make estimates of our prepaid and accrued research and development expenses as of each condensed consolidated balance sheet date in our financial statements based on facts and circumstances known to us at the time. We confirm the accuracy of estimates with the service providers and make adjustments if necessary. Examples of estimated prepaid and accrued research and development expenses include expenses for: • | Clinical Research Organizations (CROs) in connection with clinical studies; --+---------------------------------------------------------------------------- • | Investigative sites in connection with clinical studies; --+--------------------------------------------------------- • | Vendors in connection with preclinical development activities; and --+------------------------------------------------------------------- • | Vendors related to product manufacturing, development and distribution of clinical materials. --+---------------------------------------------------------------------------------------------- We base our expenses related to clinical studies on our estimates of the services received and efforts expended pursuant to contracts with multiple CROs that conduct and manage clinical studies on our behalf. The financial terms of these agreements are subject to negotiation, vary from contract to contract and may result in uneven payment flows. The scope of services under these contracts can be modified and some of the agreements may be cancelled by either party upon written notice. There may be instances in which payments made to our vendors will exceed the level of services provided and result in a prepayment of the clinical expense. Payments under some of these contracts depend on factors such as the successful enrollment of subjects and the completion of clinical study milestones. In accruing service fees, we estimate the time period over which services will be performed and the level of effort to be expended in each period. If the actual timing of the performance of services or the level of effort varies from our estimate, we adjust the accrual or prepaid accordingly. Although we do not expect our estimates to be materially different from amounts actually incurred, if our estimates of the status and timing of services performed differ from the actual status and timing of services performed we may report amounts that are too high or too low in any particular period. To date, there have been no material differences between our estimates and the amount actually incurred. 27 Stock-Based Compensation We issue stock-based awards generally in the form of stock options and restricted stock. We account for our stock-based compensation awards in accordance with FASB ASC Topic 718, Compensation—Stock Compensation , or ASC 718. ASC 718 requires all stock-based payments to employees, including grants of employee stock options and restricted stock and modifications to existing stock awards to be recognized in the statements of operations and comprehensive loss based on their fair values. Described below is the methodology we have utilized in measuring stock-based compensation expense. We estimate the fair value of our options to purchase shares of common stock to employees using the Black-Scholes option pricing model, which requires the input of highly subjective assumptions, including (a) the expected stock price volatility, (b) the calculation of the expected term of the award, (c) the risk-free interest rate and (d) expected dividends. Due to the lack of a public market for the trading of our common stock and a lack of company-specific historical and implied volatility data, we have based our estimate of expected volatility on the historical volatility of a group of similar companies that are publicly traded. The historical volatility is calculated based on a period of time commensurate with the expected term assumption. The computation of expected volatility is based on the historical volatility of a representative group of companies with similar characteristics to our company, including stage of product development and life science industry focus. We are a development stage company in an early stage of product development with no revenues and the representative group of companies has certain similar characteristics. We believe the group selected has sufficient similar economic and industry characteristics, and includes companies that are most representative of our Company. We use the simplified method as prescribed by the SEC Staff Accounting Bulletin No. 107, Share-Based Payment, to calculate the expected term for options granted to employees and non-employees as we do not have sufficient historical exercise data to provide a reasonable basis upon which to estimate the expected term. The expected term is applied to the stock option grant group as a whole, as we do not expect substantially different exercise or post-vesting termination behavior among our employee population. The risk-free interest rate is based on a treasury instrument whose term is consistent with the expected life of the stock options. The expected dividend yield is assumed to be zero as we have never paid dividends and have no current plans to pay any dividends on our common stock, similar to our peer group. The grant date fair value of restricted stock award grants is based on the estimated value of our common stock at the date of grant. Our stock-based awards are subject to service-based vesting conditions. Compensation expense related to awards to employees with service-based vesting conditions is recognized on a straight-line basis based on the grant date fair value over the associated service period of the award, which is generally the vesting term. Awards to non-employees are adjusted through share-based compensation expense as the award vests to reflect the current fair value of such awards and are expensed using an accelerated attribution model. During the three months ended September 30, 2017 and 2016, and the nine months ended September 30, 2017 and 2016 stock-based compensation expense was approximately $0.1 million, $0.1 million, $0.4 million and $0.4 million, respectively. As of September 30, 2017, we had $0.2 million of total unrecognized stock-based compensation costs for stock options, which we expect to recognize over a weighted-average period of 2.0 years. As of September 30, 2017, we had $0.2 million of total unrecognized stock-based compensation costs for restricted stock awards, which we expect to recognize over a weighted-average period of 1.2 years. Common Stock Valuations. The fair value of the common stock was determined by our Board of Directors, which intended all stock options granted to be exercisable at a price per share not less than the per share fair value of our common stock underlying those options on the date of grant. In 2016, as a privately held company, the valuations of our common stock were determined in accordance with the guidelines outlined in the American Institute of Certified Public Accountants Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation , or AICPA Practice Aid. The assumptions we used in the valuation model were based on future expectations combined with management judgment. In the absence of a public trading market, our board of directors, with input from management, exercised significant judgment and considered numerous objective and subjective factors to determine the fair value of our common stock as of the date of each option grant. including the following factors: • | valuations performed by unrelated third-party specialists; --+----------------------------------------------------------- • | the prices, rights, preferences, and privileges of our convertible preferred stock relative to those of our Common Stock; --+-------------------------------------------------------------------------------------------------------------------------- • | the prices of Aerpio’s former convertible preferred stock sold to outside investors in arm’s-length transactions; --+------------------------------------------------------------------------------------------------------------------ • | the lack of marketability of our common stock; --+----------------------------------------------- • | our actual operating and financial performance; --+------------------------------------------------ • | current business conditions and projections; --+--------------------------------------------- • | our hiring of key personnel and the experience of our management; --+------------------------------------------------------------------ 28 • | our stage of development; --+-------------------------- • | the likelihood of achieving a liquidity event, such as a public offering or a merger or acquisition of our business given prevailing market conditions; --+-------------------------------------------------------------------------------------------------------------------------------------------------------- • | the illiquidity of stock-based awards involving securities in a private company; --+--------------------------------------------------------------------------------- • | the market performance of comparable publicly traded companies; and --+-------------------------------------------------------------------- • | the U.S. and global capital market conditions. --+----------------------------------------------- For the valuation of our common stock at December 31, 2016, we used the hybrid method. As described in the AICPA’s accounting and valuation guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation , the hybrid method is a hybrid between the probability-weighted expected returns method (PWERM) and the option-pricing method (OPM). We considered a “go-public scenario”, in which our preferred shares convert to common stock, and a second scenario, in which equity value is allocated using the OPM. We used the guideline public company method under the market approach to value our equity. We estimated our equity value based on a multiple of paid-in capital as indicated by a group of guideline public companies. The group consisted of clinical-stage drug development companies which completed initial public offerings in the six months preceding our appraisal date. In addition, for each of the guideline companies, we considered the increase, or step-up, in per share value from the preferred financing preceding the public offering to the common stock value in the public offering. We also considered the equity value of each guideline company, not including the proceeds of the public offering. The OPM treats common stock and preferred stock as call options on the total equity value of a company, with exercise prices based on the value thresholds at which the allocation among the various holders of a company’s securities changes. Under this method, the common stock has value only if the funds available for distribution to stockholders exceed the value of the preferred liquidation preference at the time of a liquidity event, such as a strategic sale, merger or initial public offering. For each Black-Scholes calculation in the OPM, the option “strike price” is determined by the company’s capital structure. Additional inputs to the OPM include the estimated time to liquidity and estimated equity volatility. We applied a discount for lack of marketability to the values indicated for the common stock in the go-public and OPM scenarios. Our estimate of the appropriate discount for lack of marketability relied on an Asian put option calculation. The following table summarizes the significant assumptions used in the hybrid method to determine the fair value of our common stock as of December 31, 2016: | Go-Public Scenario | | | OPM ------------------------------------------+--------------------+-----+---+---- Key assumptions | | | | | | ------------------------------------------+--------------------+-----+---+-----+-----+-- Probability weighting | | 50 | % | | 50 | % ------------------------------------------+--------------------+-----+---+-----+-----+-- Years to liquidity | | 0.2 | | | 2.8 | ------------------------------------------+--------------------+-----+---+-----+-----+-- Weighted-average cost of equity | | 25 | % | | - | ------------------------------------------+--------------------+-----+---+-----+-----+-- Annual volatility | | - | | | 61 | % ------------------------------------------+--------------------+-----+---+-----+-----+-- Risk-free interest rate | | - | | | 1.4 | % ------------------------------------------+--------------------+-----+---+-----+-----+-- Discount for lack of marketability (DLOM) | | 5 | % | | 23 | % ------------------------------------------+--------------------+-----+---+-----+-----+-- Based on these assumptions, we estimated the fair value of our common stock on a pre-Merger basis to be $1.20 as of December 31, 2016 ($2.80 as of December 31, 2016 on an as converted basis to reflect the effect of the Merger). There are significant judgments and estimates inherent in the determination of these valuations. These judgments and estimates include assumptions regarding our future performance, including the successful enrollment and completion of our clinical studies as well as the determination of the appropriate valuation methods. If we had made different assumptions, our stock-based compensation expense could have been different. The foregoing valuation methodologies are not the only methodologies available and they will not be used to value our common stock once this offering is complete. We cannot make assurances as to any particular valuation for our common stock. Accordingly, we caution you not to place undue reliance on the foregoing valuation methodologies as an indicator of future stock prices. For the valuation of our common stock at March 31, 2017 and June 30, 2017, we used $5.00 per share, which is the share price paid by outside investors in our private placement closed on March 15, 2017 and at September 30, 2017 we used $6.00 per share, the closing share price on the OTCQB marketplace on that date. There were no stock awards granted or issued in the nine months ended September 30, 2017. 29 JOBS Act Accounting Election We are an “emerging growth company” within the meaning of the JOBS Act. Section 107 of the JOBS Act provides that an emerging growth company can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. Thus, an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have irrevocably elected not to avail ourselves of this extended transition period and, as a result, we will adopt new or revised accounting standards on the relevant dates on which adoption of such standards is required for other public companies that are not emerging growth companies. Item 3. Quantitative and Qualitative Disclosures About Market Risk. Interest Rate Risk The Company’s cash balance as of September 30, 2017 consisted of cash held in an operating account that earns nominal interest income. Therefore, there was minimal or no interest rate risk. Item 4. Controls and Procedures. Management’s Evaluation of our Disclosure Controls and Procedures Under the supervision of and with the participation of our management, including our President and Founder, who is our principal executive officer, and our Chief Financial Officer, who is our principal financial officer, we conducted an evaluation of the effectiveness of our disclosure controls and procedures as of September 30, 2017, the end of the period covered by this Quarterly Report. The term “disclosure controls and procedures,” as set forth in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, or the Exchange Act, means controls and other procedures of a company that are designed to provide reasonable assurance that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the rules and forms promulgated by the SEC. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognizes that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with policies or procedures may deteriorate. Because of the inherent limitations in a control system, misstatements due to error or fraud may occur and not be detected. Based on the evaluation of our disclosure controls and procedures as of September 30, 2017, our chief executive officer and chief financial officer concluded that, as of such date, our disclosure controls and procedures were not effective at the reasonable assurance level due to a material weakness in internal control over financial reporting. The material weakness was initially identified at December 31, 2016 as previously disclosed and relates to the effectiveness of controls over our review and approval procedures with respect to financial information generated to prepare our consolidated financial statements, coupled with a lack of segregation of duties. We are taking steps to remediate this material weakness. Changes in Internal Control over Financial Reporting During the quarter ended September 30, 2017, there have been no changes in our internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15(d)-15(f) promulgated under the Securities Exchange Act of 1934, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 30 PART II—OTHE R INFORMATION Item 1. Legal Proceedings. We are not currently subject to any material legal proceedings. Item 1A. Risk Factors. Investing in our common stock involves a high degree of risk. In addition to the information, documents or reports included or incorporated by reference in this Quarterly Report on Form 10-Q for the period ended September 30, 2017, you should carefully consider the risks described below, before making an investment decision. Our business, financial condition or results of operations could be harmed by any of these risks. As a result, you could lose some or all of your investment in our common stock. The risks and uncertainties described below are not the only ones we face. Additional risks not currently known to us or other factors not perceived by us to present significant risks to our business at this time also may impair our business operations. Risks Related to Our Financial Position and Need for Additional Capital We have incurred significant losses since inception and anticipate that we will continue to incur significant losses for the foreseeable future and may never achieve or maintain profitability. We have incurred net losses each year since our inception, including net losses of $17.0 million and $17.1 million for the years ended December 31, 2016 and 2015, respectively, and $15.1 million for the nine months ended September 30, 2017. As of September 30, 2017, we had an accumulated deficit of $102.3 million. To date, we have not commercialized any products or generated any revenues from the sale of products, and we do not expect to generate any product revenues in the foreseeable future. We do not know whether or when we will generate revenue or become profitable. We have devoted most of our financial resources to research and development, including our clinical and preclinical development activities. To date, we have financed our operations primarily through private placements of our preferred stock. The amount of our future net losses will depend, in part, on the rate of our future expenditures, and our financial position will depend, in part, on our ability to obtain funding through equity or debt financings, strategic collaborations or grants. Our lead product candidate, AKB-9778, recently completed a proof of concept Phase 2 clinical trial in April 2015. Our product candidate AKB-4924 in our HIF-1-a stabilization program recently completed a Phase 1a trial. Our other product candidates are in preclinical development. As a result, we expect that it will be several years, if ever, before we have a product candidate ready for commercialization. Even if we obtain regulatory approval to market AKB-9778, our future revenues will depend upon the size of any markets in which AKB-9778 has received approval, our ability to achieve sufficient market acceptance, reimbursement from third-party payors and other factors. We expect to continue to incur significant expenses and increasing operating losses for the foreseeable future. We anticipate that our expenses will increase significantly if and as we: • | continue our Phase 2 program and prepare for a future Phase 3 development program of AKB-9778 for the treatment of diabetic retinopathy, or DR, including as we continue our ongoing TIME-2b clinical trial. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | seek regulatory approvals for our product candidates that successfully complete clinical trials; --+------------------------------------------------------------------------------------------------- • | have our product candidates manufactured for clinical trials and for commercial sale; --+-------------------------------------------------------------------------------------- • | establish a sales, marketing and distribution infrastructure to commercialize any products for which we may obtain marketing approval; --+--------------------------------------------------------------------------------------------------------------------------------------- • | initiate additional preclinical, clinical or other studies for AKB-9778, AKB-4924, ARP-1536 and other product candidates that we may develop or acquire; --+--------------------------------------------------------------------------------------------------------------------------------------------------------- • | seek to discover and develop additional product candidates; --+------------------------------------------------------------ • | acquire or in-license other commercial products, product candidates and technologies; --+-------------------------------------------------------------------------------------- • | make royalty, milestone or other payments under any future in-license agreements; --+---------------------------------------------------------------------------------- • | maintain, protect and expand our intellectual property portfolio; --+------------------------------------------------------------------ • | attract and retain skilled personnel; and --+------------------------------------------ • | create additional infrastructure to support our operations as a public company. --+-------------------------------------------------------------------------------- 31 Because of the numerous risks and uncertainties associated with pharmaceutical product development, we are unable to accurately predict the timing or amount of increased expenses or when, if at all, we will be able to achieve profitability. If we are required by the United States Food and Drug Administration, or FDA, the European Medicines Agency, or EMA, or other regulatory authorities to perform s tudies in addition to those currently expected, or if there are any delays in completing our clinical trials or the development of any of our product candidates, our expenses could increase. The net losses we incur may fluctuate significantly from quarter to quarter and year to year, such that a period-to-period comparison of our results of operations may not be a good indication of our future performance. In any particular quarter or quarters, our operating results could be below the expectations of securities analysts or investors, which could cause our stock price to decline. To become and remain profitable, we must succeed in developing and commercializing our product candidates, which must generate significant revenue. This will require us to be successful in a range of challenging activities, including completing preclinical testing and clinical trials of our product candidates, discovering additional product candidates, obtaining regulatory approval for these product candidates and manufacturing, marketing and selling any products for which we may obtain regulatory approval. We are only in the preliminary stages of most of these activities. We may never succeed in these activities and, even if we do, may never generate revenues that are significant enough to achieve profitability. Even if we do achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis. Our failure to become and remain profitable could depress the value of our company and could impair our ability to raise capital, expand our business, maintain our research and development efforts, diversify our product offerings or even continue our operations. A decline in the value of our company could cause you to lose all or part of your investment. We will require substantial additional financing. A failure to obtain this necessary capital when needed could force us to delay, limit, reduce or terminate our product development or commercialization efforts. As of September 30, 2017, our cash and cash equivalents and short-term investments were $24.8 million. We believe that we will continue to expend substantial resources for the foreseeable future developing AKB-9778 and any other product candidates that we may develop or acquire. Additionally, we may expend substantial resources to further develop AKB-4924 if we secure sufficient additional funding, likely from a strategic and commercial partner for that candidate, as well as ARP-1536 if we secure sufficient additional funding, which may be from a partner for that candidate. These expenditures will include costs associated with research and development, potentially obtaining regulatory approvals and having our products manufactured, as well as marketing and selling products approved for sale, if any. In addition, other unanticipated costs may arise. Because the outcome of our current and anticipated clinical trials is highly uncertain, we cannot reasonably estimate the actual amounts necessary to successfully complete the development and commercialization of our product candidates. Our future capital requirements depend on many factors, including: • | the rate of progress, results and cost of completing our Phase 2 program of AKB-9778 and our operating costs incurred as we conduct these trials and through our end of Phase 2 meeting with the FDA, and equivalent meetings with the EMA and other regulatory authorities; --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | assuming AKB-9778 advances to Phase 3 clinical trials, the scope, size, rate of progress, results and costs of initiating and completing our Phase 3 development program of AKB-9778; --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | assuming favorable clinical results, the cost, timing and outcome of our efforts to obtain marketing approval for AKB-9778 in the United States, Europe and in other jurisdictions, including to fund the preparation and filing of regulatory submissions for AKB-9778 with the FDA, the EMA and other regulatory authorities; --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | the scope, progress, results and costs of preclinical development, laboratory testing and clinical trials that we may undertake for AKB-4924, ARP-1536 and any other product candidates that we may develop or acquire; --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ • | the timing of, and the costs involved in, obtaining regulatory approvals for AKB-4924 and ARP-1536 if we continue their further development upon securing sufficient additional funding and/or a strategic and commercial partner, and clinical trials of these product candidates are successful; --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | the cost and timing of future commercialization activities for our products, if any of our product candidates are approved for marketing, including product manufacturing, marketing, sales and distribution costs; --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | the revenue, if any, received from commercial sales of our product candidates for which we receive marketing approval; --+----------------------------------------------------------------------------------------------------------------------- • | the cost of having our product candidates manufactured for clinical trials in preparation for regulatory approval and in preparation for commercialization; --+------------------------------------------------------------------------------------------------------------------------------------------------------------ 32 • | our ability to establish and maintain strategic collaborations, licensing or other arrangements and the financial terms of such agreements; and --+------------------------------------------------------------------------------------------------------------------------------------------------ • | the costs involved in preparing, filing, prosecuting patent applications, maintaining, defending and enforcing our intellectual property rights, including litigation costs and the outcome of such litigation. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Based on our current operating plan, and absent any future financings or strategic partnerships, we believe that our existing cash and cash equivalents and investments will be sufficient to fund our projected operating expenses and capital expenditure requirements into the first quarter of fiscal year 2019. However, our operating plan may change as a result of many factors currently unknown to us, and we may need additional funds sooner than planned. In addition, we may seek additional capital due to favorable market conditions or strategic considerations even if we believe we have sufficient funds for our current or future operating plans. Additional funds may not be available when we need them on terms that are acceptable to us, or at all. If adequate funds are not available to us on a timely basis, we may be required to delay, limit, reduce or terminate preclinical studies, clinical trials or other development activities for AKB-9778, AKB-4924, ARP-1536 or any other product candidates that we develop or acquire, or delay, limit, reduce or terminate our establishment of sales and marketing capabilities or other activities that may be necessary to commercialize our product candidates. Raising additional capital may cause dilution to our existing stockholders, restrict our operations or require us to relinquish rights to product candidates on unfavorable terms to us. Until such time, if ever, as we can generate substantial product revenues, we expect to finance our cash needs through a combination of equity offerings, debt financings and license, development and commercialization agreements with collaborators. To the extent that we raise additional capital through the sale of equity or convertible debt securities, your ownership interest will be diluted, and the terms may include liquidation or other preferences and anti-dilution protections that adversely affect your rights as a stockholder. Debt financing, if available, may involve agreements that include covenants limiting or restricting our ability to take certain actions, such as incurring additional debt, making capital expenditures or declaring dividends. If we raise additional funds through strategic collaborations with third parties, we may have to relinquish valuable rights to our product candidates, future revenue streams, research programs or product candidates or grant licenses on terms that are not favorable to us. If we are unable to raise additional funds through equity or debt financing when needed, we may be required to delay, limit, reduce or terminate our product development or commercialization efforts for AKB-9778 and, if we secure sufficient additional funding and/or a strategic and commercial partner, to continue their development, for AKB-4924, ARP-1536 or any other product candidates that we develop or acquire, or grant rights to develop and market product candidates that we would otherwise prefer to develop and market ourselves. Our limited operating history may make it difficult for you to evaluate the success of our business to date and to assess our future viability. We commenced active operations in 2011, and our operations to date have been limited to organizing and staffing our company, business planning, raising capital, identifying potential product candidates, undertaking preclinical studies and conducting clinical trials. We currently have three product candidates, one of which is in preclinical development. Of these product candidates, we may further develop AKB-4924 and ARP-1536 only if we secure sufficient additional funding and/or a strategic and commercial partner, to continue their clinical development. Biopharmaceutical product development is a highly speculative undertaking and involves a substantial degree of risk. Only a small fraction of biopharmaceutical development programs ultimately result in commercial products or even product candidates and a number of events could delay our development efforts and negatively impact our ability to obtain regulatory approval for, and to manufacture, market and sell, a product. We have not yet demonstrated our ability to successfully complete later stage clinical trials, obtain regulatory approvals, manufacture a commercial scale product, or arrange for a third party to do so on our behalf, or conduct sales and marketing activities necessary for successful product commercialization. Consequently, any predictions you make about our future success or viability may not be as accurate as they could be if we had a longer operating history. In addition, as a young business, we may encounter unforeseen expenses, difficulties, complications, delays and other known and unknown factors. We will need to expand our capabilities to support commercial activities. We may not be successful in adding such capabilities. 33 Risks Related to Our Business and the Clinical Development, Regulatory Review and Approval of Product Candidates We depend heavily on the success of one product candidate, AKB-9778, which is in Phase 2 clinical development. Even if we obtain favorable clinical results, we may not be able to obtain regulatory approval for, or successfully commercialize, AKB-9778. We currently have only one product candidate, AKB-9778, in clinical development, and our business depends almost entirely on the successful clinical development, regulatory approval and commercialization of that product candidate, which may never occur. We currently have no products for sale, generate no revenues from sales of any drugs, and may never be able to develop marketable products. AKB-9778, which recently completed a proof of concept Phase 2 clinical trial, will require substantial additional clinical development, testing, manufacturing process development, and regulatory approval before we are permitted to commence its commercialization. In June 2017, we announced the initiation of patient dosing in our ongoing Phase 2b clinical trial of AKB-9778 in patients with DR. Additionally, in July 2017 we announced the completion of a single-center study of the safety and efficacy of treatment with concomitant anti-VEGF therapy. Our other product candidate, AKB-4924, recently completed a Phase 1a trial. We currently may further develop AKB-4924 only if we secure sufficient additional funding, likely from a strategic and commercial partner, to continue its development. In addition, we currently may further develop ARP-1536 only if we secure sufficient additional funding, which may be from a strategic and commercial partner to continue its clinical development. There can be no assurance that we will be able to secure such additional funding or a strategic or commercial partner on commercially reasonable terms or at all. Any failure to do so would impair our ability to advance AKB-4924 and ARP-1536, resulting in our even greater dependence on AKB-9778. None of our product candidates has advanced into a pivotal trial, and it may be years before such trial is initiated, if ever. The clinical trials of our product candidates are, and the manufacturing and marketing of our product candidates will be, subject to extensive and rigorous review and regulation by numerous government authorities in the United States and in other countries where we intend to test and, if approved, market any product candidates. Before obtaining regulatory approval for the commercial sale of any product candidate, we must demonstrate through extensive preclinical testing and clinical trials that any drug candidate is safe and effective and any biological product candidate is safe, pure, and potent for use in each target indication. This process can take many years. Of the large number of drugs in development in the United States, only a small percentage successfully complete the FDA regulatory approval process and are commercialized. Accordingly, even if we are able to obtain the requisite capital to continue to fund our development and clinical programs, we may be unable to successfully develop or commercialize AKB-9778. We are not permitted to market AKB-9778 in the United States until we receive approval of an NDA from the FDA, or in any foreign countries until we receive the requisite approval from such countries. As a condition to submitting an NDA to the FDA for AKB-9778 regarding its ability to treat patients with DR, we must complete our ongoing clinical trials, Phase 3 trials, and any additional non-clinical studies or clinical trials required by the FDA. To date, we have only completed a Phase 2 clinical trial for AKB-9778 and five other early stage trials. AKB-9778 may not be successful in clinical trials or receive regulatory approval. Further, AKB-9778 may not receive regulatory approval even if it is successful in clinical trials. Obtaining approval of an NDA is a complex, lengthy, expensive and uncertain process that typically takes many years following the commencement of clinical trials and depends upon numerous factors, including the substantial discretion of the regulatory authorities. In addition, the policies or regulations, or the type and amount of clinical data necessary to gain approval, may change during the course of a product candidate’s clinical development and may vary among jurisdictions. We have not obtained regulatory approval for any product candidate and it is possible that AKB-9778 will never obtain regulatory approval. The FDA may delay, limit or deny approval of AKB-9778 for many reasons, including, among others: • | we may not be able to demonstrate that AKB-9778 is safe and effective in treating patients with DR to the satisfaction of the FDA; --+----------------------------------------------------------------------------------------------------------------------------------- • | the results of our clinical trials may not meet the level of statistical or clinical significance required by the FDA for marketing approval; --+---------------------------------------------------------------------------------------------------------------------------------------------- • | the FDA may disagree with the number, design, size, conduct or implementation of our clinical trials; --+------------------------------------------------------------------------------------------------------ • | the FDA may not approve the formulation, labeling or specifications of AKB-9778; --+--------------------------------------------------------------------------------- • | the FDA may require that we conduct additional clinical trials; --+---------------------------------------------------------------- • | the contract research organizations, or CROs, that we retain to conduct our clinical trials may take actions outside of our control that materially adversely impact our clinical trials; --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ • | we may fail to perform in accordance with the FDA’s good clinical practice, or GCP, requirements; --+-------------------------------------------------------------------------------------------------- 34 • | the FDA may disagree with our interpretation of data from our preclinical studies and clinical trials; --+------------------------------------------------------------------------------------------------------- • | the FDA may find deficiencies with the manufacturing processes or facilities of third-party manufacturers with which we contract; or --+------------------------------------------------------------------------------------------------------------------------------------- • | the policies or regulations of the FDA may significantly change in a manner that renders our clinical data insufficient for approval, or requiring that we amend or submit new clinical protocols. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- In addition, similar reasons may cause the EMA or other regulatory authorities to delay, limit or deny approval of AKB-9778 outside the United States. Any of these factors, many of which are beyond our control, could jeopardize our ability to obtain regulatory approval for and successfully market AKB-9778. Because our business is almost entirely dependent upon AKB-9778, any such setback in our pursuit of regulatory approval would have a material adverse effect on our business and prospects. Alternatively, even if we obtain regulatory approval, that approval may be for indications or patient populations that are not as broad as we intend or desire or may require labeling that includes significant use or distribution restrictions or safety warnings. We may also be required to perform additional, unanticipated clinical trials to obtain approval or be subject to additional post marketing testing requirements to maintain regulatory approval. In addition, regulatory authorities may withdraw their approval of a product or the FDA may require a risk evaluation and mitigation strategy, or REMS, for a product, which could impose restrictions on its distribution. Any of the foregoing scenarios could materially harm the commercial prospects for our product candidates. We have not obtained agreement with the FDA, EMA or other regulatory authorities on the design of our Phase 3 development program. We have not obtained agreement with the FDA on the design of our Phase 3 development program. We plan to hold an end of Phase 2 meeting with the FDA upon successful completion of our Phase 2 clinical program. If the FDA determines that the Phase 2 trial results do not support moving into a pivotal program, we would be required to conduct additional Phase 2 studies. Alternatively, the FDA could disagree with our proposed design of our Phase 3 development program and could suggest a larger number of subjects or a longer course of treatment than our current expectations. If the FDA takes such positions, the costs of our AKB-9778 development program could increase materially and the potential market introduction of AKB-9778 could be delayed or we could risk not obtaining FDA approval even if the Phase 3 trials meet their primary endpoints. The FDA also may require that we conduct additional clinical, nonclinical or manufacturing validation studies and submit that data before it will consider an NDA application. While we intend to follow the regulatory pathway that ranibizumab and aflibercept undertook when they were approved for DR in the presence of DME, we have not yet sought guidance for the regulatory path for AKB-9778 with the EMA or other regulatory authorities. We cannot predict what additional requirements may be imposed by these regulatory authorities or how such requirements might delay or increase costs for our planned Phase 3 development program. For example, ranibizumab and aflibercept are anti-vascular endothelial growth factor, or anti-VEGF therapies, which block vascular endothelial growth factor, used in the treatment of DR, DME, age-related macular degeneration and retinal vein occlusion, while AKB-9778 is a small molecule activator of the Tie-2 pathway, and such differences may result in a different regulatory pathway for AKB-9778, including one that may be longer, more complex or expensive than that of ranibizumab or aflibercept. Because our business is almost entirely dependent upon the successful development, regulatory approval, and commercialization of AKB-9778, any such delay or increase costs would have an adverse effect on our business. We may find it difficult to enroll patients in our clinical trials, which could delay or prevent clinical trials of our product candidates. Identifying and qualifying patients to participate in clinical trials of our product candidates is critical to our success. The timing of our clinical trials depends on the speed at which we can recruit patients to participate in testing our product candidates. Our competitors may have ongoing clinical trials for product candidates that could be competitive with our product candidates, and patients who would otherwise be eligible for our clinical trials may instead enroll in clinical trials of our competitors’ product candidates. For example, while we have initiated patient dosing in our TIME-2b clinical trial, there is no guarantee that we can successfully enroll patients in a timely manner. As a result, the timeline for recruiting patients, conducting trials and obtaining regulatory approval of potential products may be delayed. These delays could result in increased costs, delays in advancing our development of AKB-9778 or termination of the clinical trials altogether. 35 We may not be able to identify, recruit and enroll a sufficient number of patients, or those with required or desired characteristics to achieve diversity in a trial, to complete our clinical trials in a timely manner. Patient enrollment is affected by factors including: • | severity of the disease under investigation; --+--------------------------------------------- • | design of the trial protocol; --+------------------------------ • | size and nature of the patient population; --+------------------------------------------- • | eligibility criteria for the trial in question; --+------------------------------------------------ • | perceived risks and benefits of the product candidate under study; --+------------------------------------------------------------------- • | proximity and availability of clinical trial sites for prospective patients; --+----------------------------------------------------------------------------- • | availability of competing therapies and clinical trials and clinicians’ and patients’ perceptions as to the potential advantages of AKB-9778 in relation to available therapies or other products under development; --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | efforts to facilitate timely enrollment in clinical trials; --+------------------------------------------------------------ • | patient referral practices of physicians; and --+---------------------------------------------- • | ability to monitor patients adequately during and after treatment. --+------------------------------------------------------------------- We may not be able to initiate or continue clinical trials if we cannot enroll a sufficient number of eligible patients to participate in the clinical trials required by regulatory agencies. If we have difficulty enrolling a sufficient number of patients to conduct our clinical trials as planned, we may need to delay, limit or terminate ongoing or planned clinical trials, any of which would have an adverse effect on our business. We may not be able to comply with requirements of foreign jurisdictions in conducting trials outside of the United States. In addition, we may not be able to obtain regulatory approval in foreign jurisdictions. If AKB-9778 is successful in Phase 2 development, we currently expect to conduct our Phase 3 clinical trial of AKB-9778 that may include trial sites outside of the United States, including Japan and the European Union, and seek regulatory approval for AKB-9778 for the treatment of patients with DR in major markets in addition to the United States, including the European Union. Our ability to successfully initiate, enroll and complete a clinical trial in any foreign country, should we attempt to do so, is subject to numerous risks unique to conducting business in international markets, including: • | difficulty in establishing or managing relationships with qualified CROs and physicians; --+----------------------------------------------------------------------------------------- • | different local standards for the conduct of clinical trials; --+-------------------------------------------------------------- • | the potential burden of complying with a variety of foreign laws, medical standards and regulatory requirements, including the regulation of pharmaceutical and biotechnology products and treatments; and --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | the acceptability of data obtained from trials conducted in the United States to the EMA and other regulatory authorities. --+--------------------------------------------------------------------------------------------------------------------------- If we fail to successfully meet requirements for the conduct of clinical trials outside of the United States, we may be delayed in obtaining, or be unable to obtain, regulatory approval for AKB-9778 in countries outside of the United States. Regulatory authorities outside the United States will require compliance with numerous and varying regulatory requirements. The approval procedures vary among jurisdictions and may involve requirements for additional testing, and the time required to obtain approval may differ from that required to obtain FDA approval. In addition, in many countries outside the United States, a product must be approved for reimbursement before it can be approved for sale in that country. In some cases, the price that we intend to charge for our products is also subject to approval. Approval by the FDA does not ensure approval by regulatory authorities in other countries or jurisdictions, and approval by one foreign regulatory authority does not ensure approval by regulatory authorities in other foreign countries or by the FDA. However, the failure to obtain approval in one jurisdiction may negatively impact our ability to obtain approval in another jurisdiction. The foreign regulatory approval process may include all of the risks associated with obtaining FDA approval. We may not obtain foreign regulatory approvals on a timely basis, if at all. We may not be able to file for regulatory approvals and may not receive necessary approvals to commercialize our products in any market. 36 Clinical drug development is a lengthy and expensive process with an uncertain outcome, and positive results fro m Phase 1 and Phase 2 clinical trials of AKB-9778 are not necessarily predictive of the results of our completed and any future clinical trials of AKB-9778. If we cannot replicate the positive results from our Phase 1 and Phase 2 clinical trials of AKB-977 8 in our ongoing and subsequent clinical trials, we may be unable to successfully develop, obtain regulatory approval for and commercialize AKB-9778. Clinical testing is expensive and can take many years to complete, and its outcome is inherently uncertain. Failure can occur at any time during the clinical trial process. Success in preclinical studies may not be predictive of similar results in humans during clinical trials, and successful results from early or small clinical trials may not be replicated in later and larger clinical trials. For example, our early encouraging preclinical and clinical results for AKB-9778 do not ensure that the results of our ongoing clinical trials, including TIME-2b, or any future clinical trials will demonstrate similar results. Our planned Phase 2 and Phase 3 development program will enroll a larger number of subjects and will treat subjects for longer periods than our prior trials, which will result in a greater likelihood that adverse events may be observed. Many companies in the pharmaceutical and biotechnology industries have suffered significant setbacks in late-stage clinical trials after achieving positive results in early stage development, and we may face similar setbacks. If the results of our ongoing or future clinical trials for AKB-9778 are inconclusive with respect to efficacy, if we do not meet our clinical endpoints with statistical significance, or if there are safety concerns or adverse events, we may be prevented from or delayed in obtaining marketing approval for AKB-9778. We may experience delays in our planned Phase 2 clinical trial for AKB-9778 and we do not know whether planned clinical trials will begin on time, need to be redesigned, enroll patients on time or be completed on schedule, if at all. Clinical trials can be delayed or aborted for a variety of reasons, including delay or failure to: • | obtain regulatory approval to commence a clinical trial; --+--------------------------------------------------------- • | reach agreement on acceptable terms with prospective CROs and clinical trial sites, the terms of which can be subject to extensive negotiation and may vary significantly among different CROs and trial sites; --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | obtain institutional review board, or IRB, approval at each site; --+------------------------------------------------------------------ • | recruit, enroll and retain patients through the completion of clinical trials; --+------------------------------------------------------------------------------- • | maintain clinical sites in compliance with trial protocols and regulatory requirements through the completion of clinical trials; --+---------------------------------------------------------------------------------------------------------------------------------- • | address any patient safety concerns that arise during the course of the trial; --+------------------------------------------------------------------------------- • | initiate or add a sufficient number of clinical trial sites; or --+---------------------------------------------------------------- • | manufacture sufficient quantities of our product candidate for use in clinical trials. --+--------------------------------------------------------------------------------------- We could encounter delays if a clinical trial is suspended or terminated by us, by the relevant IRBs at the sites at which such trials are being conducted, by the Data Safety Monitoring Board, or DSMB, for such trial or by the FDA or other regulatory authorities. Such authorities may impose such a suspension or termination due to a number of factors, including failure to conduct the clinical trial in accordance with regulatory requirements or our clinical protocols, inspection of the clinical trial operations or trial site by the FDA or other regulatory authorities resulting in the imposition of a clinical hold, unforeseen safety issues or adverse side effects, changes in laws or regulations, or lack of adequate funding to continue the clinical trial. Any delays in completing our clinical trials will increase our costs, slow down our product candidate development and approval process and jeopardize our ability to commence product sales and generate revenues. Any of these occurrences may harm our business, financial condition and prospects significantly. Even if we receive regulatory approval for our product candidates, such products will be subject to ongoing regulatory review, which may result in significant additional expense. Additionally, our product candidates, if approved, could be subject to labeling and other restrictions, and we may be subject to penalties if we fail to comply with regulatory requirements or experience unanticipated problems with our products. Any regulatory approvals that we receive for our product candidates may be subject to limitations on the approved indicated uses for which the product may be marketed or to conditions of approval, or contain requirements for potentially costly post-marketing testing, including Phase 4 clinical trials, and surveillance to monitor the safety and efficacy of the products. In addition, if the FDA approves any of our product candidates, the manufacturing processes, labeling, packaging, distribution, adverse event reporting, storage, advertising, promotion and recordkeeping for the product will be subject to extensive and ongoing regulatory requirements. These requirements include submissions of safety and other post-marketing information and reports, registration, as well as continued compliance with current Good Manufacturing Practice, or cGMP, requirements and GCP requirements for any clinical trials that we conduct post-approval. 37 Post-approval discovery of previously unknown problems with an approved product, including adverse events of unanticipated severity or frequency or relating to manufacturing operations or processes, or failure to comply with regulatory requirements, may result in, among other th ings: • | restrictions on the marketing or manufacturing of the product, withdrawal of the product from the market, or product recalls; --+------------------------------------------------------------------------------------------------------------------------------ • | fines, untitled or warning letters or holds on clinical trials; --+---------------------------------------------------------------- • | refusal by the FDA to approve pending applications or supplements to approved applications submitted by us, or suspension or revocation of product approvals; --+-------------------------------------------------------------------------------------------------------------------------------------------------------------- • | product seizure or detention, or refusal to permit the import or export of products; --+------------------------------------------------------------------------------------- • | a REMS program; and --+-------------------- • | injunctions or the imposition of civil or criminal penalties. --+-------------------------------------------------------------- The FDA’s policies may change and additional government regulations may be enacted. We cannot predict the likelihood, nature or extent of government regulation that may arise from future legislation or administrative action, either in the United States or abroad. If we are slow or unable to adapt to changes in existing requirements or the adoption of new requirements or policies, or are not able to maintain regulatory compliance, we may lose any marketing approval that may have been obtained and we may not achieve or sustain profitability, which would adversely affect our business. Risks Related to Our Reliance on Third Parties We rely on third parties to conduct preclinical studies and clinical trials for our product candidates, and if they do not properly and successfully perform their obligations to us, we may not be able to obtain regulatory approvals for our product candidates. We rely on third party CROs and other third parties to assist in managing, monitoring and otherwise carrying out our ongoing trials of AKB-9778. We expect to continue to rely on third parties, such as CROs, clinical data management organizations, medical institutions and clinical investigators to conduct our clinical trials in the future, including our Phase 3 development program for AKB-9778. We compete with many other companies for the resources of these third parties. The third parties on whom we rely may terminate their engagements with us at any time, and having to enter into alternative arrangements would delay development and commercialization of our product candidates. Our reliance on these third parties for research and development activities will reduce our control over these activities but will not relieve us of our responsibilities. For example, the FDA and foreign regulatory authorities require compliance with regulations and standards, including GCP requirements, for designing, conducting, monitoring, recording, analyzing and reporting the results of clinical trials to ensure that the data and results are credible and accurate and that the rights, integrity and confidentiality of trial participants are protected. Although we rely on third parties to conduct our clinical trials, we are responsible for ensuring that each of these clinical trials is conducted in accordance with its general investigational plan and protocol under legal and regulatory requirements. Regulatory authorities enforce these GCP requirements through periodic inspections of trial sponsors, principal investigators and trial sites. If we or any of our investigators or CROs fail to comply with applicable GCP requirements, the clinical data generated in our clinical trials may be deemed unreliable and the FDA, EMA or other regulatory authorities may require us to perform additional clinical trials before approving our marketing applications. We cannot assure you that upon inspection by a given regulatory authority, such regulatory authority will determine that any of our clinical trials comply with GCP requirements. In addition, our clinical trials must be conducted with product produced under applicable cGMP regulations. Failure to comply with these regulations may require us to repeat clinical trials, which would delay the regulatory approval process. If these third parties do not successfully carry out their duties under their agreements, if the quality or accuracy of the data they obtain is compromised due to their failure to adhere to clinical trial protocols or to regulatory requirements, or if they otherwise fail to comply with clinical trial protocols or meet expected deadlines, the clinical trials of our product candidates may not meet regulatory requirements. If clinical trials do not meet regulatory requirements or if these third parties need to be replaced, preclinical development activities or clinical trials may be extended, delayed, suspended or terminated. If any of these events occur, we may not be able to obtain regulatory approval of our product candidates on a timely basis or at all. We also expect to rely on other third parties to store and distribute drug supplies for our clinical trials. Any performance failure on the part of our distributors could delay clinical development or marketing approval of our product candidates or commercialization of our products, producing additional losses and depriving us of potential product revenue. 38 We intend to rely on third parties to conduct some or all aspects of our product manufacturing, and these third parties may not perform satisfactorily. We do not have any manufacturing facilities and do not expect to independently conduct our product candidate manufacturing for research and preclinical and clinical testing. We currently rely, and expect to rely, on third parties to manufacture and supply drug products for our AKB-9778 clinical trials, and we expect to continue to rely on third parties for the manufacture of clinical and, if necessary, commercial quantities of our product candidates. This reliance on third parties increases the risk that we will not have sufficient quantities of our product candidates or such quantities at an acceptable cost or quality, which could delay, prevent or impair our development or commercialization efforts. Any of these third parties may terminate their engagement with us at any time. We believe we have sufficient drug product to complete our ongoing trials of AKB-9778. We have entered into an agreement for the manufacturing of the drug substance for the Phase 2 development program of AKB-9778. However, if this manufacturer cannot perform as agreed, we may be required to find replacement manufacturers. We do not currently have arrangements in place for the manufacturing of drug product for the Phase 3 development program. Although we believe that there are several potential alternative manufacturers who could manufacture our product candidates, we may incur significant delays and added costs in identifying, qualifying and contracting with any such replacement, as well as producing the drug product. The FDA or comparable foreign regulatory authorities may find deficiencies with the manufacturing processes or facilities of third-party manufacturers with which we contract for clinical and commercial supplies. Manufacturers of drug products and their facilities are subject to continual review and periodic inspections by the FDA and other regulatory authorities for compliance with cGMP requirements relating to quality control, quality assurance and corresponding maintenance of records and documents. In addition, we have to enter into technical transfer agreements and share our know-how with the third-party manufacturers, which can be time-consuming and may result in delays. These delays could result in a suspension of our clinical trials or, if AKB-9778 is approved and marketed, a failure to satisfy patient demand. Reliance on third party manufacturers entails risks to which we would not be subject if we manufactured the product candidates ourselves, including: • | the inability to negotiate manufacturing agreements with third parties under commercially reasonable terms; --+------------------------------------------------------------------------------------------------------------ • | reduced control as a result of using third party manufacturers for all aspects of manufacturing activities, including regulatory compliance and quality assurance; --+------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | termination or nonrenewal of manufacturing agreements with third parties in a manner or at a time that is costly or damaging to us; --+------------------------------------------------------------------------------------------------------------------------------------ • | the possible misappropriation of our proprietary information, including our trade secrets and know-how; and --+------------------------------------------------------------------------------------------------------------ • | disruptions to the operations of our manufacturers or suppliers caused by conditions unrelated to our business or operations, including the bankruptcy of the manufacturer or supplier or a catastrophic event affecting our manufacturers or suppliers. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Any of these events could lead to clinical study delays or failure to obtain regulatory approval, or affect our ability to successfully commercialize future products. Some of these events could be the basis for FDA action, including injunction, recall, seizure or total or partial suspension of production. The facilities used by our contract manufacturers to manufacture our product candidates must be evaluated by the FDA pursuant to inspections that will be conducted after we submit our NDA to the FDA. We do not control the manufacturing process of, and are completely dependent on, our contract manufacturers for compliance with cGMP requirements for manufacture of both drug substance and finished drug product. If our contract manufacturers cannot successfully manufacture material that conforms to our specifications and the strict regulatory requirements of the FDA, we will not be able to secure and/or maintain regulatory approval for our product candidates. In addition, we have no control over the ability of our contract manufacturers to maintain adequate quality control, quality assurance and qualified personnel. If the FDA, EMA or other regulatory authorities find deficiencies with or do not approve these facilities for the manufacture of our product candidates or if they find deficiencies or withdraw any such approval in the future, we may need to find alternative manufacturing facilities, which would significantly impact our ability to develop, obtain regulatory approval for or market our product candidates, if approved. Moreover, our failure, or the failure of our third party manufacturers, to comply with applicable regulations could result in sanctions being imposed on us, including clinical holds, fines, injunctions, civil penalties, delays, suspension or withdrawal of approvals, license revocation, seizures or recalls of product candidates or products, operating restrictions and criminal prosecutions, any of which could significantly and adversely affect supplies of our drug products or product candidates. 39 In addition, our product candidates and any products that we may develop may compete with other product candidates and products for access to manufacturing facilities. Certain of these manufacturing facilities may be contractually prohibited from manufacturing our product due to non-compete agreements with our competitors. There are a limited number of manufacturers that operate under cGMP regulations and that might be capable of manufacturing for us. Our current and anticipated future dependence upon others for the manufacture of our product candidates or products may adversely affect our future profit margins and our ability to commercialize any products that receive marketing approval on a timely and competitive basis. If we are unable to manufacture our product candidates in sufficient quantities, at sufficient yields, we may experience delays in product development, clinical trials, regulatory approval and commercial distribution. Completion of our clinical trials and commercialization of our product candidates require access to, or development of, facilities to manufacture our product candidates at sufficient yields and at commercial scale. We have limited experience manufacturing, or managing third parties in manufacturing, any of our product candidates in the volumes that will be necessary to support large-scale clinical trials or commercial sales. Efforts to establish these capabilities may not meet initial expectations as to scheduling, scale-up, reproducibility, yield, purity, cost, potency or quality. Our reliance on contract manufacturers may adversely affect our operations or result in unforeseen delays or other problems beyond our control. Because of contractual restraints and the limited number of third-party manufacturers with the expertise and facilities to manufacture our bulk drug product on a commercial scale, replacement of a manufacturer may be expensive and time-consuming and may cause interruptions in the production of our drug product. A third-party manufacturer may also encounter difficulties in production. These problems may include: • | difficulties with production costs, scale-up and yields; --+--------------------------------------------------------- • | availability of raw materials and supplies; --+-------------------------------------------- • | quality control and assurance; --+------------------------------- • | shortages of qualified personnel; --+---------------------------------- • | compliance with strictly enforced federal, state and foreign regulations that vary in each country where a product might be sold; and --+-------------------------------------------------------------------------------------------------------------------------------------- • | lack of capital funding. --+------------------------- Any delay or interruption in our supply of product candidates could have a material adverse effect on our business, financial condition, results of operations and cash flows. We may not be successful in establishing and maintaining strategic collaborations, which could adversely affect our ability to develop and commercialize our product candidates, negatively impacting our operating results. If approved, we plan to commercialize AKB-9778 ourselves in the United States and intend to seek one or more strategic collaborators to commercialize AKB-9778 in additional markets. In addition, we may further develop and, if approved, commercialize, AKB-4924 only if we secure sufficient additional funding, likely from a strategic and commercial partner for that candidate. With respect to ARP-1536, we may further develop and, if approved, commercialize ARP-1536 only if we secure sufficient additional funding, which may be from a strategic or commercial partner. There can be no assurance that we will be able to secure such additional funding or a strategic or commercial partner on commercially reasonable terms or at all. We face competition in seeking appropriate collaborators for our product candidates, and the negotiation process is time-consuming and complex. In order for us to successfully collaborate with a third party on our product candidates, potential collaborators must view these product candidates as economically valuable. Even if we are successful in our efforts to establish strategic collaborations, the terms that we agree upon may not be favorable to us, and we may not be able to maintain such strategic collaborations if, for example, development or approval of a product is delayed or sales of an approved product are disappointing. Any delay in entering into strategic collaboration agreements related to our product candidates could delay the development and commercialization of our product candidates and reduce their competitiveness even if they reach the market. In addition, our strategic collaborators may terminate any agreements they enter into with us, and we may not be able to adequately protect our rights under these agreements. Furthermore, our strategic collaborators will likely negotiate for certain rights to control decisions regarding the development and commercialization of our product candidates, if approved, and may not conduct those activities in the same manner as we do. 40 If we fail to establish and maintain strategic collaborations related to our product candidates for the indications and in th e geographies in which we do not intend develop and commercialize ourselves, we will bear all of the risk and costs related to the development and commercialization of any such product candidate, and we may need to seek additional financing, hire additiona l employees and otherwise develop expertise. This could negatively affect the development of any product candidate for which we do not locate a suitable strategic partner. Risks Related to Our Intellectual Property If our efforts to protect our proprietary technologies are not adequate, we may not be able to compete effectively in our market. We rely upon a combination of patents, trade secret protection and confidentiality agreements to protect the intellectual property related to our technologies. We will only be able to protect our product candidates, proprietary technologies and their uses from unauthorized use by third parties to the extent that valid and enforceable patents or trade secrets cover them. Any disclosure to or misappropriation by third parties of our confidential proprietary information could enable competitors to quickly duplicate or surpass our technological achievements, thus eroding our competitive position in our market. Composition-of-matter patents on the active pharmaceutical ingredient are generally considered to be the strongest form of intellectual property protection for pharmaceutical products, as such patents provide protection without regard to any method of use. Method-of-use patents protect the use of a product for the specified method. This type of patent does not prevent a competitor from making and marketing a product that is identical to our products for an indication that is outside the scope of the patented method. Moreover, even if competitors do not actively promote their product for our targeted indications, physicians may prescribe these products “off-label.” Although off-label prescriptions may infringe or contribute to the infringement of method-of-use patents, the practice is common and such infringement is difficult to prevent or prosecute. The strength of patents in the biotechnology and pharmaceutical field involves complex legal and scientific questions and can be uncertain. The patent applications that we own or license may fail to result in issued patents in the United States or in other foreign countries. Even if the patents do successfully issue, third parties may challenge the validity, enforceability, inventorship, or scope thereof, which may result in such patents being narrowed, invalidated or held unenforceable. Furthermore, even if they are unchallenged, our patents and patent applications may not adequately protect our intellectual property or prevent others from designing around our claims. If the breadth or strength of protection provided by the patent applications we hold with respect to our product candidates is threatened, it could dissuade companies from collaborating with us to develop, and threaten our ability to commercialize, our product candidates. Further, if we encounter delays in our clinical trials, the period of time during which we could market our product candidates under patent protection would be reduced. Since patent applications in the United States and most other countries are confidential for a period of time after filing, we cannot be certain that we were the first to file any patent application related to our product candidates. Furthermore, for applications in which all claims are entitled to a priority date before March 16, 2013, an interference proceeding can be provoked by a third-party or instituted by the United States Patent and Trademark Office or the USPTO, to determine who was the first to invent any of the subject matter covered by the patent claims of our applications. For applications containing a claim not entitled to priority before March 16, 2013, there is greater level of uncertainty in the patent law with the passage of the America Invents Act (2011), which brings into effect significant changes to the U.S. patent laws and which introduces new procedures for challenging pending patent applications and issued patents. A primary change under this reform is creating a “first to file” system in the United States. This will require us to be cognizant of the time from invention to filing of a patent application. In addition to the protection afforded by patents, we seek to rely on trade secret protection and confidentiality agreements to protect proprietary know-how that is not patentable, processes for which patents are difficult to enforce and any other elements of our drug discovery and development processes that involve proprietary know-how, information or technology that is not covered by patents. Although we require all of our employees to assign their inventions to us, and require all of our employees, consultants, advisors and any third parties who have access to our proprietary know-how, information or technology to enter into confidentiality agreements, we cannot be certain that our trade secrets and other confidential proprietary information will not be disclosed or that competitors will not otherwise gain access to our trade secrets or independently develop substantially equivalent information and techniques. Furthermore, the laws of some foreign countries do not protect proprietary rights to the same extent or in the same manner as the laws of the United States. As a result, we may encounter significant problems in protecting and defending our intellectual property both in the United States and abroad. If we are unable to prevent unauthorized material disclosure of our intellectual property to third parties, we will not be able to establish or maintain a competitive advantage in our market, which could materially adversely affect our business, operating results and financial condition. 41 We currently have a non-exclusive license to one U.S. patent. We rely on the licensor to maintain this patent and otherwise protect the intellectual property covered by this non-exclusive license. We have limited control over these activities or over any other intellectual pr operty that may be related to our in-licensed intellectual property. For example, we cannot be certain that activities by the licensor have been or will be conducted in compliance with applicable laws and regulations. We may have no control or input over w hether, and in what manner, our licensor may enforce or defend the patent against a third-party. The licensor may enforce or defend the patent less vigorously than if we had enforced or defended the patent ourselves. Further, the licensor may not necessari ly seek enforcement in scenarios in which we would feel that enforcement was in our best interests. For example, the licensor may not enforce the patent against a competitor of ours who is not a direct competitor of the licensor. If our in-licensed intelle ctual property is found to be invalid or unenforceable, then the licensor may not be able to enforce the patent against a competitor of ours. Our non-exclusive license does not prevent a third party from seeking and obtaining a non-exclusive license to the same patent that we license. If we fail to meet our obligations under the non-exclusive license agreement, then the licensor may terminate the license agreement. If the license agreement is terminated, the former licensor may seek to enforce the intellect ual property against us. We may choose to terminate the license agreement, and doing so would allow a third party to seek and obtain an exclusive license to the patent. If a third party obtains an exclusive license to intellectual property formerly license d to us, then the third party may seek to enforce the intellectual property against us. Our patents covering one or more of our products or product candidates could be found invalid or unenforceable if challenged. Any of our intellectual property rights could be challenged or invalidated despite measures we take to obtain patent and other intellectual property protection with respect to our product candidates and proprietary technology. For example, if we were to initiate legal proceedings against a third party to enforce a patent covering one of our product candidates, the defendant could counterclaim that our patent is invalid and/or unenforceable. In patent litigation in the U.S. and in some other jurisdictions, defendant counterclaims alleging invalidity and/or unenforceability are commonplace. Grounds for a validity challenge could be an alleged failure to meet any of several statutory requirements, for example, lack of novelty, obviousness or non-enablement. Grounds for an unenforceability assertion could be an allegation that someone connected with prosecution of the patent withheld material information from the USPTO or the applicable foreign counterpart, or made a misleading statement, during prosecution. A litigant or the USPTO itself could challenge our patents on this basis even if we believe that we have conducted our patent prosecution in accordance with the duty of candor and in good faith. The outcome following such a challenge is unpredictable. With respect to challenges to the validity of our patents, for example, there might be invalidating prior art, of which we and the patent examiner were unaware during prosecution. If a defendant were to prevail on a legal assertion of invalidity and/or unenforceability, we would lose at least part, and perhaps all, of the patent protection on a product candidate. Even if a defendant does not prevail on a legal assertion of invalidity and/or unenforceability, our patent claims may be construed in a manner that would limit our ability to enforce such claims against the defendant and others. The cost of defending such a challenge, particularly in a foreign jurisdiction, and any resulting loss of patent protection could have a material adverse impact on one or more of our product candidates and our business. Enforcing our intellectual property rights against third parties may also cause such third parties to file other counterclaims against us, which could be costly to defend, particularly in a foreign jurisdiction, and could require us to pay substantial damages, cease the sale of certain products or enter into a license agreement and pay royalties (which may not be possible on commercially reasonable terms or at all). Any efforts to enforce our intellectual property rights are also likely to be costly and may divert the efforts of our scientific and management personnel. Our reliance on third parties requires us to share our trade secrets, which increases the possibility that a competitor will discover them or that our trade secrets will be misappropriated or disclosed. Because we rely on third parties to research and develop and to manufacture our product candidates, we must, at times, share trade secrets with them. We seek to protect our proprietary technology in part by entering into confidentiality agreements and, if applicable, material transfer agreements, consulting agreements or other similar agreements with our advisors, employees, third-party contractors and consultants prior to beginning research or disclosing proprietary information. These agreements typically limit the rights of the third parties to use or disclose our confidential information, including our trade secrets. Despite the contractual provisions employed when working with third parties, the need to share trade secrets and other confidential information increases the risk that such trade secrets become known by our competitors, are inadvertently incorporated into the technology of others, or are disclosed or used in violation of these agreements. Given that our proprietary position is based, in part, on our know-how and trade secrets, a competitor’s discovery of our trade secrets or other unauthorized use or disclosure would impair our competitive position and may have a material adverse effect on our business. 42 In addition, these agreements ty pically restrict the ability of our advisors, employees, third-party contractors and consultants to publish data potentially relating to our trade secrets, although our agreements may contain certain limited publication rights. For example, any academic in stitution that we may collaborate with in the future will usually expect to be granted rights to publish data arising out of such collaboration, provided that we are notified in advance and given the opportunity to delay publication for a limited time peri od in order for us to secure patent protection of intellectual property rights arising from the collaboration, in addition to the opportunity to remove confidential or trade secret information from any such publication. In the future we may also conduct jo int research and development programs that may require us to share trade secrets under the terms of our research and development or similar agreements. Despite our efforts to protect our trade secrets, our competitors may discover our trade secrets, either through breach of our agreements with third parties, independent development or publication of information by any of our third-party collaborators. A competitor’s discovery of our trade secrets would impair our competitive position and have an adverse imp act on our business. Third-party claims of intellectual property infringement may be costly and time consuming, and may delay or harm our drug discovery and development efforts. Our commercial success depends in part on our avoiding infringement of the patents and proprietary rights of third parties. The pharmaceutical and biotechnology industries are characterized by extensive litigation over patent and other intellectual property rights. We may become a party to, or threatened with, future adversarial litigation or other proceedings regarding intellectual property rights with respect to our drug candidates. As the pharmaceutical and biotechnology industries expand and more patents are issued, the risk increases that our drug candidates may give rise to claims of infringement of the patent rights of others. While our product candidates are in preclinical studies and clinical trials, we believe that the use of our product candidates in these preclinical studies and clinical trials in the United States falls within the scope of the exemptions provided by 35 U.S.C. Section 271(e), which provides that it shall not be an act of infringement to make, use, offer to sell, or sell within the United States or import into the United States a patented invention solely for uses reasonably related to the development and submission of information to the FDA. As our product candidates progress toward commercialization, the possibility of a patent infringement claim against us increases. We attempt to ensure that our product candidates and the methods we employ to manufacture them, as well as the methods for their use we intend to promote, do not infringe other parties’ patents and other proprietary rights. There can be no assurance they do not, however, and competitors or other parties may assert that we infringe their proprietary rights in any event. Third parties may hold or obtain patents or other intellectual property rights and allege in the future that the use of our product candidates infringes these patents or intellectual property rights, or that we are employing their proprietary technology without authorization. Under U.S. law, a party may be able to patent a discovery of a new way to use a previously known compound, even if such compound itself is patented, provided the newly discovered use is novel and nonobvious. Such a method-of-use patent, however, if valid, only protects the use of a claimed compound for the specified methods claimed in the patent. This type of patent does not prevent persons from using the compound for any previously known use of the compound. Further, this type of patent does not prevent persons from making and marketing the compound for an indication that is outside the scope of the patented method. There may be patents of third parties of which we are currently unaware with claims to materials, formulations, methods of manufacture or methods for treatment related to the use or manufacture of our drug candidates. Also, because patent applications can take many years to issue, there may be currently pending patent applications which may later result in issued patents that our product candidates may infringe. Notwithstanding the above, third parties may in the future claim that our product candidates and other technologies infringe upon these patents and may file suit against us. Parties making claims against us may seek and obtain injunctive or other equitable relief, which could effectively block our ability to further develop and commercialize AKB-9778 or AKB-4924. If any third-party patents were held by a court of competent jurisdiction to cover the manufacturing process of any of our product candidates, any molecules formed during the manufacturing process or any final product itself, the holders of any such patents may be able to block our ability to commercialize such product candidate unless we obtained a license under the applicable patents, or until such patents expire or they are finally determined to be held invalid or unenforceable. Similarly, if any third-party patent were held by a court of competent jurisdiction to cover aspects of our formulations, processes for manufacture or our intended methods of use, the holders of any such patent may be able to block or impair our ability to develop and commercialize the applicable product candidate unless we obtained a license or until such patent expires or is finally determined to be held invalid or unenforceable. We may also elect to enter into a license in order to settle litigation or in order to resolve disputes prior to litigation. Furthermore, even in the absence of litigation, we may need to obtain licenses from third parties to advance our research or allow commercialization of our product candidates. Should a license to a third-party patent become necessary, we cannot predict whether we would be able to obtain a license, or if a license were available, whether it would be available on commercially reasonable terms. If such a license is necessary and a license under the applicable patent is unavailable on commercially reasonable terms, or at all, our ability to commercialize our product candidates may be impaired or delayed, which could in turn significantly harm our business. 43 Further, defense of infringement claims, regardless of their merit, would involve substantial litigation expense a nd would be a substantial diversion of employee resources from our business. In the event of a successful claim of infringement against us, we may have to pay substantial damages, including treble damages and attorneys’ fees for willful infringement, pay r oyalties or redesign our products, which may be impossible or require substantial time and monetary expenditure. We may become involved in lawsuits to protect or enforce our patents or other intellectual property, which could be expensive, time consuming and unsuccessful. Competitors may infringe or otherwise violate our patents, trademarks, copyrights or other intellectual property. To counter infringement or other violations, we may be required to file claims, which can be expensive and time consuming. Any such claims could provoke these parties to assert counterclaims against us, including claims alleging that we infringe their patents or other intellectual property rights. In addition, in a patent infringement proceeding, a court may decide that one or more of the patents we assert is invalid or unenforceable, in whole or in part, construe the patent’s claims narrowly or refuse to prevent the other party from using the technology at issue on the grounds that our patents do not cover the technology. Similarly, if we assert trademark infringement claims, a court may determine that the marks we have asserted are invalid or unenforceable or that the party against whom we have asserted trademark infringement has superior rights to the marks in question. In such a case, we could ultimately be forced to cease use of such marks. In any intellectual property litigation, even if we are successful, any award of monetary damages or other remedy we receive may not be commercially valuable. Furthermore, because of the substantial amount of discovery required in connection with intellectual property litigation, there is a risk that some of our confidential information could be compromised by disclosure during this type of litigation. Obtaining and maintaining our patent protection depends on compliance with various procedural, document submission, fee payment and other requirements imposed by governmental patent agencies, and our patent protection could be reduced or eliminated for non-compliance with these requirements. Periodic maintenance fees on any issued patent are due to be paid to the USPTO and foreign patent agencies in several stages over the lifetime of the patent. The USPTO and various foreign governmental patent agencies also require compliance with a number of procedural, documentary, fee payment (such as annuities) and other similar provisions during the patent application process. While an inadvertent lapse can in many cases be cured by payment of a late fee or by other means in accordance with the applicable rules, there are situations in which noncompliance can result in abandonment or lapse of the patent or patent application, resulting in partial or complete loss of patent rights in the relevant jurisdiction. Non-compliance events that could result in abandonment or lapse of a patent or patent application include, but are not limited to, failure to respond to official actions within prescribed time limits, non-payment of fees and failure to properly legalize and submit formal documents. In such an event, our competitors might be able to enter the market, which would have a material adverse effect on our business. We may be subject to claims that our employees, consultants or independent contractors have wrongfully used or disclosed confidential information of third parties. We have received confidential and proprietary information from collaborators, prospective licensees and other third parties. In addition, we employ individuals who were previously employed at other biotechnology or pharmaceutical companies. We may be subject to claims that we or our employees, consultants or independent contractors have inadvertently or otherwise used or disclosed confidential information of these third parties or our employees’ former employers. We may also be subject to claims that former employees, collaborators or other third parties have an ownership interest in our patents or other intellectual property. We may be subject to ownership disputes in the future arising, for example, from conflicting obligations of consultants or others who are involved in developing our drug candidates. Litigation may be necessary to defend against these claims. If we fail in defending any such claims, in addition to paying monetary damages, we may lose valuable intellectual property rights, such as exclusive ownership of, or right to use, valuable intellectual property. Such an outcome could have a material adverse effect on our business. Even if we are successful in defending against these claims, litigation could result in substantial cost and be a distraction to our management and employees. 44 We may not be able to protect our intellectual property rights throughout the world. Filing, prosecuting and defending patents on product candidates in all countries throughout the world would be prohibitively expensive, and our intellectual property rights in some countries outside the United States can be less extensive than those in the United States. In addition, the laws of some countries do not protect intellectual property rights to the same extent as laws in the United States. Consequently, we may not be able to prevent third parties from practicing our inventions in all countries outside the United States, or from selling or importing products made using our inventions in and into the United States or other countries. Competitors may use our technologies in countries where we have not obtained patent protection to develop their own products and further, may infringe our patents in territories where we have patent protection, but enforcement is not as strong as in the United States. These products may compete with our products and our patents or other intellectual property rights may not be effective or sufficient to prevent them from competing. Many companies have encountered significant problems in protecting and defending intellectual property rights in certain countries. The legal systems of certain countries, particularly certain developing countries, do not favor the enforcement of patents, trade secrets and other intellectual property, particularly those relating to pharmaceutical and biotechnology products, which could make it difficult for us to stop the infringement of our patents or marketing of competing products in violation of our proprietary rights generally. Proceedings to enforce our patent rights in foreign countries could result in substantial costs and divert our efforts and attention from other aspects of our business, could put our patents at risk of being invalidated or interpreted narrowly and our patent applications at risk of not issuing and could provoke third parties to assert claims against us. We may not prevail in any lawsuits that we initiate and the damages or other remedies awarded, if any, may not be commercially meaningful. Accordingly, our efforts to enforce our intellectual property rights around the world may be inadequate to obtain a significant commercial advantage from the intellectual property that we develop or license. Risks Related to Commercialization Our future commercial success depends upon attaining significant market acceptance of our product candidates, if approved, among physicians, patients, third-party payors and others in the medical community. Even if we obtain marketing approval for AKB-9778, AKB-4924 or any other product candidates that we may develop or acquire in the future, these product candidates may not gain market acceptance among physicians, third-party payors, patients and others in the medical community. In addition, market acceptance of any approved products depends on a number of other factors, including: • | the efficacy and safety of the product, as demonstrated in clinical trials; --+---------------------------------------------------------------------------- • | the clinical indications for which the product is approved and the label approved by regulatory authorities for use with the product, including any warnings that may be required on the label; --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ • | acceptance by physicians and patients of the product as a safe and effective treatment and the willingness of the target patient population to try new therapies and of physicians to prescribe new therapies; --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | the cost, safety and efficacy of treatment in relation to alternative treatments; --+---------------------------------------------------------------------------------- • | the availability of adequate coverage and reimbursement by third party payors and government authorities; --+---------------------------------------------------------------------------------------------------------- • | relative convenience and ease of administration; --+------------------------------------------------- • | the prevalence and severity of adverse side effects; --+----------------------------------------------------- • | the effectiveness of our sales and marketing efforts; and --+---------------------------------------------------------- • | the restrictions on the use of our products together with other medications, if any. --+------------------------------------------------------------------------------------- For example, the current established treatments for DME are anti-VEGF medications, including bevacizumab and ranibizumab, and the current established treatments for DR in the absence of DME include laser photocoagulation. We believe that that prescribers may be resistant to prescribing AKB-9778 with or instead of anti-VEGF medications, or instead of laser photocoagulation, which is currently the standard of care for DME and DR, respectively. Market acceptance is critical to our ability to generate significant revenue. In addition, any product candidate, if approved and commercialized, may be accepted in only limited capacities or not at all. If any approved products are not accepted by the market at all or to the extent that we expect, we may not be able to generate significant revenue and our business would suffer. 45 If we are unable to establish s ales, marketing and distribution capabilities or to enter into agreements with third parties to market and sell our product candidates, we may not be successful in commercializing our product candidates if and when they are approved. We do not have a sales or marketing infrastructure and have no experience in the sale, marketing or distribution of pharmaceutical products. To achieve commercial success for any product for which we obtain marketing approval, we will need to establish a sales and marketing organization or make arrangements with third parties to perform these services. There are risks involved with establishing our own sales, marketing and distribution capabilities. For example, recruiting and training a sales force are expensive and time consuming and could delay any product launch. If the commercial launch of a product candidate for which we recruit a sales force and establish marketing capabilities is delayed or does not occur for any reason, we would have prematurely or unnecessarily incurred these commercialization expenses. This may be costly, and our investment would be lost if we cannot retain or reposition our sales and marketing personnel. Factors that may inhibit our efforts to commercialize our products on our own include: • | our inability to recruit, train and retain adequate numbers of effective sales and marketing personnel; --+-------------------------------------------------------------------------------------------------------- • | the inability of sales personnel to obtain access to physicians or persuade adequate numbers of physicians to prescribe any future products; --+--------------------------------------------------------------------------------------------------------------------------------------------- • | our inability to effectively manage geographically dispersed sales and marketing team; --+--------------------------------------------------------------------------------------- • | the lack of complementary products to be offered by sales personnel, which may put us at a competitive disadvantage relative to companies with more extensive product lines; and --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | unforeseen costs and expenses associated with creating an independent sales and marketing organization. --+-------------------------------------------------------------------------------------------------------- If we are unable to establish our own sales, marketing and distribution capabilities and have to enter into arrangements with third parties to perform these services, our profitability, if any, is likely to be materially diminished in relation to if we were to market, sell and distribute any products that we develop ourselves. In addition, we may not be successful in entering into arrangements with third parties to sell, market and distribute our product candidates or may be unable to do so on terms that are favorable to us. We likely will have little control over such third parties, and any of them may fail to devote the necessary resources and attention to sell and market our products effectively. If we do not establish sales, marketing and distribution capabilities successfully, either on our own or in collaboration with third parties, we will not be successful in commercializing our product candidates. Coverage and reimbursement may be limited or unavailable in certain market segments for any approved products, which could make it difficult for us to sell our products profitably. Market acceptance and sales of any approved products will depend significantly on the availability of adequate coverage and reimbursement from third-party payors and may be affected by existing and future healthcare reform measures. Government authorities and third-party payors decide which drugs they will pay for and establish formularies and reimbursement levels. Coverage and reimbursement by a third-party payor may depend upon a number of factors, including the third-party payor’s determination that use of a product is: • | a covered benefit under its health plan; --+----------------------------------------- • | safe, effective and medically necessary; --+----------------------------------------- • | appropriate for the specific patient; --+-------------------------------------- • | cost-effective; and --+-------------------- • | neither experimental nor investigational. --+------------------------------------------ 46 Obtaining coverage and reimbursement approval for a product from a government or other third party payor is a time consuming and costly process that could require us to provide supporting scientific, clinical and cost-effectiveness data for the use of our products to the payor. Additionally, we may be required to enter into contracts with third-party payors to obtain favorable formulary status. W e may not be able to provide data sufficient to gain acceptance with respect to coverage and reimbursement. We cannot be sure that coverage or adequate reimbursement will be available for any of our product candidates. Even if we obtain coverage for our pr oduct candidates, third-party payors may not establish adequate reimbursement amounts, which may reduce the demand for, or the price of, our products. If reimbursement is not available or is available only to limited levels, we may not be able to commercia lize certain of our products. In addition, in the United States third-party payors are increasingly attempting to contain healthcare costs by limiting both coverage and the level of reimbursement of new drugs. As a result, significant uncertainty exists as to whether and how much third-party payors will reimburse patients for their use of newly approved drugs, which in turn will put pressure on the pricing of drugs. Price controls may be imposed, which may adversely affect our future profitability. In some countries, particularly member states of the European Union, the pricing of prescription pharmaceuticals is subject to governmental control. In these countries, pricing negotiations with governmental authorities can take considerable time after receipt of marketing approval for a product. In addition, there can be considerable pressure by governments and other stakeholders on prices and reimbursement levels, including as part of cost containment measures. Political, economic and regulatory developments may further complicate pricing negotiations, and pricing negotiations may continue after reimbursement has been obtained. Reference pricing used by various European Union member states and parallel distribution, or arbitrage between low-priced and high-priced member states, can further reduce prices. In some countries, we may be required to conduct a clinical trial or other studies that compare the cost-effectiveness of our product candidates to other available products in order to obtain or maintain reimbursement or pricing approval. Publication of discounts by third-party payors or authorities may lead to further pressure on the prices or reimbursement levels within the country of publication and other countries. If reimbursement of our products is unavailable or limited in scope or amount, or if pricing is set at unsatisfactory levels, our business could be adversely affected. The impact of recent healthcare reform and other changes in the healthcare industry and in healthcare spending is currently unknown, and may adversely affect our business model. Our revenue prospects could be affected by changes in healthcare spending and policy in the United States and abroad. We operate in a highly regulated industry and new laws, regulations or judicial decisions, or new interpretations of existing laws, regulations or decisions, related to healthcare availability, the method of delivery or payment for healthcare products and services could negatively impact our business, operations and financial condition. In the United States, the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, also called the MMA, changed the way Medicare covers and pays for pharmaceutical products. The legislation expanded Medicare coverage for drug purchases by the elderly and introduced a new reimbursement methodology based on average sales prices for physician-administered drugs. In addition, this legislation provided authority for limiting the number of drugs that will be covered in any therapeutic class. As a result of this legislation and the expansion of federal coverage of products, we expect that there will be additional pressure to reduce costs. While the MMA applies only to drug benefits for Medicare beneficiaries, private payors often follow Medicare coverage policies and payment limitations in setting their own reimbursement rates, and any reduction in reimbursement that results from the MMA may cause a similar reduction in payments from private payors. Similar regulations or reimbursement policies may be enacted in international markets which could similarly impact our business. In addition, the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act of 2010, or collectively ACA, was enacted in 2010 with a goal of reducing the cost of healthcare and substantially changing the way healthcare is financed by both government and private insurers. The ACA, among other things, increases the minimum Medicaid rebates owed by manufacturers under the Medicaid Drug Rebate Program and extends the rebate program to individuals enrolled in Medicaid managed care organizations, establishes annual fees and taxes on manufacturers of certain branded prescription drugs and biologic products, and creates a new Medicare Part D coverage gap discount program, in which manufacturers must agree to offer 50% point-of-sale discounts off negotiated prices of applicable brand drugs to eligible beneficiaries during their coverage gap period as a condition for the manufacturer’s outpatient drugs to be covered under Medicare Part D. In addition, other legislative changes have been proposed and adopted in the United States since the ACA was enacted. On August 2, 2011, the Budget Control Act of 2011 created measures for spending reductions by Congress. A Joint Select Committee on Deficit Reduction, tasked with recommending a targeted deficit reduction of at least $1.2 trillion for the years 2013 through 2021, was unable to reach required goals, thereby triggering the legislation’s automatic reduction to several government programs. This includes aggregate reductions of Medicare payments to providers of up to 2% per fiscal year, which went into effect on April 1, 2013. 47 It is likely that federal and state legislatures within the United States and foreign governments will continue to consider changes to existing healthcare legislation. Some of the provisions of the ACA have yet to be fully implemented, while certain provis ions have been subject to judicial and Congressional challenges. In January 2017, Congress voted to adopt a budget resolution for fiscal year 2017, that while not a law, is widely viewed as the first step toward the passage of legislation that would repeal certain aspects of the ACA. Further, on January 20, 2017, President Trump signed an Executive Order directing federal agencies with authorities and responsibilities under the ACA to waive, defer, grant exemptions from, or delay the implementation of any p rovision of the ACA that would impose a fiscal burden on states or a cost, fee, tax, penalty or regulatory burden on individuals, healthcare providers, health insurers, or manufacturers of pharmaceuticals or medical devices. The U.S. House of Representativ es passed legislation known as the American Health Care Act of 2017 in May 2017. More recently, the Senate Republicans introduced and then updated a bill to replace without companion legislation to replace it, and a “skinny” version of the Better Care Rec onciliation Act of 2017. Each of these measures was rejected by the full U.S. Senate. Congress also could consider subsequent legislation to replace elements of the ACA Act that are repealed. We cannot predict the reform initiatives that may be adopted in the future or whether initiatives that have been adopted will be repealed or modified. The continuing efforts of the government, insurance companies, managed care organizations and other payors of healthcare services to contain or reduce costs of healthca re may adversely affect: • | the demand for any products for which we may obtain regulatory approval; --+------------------------------------------------------------------------- • | our ability to set a price that we believe is fair for our products; --+--------------------------------------------------------------------- • | our ability to obtain coverage and reimbursement approval for a product; --+------------------------------------------------------------------------- • | our ability to generate revenues and achieve or maintain profitability; and --+---------------------------------------------------------------------------- • | the level of taxes that we are required to pay. --+------------------------------------------------ We face substantial competition, which may result in others discovering, developing or commercializing products before, or more successfully, than we do. The development and commercialization of new products is highly competitive. Our future success depends on our ability to demonstrate and maintain a competitive advantage with respect to the development and commercialization of our product candidates. Our objective is to develop and commercialize new products with superior efficacy, convenience, tolerability and safety. In many cases, the products that we commercialize will compete with existing, market-leading products. If AKB-9778 is approved and launched commercially, competing drugs may include current anti-VEGF drugs, including Lucentis, Eylea and Avastin in the treatment of DME, and current therapies including laser photocoagulation in the treatment of DR. We may face competition from potential DME and DR treatments. Many of our potential competitors have significantly greater financial, manufacturing, marketing, drug development, technical and human resources than we do. Large pharmaceutical companies, in particular, have extensive experience in clinical testing, obtaining regulatory approvals, recruiting patients and in manufacturing pharmaceutical products. Large and established companies such as Roche and Regeneron, among others, compete in the market for products to treat DR and DME. In particular, these companies have greater experience and expertise in securing government contracts and grants to support their research and development efforts, conducting testing and clinical trials, obtaining regulatory approvals to market products, manufacturing such products on a broad scale and marketing approved products. These companies also have significantly greater research and marketing capabilities than we do and may also have products that have been approved or are in late stages of development, and have collaborative arrangements in our target markets with leading companies and research institutions. Established pharmaceutical companies may also invest heavily to accelerate discovery and development of novel compounds or to in-license novel compounds that could make the product that we develop obsolete. As a result of all of these factors, our competitors may succeed in obtaining patent protection and/or FDA approval or discovering, developing and commercializing products before, or more effectively than, we do. In addition, any new product that competes with an approved product must demonstrate compelling advantages in efficacy, convenience, tolerability and safety in order to overcome price competition and to be commercially successful. If we are not able to compete effectively against potential competitors, our business will not grow and our financial condition and operations will suffer. 48 Our products may cause undesirable side effects or have other properties that delay or prevent their regulatory approval or limit their commercial potential. Undesirable side effects caused by our products or even competing products in development that utilize a common mechanism of action could cause us or regulatory authorities to interrupt, delay or halt clinical trials and could result in the denial of regulatory approval by the FDA or other regulatory authorities and potential products liability claims. AKB-9778 is currently in Phase 2 clinical development. Serious adverse events deemed to be caused by our product candidates could have a material adverse effect on the development of our product candidates and our business as a whole. The most common drug-related adverse events to date in the clinical trial evaluating the safety and tolerability of AKB-9778 in DME have been dizziness and asymptomatic decreases in blood pressure. Our understanding of the relationship between AKB-9778 and these events, as well as our understanding of adverse events in future clinical trials of other product candidates, may change as we gather more information, and additional unexpected adverse events may be observed. If we or others identify undesirable side effects caused by our product candidates either before or after receipt of marketing approval, a number of potentially significant negative consequences could result, including: • | our clinical trials may be put on hold; --+---------------------------------------- • | patient recruitment could be slowed, or enrolled patients may not want to complete a clinical trial; --+----------------------------------------------------------------------------------------------------- • | we may be unable to obtain regulatory approval for our product candidates or regulatory authorities may withdraw approvals of product candidates; --+-------------------------------------------------------------------------------------------------------------------------------------------------- • | regulatory authorities may require additional warnings on the label; --+--------------------------------------------------------------------- • | a medication guide outlining the risks of such side effects for distribution to patients may be required; --+---------------------------------------------------------------------------------------------------------- • | we could be sued and held liable for harm caused to patients; and --+------------------------------------------------------------------ • | our reputation may suffer. --+--------------------------- Any of these events could prevent us from achieving or maintaining market acceptance of our products and could substantially increase commercialization costs. Risks Related to Our Business and Industry If we fail to attract and keep senior management and key scientific personnel, we may be unable to successfully develop our products, conduct our clinical trials and commercialize our product candidates. We are highly dependent on members of our senior management, including Joseph Gardner, our President and Founder and former Chief Executive Officer, Kevin G. Peters, our Chief Scientific Officer and Stephen Pakola, our Chief Medical Officer. Additionally, we announced on October 10, 2017 that Stephen Hoffman will be joining the Company to serve as our Chief Executive Officer effective December 1, 2017. The loss of the services of any of these persons could impede the achievement of our research, development and commercialization objectives. Recruiting and retaining qualified scientific, clinical, manufacturing and sales and marketing personnel will also be critical to our success. The loss of the services of our executive officers or other key employees could impede the achievement of our research, development and commercialization objectives and seriously harm our ability to successfully implement our business strategy. Furthermore, replacing executive officers and key employees may be difficult and may take an extended period of time because of the limited number of individuals in our industry with the breadth of skills and experience required to successfully develop, gain regulatory approval of and commercialize products. We may be unable to hire, train, retain or motivate these key personnel on acceptable terms given the intense competition among numerous biopharmaceutical companies for similar personnel. We also experience competition for the hiring of scientific and clinical personnel from universities and research institutions. In addition, we rely on consultants and advisors, including scientific and clinical advisors, to assist us in formulating our research and development and commercialization strategy. Our consultants and advisors may be employed by employers other than us and may have commitments under consulting or advisory contracts with other entities that may limit their availability to us. If we are unable to continue to attract and retain high quality personnel, our ability to pursue our growth strategy will be limited. 49 Our employees, independent contractors, principal investigators, contract research organizations, consultants and vendors may engage in misconduct or other improper activities, including noncompliance with regulatory standards and requirement s and insider trading. We are exposed to the risk that our employees, independent contractors, principal investigators, contract research organizations or CROs, consultants and vendors may engage in fraudulent conduct or other illegal activity. Misconduct by these parties could include intentional, reckless and/or negligent conduct or unauthorized activities that violate: (1) FDA regulations, including those laws that require the reporting of true, complete and accurate information to the FDA, (2) manufacturing standards, (3) federal and state healthcare fraud and abuse laws and regulations, or (4) laws that require the reporting of true and accurate financial information and data. Specifically, sales, marketing and business arrangements in the healthcare industry are subject to extensive laws and regulations intended to prevent fraud, kickbacks, self-dealing and other abusive practices. These laws and regulations may restrict or prohibit a wide range of pricing, discounting, marketing and promotion, sales commission, customer incentive programs and other business arrangements. It is not always possible to identify and deter misconduct by employees and other third parties, and the precautions we take to detect and prevent this activity may not be effective in controlling unknown or unmanaged risks or losses or in protecting us from governmental investigations or other actions or lawsuits stemming from a failure to be in compliance with such laws or regulations. If any such actions are instituted against us, and we are not successful in defending ourselves or asserting our rights, those actions could have a significant impact on our business, including the imposition of civil, criminal and administrative penalties, damages, monetary fines, possible exclusion from participation in Medicare, Medicaid and other federal healthcare programs, contractual damages, reputational harm, diminished profits and future earnings, and curtailment of our operations, any of which could adversely affect our ability to operate our business and our results of operations. We may encounter difficulties in managing our growth and expanding our operations successfully. As we seek to advance our product candidates through clinical trials and commercialization, we will need to expand our development, regulatory, manufacturing, marketing and sales capabilities or contract with third parties to provide these capabilities for us. As our operations expand, we expect that we will need to manage additional relationships with various strategic collaborators, suppliers and other third parties. Future growth will impose significant added responsibilities on members of management. Our future financial performance and our ability to commercialize AKB-9778, if approved, and any other product candidates and to compete effectively will depend, in part, on our ability to manage any future growth effectively. To that end, we must be able to manage our development efforts and clinical trials effectively and hire, train and integrate additional management, administrative and, if necessary, sales and marketing personnel. We may not be able to accomplish these tasks, and our failure to accomplish any of them could prevent us from successfully growing our company. If product liability lawsuits are brought against us, we may incur substantial liabilities and may be required to limit commercialization of our product candidates. We face an inherent risk of product liability as a result of the clinical testing of our product candidates and will face an even greater risk if we commercialize any products. For example, we may be sued if any product we develop allegedly causes injury or is found to be otherwise unsuitable during product testing, manufacturing, marketing or sale. Any such product liability claims may include allegations of defects in manufacturing, defects in design, a failure to warn of dangers inherent in the product, negligence, strict liability and a breach of warranties. Claims could also be asserted under state consumer protection acts. If we cannot successfully defend ourselves against product liability claims, we may incur substantial liabilities or be required to limit commercialization of our product candidates. Even a successful defense would require significant financial and management resources. Regardless of the merits or eventual outcome, liability claims may result in: • | decreased demand for any product candidates or products that we may develop; --+----------------------------------------------------------------------------- • | injury to our reputation and significant negative media attention; --+------------------------------------------------------------------- • | withdrawal of clinical trial participants; --+------------------------------------------- • | significant costs to defend the related litigation; --+---------------------------------------------------- • | a diversion of management’s time and our resources; --+---------------------------------------------------- • | substantial monetary awards to trial participants or patients; --+--------------------------------------------------------------- • | product recalls, withdrawals, or labeling, marketing or promotional restrictions; --+---------------------------------------------------------------------------------- • | loss of revenue; --+----------------- • | the inability to commercialize any product candidates that we may develop; and --+------------------------------------------------------------------------------- • | a decline in our stock price. --+------------------------------ 50 Failure to obtain and retain sufficient product liability insurance at an acceptable cost to protect against potential product lia bility claims could prevent or inhibit the commercialization of products we develop. We currently carry product liability insurance covering our clinical trials in the amount of $10 million in the aggregate. Although we maintain product liability insurance , any claim that may be brought against us could result in a court judgment or settlement in an amount that is not covered, in whole or in part, by our insurance or that is in excess of the limits of our insurance coverage. Our insurance policies also have various exclusions, and we may be subject to a product liability claim for which we have no coverage. We will have to pay any amounts awarded by a court or negotiated in a settlement that exceed our coverage limitations or that are not covered by our insu rance, and we may not have, or be able to obtain, sufficient capital to pay such amounts. If we fail to comply with environmental, health and safety laws and regulations, we could become subject to fines or penalties or incur costs that could harm our business. We are subject to numerous environmental, health and safety laws and regulations, including those governing laboratory procedures and the handling, use, storage, treatment and disposal of hazardous materials and wastes. Our operations involve the use of hazardous and flammable materials, including chemicals and biological materials. Our operations also produce hazardous waste products. We generally contract with third parties for the disposal of these materials and wastes. We cannot eliminate the risk of contamination or injury from these materials. In the event of contamination or injury resulting from our use of hazardous materials, we could be held liable for any resulting damages, and any liability could exceed our resources. We also could incur significant costs associated with civil or criminal fines and penalties for failure to comply with such laws and regulations. Although we maintain workers’ compensation insurance to cover us for costs and expenses we may incur due to injuries to our employees resulting from the use of hazardous materials, this insurance may not provide adequate coverage against potential liabilities. We do not maintain insurance for environmental liability or toxic tort claims that may be asserted against us in connection with our storage or disposal of biological, hazardous or radioactive materials. In addition, we may incur substantial costs in order to comply with current or future environmental, health and safety laws and regulations. These current or future laws and regulations may impair our research, development or production efforts. Our failure to comply with these laws and regulations also may result in substantial fines, penalties or other sanctions. Risks Related to Ownership of Our Common Stock We are eligible to be treated as an “emerging growth company” as defined in the Jumpstart Our Business Startups Act of 2012, and we cannot be certain if the reduced disclosure requirements applicable to emerging growth companies will make our common stock less attractive to investors. We are an “emerging growth company”, as defined in the Jumpstart Our Business Startups Act of 2012, or the JOBS Act. For as long as we continue to be an emerging growth company, we may take advantage of exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies. These exemptions include: • | being permitted to provide only two years of audited financial statements, in addition to any required unaudited interim financial statements, with correspondingly reduced “Management’s Discussion and Analysis of Financial Condition and Results of Operations” disclosure; --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | not being required to comply with the auditor attestation requirements in the assessment of our internal control over financial reporting; --+------------------------------------------------------------------------------------------------------------------------------------------- • | not being required to comply with any requirement that may be adopted by the Public Company Accounting Oversight Board; --+------------------------------------------------------------------------------------------------------------------------ • | reduced disclosure obligations regarding executive compensation; and --+--------------------------------------------------------------------- • | exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ We have taken advantage of these reduced reporting burdens. In particular, we have provided only two years of audited financial statements and have not included all of the executive compensation related information that would be required if we were not an emerging growth company. Investors may find our common stock less attractive if we continue to rely on these exemptions. If some investors find our common stock less attractive as a result, there may be a less active trading market for our common stock and our stock price may be more volatile. In addition, the JOBS Act provides that an emerging growth company can take advantage of an extended transition period for complying with new or revised accounting standards. This allows an emerging growth company to delay the adoption of these accounting standards until they would otherwise apply to private companies. We have irrevocably elected not to avail ourselves of this exemption and, therefore, we will be subject to the same new or revised accounting standards as other public companies that are not emerging growth companies. 51 We could be an emerging growth company for up to five ye ars, although circumstances could cause us to lose that status earlier, including if the market value of our common stock held by non-affiliates exceeds $700 million as of any June 30 before that time or if we have total annual gross revenue of $1 billion (as may be inflation-adjusted by the SEC from time to time) or more during any fiscal year before that time, in which cases we would no longer be an emerging growth company as of the following December 31 or, if we issue more than $1 billion in non-convert ible debt during any three-year period before that time, we would cease to be an emerging growth company immediately. Even after we no longer qualify as an emerging growth company, we may still qualify as a “smaller reporting company” if the market value o f our common stock held by non-affiliates is below $75 million as of June 30 in any given year, which would allow us to take advantage of many of the same exemptions from disclosure requirements, including exemption from the auditor attestation requirement s of Section 404 of the Sarbanes-Oxley Act and reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements. Because we are quoted on the OTCQB instead of a national exchange or quotation system, our investors may experience significant volatility in the market price of our stock and have difficulty selling their shares. Our common stock is currently quoted on the OTC Market Group’s OTCQB Market quotation system under the ticker symbol “ARPO.” The OTCQB are regulated quotation services that display real-time quotes, last sale prices and volume limitations in over-the-counter securities. Trading in shares quoted on the OTCQB is often thin and characterized by volatility in trading prices. This volatility may be caused by a variety of factors, including the lack of readily available price quotations, the absence of consistent administrative supervision of bid and ask quotations, lower trading volume and market conditions. As a result, there may be wide fluctuations in the market price of the shares of our common stock for reasons unrelated to operating performance, and this volatility, when it occurs, may have a negative effect on the market price for our securities. Moreover, the OTCQB is not a stock exchange, and trading of securities on them is often more sporadic than the trading of securities listed on a national quotation system or stock exchange. Accordingly, our stockholders may not be able to realize a fair price from their shares when they determine to sell them or may have to hold them for a substantial period of time until the market for our common stock improves. The designation of our common stock as a “penny stock” would limit the liquidity of our common stock. Our common stock may be deemed a “penny stock” (as that term is defined under Rule 3a51-1 of the Exchange Act) in any market that may develop in the future. Generally, a “penny stock” is a common stock that is not listed on a securities exchange and trades for less than $5.00 a share. Prices often are not available to buyers and sellers and the market may be very limited. Penny stocks in start-up companies are among the riskiest equity investments. Broker-dealers who sell penny stocks must provide purchasers of these stocks with a standardized risk-disclosure document prepared by the SEC. The document provides information about penny stocks and the nature and level of risks involved in investing in the penny stock market. A broker must also provide purchasers with bid and offer quotations and information regarding broker and salesperson compensation and make a written determination that the penny stock is a suitable investment for the purchaser and obtain the purchaser’s written agreement to the purchase. Many brokers choose not to participate in penny stock transactions. Because of the penny stock rules, there may be less trading activity in penny stocks in any market that develops for our common stock in the future and stockholders are likely to have difficulty selling their shares. FINRA sales practice requirements may limit a stockholder’s ability to buy and sell our stock. The Financial Industry Regulatory Authority, or FINRA, has adopted rules requiring that, in recommending an investment to a customer, a broker-dealer must have reasonable grounds for believing that the investment is suitable for that customer. Prior to recommending speculative or low-priced securities to their non-institutional customers, broker-dealers must make reasonable efforts to obtain information about the customer’s financial status, tax status, investment objectives and other information. Under interpretations of these rules, FINRA has indicated its belief that there is a high probability that speculative or low-priced securities will not be suitable for at least some customers. If these FINRA requirements are applicable to us or our securities, they may make it more difficult for broker-dealers to recommend that at least some of their customers buy our common stock, which may limit the ability of our stockholders to buy and sell our common stock and could have an adverse effect on the market for and price of our common stock. 52 The market price of our common stock may be highly volatile, and may be influenced by numerous factors, some of which are beyond our control. If a market for our common stock develops, its market price could fluctuate substantially due to a variety of factors, including market perception of our ability to meet our growth projections and expectations, quarterly operating results of other companies in the same industry, trading volume in our common stock, changes in general conditions in the economy and the financial markets or other developments affecting our business and the business of others in our industry. In addition, the stock market itself is subject to extreme price and volume fluctuations. This volatility has had a significant effect on the market price of securities issued by many companies for reasons related and unrelated to their operating performance and could have the same effect on our common stock. The market price of shares of our common stock could be subject to wide fluctuations in response to many risk factors listed in this section, and others beyond our control, including: • | results of clinical trials of our product candidates; --+------------------------------------------------------ • | the timing of the release of results of our clinical trials; --+------------------------------------------------------------- • | results of clinical trials of our competitors’ products; --+--------------------------------------------------------- • | safety issues with respect to our products or our competitors’ products; --+------------------------------------------------------------------------- • | regulatory actions with respect to our products or our competitors’ products; --+------------------------------------------------------------------------------ • | actual or anticipated fluctuations in our financial condition and operating results; --+------------------------------------------------------------------------------------- • | publication of research reports by securities analysts about us or our competitors or our industry; --+---------------------------------------------------------------------------------------------------- • | our failure or the failure of our competitors to meet analysts’ projections or guidance that we or our competitors may give to the market; --+------------------------------------------------------------------------------------------------------------------------------------------- • | additions and departures of key personnel; --+------------------------------------------- • | strategic decisions by us or our competitors, such as acquisitions, divestitures, spin-offs, joint ventures, strategic investments or changes in business strategy; --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | the passage of legislation or other regulatory developments affecting us or our industry; --+------------------------------------------------------------------------------------------ • | fluctuations in the valuation of companies perceived by investors to be comparable to us; --+------------------------------------------------------------------------------------------ • | sales of our common stock by us, our insiders or our other stockholders; --+------------------------------------------------------------------------- • | speculation in the press or investment community; --+-------------------------------------------------- • | announcement or expectation of additional financing efforts; --+------------------------------------------------------------- • | changes in accounting principles; --+---------------------------------- • | terrorist acts, acts of war or periods of widespread civil unrest; --+------------------------------------------------------------------- • | natural disasters and other calamities; --+---------------------------------------- • | changes in market conditions for biopharmaceutical stocks; and --+--------------------------------------------------------------- • | changes in general market and economic conditions. --+--------------------------------------------------- In addition, the stock market has recently experienced significant volatility, particularly with respect to pharmaceutical, biotechnology and other life sciences company stocks. The volatility of pharmaceutical, biotechnology and other life sciences company stocks often does not relate to the operating performance of the companies represented by the stock. As we operate in a single industry, we are especially vulnerable to these factors to the extent that they affect our industry or our products, or to a lesser extent our markets. In the past, securities class action litigation has often been initiated against companies following periods of volatility in their stock price. This type of litigation could result in substantial costs and divert our management’s attention and resources, and could also require us to make substantial payments to satisfy judgments or to settle litigation. 53 Our principal stockholders and management own a significant percentage of our stock and will be able to exercise significant influence over matters subject to stockholder approval. As of March 15, 2017, our executive officers, directors and principal stockholders, together with their respective affiliates, owned approximately 65.9% of our common stock, including shares subject to outstanding options that are exercisable within 60 days after such date. Accordingly, these stockholders will be able to exert a significant degree of influence over our management and affairs and over matters requiring stockholder approval, including the election of our board of directors and approval of significant corporate transactions. This concentration of ownership could have the effect of entrenching our management and/or the board of directors, delaying or preventing a change in our control or otherwise discouraging a potential acquirer from attempting to obtain control of us, which in turn could have a material and adverse effect on the fair market value of our common stock. Because we became a reporting company under the Exchange Act by means other than a traditional underwritten initial public offering, we may not be able to attract the attention of research analysts at major brokerage firms. Because we did not become a reporting company by conducting an underwritten initial public offering of our common stock, and because we will not be listed on a national securities exchange, security analysts of brokerage firms may not provide coverage of our company. In addition, investment banks may be less likely to agree to underwrite secondary offerings on our behalf than they might if we became a public reporting company by means of an underwritten initial public offering, because they may be less familiar with our company as a result of more limited coverage by analysts and the media, and because we became public at an early stage in our development. The failure to receive research coverage or support in the market for our shares will have an adverse effect on our ability to develop a liquid market for our common stock. Because the Merger was a reverse merger, we may not be able to attract the attention of major brokerage firms. Additional risks may exist as a result of our becoming a public reporting company through a “reverse merger.” Securities analysts of major brokerage firms may not provide coverage of our capital stock or business. Because we became a public reporting operating company through a reverse merger, there is no incentive to brokerage firms to recommend the purchase of our common stock. We cannot assure you that brokerage firms will want to provide analyst coverage of our capital stock or business in the future. The resale of shares covered by a registration statement could adversely affect the market price of our common stock in the public market, should one develop, which result would in turn negatively affect our ability to raise additional equity capital. The sale, or availability for sale, of our common stock in the public market may adversely affect the prevailing market price of our common stock and may impair our ability to raise additional capital by selling equity or equity-linked securities. We filed and caused to become effective a registration statement with the SEC registering the resale of 27,367,117 shares of our common stock issued in connection with the Merger and the Offering. This registration statement permits the resale of these shares at any time. The resale of a substantial number of shares of our common stock in the public market could adversely affect the market price for our common stock and make it more difficult for you to sell shares of our Common Stock at times and prices that you feel are appropriate. Furthermore, we expect that, because there will be a large number of shares registered pursuant to a registration statement, selling stockholders will continue to offer shares covered by such registration statement for a significant period of time, the precise duration of which cannot be predicted. Accordingly, the adverse market and price pressures resulting from an offering pursuant to a registration statement may continue for an extended period of time and continued negative pressure on the market price of our common stock could have a material adverse effect on our ability to raise additional equity capital. Issuance of stock to fund our operations may dilute your investment and reduce your equity interest. We may need to raise capital in the future to fund the development of our drug candidates or for other purposes. Any equity financing may have significant dilutive effect to stockholders and a material decrease in our stockholders’ equity interest in us. Equity financing, if obtained, could result in substantial dilution to our existing stockholders. At its sole discretion, our board of directors may issue additional securities without seeking stockholder approval, and we do not know when we will need additional capital or, if we do, whether it will be available to us. We have broad discretion in the use of our cash and may not use them effectively. We currently intend to use our cash resources for continuing clinical development of AKB-9778 in patients with diabetic retinopathy, including the continuation of our ongoing trials and the preparation for and initiation of the Phase 3 trials and for working capital and other general corporate purposes. Although we currently intend to use our cash resources in such a manner, we will have broad discretion in the application of such cash resources. Our failure to apply these funds effectively could affect our ability to continue to develop and commercialize our product candidates. Pending their use, we may invest our cash resources in a manner that does not produce income or loses value. 54 We will incur increased costs as a result of being a public company and our management expects to devote substantial time to public company compliance programs. As a public company, we will incur significant legal, insurance, accounting and other expenses that we did not incur as a private company. In addition, our administrative staff will be required to perform additional tasks. We intend to invest resources to comply with evolving laws, regulations and standards, and this investment will result in increased general and administrative expenses and may divert management’s time and attention from product development activities. If our efforts to comply with new laws, regulations and standards differ from the activities intended by regulatory or governing bodies due to ambiguities related to practice, regulatory authorities may initiate legal proceedings against us and our business may be harmed. In connection with the Merger, pursuant to which we acquired Aerpio, we are increasing our directors’ and officers’ insurance coverage, which will increase our insurance cost. In the future, it will be more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. These factors could also make it more difficult for us to attract and retain qualified members of our board of directors, particularly to serve on our audit committee and compensation committee, and qualified executive officers. In addition, in order to comply with the requirements of being a public company, we may need to undertake various actions, including implementing new internal controls and procedures and hiring new accounting or internal audit staff. The Sarbanes-Oxley Act requires that we maintain effective disclosure controls and procedures and internal control over financial reporting. We are continuing to develop and refine our disclosure controls and other procedures that are designed to ensure that information required to be disclosed by us in the reports that we file with the SEC is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that information required to be disclosed in reports under the Securities Exchange Act of 1934 as amended, or the Exchange Act, is accumulated and communicated to our principal executive and financial officers. Any failure to develop or maintain effective controls could adversely affect the results of periodic management evaluations. In the event that we are not able to demonstrate compliance with the Sarbanes-Oxley Act, that our internal control over financial reporting is perceived as inadequate, or that we are unable to produce timely or accurate financial statements, investors may lose confidence in our operating results and the price of our ordinary shares could decline. In addition, if we are unable to continue to meet these requirements, we may not be able to obtain listing on a national securities exchange. Our management team and board of directors will need to devote significant efforts to maintaining adequate and effective disclosure controls and procedures and internal control over financial reporting in order to comply with applicable regulations, which may include hiring additional legal, financial reporting and other finance and accounting staff and engaging consultants to assist in designing and implementing such procedures. Additionally, any of our efforts to improve our internal controls and design, implement and maintain an adequate system of disclosure controls may not be successful and will require that we expend significant cash and other resources. In addition, our management will be required to certify financial and other information in our quarterly and annual reports and provide an annual management report on the effectiveness of our internal control over financial reporting commencing with our second annual report. This assessment will need to include the disclosure of any material weaknesses in our internal control over financial reporting identified by our management or our independent registered public accounting firm. To achieve compliance with Section 404 within the prescribed period, we will be engaged in a process to document and evaluate our internal control over financial reporting, which is both costly and challenging. In this regard, we will need to continue to dedicate internal resources, potentially engage outside consultants and adopt a detailed work plan to assess and document the adequacy of internal control over financial reporting, continue steps to improve control processes as appropriate, validate through testing that controls are functioning as documented and implement a continuous reporting and improvement process for internal control over financial reporting. Despite our efforts, there is a risk that we will not be able to conclude, within the prescribed timeframe or at all, that our internal control over financial reporting is effective as required by Section 404. If we identify one or more material weaknesses, it could result in an adverse reaction in the financial markets due to a loss of confidence in the reliability of our financial statement. Our independent registered public accounting firm will not be required to formally attest to the effectiveness of our internal control over financial reporting until the later of our second annual report or the first annual report required to be filed with the SEC following the date we are no longer an “emerging growth company” as defined in the JOBS Act. We cannot assure you that there will not be material weaknesses or significant deficiencies in our internal controls in the future. Our independent registered public accounting firm has identified a material weakness in our internal control over financial reporting which will require remediation. Our independent registered public accounting firm issued a letter to our audit committee and management in which they identified certain matters that they consider to constitute material weaknesses in the design and operation of our internal control over financial reporting as of December 31, 2016. A deficiency in internal control over financial reporting exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent or detect misstatements on a timely basis. A significant deficiency is a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for the oversight of the company’s financial reporting. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. 55 The material weaknesses identified by our auditors relate to deficiencies with our disclosure controls and p rocedures, including review and approval procedures with respect to financial information generated to prepare our consolidated financial statements, coupled with a lack of segregation of duties as a result of our size and overall lack of resources in the accounting department. This resulted in not ensuring appropriate segregation of duties between incompatible functions, and made it more difficult to ensure review of financial reporting issues. We are taking steps to remediate this material weakness. If we fail to remediate the material weakness, we may fail to meet our future reporting obligations, our financial statements may contain material misstatements and our operational results may be harmed. Any such failure could also adversely affect the results of the periodic management evaluations and, to the extent we are no longer an emerging growth company, the annual auditor attestation reports regarding the effectiveness of our internal control over financial reporting that will be required under Section 404 of the Sarbanes-Oxley Act of 2002. Internal control deficiencies could also cause investors to lose confidence in our reported financial information. Provisions in our charter documents and Delaware law may have anti-takeover effects that could discourage an acquisition of us by others, even if an acquisition would be beneficial to our stockholders, and may prevent attempts by our stockholders to replace or remove our current management. Provisions in our amended and restated certificate of incorporation and amended and restated by-laws may have the effect of discouraging, delaying or preventing a change in control of us or changes in our management. These provisions could also limit the price that investors might be willing to pay in the future for shares of our common stock, thereby depressing the market price of our common stock. In addition, because our board of directors is responsible for appointing the members of our management team, these provisions may frustrate or prevent any attempts by our stockholders to replace or remove our current management by making it more difficult for stockholders to replace members of our board of directors. Among other things, these provisions: • | authorize “blank check” preferred stock, which could be issued by our board of directors without stockholder approval and may contain voting, liquidation, dividend and other rights superior to our common stock; --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | create a classified board of directors whose members serve staggered three-year terms; --+--------------------------------------------------------------------------------------- • | specify that special meetings of our stockholders can be called only by our board of directors pursuant to a resolution adopted by a majority of the directors then in office; --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | prohibit stockholder action by written consent; --+------------------------------------------------ • | establish an advance notice procedure for stockholder approvals to be brought before an annual meeting of our stockholders, including proposed nominations of persons for election to our board of directors; --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | prohibit the consummation of a liquidation event unless approved by a supermajority (66 2/3% and majority of the minority, if applicable) vote of the holders of our voting stock; --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | prohibit the consummation of an affiliate transaction with a majority stockholder that holds more than 50% of the voting power of our capital stock unless approved by a supermajority (66 2/3%) vote of directors then in office; --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | provide that the number of directors on our board of directors may only be changed with a supermajority (66 2/3%) of directors then in office, even though less than a quorum; --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | provide that our directors may be removed only for cause and by a supermajority (66 2/3%) vote of the holders of our voting stock; --+----------------------------------------------------------------------------------------------------------------------------------- • | provide that vacancies on our board of directors may be filled only by a supermajority (66 2/3%) of directors then in office, even though less than a quorum; --+-------------------------------------------------------------------------------------------------------------------------------------------------------------- • | require a supermajority (66 2/3% and majority of the minority, if applicable) vote of the holders of our voting stock or the supermajority (66 2/3%) vote of the members of our board of directors then in office to amend our amended and restated by-laws; and --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | require a supermajority (66 2/3% and majority of the minority, if applicable) vote of the holders of our voting stock and a supermajority (66 2/3%) vote of the holders of each class of our voting stock entitled to vote thereon to amend certain provisions of our amended and restated certificate of incorporation. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- These provisions, alone or together, could delay or prevent hostile takeovers and changes in control or changes in our management. 56 Moreover, because we are incorporated in Delaware, we are governed by the pr ovisions of Section 203 of the Delaware General Corporation Law, which prohibits a person who owns in excess of 15% of our outstanding voting stock from merging or combining with us for a period of three years after the date of the transaction in which the person acquired in excess of 15% of our outstanding voting stock, unless the merger or combination is approved in a prescribed manner. Any provision of our amended and restated certificate of incorporation, our amended and restated by-laws or Delaware law that has the effect of delaying or deterring a change in control could limit the opportunity for our stockholders to receive a premium for their shares of our common stock, and could also affect the price that some investors are willing to pay for our common stock. Our ability to use net operating losses to offset future taxable income may be subject to certain limitations. In general, under Section 382 of the Internal Revenue Code of 1986, as amended, or the Code, a corporation that undergoes an “ownership change” is subject to limitations on its ability to utilize its pre-change net operating losses, or NOLs, to offset future taxable income. Our existing NOLs may be subject to substantial limitations arising from previous ownership changes, and if we undergo an ownership change in connection with our private placement offering, our ability to utilize NOLs could be further limited by Section 382 of the Code. In addition, future changes in our stock ownership, many of which are outside of our control, could result in an ownership change under Section 382 of the Code. Our NOLs may also be impaired under state law. Accordingly, we may not be able to utilize a material portion of our NOLs. Furthermore, our ability to utilize our NOLs is conditioned upon our attaining profitability and generating U.S. federal taxable income. As described above under “—Risks related to our financial position and need for additional capital,” we have incurred significant net losses since our inception and anticipate that we will continue to incur significant losses for the foreseeable future; thus, we do not know whether or when we will generate the U.S. federal taxable income necessary to utilize our NOLs. A full valuation allowance has been provided for the entire amount of our NOLs. Because we do not anticipate paying any cash dividends on our capital stock in the foreseeable future, capital appreciation, if any, will be your sole source of gain. You should not rely on an investment in our common stock to provide dividend income. We do not anticipate that we will pay any cash dividends to holders of our common stock in the foreseeable future. Instead, we plan to retain any earnings to maintain and expand our operations. In addition, any future debt financing arrangement may contain terms prohibiting or limiting the amount of dividends that may be declared or paid on our common stock. Accordingly, investors must rely on sales of their common stock after price appreciation, which may never occur, as the only way to realize any return on their investment. As a result, investors seeking cash dividends should not purchase our common stock. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds. None Item 3. Defaults Upon Senior Securities. None Item 4. Mine Safety Disclosures. Not applicable. Item 5. Other Information. None 57 Item 6. E xhibits. Furnish the exhibits required by Item 601 of Regulation S-K (§ 229.601 of this chapter). Exhibit Number | Description ---------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.1* | Certification of Principal Executive Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. ---------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.2* | Certification of Principal Financial Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. ---------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 32.1** | Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. ---------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 32.2** | Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. ---------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.INS | XBRL Instance Document ---------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.SCH | XBRL Taxonomy Extension Schema Document ---------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document ---------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document ---------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.LAB | XBRL Taxonomy Extension Label Linkbase Document ---------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document ---------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- * | Filed herewith. --+---------------- ** | The certification furnished in Exhibit 32.1 hereto is deemed to be furnished with this Quarterly Report on Form 10-Q and will not be deemed to be “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, except to the extent that the Registrant specifically incorporates it by reference. ---+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- # | Indicates a management contract or any compensatory plan, contract or arrangement. --+----------------------------------------------------------------------------------- 58 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. | Company Name -------------------------+------------- Date: November 13, 2017 | By: | /s/ Joseph H. Gardner -------------------------+--------------+------------------------ | | Joseph H. Gardner -------------------------+--------------+------------------------ | | President and Founder -------------------------+--------------+------------------------ Date: November 13, 2017 | By: | /s/ James B. Murphy -------------------------+--------------+------------------------ | | James B. Murphy -------------------------+--------------+------------------------ | | Chief Financial Officer -------------------------+--------------+------------------------ 59

Agape ATP Corp

1713210

10-Q

0001493152-17-012808

UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For The Quarterly Period Ended September 30, 2017 or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _______________ to _______________ Commission File Number 333-220144 AGAPE ATP CORPORATION (Exact name of registrant issuer as specified in its charter) Nevada | 36-4838886 ----------------------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------- (State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) ----------------------------------------------------------------------------------------------------------------+-------------------------------------------------------------------------------------- No. 17, 17-1, 17-2, 17-3, Wisma Laxton, Jalan Desa, Taman Desa, Off Jalan Klang Lama, 58100 Kuala Lumpur, Malaysia. (Address of principal executive offices, including zip code) Registrant’s phone number, including area code (60) 192230099 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [ ] Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (section 232.405 of this chapter) during the preceding twelve months (or shorter period that the registrant was required to submit and post such files). YES [ ] NO [X] Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one): Large Accelerated Filer [ ] Accelerated Filer [ ] Non-accelerated Filer [ ] Smaller reporting company [X] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X] Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date. Class | Outstanding at November 13, 2017 | -----------------------------------+--------------------------------------+------------ Common Stock, $.0001 par value | | 371,350,000 -----------------------------------+--------------------------------------+------------ TABLE OF CONTENTS | | Page ------------+-------------------------------------------------------------------------------------------------------------------------------------------------+--------------- PART I | FINANCIAL INFORMATION | ------------+-------------------------------------------------------------------------------------------------------------------------------------------------+--------------- ITEM 1. | UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS: | F-1 ------------+-------------------------------------------------------------------------------------------------------------------------------------------------+--------------- | Condensed Consolidated Balance Sheets as of September 30, 2017(unaudited) and June 30, 2017 (audited) | F-2 ------------+-------------------------------------------------------------------------------------------------------------------------------------------------+--------------- | Condensed Consolidated Statements of Operations and Comprehensive Income for the Three Months Ended September 30, 2017 and 2016 (unaudited) | F-3 ------------+-------------------------------------------------------------------------------------------------------------------------------------------------+--------------- | Condensed Consolidated Statements of Cash Flows for the Three Months Ended September 30, 2017 and 2016 (unaudited) | F-4 ------------+-------------------------------------------------------------------------------------------------------------------------------------------------+--------------- | Notes to the Condensed Consolidated Financial Statements | F-5 - F-13 ------------+-------------------------------------------------------------------------------------------------------------------------------------------------+--------------- ITEM 2. | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS | 3 ------------+-------------------------------------------------------------------------------------------------------------------------------------------------+--------------- ITEM 3. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK | 5 ------------+-------------------------------------------------------------------------------------------------------------------------------------------------+--------------- ITEM 4. | CONTROLS AND PROCEDURES | 5 ------------+-------------------------------------------------------------------------------------------------------------------------------------------------+--------------- PART II | OTHER INFORMATION | ------------+-------------------------------------------------------------------------------------------------------------------------------------------------+--------------- ITEM 1. | LEGAL PROCEEDINGS | 6 ------------+-------------------------------------------------------------------------------------------------------------------------------------------------+--------------- ITEM 2. | UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS | 6 ------------+-------------------------------------------------------------------------------------------------------------------------------------------------+--------------- ITEM 3. | DEFAULTS UPON SENIOR SECURITIES | 6 ------------+-------------------------------------------------------------------------------------------------------------------------------------------------+--------------- ITEM 4. | MINE SAFETY DISCLOSURES | 6 ------------+-------------------------------------------------------------------------------------------------------------------------------------------------+--------------- ITEM 5. | OTHER INFORMATION | 6 ------------+-------------------------------------------------------------------------------------------------------------------------------------------------+--------------- ITEM 6. | EXHIBITS | 7 ------------+-------------------------------------------------------------------------------------------------------------------------------------------------+--------------- | SIGNATURES | 8 ------------+-------------------------------------------------------------------------------------------------------------------------------------------------+--------------- 2 - PART I FINANCIAL INFORMATION Item 1. Unaudited condensed consolidated financial statements: AGAPE ATP CORPORATION CONDENSED CONSOLIDATED FINANCIAL STATEMENTS | Page ------------------------------------------------------------------------------------------------------------------------------------------------+--------- Condensed Consolidated Financial Statements | ------------------------------------------------------------------------------------------------------------------------------------------------+--------- Condensed Consolidated Balance Sheets as of September 30, 2017 (unaudited) and June 30, 2017 (audited) | F-2 ------------------------------------------------------------------------------------------------------------------------------------------------+--------- Condensed Consolidated Statements of Operations and Comprehensive Income for the Three Months Ended September 30, 2017 and 2016 (unaudited) | F-3 ------------------------------------------------------------------------------------------------------------------------------------------------+--------- Condensed Consolidated Statements of Cash Flows for the Three Months Ended September 30, 2017 and 2016 (unaudited) | F-4 ------------------------------------------------------------------------------------------------------------------------------------------------+--------- Notes to the Condensed Consolidated Financial Statements | F-5-F-13 ------------------------------------------------------------------------------------------------------------------------------------------------+--------- F-1 --- AGAPE ATP CORPORATION CONDENSED CONSOLIDATED BALANCE SHEETS As of September 30, 2017 and June 30, 2017 (Currency expressed in United States Dollars (“US$”), except for number of shares) | As of September 30, 2017 | | | As of June 30, 2017 | --------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+-----------+---+--------------------------+-- | Unaudited | | | Audited | --------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+-----------+---+--------------------------+-- ASSETS | | | | | --------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+-----------+---+--------------------------+-- CURRENT ASSETS | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+-----------+---+--------------------------+---+-----------+-- Cash and cash equivalents | $ | 2,157,723 | | | $ | 2,312,748 | --------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+-----------+---+--------------------------+---+-----------+-- Account receivables | | 490,466 | | | | - | --------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+-----------+---+--------------------------+---+-----------+-- Total Current Assets | | 2,648,189 | | | | 2,312,748 | --------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+-----------+---+--------------------------+---+-----------+-- TOTAL ASSETS | $ | 2,648,189 | | | $ | 2,312,748 | --------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+-----------+---+--------------------------+---+-----------+-- LIABILITIES AND STOCKHOLDERS’ EQUITY | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+-----------+---+--------------------------+---+-----------+-- CURRENT LIABILITIES | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+-----------+---+--------------------------+---+-----------+-- Accounts payables | | 387,052 | | | | - | --------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+-----------+---+--------------------------+---+-----------+-- Other payables and accrued liabilities | | - | | | | 8,000 | --------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+-----------+---+--------------------------+---+-----------+-- Income tax provision | | 7,152 | | | | - | --------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+-----------+---+--------------------------+---+-----------+-- Amount due to a director | | 3,946 | | | | 100 | --------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+-----------+---+--------------------------+---+-----------+-- Total Current Liabilities | | 398,150 | | | | 8,100 | --------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+-----------+---+--------------------------+---+-----------+-- TOTAL LIABILITIES | $ | 390,998 | | | $ | 8,100 | --------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+-----------+---+--------------------------+---+-----------+-- STOCKHOLDERS’ EQUITY | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+-----------+---+--------------------------+---+-----------+-- Preferred stock, $0.0001 par value; 200,000,000 shares authorized; None issued and outstanding | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+-----------+---+--------------------------+---+-----------+-- Common Stock, par value $0.0001; 1,000,000,000 shares authorized, 371,350,000 issued and outstanding as of September 30, 2017 and June 30, 2017 | | 37,135 | | | | 37,135 | --------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+-----------+---+--------------------------+---+-----------+-- Additional paid in capital | | 2,367,875 | | | | 2,367,875 | --------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+-----------+---+--------------------------+---+-----------+-- Accumulated incomes/(losses) | | (154,971 | ) | | | (100,362 | ) --------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+-----------+---+--------------------------+---+-----------+-- TOTAL STOCKHOLDERS’ EQUITY | $ | 2,250,039 | | | $ | 2,304,648 | --------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+-----------+---+--------------------------+---+-----------+-- TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY | $ | 2,648,189 | | | $ | 2,312,748 | --------------------------------------------------------------------------------------------------------------------------------------------------------+-------------------------------+-----------+---+--------------------------+---+-----------+-- See accompanying notes to condensed consolidated financial statements. F-2 --- AGAPE ATP CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME For the three months ended September 30, 2017 and 2016 (Currency expressed in United States Dollars (“US$”), except for number of shares) (Unaudited) | Three months ended September 30, | -----------------------------------------------------------------------------+---------------------------------------+------------ | 2017 | | | 2016 | -----------------------------------------------------------------------------+---------------------------------------+-------------+---+------+-- REVENUE | $ | 490,126 | | | $ | - | -----------------------------------------------------------------------------+---------------------------------------+-------------+---+------+---+---------+-- COST OF SALES | | (444,238 | ) | | | - | -----------------------------------------------------------------------------+---------------------------------------+-------------+---+------+---+---------+-- GROSS PROFIT | | 45,888 | | | | - | -----------------------------------------------------------------------------+---------------------------------------+-------------+---+------+---+---------+-- OTHER OPERATING INCOME | | 5 | | | | - | -----------------------------------------------------------------------------+---------------------------------------+-------------+---+------+---+---------+-- | | 45,893 | | | | - | -----------------------------------------------------------------------------+---------------------------------------+-------------+---+------+---+---------+-- OPERATING EXPENSES | | | | | | | -----------------------------------------------------------------------------+---------------------------------------+-------------+---+------+---+---------+-- Bank charges | $ | (2,092 | ) | | $ | - | -----------------------------------------------------------------------------+---------------------------------------+-------------+---+------+---+---------+-- GST paid | | (495 | ) | | | - | -----------------------------------------------------------------------------+---------------------------------------+-------------+---+------+---+---------+-- Printing | | (250 | ) | | | - | -----------------------------------------------------------------------------+---------------------------------------+-------------+---+------+---+---------+-- Professional fee | | (90,000 | ) | | | - | -----------------------------------------------------------------------------+---------------------------------------+-------------+---+------+---+---------+-- Trademark application | | (513 | ) | | | - | -----------------------------------------------------------------------------+---------------------------------------+-------------+---+------+---+---------+-- Total operating expenses | $ | (93,350 | ) | | $ | - | -----------------------------------------------------------------------------+---------------------------------------+-------------+---+------+---+---------+-- LOSS BEFORE INCOME TAX | $ | (47,457 | ) | | $ | - | -----------------------------------------------------------------------------+---------------------------------------+-------------+---+------+---+---------+-- INCOME TAX PROVISION | $ | (7,152 | ) | | $ | - | -----------------------------------------------------------------------------+---------------------------------------+-------------+---+------+---+---------+-- NET LOSS | $ | (54,609 | ) | | $ | - | -----------------------------------------------------------------------------+---------------------------------------+-------------+---+------+---+---------+-- Net loss per share, basic and diluted: | | (0.00 | ) | | | (0.00 | ) -----------------------------------------------------------------------------+---------------------------------------+-------------+---+------+---+---------+-- Weighted average number of common shares outstanding – Basic and diluted | | 371,350,000 | | | | 100,000 | -----------------------------------------------------------------------------+---------------------------------------+-------------+---+------+---+---------+-- See accompanying notes to condensed consolidated financial statements. F-3 --- AGAPE ATP CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS For the three months ended September 30, 2017 and 2016 (Currency expressed in United States Dollars (“US$”), except for number of shares) (Unaudited) | Three months ended September 30, | ---------------------------------------------------+-------------------------------------------+---------- | 2017 | | | 2016 | ---------------------------------------------------+-------------------------------------------+-----------+---+------+-- CASH FLOWS FROM OPERATING ACTIVITIES: | | | | | | ---------------------------------------------------+-------------------------------------------+-----------+---+------+---+--- Net loss | $ | (54,609 | ) | | $ | - ---------------------------------------------------+-------------------------------------------+-----------+---+------+---+--- Changes in operating assets and liabilities: | | | | | | ---------------------------------------------------+-------------------------------------------+-----------+---+------+---+--- Accounts receivables | $ | (490,466 | ) | | $ | - ---------------------------------------------------+-------------------------------------------+-----------+---+------+---+--- Accounts payables | $ | 387,052 | | | $ | - ---------------------------------------------------+-------------------------------------------+-----------+---+------+---+--- Other payables and accrued liabilities | $ | (8,000 | ) | | $ | - ---------------------------------------------------+-------------------------------------------+-----------+---+------+---+--- Income tax provision | $ | 7,152 | | | $ | - ---------------------------------------------------+-------------------------------------------+-----------+---+------+---+--- Amount due to a director | $ | 3,846 | | | $ | - ---------------------------------------------------+-------------------------------------------+-----------+---+------+---+--- Net cash (used in) operating activities | $ | (155,025 | ) | | $ | - ---------------------------------------------------+-------------------------------------------+-----------+---+------+---+--- Net decrease in cash and cash equivalents | | (155,025 | ) | | | - ---------------------------------------------------+-------------------------------------------+-----------+---+------+---+--- Cash and cash equivalents, beginning of period | | 2,312,748 | | | | 10 ---------------------------------------------------+-------------------------------------------+-----------+---+------+---+--- CASH AND CASH EQUIVALENTS, END OF PERIOD | $ | 2,157,723 | | | $ | 10 ---------------------------------------------------+-------------------------------------------+-----------+---+------+---+--- SUPPLEMENTAL CASH FLOWS INFORMATION | | | | | | ---------------------------------------------------+-------------------------------------------+-----------+---+------+---+--- Income taxes paid | $ | - | | | $ | - ---------------------------------------------------+-------------------------------------------+-----------+---+------+---+--- Interest paid | $ | - | | | $ | - ---------------------------------------------------+-------------------------------------------+-----------+---+------+---+--- See accompanying notes to condensed consolidated financial statements. F-4 --- AGAPE ATP CORPORATION NOTES TO CONDENSED FINANCIAL STATEMENTS For the three months ended September 30, 2017 (Currency expressed in United States Dollars (“US$”), except for number of shares) (UNAUDITED) 1. DESCRIPTION OF BUSINESS AND ORGANIZATION Agape ATP Corporation was incorporated on June 1, 2016 under the laws of the state of Nevada. The Company, through its subsidiaries, mainly engages in providing health and wellness products and health solution advisory services. | Company name | Place and date of incorporation | Principal activities ---+---------------------------------------------+--------------------------------------------------------------------------+------------------------------------------------------------------------ 1. | Agape ATP Corporation | Labuan, March 6, 2017 | Investment holding ---+---------------------------------------------+--------------------------------------------------------------------------+------------------------------------------------------------------------ 2. | Agape ATP International Holding Limited | Hong Kong, June 1, 2017 | Health and wellness products and health solution advisory services. ---+---------------------------------------------+--------------------------------------------------------------------------+------------------------------------------------------------------------ We are a development-stage company with a fiscal year end of June 30. At this moment, we operate exclusively through our wholly owned subsidiaries Agape ATP Corporation and Agape ATP International Holding Limited, and share the same business plan of our subsidiaries which is to provide health and wellness products and health solution advisory services. Agape ATP Corporation and its subsidiaries are hereinafter referred to as the “Company”. F-5 --- AGAPE ATP CORPORATION NOTES TO CONDENSED FINANCIAL STATEMENTS For the three months ended September 30, 2017 (Currency expressed in United States Dollars (“US$”), except for number of shares) (UNAUDITED) 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of presentation The consolidated financial statements for Agape ATP Corporation and its subsidiaries for the three months ended September 30, 2017 and 2016 are prepared in accordance with accounting principles generally accepted in the United States of America (“US GAAP”) and include the accounts of Agape ATP Corporation and its wholly owned subsidiaries, Agape ATP Corporation and Agape ATP International Holding Limited. Intercompany accounts and transactions have been eliminated in consolidation. The Company has adopted June 30 as its fiscal year end. Basis of consolidation The condensed consolidated financial statements include the accounts of the Company and its subsidiaries. All inter-company accounts and transactions have been eliminated upon consolidation. Use of estimates Management uses estimates and assumptions in preparing these financial statements in accordance with US GAAP. Those estimates and assumptions affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities in the balance sheets, and the reported revenue and expenses during the periods reported. Actual results may differ from these estimates. Revenue recognition In accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 605, “Revenue Recognition”, the Company recognizes revenue from sales of goods when the following four revenue criteria are met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred; (3) selling price is fixed or determinable; and (4) collectability is reasonably assured. Revenue from supplies of healthy food products is recognized when title and risk of loss are transferred and there are no continuing obligations to the customer. Title and the risks and rewards of ownership transfer to and accepted by the customer when the products are collected by the customer at the Company’s office. Revenue is recorded net of sales discounts, returns, allowances, and other adjustments that are based upon management’s best estimates and historical experience and are provided for in the same period as the related revenues are recorded. Based on limited operating history, management estimates that there were no sales return for the three months ended September 30, 2017. Cost of revenue Cost of revenue includes the purchase cost of manufactured goods for sale to customers. It excludes purchasing and receiving costs, inspection costs, warehousing costs, internal transfer costs and other costs of distribution network in cost of revenues. Cash and cash equivalents Cash and cash equivalents are carried at cost and represent cash on hand, demand deposits placed with banks or other financial institutions and all highly liquid investments with an original maturity of three months or less as of the purchase date of such investments. Accounts receivable Accounts receivable are recorded at the invoiced amount less an allowance for any uncollectible accounts and do not bear interest, which are due on demand. Management reviews the adequacy of the allowance for doubtful accounts on an ongoing basis, using historical collection trends and aging of receivables. Management also periodically evaluates individual customer’s financial condition, credit history, and the current economic conditions to make adjustments in the allowance when it is considered necessary. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. F-6 --- AGAPE ATP CORPORATION NOTES TO CONDENSED FINANCIAL STATEMENTS For the three months ended September 30, 2017 (Currency expressed in United States Dollars (“US$”), except for number of shares) (UNAUDITED) Income taxes Income taxes are determined in accordance with the provisions of ASC Topic 740, “Income Taxes” (“ASC Topic 740”). Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted income tax rates expected to apply to taxable income in the periods in which those temporary differences are expected to be recovered or settled. Any effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. ASC 740 prescribes a comprehensive model for how companies should recognize, measure, present, and disclose in their financial statements uncertain tax positions taken or expected to be taken on a tax return. Under ASC 740, tax positions must initially be recognized in the financial statements when it is more likely than not the position will be sustained upon examination by the tax authorities. Such tax positions must initially and subsequently be measured as the largest amount of tax benefit that has a greater than 50% likelihood of being realized upon ultimate settlement with the tax authority assuming full knowledge of the position and relevant facts. Net income/(loss) per share The Company calculates net income/(loss) per share in accordance with ASC Topic 260, “Earnings per Share.” Basic income/(loss) per share is computed by dividing the net income/(loss) by the weighted-average number of common shares outstanding during the period. Diluted income per share is computed similar to basic income/(loss) per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potential common stock equivalents had been issued and if the additional common shares were dilutive. Related parties Parties, which can be a corporation or individual, are considered to be related if the Company has the ability, directly or indirectly, to control the other party or exercise significant influence over the other party in making financial and operating decisions. Companies are also considered to be related if they are subject to common control or common significant influence. F-7 --- AGAPE ATP CORPORATION NOTES TO CONDENSED FINANCIAL STATEMENTS For the three months ended September 30, 2017 (Currency expressed in United States Dollars (“US$”), except for number of shares) (UNAUDITED) Foreign currencies translation Transactions denominated in currencies other than the functional currency are translated into the functional currency at the exchange rates prevailing at the dates of the transaction. Monetary assets and liabilities denominated in currencies other than the functional currency are translated into the functional currency using the applicable exchange rates at the balance sheet dates. The resulting exchange differences are recorded in the Condensed Consolidated Statements of Operations and Comprehensive Income. The reporting currency of the Company is United States Dollars (“US$”). The Company’s subsidiary in Labuan and Hong Kong maintains its books and record in United States Dollars (“US$”) respectively, and Ringgits Malaysia (“RM”) is functional currency as being the primary currency of the economic environment in which the entity operates. In general, for consolidation purposes, assets and liabilities of its subsidiaries whose functional currency is not US$ are translated into US$, in accordance with ASC Topic 830-30, “Translation of Financial Statement”, using the exchange rate on the balance sheet date. Revenues and expenses are translated at average rates prevailing during the period. The gains and losses resulting from translation of financial statements of foreign subsidiary are recorded as a separate component of accumulated other comprehensive income within the statements of stockholders’ equity. Translation of amounts from RM into US$1 has been made at the following exchange rates for the respective periods: | As of and for the three months ended | ---------------------------------------+-----------------------------------------------+----- | September 30 | ---------------------------------------+-----------------------------------------------+----- | 2017 | | 2016 ---------------------------------------+-----------------------------------------------+------+----- Period-end RM : US$1 exchange rate | | 4.22 | | 4.12 ---------------------------------------+-----------------------------------------------+------+------+----- Period-average RM : US$1 exchange rate | | 4.26 | | 4.29 ---------------------------------------+-----------------------------------------------+------+------+----- F-8 --- AGAPE ATP CORPORATION NOTES TO CONDENSED FINANCIAL STATEMENTS For the three months ended September 30, 2017 (Currency expressed in United States Dollars (“US$”), except for number of shares) (UNAUDITED) Fair value of financial instruments: The carrying value of the Company’s financial instruments: cash and cash equivalents, account receivables, amount due to a director, and accounts payable and approximate at their fair values because of the short-term nature of these financial instruments. The Company also follows the guidance of the ASC Topic 820-10, “Fair Value Measurements and Disclosures” (“ASC 820-10”), with respect to financial assets and liabilities that are measured at fair value. ASC 820-10 establishes a three-tier fair value hierarchy that prioritizes the inputs used in measuring fair value as follows: Level 1: Observable inputs such as quoted prices in active markets; Level 2: Inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and Level 3: Unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions. Recent accounting pronouncements The Company has reviewed all recently issued, but not yet effective, accounting pronouncements and do not believe the future adoption of any such pronouncements may be expected to cause a material impact on its financial condition or the results of its operations. F-9 --- AGAPE ATP CORPORATION NOTES TO CONDENSED FINANCIAL STATEMENTS For the three months ended September 30, 2017 (Currency expressed in United States Dollars (“US$”), except for number of shares) (UNAUDITED) 3. COMMON STOCK On June 1, 2016, the founder of the Company, Mr. How Kok Choong purchased 100,000 shares of restricted common stock of the Company at a par value of $0.0001 per share for the Company’s initial working capital. On April 10, 2017, the Company issued 245,000,000 and 70,000,000 shares of restricted common stock to How Kok Choong and HKC Holdings Sdn Bhd respectively, each with a par value of $0.0001 per share, for total additional working capital of $31,500. On April 13, 2017, the Company issued 17,500,000 shares of restricted common stock to Greenpro Asia Strategic Fund SPC, with a par value of $0.0001 per share, for additional working capital of $1,750. On April 14, 2017, the Company issued 17,500,000 shares of restricted common stock to Greenpro Venture Capital Limited, with a par value of $0.0001 per share, for additional working capital of $1,750. On May 3, 2017, the Company sold shares to 2 shareholders, of whom reside in Malaysia. A total of 1,400,000 shares of restricted common stock were sold at a price of $0.05 per share. The total proceeds to the Company amounted to a total of $70,000. In between May 8, 2017 and May 25, 2017, the Company sold shares to 67 shareholders, of whom reside in Malaysia. A total of 17,400,000 shares of restricted common stock were sold at a price of $0.1 per share. The total proceeds to the Company amounted to a total of $1,740,000. In between June 6, 2017 and June 23, 2017, the Company sold shares to 19 shareholders, of whom reside in Malaysia. A total of 2,100,000 shares of restricted common stock were sold at a price of $0.2 per share. The total proceeds to the Company amounted to a total of $420,000. On June 26, 2017, the Company sold shares to 7 shareholders of whom reside in Malaysia. A total of 350,000 shares of restricted common stock were sold at a price of $0.4 per share. The total proceeds to the Company amounted to a total of $140,000. F-10 ---- AGAPE ATP CORPORATION NOTES TO CONDENSED FINANCIAL STATEMENTS For the three months ended September 30, 2017 (Currency expressed in United States Dollars (“US$”), except for number of shares) (UNAUDITED) 4. INCOME TAXES For the three months ended September 30 2017 and 2016, the local (United States) and foreign components of income/(loss) before income taxes were comprised of the following: | Three Months Ended September 30 | -----------------------------+------------------------------------------+-------- | 2017 | | | 2016 | -----------------------------+------------------------------------------+---------+---+------+-- Tax jurisdictions from: | | | | | | -----------------------------+------------------------------------------+---------+---+------+---+-- - Local | $ | (90,745 | ) | | $ | - -----------------------------+------------------------------------------+---------+---+------+---+-- - Foreign, representing | | | | | | -----------------------------+------------------------------------------+---------+---+------+---+-- Labuan, Malaysia | | (58 | ) | | | - -----------------------------+------------------------------------------+---------+---+------+---+-- Hong Kong | | 43,346 | | | | - -----------------------------+------------------------------------------+---------+---+------+---+-- (Loss) before income tax | $ | (47,457 | ) | | $ | - -----------------------------+------------------------------------------+---------+---+------+---+-- The provision for income taxes consisted of the following: | Three Months Ended September 30 | -------------------+------------------------------------------+------ | 2017 | | 2016 | -------------------+------------------------------------------+-------+------+-- Current: | | | | | -------------------+------------------------------------------+-------+------+---+-- - Local | $ | - | | $ | - -------------------+------------------------------------------+-------+------+---+-- - Foreign | | 7,152 | | | - -------------------+------------------------------------------+-------+------+---+-- Deferred: | | | | | -------------------+------------------------------------------+-------+------+---+-- - Local | | - | | | - -------------------+------------------------------------------+-------+------+---+-- - Foreign | | - | | | - -------------------+------------------------------------------+-------+------+---+-- Income tax expense | $ | 7,152 | | $ | - -------------------+------------------------------------------+-------+------+---+-- The effective tax rate in the periods presented is the result of the mix of income earned in various tax jurisdictions that apply a broad range of income tax rates. The Company has subsidiaries that operate in various countries: United States, Labuan and Hong Kong that are subject to taxes in the jurisdictions in which they operate, as follows: United States of America The Company is registered in the State of Nevada and is subject to the tax laws of the United States of America. As of September 30, 2017, the operations in the United States of America incurred $190,945 of cumulative net operating losses which can be carried forward to offset future taxable income. The net operating loss carryforwards begin to expire in 2037, if unutilized. The Company has provided for a full valuation allowance of $66,831 against the deferred tax assets on the expected future tax benefits from the net operating loss carryforwards as the management believes it is more likely than not that these assets will not be realized in the future. Labuan Under the current laws of the Labuan, Agape ATP Corporation is governed under the Labuan Business Activity Act, 1990. The tax charge for such company is based on 3% of net audited profit or at a fixed rate of RM20,000. F-11 ---- Hong Kong Agape ATP International Holding Limited is subject to Hong Kong Profits Tax, which is charged at the statutory income rate of 16.5% on its assessable income. The following table sets forth the significant components of the aggregate deferred tax assets of the Company as of September 30, 2017 and June 30, 2017: | As of September 30, 2017 | | | As of June 30, 2017 | ---------------------------------+-----------------------------------+---------+---+------------------------------+-- | (unaudited) | | | (audited) | ---------------------------------+-----------------------------------+---------+---+------------------------------+-- Deferred tax assets: | | | | | | ---------------------------------+-----------------------------------+---------+---+------------------------------+---+-- Net operating loss carryforwards | | | | | | ---------------------------------+-----------------------------------+---------+---+------------------------------+---+-- - United States of America | $ | (66,831 | ) | | $ | - ---------------------------------+-----------------------------------+---------+---+------------------------------+---+-- - Hong Kong | | - | | | | - ---------------------------------+-----------------------------------+---------+---+------------------------------+---+-- | $ | (66,831 | ) | | $ | - ---------------------------------+-----------------------------------+---------+---+------------------------------+---+-- Less: valuation allowance | | | | | | ---------------------------------+-----------------------------------+---------+---+------------------------------+---+-- Deferred tax assets | $ | - | | | $ | - ---------------------------------+-----------------------------------+---------+---+------------------------------+---+-- 5. OTHER PAYABLES AND ACCRUED LIABILITIES Other payables and accrued liabilities consisted of the following at September 30, 2017 and June 30, 2017: | As of September 30, 2017 | | As of June 30, 2017 | ---------------------------------------------+-------------------------------+---+--------------------------+-- Accrued Audit Fees | $ | - | | $ | 8,000 ---------------------------------------------+-------------------------------+---+--------------------------+---+------ Total other payables and accrued liabilities | $ | - | | $ | 8,000 ---------------------------------------------+-------------------------------+---+--------------------------+---+------ F-12 ---- AGAPE ATP CORPORATION NOTES TO CONDENSED FINANCIAL STATEMENTS For the three months ended September 30, 2017 (Currency expressed in United States Dollars (“US$”), except for number of shares) (UNAUDITED) 6. COMMITMENTS AND CONTINGENCIES As of September 30, 2017, the Company has no commitments or contingencies involved. 7. AMOUNT DUE TO A DIRECTOR As of September 30, 2017 and June 30, 2017, a director of the Company advanced $3,946 and $100, respectively to the Company, which is unsecured, interest-free with no fixed repayment term, for working capital purpose. Imputed interest is considered insignificant. 8. RELATED PARTY TRANSACTIONS | Three months ended September 30, 2017 | | Three months ended September 30, 2016 | ---------------------------+-----------------------------------------------------+---------+-----------------------------------------------------+-- Revenue: | | | | | ---------------------------+-----------------------------------------------------+---------+-----------------------------------------------------+---+-- - Related Party A | $ | 490,126 | | $ | - ---------------------------+-----------------------------------------------------+---------+-----------------------------------------------------+---+-- Professional Fee: | | | | | ---------------------------+-----------------------------------------------------+---------+-----------------------------------------------------+---+-- - Related Party B | $ | 90,000 | | $ | - ---------------------------+-----------------------------------------------------+---------+-----------------------------------------------------+---+-- Trademark Application Fee: | | | | | ---------------------------+-----------------------------------------------------+---------+-----------------------------------------------------+---+-- - Related Party B | $ | 513 | | $ | - ---------------------------+-----------------------------------------------------+---------+-----------------------------------------------------+---+-- The director of related party A is the CEO and the Director of the Company. Related party B is a 4.7% shareholder of the Company. 9. CONCENTRATIONS OF RISK The Company is exposed to the following concentrations of risk: (a) Major customers For three months ended September 30, 2017 and 2016, the customers who accounted for 10% or more of the Company’s sales and its outstanding receivable balance at period-end are presented as follows: | 2017 | | 2016 | | 2017 | 2016 | | 2017 | | 2016 | -----------+----------+---------+------------------------+---+----------------------------+------+---+------+---+------+-- | Revenues | | Percentage of revenues | | Accounts receivable, trade -----------+----------+---------+------------------------+---+--------------------------- Customer A | $ | 490,126 | | - | | 100 | % | | - | | $ | 490,466 | - -----------+----------+---------+------------------------+---+----------------------------+------+---+------+---+------+---+---------+-- | $ | 490,126 | | - | | 100 | % | | - | | $ | 490,466 | - -----------+----------+---------+------------------------+---+----------------------------+------+---+------+---+------+---+---------+-- (b) Major vendors For three months ended September 30, 2017 and 2016, the vendors who accounted for 10% or more of the Company’s purchases and its outstanding payable balance at period-end are presented as follows: | 2017 | | 2016 | | 2017 | 2016 | | 2017 | | 2016 | ---------+----------+---------+-----------------------------+---+-----------------------------+------+---+------+---+------+-- | Purchase | | Percentage of purchases | | Accounts payable, trade ---------+----------+---------+-----------------------------+---+---------------------------- Vendor A | $ | 444,238 | | - | | 100 | % | | - | | $ | 387,052 | - ---------+----------+---------+-----------------------------+---+-----------------------------+------+---+------+---+------+---+---------+-- | $ | 444,238 | | - | | 100 | % | | - | | $ | 387,052 | - ---------+----------+---------+-----------------------------+---+-----------------------------+------+---+------+---+------+---+---------+-- 10. SUBSEQUENT EVENTS The Company has evaluated subsequent events from the balance sheet date through November 13, 2017, the date the Company issued unaudited consolidated financial statements in accordance with ASC Topic 855, “Subsequent Events”, which establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued. During this period, there was no subsequent event that required recognition or disclosure. F-13 ---- AGAPE ATP CORPORATION NOTES TO CONDENSED FINANCIAL STATEMENTS For the three months ended September 30, 2017 (Currency expressed in United States Dollars (“US$”), except for number of shares) (UNAUDITED) ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information contained in this quarter report on Form 10-Q is intended to update the information contained in our Form S-1 Amendment No.2, dated October 26, 2017, for the year ended June 30, 2017 and presumes that readers have access to, and will have read, the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other information contained in such Form S-1. The following discussion and analysis also should be read together with our consolidated financial statements and the notes to the consolidated financial statements included elsewhere in this Form 10-Q. The following discussion contains certain statements that may be deemed “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements appear in a number of places in this Report, including, without limitation, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” These statements are not guarantees of future performance and involve risks, uncertainties and requirements that are difficult to predict or are beyond our control. Forward-looking statements speak only as of the date of this quarterly report. You should not put undue reliance on any forward-looking statements. We strongly encourage investors to carefully read the factors described in our Form S-1 Amendment No.2, dated October 26, 2017, in the section entitled “Risk Factors” for a description of certain risks that could, among other things, cause actual results to differ from these forward-looking statements. We assume no responsibility to update the forward-looking statements contained in this transition report on Form 10-Q. The following should also be read in conjunction with the unaudited Condensed Consolidated Financial Statements and notes thereto that appear elsewhere in this report. Company Overview Agape ATP Corporation., a Nevada corporation (“the Company”) was incorporated under the laws of the State of Nevada on June 1, 2016. Agape ATP Corporation is a company that operates through its wholly owned subsidiary, Agape ATP Corporation, a company organized in Labuan, Malaysia. Our wholly owned subsidiary, Agape ATP Corporation owns 100% of Agape ATP International Holding Limited, the operating Hong Kong company. Agape ATP Corporation is a company which plans to develop and provide health solution advisory services to our future clients. We will, at least initially, primarily focus our efforts on attracting customers in Malaysia. Our advisory services will center around the “ATP Zeta Health Program”, which is a health program designed to assist in the elimination of various diseases caused by polluted environments, unhealthy dietary intake and unhealthy lifestyles. The program aims to promote improved health and longevity in our clients through a combination of modern medicine, proper nutrition, and advice from skilled dieticians. At its core, the ATP Zeta Super Health Program is focused upon biological energy, Adenosine Trisophate (ATP), at the cellular level. The stimulation of ATP production at the cellular level can increase the metabolism and service to promote and maintain normal and healthy functioning of the body’s systems. Our program emphasizes nutrient absorption through the membrane ion channel to provide complete and balanced nutrients to improve cell health. Thus, ATP Zeta Super Health Program provides ionized and high zeta potential (high bioavailability) nutrients to enhance the absorption at the cellular level. Results of Operation For Three Months Ended September 30, 2017 and September 30, 2016. Revenues For three months ended September 30, 2017, we realized revenue in the amount of $490,126, which came from the sale of our healthy food products. Our gross profits for the three months ended September 30, 2017 were $45,888, which is greater than $Nil for three months ended September 30, 2016. We attribute the increase in revenue and gross profit to increase of market exposure and the introduction of new products in 2017. We believe that in order to retain and maintain more customers in the future we must increase our marketing efforts and or develop new products. 3 - Net Loss Our net loss for three months ended September 30, 2017 were $54,609, while for three months ended September 30, 2016 were $Nil. We attribute the net loss due to higher operating expenses incurred on professional fee. Liquidity and Capital Resources For the three months ended September 30, 2017, we had working capital surplus of $2,250,039 consisting of cash on hand of $2,157,723 as compared to working capital surplus of $2,304,648 and cash on hand of $2,312,748 as of June 30, 2017. We have negative operating cash flows and our working capital has been and will continue to be significant. As a result, we depend substantially on our previous financing activities to provide us with the liquidity and capital resources we need to meet our working capital requirements and to make capital investments in connection with ongoing operations. The Company expects its current capital resources to meet our basic operating requirements for approximately twelve months. Cash Used In Operating Activities For the three months ended September 30, 2017, net cash used in operating activities was $155,025. The operating cash flow performance primarily reflects the increase of accounts receivables of the Company. Credit Facilities We do not have any credit facilities or other access to bank credit. Off-balance Sheet Arrangements We have no significant off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to our stockholders as of September 30, 2017. Recent Accounting Pronouncements The Company has reviewed all recently issued, but not yet effective, accounting pronouncements and do not believe the future adoption of any such pronouncements may be expected to cause a material impact on its financial condition or the results of its operations. 4 - ITEM 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK As a “smaller reporting company” as defined by Item 10 of Regulation S-K, the Company is not required to provide information required by this Item. ITEM 4 CONTROLS AND PROCEDURES Evaluation of Disclosure Controls and Procedures: We carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of September 30, 2017. This evaluation was carried out under the supervision and with the participation of our Chief Executive Officer and our Chief Financial Officer. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of September 30, 2017, our disclosure controls and procedures were not effective due to the presence of material weaknesses in internal control over financial reporting. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. Management has identified the following material weaknesses which have caused management to conclude that, as of September 30, 2017, our disclosure controls and procedures were not effective: (i) inadequate segregation of duties and effective risk assessment; and (ii) insufficient written policies and procedures for accounting and financial reporting with respect to the requirements and application of both US GAAP and SEC guidelines. Changes in Internal Control over Financial Reporting: There were no changes in our internal control over financial reporting during the quarter ended September 30, 2017, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 5 - PART II — OTHER INFORMATION Item 1. Legal Proceedings We know of no materials, active or pending legal proceedings against us, nor are we involved as a plaintiff in any material proceedings or pending litigation. There are no proceedings in which any of our directors, officers or affiliates, or any beneficial shareholder are an adverse party or has a material interest adverse to us. Item 1A. Risk Factors We are a smaller reporting company as defined by Rule 12b-2 of the Securities Exchange Act of 1934 and are not required to provide the information under this item. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds None. Item 3. Defaults Upon Senior Securities None Item 4. Mine Safety Disclosures Not applicable. Item 5. Other Information None. 6 - ITEM 6. Exhibits Exhibit No. | Description ----------------+-------------------------------------------------------------------------------------------------------------------- 31.1 | Rule 13(a)-14(a)/15(d)-14(a) Certification of principal executive officer* ----------------+-------------------------------------------------------------------------------------------------------------------- 32.1 | Section 1350 Certification of principal executive officer* ----------------+-------------------------------------------------------------------------------------------------------------------- 101.INS | XBRL Instance Document* ----------------+-------------------------------------------------------------------------------------------------------------------- 101.SCH | XBRL Schema Document* ----------------+-------------------------------------------------------------------------------------------------------------------- 101.CAL | XBRL Calculation Linkbase Document* ----------------+-------------------------------------------------------------------------------------------------------------------- 101.DEF | XBRL Definition Linkbase Document* ----------------+-------------------------------------------------------------------------------------------------------------------- 101.LAB | XBRL Label Linkbase Document* ----------------+-------------------------------------------------------------------------------------------------------------------- 101.PRE | XBRL Presentation Linkbase Document* ----------------+-------------------------------------------------------------------------------------------------------------------- * Filed herewith. 7 - SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. | AGAPE ATP CORPORATION ----------------------------+-------------------------- | (Name of Registrant) ----------------------------+-------------------------- Date: November 13, 2017 | | ----------------------------+---------------------------+----------------------------------------------------------------------------------------------------------------------- | By: | /s/ How Kok Choong ----------------------------+---------------------------+----------------------------------------------------------------------------------------------------------------------- | Title: | Chief Executive Officer, President, Director, Secretary and Treasurer ----------------------------+---------------------------+----------------------------------------------------------------------------------------------------------------------- | | (Principal Executive Officer) ----------------------------+---------------------------+----------------------------------------------------------------------------------------------------------------------- 8 -

Almost Never Films Inc.

1422768

10-Q

0001640334-17-002354

hlwd_10q.htm UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-Q (Mark One) x QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED: September 30, 2017 ¨ TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ___________ to __________ Commission File Number: ________________ ALMOST NEVER FILMS INC. ------------------------------------------------------ (Exact name of registrant as specified in its charter) ------------------------------------------------------ Nevada | 26-1665960 ---------------------------------------------------------------+------------------------------------- (State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) ---------------------------------------------------------------+------------------------------------- 8605 Santa Monica Blvd #98258, West Hollywood, CA 90069-4109 (Address of principal executive offices, Zip Code) (213) 296-3005 (Registrant’s telephone number, including area code) ____________________________________________________________ (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No x Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. Large accelerated filer | ¨ | Accelerated filer | ¨ ------------------------+---+---------------------------+-- Non-accelerated filer | ¨ | Smaller reporting company | x ------------------------+---+---------------------------+-- | | Emerging growth company | ¨ ------------------------+---+---------------------------+-- If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨ The number of shares of registrant’s common stock outstanding as of November 13, 2017 was 4,670,049. FORM 10-Q ALMOST NEVER FILMS INC. (F/K/A SMACK SPORTSWEAR) September 30, 2017 TABLE OF CONTENTS | | Page No. --------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------+--------- PART I. - FINANCIAL INFORMATION | --------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------ Item 1. | Condensed Consolidated Financial Statements (Unaudited) | 4 --------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------+--------- | Condensed Consolidated Balance Sheets as of September 30, 2017 (Unaudited) and June 30, 2017 | 4 --------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------+--------- | Unaudited Condensed Consolidated Statements of Operations and Comprehensive Loss for the Three Months Ended September 30, 2017 and September 30, 2016 | 5 --------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------+--------- | Unaudited Condensed Consolidated Statements of Cash Flows for the Three Months Ended September 30, 2017 and September 30, 2016 | 6 --------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------+--------- | Notes to Condensed Consolidated Financial Statements | 7 --------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------+--------- Item 2. | Management's Discussion and Analysis of Financial Condition and Results of Operations. | 12 --------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------+--------- Item 3. | Quantitative and Qualitative Disclosures About Market Risk | 18 --------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------+--------- Item 4. | Controls and Procedures | 18 --------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------+--------- PART II - OTHER INFORMATION | --------------------------------+------------------------------------------------------------------------------------------------------------------------------------------------------ Item 1. | Legal Proceedings | 20 --------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------+--------- Item 1A | Risk Factors | 20 --------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------+--------- Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | 20 --------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------+--------- Item 3. | Defaults Upon Senior Securities | 20 --------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------+--------- Item 4. | Mine Safety Disclosures | 20 --------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------+--------- Item 5. | Other Information | 20 --------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------+--------- Item 6. | Exhibits | 21 --------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------+--------- | Signature | 22 --------------------------------+-------------------------------------------------------------------------------------------------------------------------------------------------------+--------- 2 - FORWARD LOOKING STATEMENTS This report contains forward-looking statements regarding our business, financial condition, results of operations and prospects. Words such as "expects," "anticipates," "intends," "plans," "believes," "seeks," "estimates" and similar expressions or variations of such words are intended to identify forward-looking statements, but are not deemed to represent an all-inclusive means of identifying forward-looking statements as denoted in this report. Additionally, statements concerning future matters are forward-looking statements. Although forward-looking statements in this report reflect the good faith judgment of our management, such statements can only be based on facts and factors currently known by us. Consequently, forward-looking statements are inherently subject to risks and uncertainties and actual results and outcomes may differ materially from the results and outcomes discussed in or anticipated by the forward-looking statements. Factors that could cause or contribute to such differences in results and outcomes include, without limitation, those specifically addressed under the headings "Risks Factors" and "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our report on Form 8-K which was filed with the SEC on January 20, 2016 (the "Super 8-K"), in "Management's Discussion and Analysis of Financial Condition and Results of Operations" in this Form 10-Q and information contained in other reports that we file with the SEC. You are urged not to place undue reliance on these forward-looking statements, which speak only as of the date of this report. We file reports with the SEC. The SEC maintains a website (www.sec.gov) that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC, including us. You can also read and copy any materials we file with the SEC at the SEC's Public Reference Room at 100 F Street, NE, Washington, DC 20549. You can obtain additional information about the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. We undertake no obligation to revise or update any forward-looking statements in order to reflect any event or circumstance that may arise after the date of this report, except as required by law. Readers are urged to carefully review and consider the various disclosures made throughout the entirety of this quarterly report, which are designed to advise interested parties of the risks and factors that may affect our business, financial condition, results of operations and prospects. 3 - PART I. FINANCIAL INFORMATION ----------------------------- ITEM I. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS Almost Never Films Inc. and Subsidiaries Condensed Consolidated Balance Sheets | September 30, | | | June 30, | --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+-- | 2017 | | | 2017 | --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+-- | (Unaudited) | | | | --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+-- ASSETS | | | | | --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+-- Current Assets | | | | | --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+-- Cash and cash equivalents | $ | 640,937 | | | $ | 91,590 | --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+---+----------+-- Interest receivable | | - | | | | 5,159 | --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+---+----------+-- Promissory notes receivable | | - | | | | 400,000 | --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+---+----------+-- Prepaid expenses | | 8,826 | | | | 16,607 | --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+---+----------+-- Loan Receivable | | 12,000 | | | | - | --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+---+----------+-- Total Current Assets | | 661,763 | | | | 513,356 | --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+---+----------+-- TOTAL ASSETS | $ | 661,763 | | | $ | 513,356 | --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+---+----------+-- LIABILITIES AND STOCKHOLDERS' EQUITY | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+---+----------+-- Current Liabilities | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+---+----------+-- Accrued liabilities | $ | 56,681 | | | $ | 41,436 | --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+---+----------+-- Interest payable | | 14,906 | | | | 17,068 | --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+---+----------+-- Note payable | | 66,613 | | | | 66,613 | --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+---+----------+-- Promissory Note Payable | | - | | | | 200,000 | --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+---+----------+-- Promissory note payable - related party | | - | | | | 200,000 | --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+---+----------+-- Total Current Liabilities | | 138,200 | | | | 525,117 | --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+---+----------+-- Long-term Liabilities | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+---+----------+-- Promissory note payable - related party | | 350,000 | | | | - | --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+---+----------+-- TOTAL LIABILITIES | | 488,200 | | | | 525,117 | --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+---+----------+-- Stockholders' Equity | | | | | | | --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+---+----------+-- Preferred stock: no par value, 5,000,000 authorized; Series A Preferred stock: 2,000,000 authorized; No shares issued and outstanding | | - | | | | - | --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+---+----------+-- Common stock: 25,000,000 authorized; $0.001 par value 4,670,049 and 4,755,524 shares issued and outstanding respectively. | | 4,670 | | | | 4,756 | --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+---+----------+-- Additional paid in capital | | 908,826 | | | | 928,740 | --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+---+----------+-- Stock subscription | | 250,000 | | | | - | --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+---+----------+-- Accumulated deficit | | (989,933 | ) | | | (945,257 | ) --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+---+----------+-- Total Stockholders' Equity | | 173,563 | | | | (11,761 | ) --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+---+----------+-- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY | $ | 661,763 | | | $ | 513,356 | --------------------------------------------------------------------------------------------------------------------------------------+---------------+----------+---+----------+---+----------+-- The accompanying notes are an integral part of these financial statements. 4 - Almost Never Films Inc. and Subsidiaries Condensed Consolidated Statements of Operations and Comprehensive Loss (Unaudited) | Three Months Ended | ----------------------------------------------+--------------------+---------- | September 30, | ----------------------------------------------+--------------------+---------- | 2017 | | | 2016 | ----------------------------------------------+--------------------+-----------+---+------+-- Revenues | $ | - | | | $ | - | ----------------------------------------------+--------------------+-----------+---+------+---+-----------+-- Operating Expenses | | | | | | | ----------------------------------------------+--------------------+-----------+---+------+---+-----------+-- General and administration | | 21,976 | | | | 4,060 | ----------------------------------------------+--------------------+-----------+---+------+---+-----------+-- Professional | | 19,703 | | | | 13,465 | ----------------------------------------------+--------------------+-----------+---+------+---+-----------+-- Total operating expenses | | 41,679 | | | | 17,525 | ----------------------------------------------+--------------------+-----------+---+------+---+-----------+-- Loss from operations | | (41,679 | ) | | | (17,525 | ) ----------------------------------------------+--------------------+-----------+---+------+---+-----------+-- Other Expenses (Income) | | | | | | | ----------------------------------------------+--------------------+-----------+---+------+---+-----------+-- Interest income | | 4,841 | | | | - | ----------------------------------------------+--------------------+-----------+---+------+---+-----------+-- Interest expense | | (7,838 | ) | | | (1,679 | ) ----------------------------------------------+--------------------+-----------+---+------+---+-----------+-- Total other income (expense) | | (2,997 | ) | | | (1,679 | ) ----------------------------------------------+--------------------+-----------+---+------+---+-----------+-- Net loss before taxes | | (44,676 | ) | | | (19,204 | ) ----------------------------------------------+--------------------+-----------+---+------+---+-----------+-- Provision for income taxes | | - | | | | - | ----------------------------------------------+--------------------+-----------+---+------+---+-----------+-- Net loss | $ | (44,676 | ) | | $ | (19,204 | ) ----------------------------------------------+--------------------+-----------+---+------+---+-----------+-- Net Loss Per Common Share – Basic and Diluted | $ | (0.01 | ) | | $ | (0.00 | ) ----------------------------------------------+--------------------+-----------+---+------+---+-----------+-- Weighted Average Common Shares Outstanding | | 4,673,765 | | | | 4,442,691 | ----------------------------------------------+--------------------+-----------+---+------+---+-----------+-- The accompanying notes are an integral part of these financial statements. 5 - Almost Never Films Inc. and Subsidiaries Condensed Consolidated Statements of Cash Flows (Unaudited) | Three Months Ended | ----------------------------------------------------------------------------+--------------------+--------- | September 30, | ----------------------------------------------------------------------------+--------------------+--------- | 2017 | | | 2016 | ----------------------------------------------------------------------------+--------------------+----------+---+------+-- Cash Flows from Operating Activities: | | | | | ----------------------------------------------------------------------------+--------------------+----------+---+------+-- Net loss | $ | (44,676 | ) | | $ | (19,204 | ) ----------------------------------------------------------------------------+--------------------+----------+---+------+---+---------+-- Adjustments to reconcile net loss to net cash used in operating activities: | | | | | | | ----------------------------------------------------------------------------+--------------------+----------+---+------+---+---------+-- Interest receivable | | 5,159 | | | | - | ----------------------------------------------------------------------------+--------------------+----------+---+------+---+---------+-- Prepaid expense | | 7,781 | | | | 1,876 | ----------------------------------------------------------------------------+--------------------+----------+---+------+---+---------+-- Accrued liabilities | | 15,245 | | | | 3,459 | ----------------------------------------------------------------------------+--------------------+----------+---+------+---+---------+-- Interest payable | | (2,162 | ) | | | - | ----------------------------------------------------------------------------+--------------------+----------+---+------+---+---------+-- Net Cash Used in Operating Activities | | (18,653 | ) | | | (13,869 | ) ----------------------------------------------------------------------------+--------------------+----------+---+------+---+---------+-- Cash Flows from Investing Activities: | | | | | | | ----------------------------------------------------------------------------+--------------------+----------+---+------+---+---------+-- Promissory note receivable | | 400,000 | | | | - | ----------------------------------------------------------------------------+--------------------+----------+---+------+---+---------+-- Net Cash provided by Investing Activities | | 400,000 | | | | - | ----------------------------------------------------------------------------+--------------------+----------+---+------+---+---------+-- Cash Flows from Financing Activities: | | | | | | | ----------------------------------------------------------------------------+--------------------+----------+---+------+---+---------+-- Proceeds from common stock subscribed | | 250,000 | | | | - | ----------------------------------------------------------------------------+--------------------+----------+---+------+---+---------+-- Retirement of Common Stock | | (20,000 | ) | | | - | ----------------------------------------------------------------------------+--------------------+----------+---+------+---+---------+-- Loan receivable | | (12,000 | ) | | | - | ----------------------------------------------------------------------------+--------------------+----------+---+------+---+---------+-- Promissory note payable – related party | | 350,000 | | | | - | ----------------------------------------------------------------------------+--------------------+----------+---+------+---+---------+-- Payment of Promissory note payable | | (200,000 | ) | | | - | ----------------------------------------------------------------------------+--------------------+----------+---+------+---+---------+-- Payment of Promissory note payable - related party | | (200,000 | ) | | | - | ----------------------------------------------------------------------------+--------------------+----------+---+------+---+---------+-- Net Cash Provided By Financing Activities | | 168,000 | | | | - | ----------------------------------------------------------------------------+--------------------+----------+---+------+---+---------+-- Net Increase in Cash and Cash Equivalents | | 549,347 | | | | (13,869 | ) ----------------------------------------------------------------------------+--------------------+----------+---+------+---+---------+-- Cash and Cash Equivalents, beginning of period | | 91,590 | | | | 84,967 | ----------------------------------------------------------------------------+--------------------+----------+---+------+---+---------+-- Cash and Cash Equivalents, end of period | $ | 640,937 | | | $ | 71,098 | ----------------------------------------------------------------------------+--------------------+----------+---+------+---+---------+-- Supplemental Disclosure Information: | | | | | | | ----------------------------------------------------------------------------+--------------------+----------+---+------+---+---------+-- Cash paid for interest | $ | 10,000 | | | $ | - | ----------------------------------------------------------------------------+--------------------+----------+---+------+---+---------+-- Cash paid for taxes | $ | - | | | $ | - | ----------------------------------------------------------------------------+--------------------+----------+---+------+---+---------+-- The accompanying notes are an integral part of these financial statements. 6 - Almost Never Films Inc. and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 NOTE 1 - ORGANIZATION, OPERATIONS AND BASIS OF ACCOUNTING Nature of the Business Almost Never Films Inc. (the “Company”) was originally incorporated in Nevada in October 2007 as Smack Sportswear (“Smack”), which originally manufactured and sold performance and lifestyle based indoor and sand volleyball apparel and accessories. The Company is now an independent film company focused on film production and production related services in connection with genre specific motion pictures with production costs in the $5.0 million to $50.0 million range. Share Exchange and Recapitalization On January 15, 2016, Smack entered into a share exchange agreement with Almost Never Films Inc., a private company incorporated in Indiana on July 8, 2015, and its two shareholders, Danny Chan and Derek Williams. Pursuant to the agreement, Smack issued 1,000,000 shares of our Series A Convertible Preferred Stock to Mr. Chan and Mr. Williams in exchange for all 2,500,000 shares of issued and outstanding common stock of Almost Never Films Inc. (Indiana). As a result of the share exchange, Almost Never Films Inc. (Indiana) became Smack’s wholly-owned subsidiary, and Mr. Chan and Mr. Williams acquired a controlling interest in the Company. The share exchange was accounted for as a "reverse acquisition," and resulted in a recapitalization. Almost Never Films Inc. (Indiana) is deemed to be the acquirer for accounting purposes. The assets acquired and liabilities assumed were $6,566 and $598,869, respectively. Consequently, the assets and liabilities and the historical operations that will be reflected in the financial statements prior to the share exchange will be those of Almost Never Films Inc. (Indiana) and will be recorded at the historical cost basis of Almost Never Films Inc. (Indiana), and the combined financial statements after completion of the share exchange include the assets and liabilities of Almost Never Films Inc. (Indiana), historical operations of Almost Never Films Inc. (Indiana), and operations of Almost Never Films Inc. (Indiana) from the closing date of the share exchange. As a result of the issuance of the shares of our Series A Convertible Preferred Stock pursuant to the share exchange, a change in control of the Company occurred as of the date of consummation of the share exchange. All share and per share information in the accompanying consolidated financial statements and footnotes has been retroactively restated to reflect the recapitalization. The Company has not yet generated any revenue since inception. On February 29, 2016, the stockholders of Smack voted to amend the Articles of Incorporation of the Company to (i) increase the authorized capital of the Company to 5,000,000 shares of common stock and (ii) to change the name of the Company to “Almost Never Films Inc.” which took effect on March 2, 2016. On August 9, 2017, the Company has approved a 1 for 40 reverse split of its issued and outstanding common stock. The common stock accounts and all share related balances have been be applied retroactively for all periods presented. The new symbol of the Company is HLWD in OTCQB. Going Concern The accompanying consolidated financial statements have been prepared on a going concern basis of accounting, which contemplates continuity of operations, realization of assets and liabilities and commitments in the normal course of business. The accompanying consolidated financial statements do not reflect any adjustments that might result if the Company is unable to continue as a going concern. During the three months ended September 30, 2017, the Company had a net loss from continuing operations of $44,676 and net cash outflows from operating activities of $18,653. As of September 30, 2017, the Company is delinquent in payments of $66,613 of a note payable and an accumulated deficit of $989,933. These factors, among others, raise substantial doubt about the Company’s ability to continue as a going concern. 7 - The ability of the Company to continue as a going concern and appropriateness of using the going concern basis is dependent upon, among other things, an additional cash infusion and an identification of new business opportunities. Management has reviewed the entity’s financial condition, and has improved the Company’s working capital during the past fiscal year. Management believes the Company will be able to fund operations for the next year through cash on hand, and further potential equity and debt offerings. There are no other significant conditions or events that management has identified that will adversely affect the Company’s ability to meet its obligations over the next year of operations. NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES This summary of significant accounting policies of the Company is presented to assist in understanding the Company’s financial statements. The financial statements and notes are representations of the Company’s management, which is responsible for their integrity and objectivity. These accounting policies conform to accounting principles generally accepted in the United States of America and have been consistently applied in the preparation of the financial statements. Basis of Consolidation The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, Team Sports Superstore (Inactive) and Almost Never Films Inc. (Indiana). All significant intercompany transactions and balances have been eliminated in consolidation. Basis of Presentation The unaudited condensed consolidated financial statements presented herein have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and in accordance with the instructions to Form 10-Q and Regulation S-X. Accordingly, the financial statements do not include all of the information and notes required by GAAP for complete financial statements. In the opinion of management, all adjustments, including normal recurring adjustments, considered necessary for a fair statement of the financial statements have been included. Operating results for the three months ended September 30, 2017 are not necessarily indicative of the results that may be expected for the year ending June 30, 2018. These unaudited condensed consolidated financial statements and notes thereto should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto for the year ended June 30, 2017, which were included in the Company’s 2017 Annual Report on Form 10-K. The accompanying condensed consolidated balance sheet as of June 30, 2017, has been derived from the Company’s audited consolidated financial statements as of that date. Use of Estimates The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the U.S requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the financial statement date, and reported amounts of revenue and expenses during the reporting period. Significant estimates are used in valuing the fair value of common stock issued for services, among others. Actual results could differ from these estimates. 8 - Cash Cash includes demand deposits with banks or other financial institutions. All cash balances are hold by major banking institutions. The Company maintains its cash with a financial institution, and at times, amounts may exceed federally insured limits. Currently the FDIC insurance coverage limit is $250,000, and therefore the Company is potentially exposed to un-insured cash balances of $390,937. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant credit risk on cash. Fair Value of Financial Instruments Fair value is defined as the price that would be received upon sale of an asset or paid upon transfer of a liability in an orderly transaction between market participants at the measurement date and in the principal or most advantageous market for that asset or liability. The fair value should be calculated based on assumptions that market participants would use in pricing the asset or liability, not on assumptions specific to the entity. In addition, the fair value of liabilities should include consideration of non-performance risk including our own credit risk. In addition to defining fair value, the standard expands the disclosure requirements around fair value and establishes a fair value hierarchy for valuation inputs. The hierarchy prioritizes the inputs into three levels based on the extent to which inputs used in measuring fair value are observable in the market. Each fair value measurement is reported in one of the three levels which are determined by the lowest level input that is significant to the fair value measurement in its entirety. These levels are: Level 1 – inputs are based upon unadjusted quoted prices for identical instruments traded in active markets. Level 2 – inputs are based upon significant observable inputs other than quoted prices included in Level 1, such as quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 3 – inputs are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability. The fair values are therefore determined using model-based techniques that include option pricing models, discounted cash flow models, and similar techniques. As of September 30, 2017, the balance reported for cash approximates its fair value because of its short maturities. Notes payable are recorded at agreed values. Debt balances are stated at historical amounts less principal payments, which approximate fair market value. Promissory notes receivable and payable are stated at historical amounts less principal payments. The Company believes interest rates in its debt agreements are commensurate with lender risk profiles for similar companies. Stock Repurchase and Cancellation During the three months ended September 30, 2017, the Company repurchased and cancelled 85,475 shares of common stock. The Company accounted for the transaction in accordance with ASC 505 – Equity – 30 Treasury Stock, Purchase of Treasury Shares or Stock Rights. Loss per Share Calculations Basic earnings per share is computed by dividing income available to common shareholders by the weighted-average number of common shares available. Diluted earnings per share is computed similar to basic earnings per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potential common shares had been issued and if the additional common shares were dilutive. The Company’s diluted loss per share is the same as the basic loss per share for the three months ended September 30, 2017, and 2016, as there are no potential shares outstanding that would have a dilutive effect. 9 - Recently Issued Accounting Pronouncements Management has considered all recent accounting pronouncements issued since the last audit of our financial statements. The Company’s management believes that these recent pronouncements will not have a material effect on the Company’s financial statements. NOTE 3 – PROMISSORY NOTES RECEIVABLE On June 7, 2017, the Company received a 2.5% promissory note in exchange for lending $200,000 to a third party. The principal of $200,000 is due to the Company forty-five (45) days from receipt of the funds. On June 12, 2017, the Company received a 2.5% promissory note in exchange for lending $200,000 to a third party. The principal of $200,000 is due to the Company forty-five (45) days from receipt of the funds. The proceeds from the two Promissory Notes Receivable were utilized in order to provide a Bridge Loan to a third party in connection with the productions of the certain motion pictures. During the three months ended September 30, 2017, a total amount of $4,841 was recorded as interest income. The Company received full payments for the two Promissory Notes Receivable and $10,000 of interest income related to the two Promissory Notes Receivable during the three months ended September 30, 2017. NOTE 4 – PROMISSORY NOTES PAYABLE On June 6, 2017, the Company issued a 2.5% promissory note in exchange for receiving $200,000 to an unrelated third party. The principal of $200,000 is due to the lender ninety (90) days from receipt of the funds. The promissory note payable, was fully paid along with interest payable as of September 30, 2017. During the three months ended September 30, 2017, a total amount of $2,396 was recorded as interest expense. NOTE 5 – RELATED PARTY TRANSACTIONS On June 9, 2017, the Company issued a 2.5% promissory note in exchange for receiving $200,000 to William R. Kruse, one of the Company’s principle owners. The principal of $200,000 was due to the lender ninety (90) days from receipt of the funds. The note was fully paid along with interest of $5,000, during the three months ended September 30, 2017. During the three months ended September 30, 2017, interest expense of $2,708 was recorded. On September 19, 2017 the company issued a 10% Promissory Note in exchange for receiving $350,000 to Kruse Farms, LP., a Company owned by one of the Company’s principle owners. The principal of $350,000 is due to the lender in twenty four (24) months from receipt of the funds. An interest payable of $1,055 has been recorded as of September 30, 2017. During the three months ended September 30, 2017, interest expense of $1,055 was recorded. The proceeds will be used by the Company to fund production of a motion picture. NOTE 6 – NOTE PAYABLE In August 2015, Smack entered into an unsecured promissory note agreement with an individual. The agreement allowed for Smack to borrow up to $66,613 at an interest rate of 10 percent per year. This $66,613 note was assumed by the Company during the recapitalization. The outstanding principal balance under the agreement at September 30, 2017 was $66,613. The outstanding principal amount and all accrued and unpaid interest was due by August 2016 and is currently delinquent. As of September 30, 2017 and June 30, 2017 amounts of $13,851 and $12,172 have recorded as interest payable. For the three months ended September 30, 2017, and 2016 interest expense of $1,679 was recorded. 10 -- NOTE 7 – SHARE CAPITAL Common Stock On August 9, 2017, the Company has approved a 1 for 40 reverse split of its issued and outstanding common stock. The common stock accounts and all share related balances have been be applied retroactively for all periods presented. On September 11, 2017, the Company amended the Articles of Incorporation to decrease the authorized capital to 25,000,000 shares of common stock. During the three months ended September 30, 2017, the company entered into two share purchase agreements with two investors for 250,000 shares at $1 per share. The company has received a $250,000 and has recorded as stock subscription of $250,000. On July 5, the Company repurchased and cancelled 85,475 shares of common stock of the company for $20,000. There were 4,670,049 shares of common stock issued and outstanding as September 30, 2017. NOTE 8 – COMMITMENTS AND CONTINGENCIES The Company neither owns nor leases any real or personal property. The Company's officers have provided office services without charge. There is no obligation for the officer to continue this arrangement. Such costs are immaterial to the financial statements and accordingly are not reflected herein. The officers and directors are involved in other business activities and most likely will become involved in other business activities in the future. On December 12, 2016, the Company entered into an agreement with Saisam Entertainment, LLC to develop, finance, and produce a motion picture project. Per the terms of the agreement, the Company will provide or source equity financing for the project in the amount of approximately $1,300,000. Per the terms of the agreement, the Company and Saisam Entertainment, LLC will create an LLC or other entity for the project currently entitled “Love is not Easy”. Saisam Entertainment, LLC owns and controls the rights to the screenplay, and will assign all rights in and to the project, pursuant to the terms of an option purchase agreement between the two parties, which includes an initial option fee of $10,000 for an option period of 18 months, a lien for all of the Company’s out of pocket costs, and will assist in additional funding. The Company will make or source financial contributions in accordance with the terms of the agreement, assist in the raising of additional financing, and will participate in the development and production. The Company and Saisam Entertainment, LLC will own an undivided 50% interest in the LLC or entity that is formed. The Company will be the managing member of the LLC or entity. The approved budget for the project is approximately $2,000,000. In consideration, the Company will receive a return of 20% of its investment, and will subsequently receive its portion of the net profits per the terms of the agreement. The LLC or entity has not been formed to date. NOTE 9 – SUBSEQUENT EVENTS On October 11, 2017, the Company received $150,000 and issued a promissory note for $150,000 to an unrelated party, due on December 11, 2017, bearing a total of 10% interest for the duration of the note. The Company will use the proceeds to fund the production of a motion picture. On October 9, 2017, the Company registered One HLWD KY LLC, a limited liability corporation that will be used for the operations of a motion picture the Company plans on creating. 11 -- ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Business Development Almost Never Films Inc. (the “Company”) was originally incorporated in Nevada in October 2007 as Smack Sportswear (“Smack”), which originally manufactured and sold performance and lifestyle based indoor and sand volleyball apparel and accessories. The Company is now an independent film company focused on film production and production related services in connection with genre specific motion pictures with production costs in the $5.0 million to $50.0 million range. On January 15, 2016, pursuant to the share exchange agreement, among Almost Never Films Inc. f/k/a Smack Sportswear (the “Company”, “we,” “our” or “us”), Almost Never Films Inc. (“ANF”), an Indiana corporation, and the two shareholders of ANF (the “ANF Shareholders”), we issued to the ANF Shareholders, 1,000,000 shares of our Series A Convertible Preferred Stock (the “Series A Preferred Stock”), par value $0.001 per share in exchange for all 100,000,000 shares of the issued and outstanding common stock of ANF (the “Share Exchange”). As a result of the Share Exchange, ANF became our wholly-owned subsidiary, and our business has become the business of ANF, effective January 15, 2017. The share exchange was accounted for as a "reverse acquisition," and resulted in a recapitalization. Almost Never Films Inc. (Indiana) is deemed to be the acquirer for accounting purposes. The assets acquired and liabilities assumed were $6,566 and $598,869, respectively. Consequently, the assets and liabilities and the historical operations that will be reflected in the financial statements prior to the share exchange will be those of Almost Never Films Inc. (Indiana) and will be recorded at the historical cost basis of Almost Never Films Inc. (Indiana), and the combined financial statements after completion of the share exchange include the assets and liabilities of Almost Never Films Inc. (Indiana), historical operations of Almost Never Films Inc. (Indiana), and operations of Almost Never Films Inc. (Indiana) from the closing date of the share exchange. As a result of the issuance of the shares of our Series A Convertible Preferred Stock pursuant to the share exchange, a change in control of the Company occurred as of the date of consummation of the share exchange. All share and per share information in the accompanying consolidated financial statements and footnotes has been retroactively restated to reflect the recapitalization. The Company has not yet generated any revenue since the reverse acquisition. On February 29, 2016, the stockholders of Smack voted to amend the Articles of Incorporation of the Company to (i) increase the authorized capital of the Company to 5,000,000 shares of common stock and (ii) to change the name of the Company to “Almost Never Films Inc.” which took effect on March 2, 2017. The Company has 5,000,000 authorized preferred shares with no par value. Smack issued 1,000,000 shares of our Series A Convertible Preferred Stock to the Mr. Chan and Mr. Williams in exchange for all 2,500,000 shares of issued and outstanding common stock of Almost Never Films Inc. (Indiana), with a value of $10,000. On March 4, 2016, all 1,000,000 preferred shares were converted into 2,500,000 common shares. There were no shares of preferred stock issued and outstanding as of March 31, 2017. On March 8, 2016, the Company executed a Stock Purchase Agreement with a shareholder. Pursuant to the Stock Purchase Agreement, the Company sold, and said shareholder purchased, an aggregate of 1,243,000 shares of the Company’s Common Stock at a price of $0.20 per share in exchange for the cancellation of and discharge of certain promissory notes issued by the Company and payable to said shareholder. The foregoing issuance was deemed to be exempt from registration under Section 4(a)(2) of the Securities Act as not involving any public offering and/or Regulation D promulgated thereunder and in reliance on similar exemptions under applicable state laws. 12 -- In March through November 2016, the Company entered into four share purchase agreements with four investors for 312,500 common shares at $0.80 per share for total proceeds of $250,000 On November 16, 2016, the company entered into a collaboration agreement (the “KBM Agreement”) with Konwiser Brothers Media (“KBM”, and together with ANF, the “Parties). Pursuant to the Agreement, the Parties will create an LLC or other entity (the “Company”), for the purpose of developing, producing and exploiting proposed motion picture project currently entitled “Field Trip” (the “Picture”). KBM will contribute its development and producing services to the Company and all rights to the Screenplay, and ANF will make financial contributions, assist in the raising of additional financing and participate in the development and production process as set forth more fully herein. The Company will own 100% of the copyright to the Picture and all other ancillary and related rights, and each of KBM and ANF will own an undivided 50% interest in the Company. KBM will be the managing member of the Company. The operating agreement for the Company will be consistent with the terms of this Agreement. This transaction, and the ones mentioned below, removed the Company from its prior shell status. On September 27, 2017, KBM informed the Company of its intent to terminate the KBM Agreement. On December 1, 2016, the Company filed a registration statement on Form S-1, registering 250,000 shares for certain selling shareholders. The Form S-1 was declared effective on December 9. On December 12, 2016, the Company entered into a collaboration agreement (the “SAE Agreement”) with Saisam Entertainment, LLC (“SAE”, and together with the Company, the “Parties). Pursuant to the Agreement, the Parties will create an LLC or other entity (the “Company”), for the purpose of developing, producing and exploiting proposed motion picture project currently entitled “Love is not Easy” (the “Picture”). The Company owns and controls the rights to the screenplay for the Picture. On June 6, 2017, the Company issued a 2.5% promissory note (the “ANF Note”) to Weirong Zhang (the “Investor”). Pursuant to the ANF Note, the Company received $200,000, which is due to the Lender ninety (90) days from the date the purchase price of $200,000 was paid. The ANF Note accrues interest at 2.5% per 90 days. Thereafter, on June 7, 2017, The Money Pool, LLC (“Money Pool”) issued a non-transferable promissory note to the Company for $200,000 (the “Money Pool Note”). The Company funded the Money Pool Note with the funds received from the Investor. Money Pool shall use the funds from the Money Pool Note, along with its own funds, in order to provide a bridge loan to Blue Rider San Juan, LLC (“Blue Rider”), in connection with the production of a motion picture known as “Speed Kills”. Blue Rider is the international sales agent for “Speed Kills.” The Money Pool Notes accrues interest of a flat 2.5% for the first 45 days from funding. In the event the Money Pool Note is not paid in full within 45 days, the flat interest rate will increase to 3.5% for each 45-day period any balance or accrued interest remains unpaid. The principal and interest shall be payable by Money Pool to the Company from payments made by Blue Rider on the bridge loan provided by Money Pool. On June 9, 2017, the Company issued a 2.5% promissory note (the “Kruse Note”) to William R. Kruse (the “Kruse”). Pursuant to the Kruse Note, the Company received $200,000, which is due to Kruse ninety (90) days from the date the purchase price of $200,000 was paid. The Kruse Note accrues interest at 2.5% per annum. Thereafter, on June 12, 2017, Money Pool issued a non-transferable promissory note to the Company for $200,000 (the “Pool Note”). The Company shall fund the Pool Note with the funds received from Kruse. Money Pool shall use the funds from the Pool Note, along with its own funds, in order to provide a bridge loan to Blue Rider, in connection with the production of a motion picture known as “Ana”. Blue Rider is the international sales agent for “Ana.” The Pool Notes accrues interest of a flat 2.5% for the first 45 days from funding. In the event the Pool Note is not paid in full within 45 days, the flat interest rate will increase to 3.5% for each 45-day period any balance or accrued interest remains unpaid. The principal and interest shall be payable by Money Pool to the Company from payments made by Blue Rider on the bridge loan provided by Money Pool. On August 2, 2017, Derek Williams presented the Board of Directors of the Company with his resignation as Chief Operating Officer and a member of the Board of Directors of the Company. Mr. William’s decision to resign was not due to any disagreement with the Company. 13 -- On August 24, 2017, the Board of Directors of the Company appointed Daniel Roth as Chief Creative Officer of the Corporation and Damiano Tucci as Chief Operating Officer of the Corporation. On September 13, 2017, the Company completed a 1 for 40 reverse stock split and changed the authorized capital of the Company to 25,000,000 shares of common stock, par value $.001 per share. Criteria We are a film company focused on film production and production related services in connection with genre specific motion pictures with production costs in the $5.0 million to $50.0 million range. The Company was originally incorporated in Nevada in October 2007 as Smack Sportswear (“Smack”), which originally manufactured and sold performance and lifestyle based indoor and sand volleyball apparel and accessories. The Company is now an independent film company focused on film production and production related services in connection with genre specific motion pictures with production costs in the $5.0 million to $50.0 million range. History As described above, we were incorporated in Nevada in October 2007 under the name SMACK Sportswear under which we manufactured and sold performance and lifestyle based indoor and sand volleyball apparel and accessories. As a result of the sale of certain inventory from the Company to Mr. Sigler in July 2015, the Company became a “shell company” (as such term is defined in Rule 12b-2 of the Securities Exchange Act of 1934, as amended). As a result of the Share Exchange, we acquired the proposed business of Almost Never. Almost Never, our wholly-owned subsidiary upon the closing of Share Exchange, was incorporated in the State of Indiana on July 8, 2015. As a result of the Share Exchange, the Company amended its Articles of Incorporation to change its name from “Smack Sportswear” to “Almost Never Films Inc.” to more accurately reflect its new business. We also request changed the Company’s OTCQB trading symbol to "HLWD". We have authorized 30,000,000 shares of capital stock, consisting of (i) 25,000,000 shares of Common Stock, and (ii) 5,000,000 shares designated as preferred stock containing such rights, privileges and designations as our Board of directors may, from time to time, determine. On September 13, 2017, the Company completed a 1 for 40 reverse stock split and changed the authorized capital of the Company to 25,000,000 shares of common stock, par value $.001 per share. As of the date of this Report, an aggregate of 4,670,049 shares of our Common Stock. On March 4, 2016, all 1,000,000 preferred shares were converted into 2,500,000 common shares. Our principal executive office is now located at 8605 Santa Monica Blvd #98258, West Hollywood, CA 90069-4109. Our Business We are an independent film company focused on film production and production related services in connection with genre specific motion pictures with production costs in the $5.0 million to $50.0 million range. Our proposed business is to facilitate relationships (and as such, provide production related services) between creative talent (including writers, actors and directors) and companies who produce, finance and distribute motion pictures. We intend to acquire or license rights to materials upon which we believe motion pictures can be based (screenplays, books, short stories etcetera, which are referred to within the entertainment industry as the “underlying property”). We may further develop an underlying property by contracting for additional writing services and/or by bringing in new writers to perform “polishes” or “rewrites” on a particular underlying property. 14 -- If we are satisfied with the creative state of the underlying property, we then intend to make offers to directors and/or actors, to perform services in connection with a particular motion picture based on that underlying property. These offers are very often contingent and subject to the satisfaction of certain production elements, such as financier approval of the screenplay and the financier’s selection of a start date for principal photography. If a director or actors accepts one of our offers, the director or actors are said to be “attached” to the motion picture project. Armed with the underlying property and the attached creative element(s) (these elements are often called the “package” in Hollywood), we may then approach third party financiers seeking financing as well as distribution for the potential motion picture. Another approach that we may take is to contact the financiers first, seeking first to produce the film, and then with a finished (or nearly finished) motion picture product, obtain distribution for the picture. Motion Picture Property Acquisition Process Our acquisition process is the process by which we intend to acquire or license “underlying properties”. In turn, we expect to use those properties to attract creative talent (including writers, actors and directors) to the potential motion picture project. If successful, we will then grant or license out those rights to third party financiers of motion pictures, who will then contract with the creative talent we have attracted to the property as well as finance, produce and distribute/exploit the motion picture. Almost Never Feature Film Production Our initial primary involvement with feature film production is in the area of the development of “underlying properties”. We intend to engage third parties to produce, finance and exploit/distribute the motion picture “packages” we put together. We may also provide production expertise (i.e. “production services”) to the third party producer and/or financier of the motion picture in question. If we do provide production expertise, we, or members of our executive team, Danny Chan, Daniel Roth, and Damiano Tucci, may be credited as “producers” or “executive producers” of the particular film in question. We expect to primarily derive our income from producer fees, consulting and service fees as well as our participation in the profits of the various pictures produced by third parties, that were developed and/or “packaged” by us. Our feature film strategy generally is to perform production services, develop and/or produce feature films when the production budgets for the films are expected to be entirely or substantially covered by a third party. In this way, we believe our risk is, by in large, only the capital required, if any, to develop and package the motion picture project. The entirety of the production budget, as well as any costs associated with distributing and/or exploiting the motion pictures in question, will be expected to be borne by a third party or parties who have the resources and expertise to produce and/or distribute motion pictures. Distributing Almost Never Motion Pictures Currently, we do not intend to directly distribute motion pictures. Instead, when we seek financing for our motion picture “packages,” the distribution rights are often obtained by the financier as collateral for their investment; in other words, third parties purchase the world-wide exploitation and distribution rights to a motion picture for the cost it takes to produce the motion picture. Foreign Markets In general, a very important portion of the financing for “independent” (i.e., not produced by a major studio or one of their subsidiaries) motion pictures comes from the “foreign markets” (i.e., those markets outside of the United States and English-speaking Canada). With respect to productions we are associated with, the third party financier owns and/or controls the production rights and uses these rights as collateral or purchases the rights outright in connection with the funding of the pictures we develop. 15 -- Profit Participation Our profit participation in motion picture projects will be determined by a calculation that assumes that all “negative costs” (production costs) of the picture (including, but not limited to, costs for development, principal photography and post-production) and “distribution expenses” (including, but not limited to, costs for marketing the film at various international film markets as well as costs associated with the delivery of the film and the physical elements to the various licensees of the film) are recovered by the financier plus interest thereon. After repayment of all negative costs, distribution expenses and interest thereon, the financier/distributor will charge a “distribution fee” (often a percentage of the gross income) for performing any sales or distribution services in connection with the picture. Following the payment of distribution fees and other costs, any amounts payable to creative elements that are contingent compensation (including, but not limited to, deferred compensation and bonuses) are paid to those third parties. Any money remaining is considered net profits from which profit participation is derived. Competition The motion picture industry is intensely competitive. In addition to competing with the major film studios that dominate the motion picture industry, we will also compete with numerous independent motion picture production companies, television networks, pay television systems, and online streaming media companies such as Netflix, Hulu, and Amazon Prime. Virtually all of our competitors are significantly larger than we are, have been in business much longer than we have, and have significantly more resources at their disposal. Our competitors range from small independent producers to well financed established film studios, particularly, major U.S. film studios. Intellectual Property We believe that intellectual property will be material to our business and we will expend cost and effort in an attempt to develop and protect our intellectual property and to maintain compliance vis-à-vis other parties' intellectual property. Our ability to protect and enforce our intellectual property rights is subject to certain risks. Enforcement of intellectual property rights is costly and time consuming. From time to time, we may encounter disputes over rights and obligations concerning intellectual property. We cannot offer any assurances that we will prevail in any intellectual property dispute. Critical accounting policies and estimates Our condensed consolidated financial statements are prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. We continually evaluate our estimates and judgments, our commitments to strategic alliance partners and the timing of the achievement of collaboration milestones. We base our estimates and judgments on historical experience and other factors that we believe to be reasonable under the circumstances. All estimates, whether or not deemed critical, affect reported amounts of assets, liabilities, revenues and expenses, as well as disclosures of contingent assets and liabilities. These estimates and judgments are also based on historical experience and other factors that are believed to be reasonable under the circumstances. Materially different results can occur as circumstances change and additional information becomes known, even for estimates and judgments that are not deemed critical. Going Concern The accompanying financial statements have been prepared in conformity with GAAP, which contemplate continuation of the Company as a going concern. The Company has not completed its efforts to establish a stabilized source of revenues sufficient to cover operating costs over an extended period of time. These conditions raise substantial doubt as to our ability to continue as a going concern. 16 -- Management anticipates that the Company will be dependent, for the near future, on additional investment capital to fund operating expenses. The Company intends to position itself so that it may be able to raise additional funds through the capital markets. In light of management's efforts, there are no assurances that the Company will be successful in this or any of its endeavors or become financially viable and continue as a going concern. Results of Operations For the three months ended September 30, 2017 compared to September 30, 2016 During the three months ended September 30, 2017, the Company had no revenue and incurred $21,976 on general and administrative expenses and $19,703 on professional fees. The Company’s professional fees were primarily for ongoing regulatory requirements. During the three months ended September 30, 2016, the Company had no revenue and incurred $4,060 on general and administrative expenses and $13,465 on professional fees. The Company’s professional fees were primarily for ongoing regulatory requirements Other Expense During the three months ended September 30, 2017, the Company incurred interest expenses of $7,838, relating to an unsecured promissory notes payable. During the three months ended September 30, 2016, the Company incurred interest expenses of $1,679, relating to an unsecured promissory notes payable Net Loss The Company’s net loss for the three months ended September 30, 2017 was $44,676. The Company’s net loss for the three months ended September 30, 2016 was $19,204. Liquidity and Capital Resources Liquidity is the ability of a company to generate funds to support its current and future operations, satisfy its obligations, and otherwise operate on an ongoing basis. Significant factors in the management of liquidity are funds generated by operations, levels of accounts receivable and accounts payable and capital expenditures. As of September 30, 2017, we had a cash balance of $640,937. As of June 30, 2016, we had a cash balance of $91,590. Per management’s estimates, the Company has sufficient funds to operate for the next twelve months. There can be no assurance that additional capital will be available to the Company. We currently have no agreements, arrangements or understandings with any person or entity to obtain funds through bank loans, lines of credit or any other sources. Since the Company has no such arrangements or plans currently in effect, its inability to raise funds for the above purposes will have a severe negative impact on its ability to remain a viable company. Going Concern Consideration The accompanying condensed consolidated financial statements have been prepared on a going concern basis of accounting, which contemplates continuity of operations, realization of assets and liabilities and commitments in the normal course of business. The accompanying condensed consolidated financial statements do not reflect any adjustments that might result if the Company is unable to continue as a going concern. During the three months ended September 30, 2017, the Company incurred a net loss from continuing operations of $44,676 and cash used in operating activities was $18,653. As of September 30, 2017, the Company is delinquent in payments of $66,613 of a note payable. As of September 30, 2017, the Company had working capital of $523,563 and a shareholders’ equity of $173,563. These factors, among others, raise substantial doubt about the Company’s ability to continue as a going concern. 17 -- The ability of the Company to continue as a going concern and appropriateness of using the going concern basis is dependent upon, among other things, an additional cash infusion and an identification of new business opportunities. No assurance can be given that any future financing will be available or, if available, that it will be on terms that are satisfactory to the Company. Even if the Company is able to obtain additional financing, it may contain undue restrictions on operations, in the case of debt financing, or cause substantial dilution for our stock holders, in case of equity financing. There were no cash flows used in investing activities or financing in the three months ended September 30, 2017. We do not have any material commitments for capital expenditures during the next twelve months. Although our proceeds from the issuance of debt and our offering of shares of common stock is currently sufficient to fund our operating expenses, we anticipate we will need to raise additional funds in the future so that we can expand our operations. Therefore, our future operations are dependent on our ability to secure additional financing. Financing transactions may include the issuance of equity or debt securities, obtaining credit facilities, or other financing mechanisms. However, the trading price of our common stock and a downturn in the U.S. equity and debt markets could make it more difficult to obtain financing through the issuance of equity or debt securities. Even if we are able to raise the funds required, it is possible that we could incur unexpected costs and expenses, fail to collect significant amounts owed to us, or experience unexpected cash requirements that would force us to seek alternative financing. Furthermore, if we issue additional equity or debt securities, stockholders may experience additional dilution or the new equity securities may have rights, preferences or privileges senior to those of existing holders of our common stock. The inability to obtain additional capital may restrict our ability to grow and may reduce our ability to continue to conduct business operations. If we are unable to obtain additional financing, we may have to curtail our marketing and development plans and possibly cease our operations. Off-balance sheet arrangements During the three months ended September 30, 2017, we did not have any "off-balance sheet arrangements" (as that term is defined in Item 303(a)(4)(ii) of Regulation S-K). Recent accounting pronouncements Management has considered all recent accounting pronouncements issued since the last audit of our financial statements. The Company's management believes that these recent pronouncements will not have a material effect on the Company's financial statements. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are a smaller reporting company as defined by Rule 12b-2 of the Securities Exchange Act of 1934 and are not required to provide the information under this item. ITEM 4. CONTROLS AND PROCEDURES Evaluation of Disclosure Controls and Procedures Our management is responsible for establishing and maintaining a system of disclosure controls and procedures (as defined in Rule 13a-15(e)) under the Exchange Act) that is designed to ensure that information required to be disclosed by the Company in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time specified in the Commission's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Exchange Act is accumulated and communicated to the issuer's management, including its principal executive officer or officers and principal financial officer or officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. 18 -- Pursuant to Rule 13a-15(b) under the Exchange Act, the Company carried out an evaluation with the participation of the Company's management, including the Company's Chief Executive Officer ("CEO") and the Company's Chief Financial Officer ("CFO"), of the effectiveness of the Company's disclosure controls and procedures (as defined under Rule 13a-15(e) under the Exchange Act) as of September 30, 2017. Based upon that evaluation, the Company's CEO and CFO concluded that the Company's disclosure controls and procedures were not effective as of September 30, 2017 due to the Company’s limited internal resources and lack of ability to have multiple levels of transaction review. Management is in the process of determining how best to change our current system and implement a more effective system to insure that information required to be disclosed in the reports that we file or submit under the Exchange Act have been recorded, processed, summarized and reported accurately. Our management intends to develop procedures to address the current deficiencies to the extent possible given limitations in financial and manpower resources. While management is working on a plan, no assurance can be made at this point that the implementation of such controls and procedures will be completed in a timely manner or that they will be adequate once implemented. Changes in Internal Control over Financial Reporting There have been no changes in our internal controls over financial reporting that occurred during the quarter ended September 30, 2017, that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting. 19 -- PART II ITEM 1. LEGAL PROCEEDINGS There are no pending legal proceedings to which the Company is a party or in which any director, officer or affiliate of the Company, any owner of record or beneficially of more than 5% of any class of voting securities of the Company, or security holder is a party adverse to the Company or has a material interest adverse to the Company. The Company’s property is not the subject of any pending legal proceedings. ITEM 1A. RISK FACTORS We are a smaller reporting company as defined by Rule 12b-2 of the Securities Exchange Act of 1934 and are not required to provide the information under this item. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS None. ITEM 3. DEFAULTS UPON SENIOR SECURITIES None. ITEM 4. MINE SAFETY DISCLOSURES Not applicable. ITEM 5. OTHER INFORMATION None. 20 -- ITEM 6. EXHIBITS | | | Incorporated by Reference | ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------+---------------------------+-------- Exhibit No. | Description | Form | SEC File No. | Exhibit | Filing Date | Filed Herewith ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------+---------------------------+---------+-------------+--------------- 3.1 | Articles of Incorporation of the Company | SB2 | 333-148510 | 3.1 | 1/7/2008 | ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------+---------------------------+---------+-------------+--------------- 3.2 | Amendment to Articles of Incorporation of the Company | 8-K | 000-53049 | 3.2 | 4/13/2012 | ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------+---------------------------+---------+-------------+--------------- 3.3 | Amendment to Articles of Incorporation of the Company | 8-K | 000-53049 | 3.1 | 2/29/2016 | ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------+---------------------------+---------+-------------+--------------- 3.4 | Bylaws of the Company | SB2 | 333-148510 | 3.2 | 1/7/2008 | ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------+---------------------------+---------+-------------+--------------- 4.1 | Certificate of Designation of Series A Convertible Preferred Stock | 8-K | 000-53049 | 4.1 | 1/18/2016 | ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------+---------------------------+---------+-------------+--------------- 10.1 | Share Exchange Agreement dated January 15, 2016 by and among SMACK Sportswear, Inc., Almost Never Films Inc., and the Shareholders of Almost Never Films Inc. | 8-K | 000-53049 | 2.1 | 1/18/2016 | ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------+---------------------------+---------+-------------+--------------- 31.1 | Certification by Chief Executive Officer and Chief Financial Officer, required by Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act | | | | | x ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------+---------------------------+---------+-------------+--------------- 31.2 | Certification by Chief Executive Officer and Chief Financial Officer, required by Rule 13a-14(b) or Rule 15d-14(b) of the Exchange Act and Section 1350 of Chapter 63 of Title 18 of the United States Code | | | | | x ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+------+---------------------------+---------+-------------+--------------- 101.INS | XBRL Instance Document.* --------+----------------------------------------------- 101.SCH | XBRL Taxonomy Extension Schema.* --------+----------------------------------------------- 101.CAL | XBRL Taxonomy Extension Calculation Linkbase.* --------+----------------------------------------------- 101.DEF | XBRL Taxonomy Extension Definition Linkbase.* --------+----------------------------------------------- 101.LAB | XBRL Taxonomy Extension Label Linkbase.* --------+----------------------------------------------- 101.PRE | XBRL Extension Presentation Linkbase.* --------+----------------------------------------------- _____________ * | Attached as Exhibit 101 to this report are the following financial statements from the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2017 formatted in XBRL (eXtensible Business Reporting Language): (i) the Condensed Consolidated Balance Sheet, (ii) the Condensed Consolidated Statement of Operations, (iii) the Condensed Consolidated Statement of Cash Flows, and (iv) Notes to Combined Financial Statements. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 21 -- SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. | ALMOST NEVER FILMS INC. | ------------------------+-------------------------+--------------------------------------------------------------------------------------------------------------------------------------------- Date: November 13, 2017 | By: | /s/ Danny Chan ------------------------+-------------------------+--------------------------------------------------------------------------------------------------------------------------------------------- | | Danny Chan, Chief Executive Officer and Chief Financial Officer (principal executive officer and principal financial and accounting officer) ------------------------+-------------------------+--------------------------------------------------------------------------------------------------------------------------------------------- 22 --

American Finance Trust, Inc

1568162

10-Q

0001568162-17-000016

Document UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 --+---------------------------------------------------------------------------------------- For the quarterly period ended September 30, 2017 | OR --+----------------------------------------------------------------------------------------- o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 --+----------------------------------------------------------------------------------------- For the transition period from _________ to __________ Commission file number: 000-55197 American Finance Trust, Inc. (Exact name of registrant as specified in its charter) Maryland | 90-0929989 ----------------------------------------------------------------+------------------------------------- (State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) ----------------------------------------------------------------+------------------------------------- 405 Park Ave., 4th Floor, New York, New York | 10022 ----------------------------------------------------------------+------------------------------------- (Address of principal executive offices) | (Zip Code) ----------------------------------------------------------------+------------------------------------- (212) 415-6500 --------------------------------------------------------------- (Registrant's telephone number, including area code) --------------------------------------------------------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web Site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See definition of "large accelerated filer," "accelerated filer,," "smaller reporting company" and "emerging growth company" in Rule 12b-2 of the Exchange Act. Large accelerated filer o | Accelerated filer o ----------------------------------------------------------------------+---------------------------- Non-accelerated filer x (Do not check if a smaller reporting company) | Smaller reporting company o ----------------------------------------------------------------------+---------------------------- | Emerging growth company o ----------------------------------------------------------------------+---------------------------- If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: As of October 31, 2017 , the registrant had 104,820,978 shares of common stock outstanding. AMERICAN FINANCE TRUST, INC. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS | Page -----------------------------------------------------------------------------------------------------------------------------------------+----- PART I - FINANCIAL INFORMATION | -----------------------------------------------------------------------------------------------------------------------------------------+----- Item 1. Financial Statements. | -----------------------------------------------------------------------------------------------------------------------------------------+----- Consolidated Balance Sheets as of September 30, 2017 (Unaudited) and December 31, 2016 | 3 -----------------------------------------------------------------------------------------------------------------------------------------+----- Consolidated Statements of Operations and Comprehensive Loss for the Three and Nine Months Ended September 30, 2017 and 2016 (Unaudited) | 4 -----------------------------------------------------------------------------------------------------------------------------------------+----- Consolidated Statement of Changes in Equity for the Nine Months Ended September 30, 2017 (Unaudited) | 5 -----------------------------------------------------------------------------------------------------------------------------------------+----- Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2017 and 2016 (Unaudited) | 6 -----------------------------------------------------------------------------------------------------------------------------------------+----- Notes to Consolidated Financial Statements (Unaudited) | 8 -----------------------------------------------------------------------------------------------------------------------------------------+----- Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. | 36 -----------------------------------------------------------------------------------------------------------------------------------------+----- Item 3. Quantitative and Qualitative Disclosures About Market Risk. | 57 -----------------------------------------------------------------------------------------------------------------------------------------+----- Item 4. Controls and Procedures. | 57 -----------------------------------------------------------------------------------------------------------------------------------------+----- PART II - OTHER INFORMATION | 58 -----------------------------------------------------------------------------------------------------------------------------------------+----- Item 1. Legal Proceedings. | 58 -----------------------------------------------------------------------------------------------------------------------------------------+----- Item 1A. Risk Factors. | 58 -----------------------------------------------------------------------------------------------------------------------------------------+----- Item 2. Unregistered Sales of Equity Securities and Use of Proceeds. | 59 -----------------------------------------------------------------------------------------------------------------------------------------+----- Item 3. Defaults Upon Senior Securities. | 59 -----------------------------------------------------------------------------------------------------------------------------------------+----- Item 4. Mine Safety Disclosures. | 59 -----------------------------------------------------------------------------------------------------------------------------------------+----- Item 5. Other Information. | 59 -----------------------------------------------------------------------------------------------------------------------------------------+----- Item 6. Exhibits. | 60 -----------------------------------------------------------------------------------------------------------------------------------------+----- Signatures | 61 -----------------------------------------------------------------------------------------------------------------------------------------+----- 2 PART I — FINANCIAL INFORMATION Item 1. Financial Statements. AMERICAN FINANCE TRUST, INC. CONSOLIDATED BALANCE SHEETS (In thousands, except share and per share data) | September 30, 2017 | | December 31, 2016 ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+------------------ | (Unaudited) | | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+------------------ ASSETS | | | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+------------------ Real estate investments, at cost: | | | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+------------------ Land | $ | 606,296 | | | $ | 328,656 ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+---+---------- Buildings, fixtures and improvements | 2,444,410 | | | 1,395,602 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+-- Acquired intangible lease assets | 461,550 | | | 300,129 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+-- Total real estate investments, at cost | 3,512,256 | | | 2,024,387 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+-- Less: accumulated depreciation and amortization | (380,468 | ) | | (287,090 | ) ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+-- Total real estate investments, net | 3,131,788 | | | 1,737,297 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+-- Cash and cash equivalents | 68,543 | | | 131,215 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+-- Restricted cash | 17,729 | | | 7,890 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+-- Commercial mortgage loan, held for investment, net | 17,191 | | | 17,175 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+-- Deposits for real estate acquisitions | 810 | | | — | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+-- Prepaid expenses and other assets | 53,140 | | | 29,513 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+-- Goodwill | 1,605 | | | — | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+-- Deferred costs, net | 8,280 | | | 3,767 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+-- Assets held for sale | 2,489 | | | 137,602 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+-- Total assets | $ | 3,301,575 | | | $ | 2,064,459 ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+---+---------- LIABILITIES AND EQUITY | | | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+------------------ Mortgage notes payable, net of deferred financing costs | $ | 1,083,079 | | | $ | 1,022,275 ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+---+---------- Mortgage premiums, net | 11,707 | | | 10,681 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+-- Credit facility | 260,000 | | | — | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+-- Market lease liabilities, net | 112,673 | | | 13,915 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+-- Accounts payable and accrued expenses (including $1,798 and $910 due to related parties as of September 30, 2017 and December 31, 2016, respectively) | 29,849 | | | 13,553 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+-- Derivatives, at fair value | 53 | | | — | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+-- Deferred rent and other liabilities | 10,482 | | | 9,970 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+-- Distributions payable | 11,185 | | | 9,199 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+-- Total liabilities | 1,519,028 | | | 1,079,593 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+-- Preferred stock, $0.01 par value per share, 50,000,000 shares authorized, none issued and outstanding | — | | | — | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+-- Common stock, $0.01 par value per share, 300,000,000 shares authorized, 104,644,581 and 65,805,184 shares issued and outstanding as of September 30, 2017 and December 31, 2016, respectively | 1,046 | | | 658 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+-- Additional paid-in capital | 2,380,885 | | | 1,449,662 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+-- Accumulated other comprehensive income | 44 | | | — | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+-- Accumulated deficit | (604,079 | ) | | (465,454 | ) ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+-- Total stockholders' equity | 1,777,896 | | | 984,866 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+-- Non-controlling interests | 4,651 | | | — | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+-- Total equity | 1,782,547 | | | 984,866 | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+-- Total liabilities and equity | $ | 3,301,575 | | | $ | 2,064,459 ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+--------------------+-----------+-------------------+-----------+---+---------- The accompanying notes are an integral part of these unaudited consolidated financial statements. 3 AMERICAN FINANCE TRUST, INC. CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS (In thousands, except per share data) (Unaudited) | Three Months Ended September 30, | | Nine Months Ended September 30, ------------------------------------------------------------------+----------------------------------+---------+-------------------------------- | 2017 | | 2016 | | 2017 | | 2016 ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+----------- Revenues: | | | | | | | ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+----------- Rental income | $ | 62,287 | | | $ | 41,357 | | | $ | 176,867 | | $ | 123,033 | ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+------------+---+---+------------+---+---+---------+-- Operating expense reimbursements | 7,182 | | | 3,162 | | | 20,936 | | | 8,979 | ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+------------+---+---+------------+-- Interest income from debt investments | 260 | | | 239 | | | 753 | | | 809 | ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+------------+---+---+------------+-- Total revenues | 69,729 | | | 44,758 | | | 198,556 | | | 132,821 | ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+------------+---+---+------------+-- Operating expenses: | | | | | | | ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+----------- Asset management fees to related party | 5,250 | | | 4,500 | | | 15,250 | | | 13,500 | ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+------------+---+---+------------+-- Property operating | 10,760 | | | 3,511 | | | 29,996 | | | 10,131 | ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+------------+---+---+------------+-- Impairment charges | 7,605 | | | 117 | | | 14,183 | | | 117 | ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+------------+---+---+------------+-- Acquisition and transaction related | 1,173 | | | 4,381 | | | 7,556 | | | 5,458 | ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+------------+---+---+------------+-- General and administrative | 4,986 | | | 2,998 | | | 15,067 | | | 8,840 | ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+------------+---+---+------------+-- Depreciation and amortization | 41,132 | | | 25,446 | | | 113,048 | | | 76,477 | ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+------------+---+---+------------+-- Total operating expenses | 70,906 | | | 40,953 | | | 195,100 | | | 114,523 | ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+------------+---+---+------------+-- Operating income | (1,177 | ) | | 3,805 | | | 3,456 | | | 18,298 | ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+------------+---+---+------------+-- Other (expense) income: | | | | | | | ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+----------- Interest expense | (14,502 | ) | | (12,574 | ) | | (44,912 | ) | | (37,533 | ) ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+------------+---+---+------------+-- Gain on sale of real estate investments | 264 | | | — | | | 14,095 | | | 454 | ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+------------+---+---+------------+-- Other income | 18 | | | 40 | | | 211 | | | 121 | ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+------------+---+---+------------+-- Total other expense, net | (14,220 | ) | | (12,534 | ) | | (30,606 | ) | | (36,958 | ) ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+------------+---+---+------------+-- Net loss | (15,397 | ) | | (8,729 | ) | | (27,150 | ) | | (18,660 | ) ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+------------+---+---+------------+-- Net loss attributable to non-controlling interests | 30 | | | — | | | 45 | | | — | ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+------------+---+---+------------+-- Net loss attributable to stockholders | (15,367 | ) | | (8,729 | ) | | (27,105 | ) | | (18,660 | ) ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+------------+---+---+------------+-- Other comprehensive income: | | | | | | | ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+----------- Change in unrealized gain on derivative | 10 | | | — | | | 44 | | | — | ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+------------+---+---+------------+-- Comprehensive loss attributable to stockholders | $ | (15,357 | ) | | $ | (8,729 | ) | | $ | (27,061 | ) | $ | (18,660 | ) ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+------------+---+---+------------+---+---+---------+-- Basic and diluted weighted-average shares outstanding | 104,545,591 | | | 65,741,735 | | | 97,852,337 | | | 65,334,465 | ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+------------+---+---+------------+-- Basic and diluted net loss per share attributable to stockholders | $ | (0.15 | ) | | $ | (0.13 | ) | | $ | (0.28 | ) | $ | (0.29 | ) ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+------------+---+---+------------+---+---+---------+-- The accompanying notes are an integral part of these unaudited consolidated financial statements. 4 AMERICAN FINANCE TRUST, INC. CONSOLIDATED STATEMENT OF CHANGES IN EQUITY For the Nine Months Ended September 30, 2017 (In thousands, except share data) (Unaudited) | Common Stock | | | | | | | | | | | -----------------------------------------------------------+-----------------+---+-----------+-----+---------------------------+----------------------------------------+---+---------------------+----+----------------------------+---+-------------------------- | Number ofShares | | Par Value | | Additional Paid-inCapital | Accumulated Other Comprehensive Income | | Accumulated Deficit | | Total Stockholders' Equity | | Non-controlling Interests | | Total Equity -----------------------------------------------------------+-----------------+---+-----------+-----+---------------------------+----------------------------------------+---+---------------------+----+----------------------------+---+---------------------------+---+------------- Balance, December 31, 2016 | 65,805,184 | | | $ | 658 | | $ | 1,449,662 | | | — | | | $ | (465,454 | ) | | $ | 984,866 | | | $ | — | | $ | 984,866 | -----------------------------------------------------------+-----------------+---+-----------+-----+---------------------------+----------------------------------------+---+---------------------+----+----------------------------+---+---------------------------+---+--------------+----------+----------+---+-------+---------+-----------+----------+---+---+-------+---+---------+---------- Issuances of common stock | 38,210,213 | | | 382 | | 916,664 | | | — | | | — | | | 917,046 | | | — | | | 917,046 | -----------------------------------------------------------+-----------------+---+-----------+-----+---------------------------+----------------------------------------+---+---------------------+----+----------------------------+---+---------------------------+---+--------------+----------+----------+---+-------+---------+-----------+----------+-- Common stock issued through distribution reinvestment plan | 1,845,665 | | | 18 | | 43,506 | | | — | | | — | | | 43,524 | | | — | | | 43,524 | -----------------------------------------------------------+-----------------+---+-----------+-----+---------------------------+----------------------------------------+---+---------------------+----+----------------------------+---+---------------------------+---+--------------+----------+----------+---+-------+---------+-----------+----------+-- Common stock repurchases | (1,225,378 | ) | | (12 | ) | (29,049 | ) | | — | | | — | | | (29,061 | ) | | — | | | (29,061 | ) -----------------------------------------------------------+-----------------+---+-----------+-----+---------------------------+----------------------------------------+---+---------------------+----+----------------------------+---+---------------------------+---+--------------+----------+----------+---+-------+---------+-----------+----------+-- Share-based compensation, net of forfeitures | 8,897 | | | — | | 102 | | | — | | | — | | | 102 | | | — | | | 102 | -----------------------------------------------------------+-----------------+---+-----------+-----+---------------------------+----------------------------------------+---+---------------------+----+----------------------------+---+---------------------------+---+--------------+----------+----------+---+-------+---------+-----------+----------+-- Distributions declared | — | | | — | | — | | | — | | | (111,520 | ) | | (111,520 | ) | | — | | | (111,520 | ) -----------------------------------------------------------+-----------------+---+-----------+-----+---------------------------+----------------------------------------+---+---------------------+----+----------------------------+---+---------------------------+---+--------------+----------+----------+---+-------+---------+-----------+----------+-- Issuances of operating partnership units | — | | | — | | — | | | — | | | — | | | — | | | 4,887 | | | 4,887 | -----------------------------------------------------------+-----------------+---+-----------+-----+---------------------------+----------------------------------------+---+---------------------+----+----------------------------+---+---------------------------+---+--------------+----------+----------+---+-------+---------+-----------+----------+-- Distributions to non-controlling interest holders | — | | | — | | — | | | — | | | — | | | — | | | (191 | ) | | (191 | ) -----------------------------------------------------------+-----------------+---+-----------+-----+---------------------------+----------------------------------------+---+---------------------+----+----------------------------+---+---------------------------+---+--------------+----------+----------+---+-------+---------+-----------+----------+-- Net loss | — | | | — | | — | | | — | | | (27,105 | ) | | (27,105 | ) | | (45 | ) | | (27,150 | ) -----------------------------------------------------------+-----------------+---+-----------+-----+---------------------------+----------------------------------------+---+---------------------+----+----------------------------+---+---------------------------+---+--------------+----------+----------+---+-------+---------+-----------+----------+-- Other comprehensive income | — | | | — | | — | | | 44 | | | — | | | 44 | | | — | | | 44 | -----------------------------------------------------------+-----------------+---+-----------+-----+---------------------------+----------------------------------------+---+---------------------+----+----------------------------+---+---------------------------+---+--------------+----------+----------+---+-------+---------+-----------+----------+-- Balance, September 30, 2017 | 104,644,581 | | | $ | 1,046 | | $ | 2,380,885 | | | $ | 44 | | | $ | (604,079 | ) | | $ | 1,777,896 | | | $ | 4,651 | | $ | 1,782,547 -----------------------------------------------------------+-----------------+---+-----------+-----+---------------------------+----------------------------------------+---+---------------------+----+----------------------------+---+---------------------------+---+--------------+----------+----------+---+-------+---------+-----------+----------+---+---+-------+---+---------+---------- The accompanying notes are an integral part of this unaudited consolidated financial statement. 5 AMERICAN FINANCE TRUST, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) (Unaudited) | Nine Months Ended September 30, --------------------------------------------------------------------------------+-------------------------------- | 2017 | | 2016 --------------------------------------------------------------------------------+---------------------------------+---------+----- Cash flows from operating activities: | | | --------------------------------------------------------------------------------+---------------------------------+---------+----- Net loss | $ | (27,150 | ) | | $ | (18,660 | ) --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+---+---------+-- Adjustments to reconcile net loss to net cash provided by operating activities: | | | --------------------------------------------------------------------------------+---------------------------------+---------+----- Depreciation | 62,719 | | | 50,595 | --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Amortization of in-place lease assets | 50,149 | | | 25,841 | --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Amortization (including accelerated write-off) of deferred costs | 5,734 | | | 3,408 | --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Amortization of mortgage premiums on borrowings | (3,117 | ) | | (3,221 | ) --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Discount accretion on commercial mortgage loan | (16 | ) | | (28 | ) --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Amortization of market lease intangibles, net | (3,085 | ) | | 506 | --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Share-based compensation | 102 | | | 52 | --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Mark-to-market adjustments | (105 | ) | | — | --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Gain on sale of real estate investments | (14,095 | ) | | (454 | ) --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Impairment charges | 14,183 | | | 117 | --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Changes in assets and liabilities: | | | --------------------------------------------------------------------------------+---------------------------------+---------+----- Prepaid expenses and other assets | (7,912 | ) | | (6,638 | ) --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Accounts payable and accrued expenses | (5,297 | ) | | 6,101 | --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Deferred rent and other liabilities | (8,295 | ) | | (1,865 | ) --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Restricted cash | 659 | | | — | --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Net cash provided by operating activities | 64,474 | | | 55,754 | --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Cash flows from investing activities: | | | --------------------------------------------------------------------------------+---------------------------------+---------+----- Proceeds from sale of commercial mortgage loans | — | | | 56,884 | --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Capital expenditures | (4,344 | ) | | — | --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Investments in real estate and other assets | (107,108 | ) | | (34,244 | ) --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Deposits for real estate investments | (810 | ) | | — | --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Proceeds from sale of real estate investments | 179,014 | | | 15,521 | --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Cash paid in merger transaction | (94,502 | ) | | — | --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Cash acquired in merger transaction | 21,922 | | | — | --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Restricted cash | (1,033 | ) | | — | --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Net cash (used in) provided by investing activities | (6,861 | ) | | 38,161 | --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Cash flows from financing activities: | | | | --------------------------------------------------------------------------------+---------------------------------+---------+------+-------- Proceeds from mortgage notes payable | 23,950 | | | — | --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Payments on mortgage notes payable | (3,364 | ) | | (752 | ) --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Proceeds from credit facility | 70,000 | | | — | --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Payments on credit facility | (114,000 | ) | | — | --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Payments of financing costs | (1,576 | ) | | (3,512 | ) --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Common stock repurchases | (29,061 | ) | | (16,253 | ) --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Distributions paid | (66,010 | ) | | (60,509 | ) --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Restricted cash | (224 | ) | | (3 | ) --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Net cash used in financing activities | (120,285 | ) | | (81,029 | ) --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Net change in cash and cash equivalents | (62,672 | ) | | 12,886 | --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Cash and cash equivalents, beginning of period | 131,215 | | | 130,500 | --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+-- Cash and cash equivalents, end of period | $ | 68,543 | | | $ | 143,386 | --------------------------------------------------------------------------------+---------------------------------+---------+------+---------+---+---------+-- 6 AMERICAN FINANCE TRUST, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) (Unaudited) Supplemental Disclosures: | | | ------------------------------------------------------------------------------+---+---------+-- Cash paid for interest | $ | 41,534 | | $ | 36,901 | ------------------------------------------------------------------------------+---+---------+---+---+---------+-- Cash paid for income taxes | $ | 736 | | $ | 738 | ------------------------------------------------------------------------------+---+---------+---+---+---------+-- Non-Cash Investing and Financing Activities: | | | ------------------------------------------------------------------------------+---+---------+-- Equity issued in the merger transaction | $ | 921,930 | | $ | — | ------------------------------------------------------------------------------+---+---------+---+---+---------+-- Credit facility assumed or used to acquire investments in real estate | $ | 304,000 | | $ | — | ------------------------------------------------------------------------------+---+---------+---+---+---------+-- Mortgage notes payable assumed or used to acquire investments in real estate | $ | 127,651 | | $ | — | ------------------------------------------------------------------------------+---+---------+---+---+---------+-- Premiums on assumed mortgage notes payable | $ | 4,143 | | $ | — | ------------------------------------------------------------------------------+---+---------+---+---+---------+-- Mortgage notes payable released in connection with disposition of real estate | $ | (89,978 | ) | $ | (13,941 | ) ------------------------------------------------------------------------------+---+---------+---+---+---------+-- Common stock issued through distribution reinvestment plan | $ | 43,524 | | $ | 20,499 | ------------------------------------------------------------------------------+---+---------+---+---+---------+-- Accrued capital expenditures | $ | 1,012 | | $ | — | ------------------------------------------------------------------------------+---+---------+---+---+---------+-- The accompanying notes are an integral part of these unaudited consolidated financial statements. 7 AMERICAN FINANCE TRUST, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) Note 1 — Organization American Finance Trust, Inc. (the "Company") is a diversified REIT with a retail focus. The Company owns a diversified portfolio of commercial properties comprised primarily of freestanding single-tenant properties that are net leased to investment grade and other creditworthy tenants and a portfolio of stabilized core retail properties, consisting primarily of power centers and lifestyle centers, which were acquired in the Merger (as defined below). The Company intends to focus its future acquisitions primarily on net leased retail properties and stabilized core retail properties. As of September 30, 2017 , the Company owned 517 properties, comprised of 19.4 million rentable square feet, which were 96.0% leased, including 482 net leased commercial properties ( 443 of which are retail properties) and 35 stabilized core retail properties. The Company, incorporated on January 22, 2013 , is a Maryland corporation that elected and qualified to be taxed as a real estate investment trust for U.S. federal income tax purposes ("REIT") beginning with the taxable year ended December 31, 2013. Substantially all of the Company's business is conducted through American Finance Operating Partnership, L.P. (the "OP"), a Delaware limited partnership, and its wholly-owned subsidiaries. As of September 30, 2017 , the Company had 104.6 million shares of common stock outstanding, including unvested restricted shares of common stock ("restricted shares") and shares issued pursuant to the Company's distribution reinvestment plan (the "DRIP"). The Company has no employees. The Company has retained American Finance Advisors, LLC (the "Advisor") to manage the Company's affairs on a day-to-day basis. American Finance Properties, LLC (the "Property Manager") serves as the Company's property manager. The Advisor and the Property Manager are wholly owned subsidiaries of AR Global Investments, LLC (the successor business to AR Capital, LLC, the "Sponsor" or "AR Global"), as a result of which, they are related parties of the Company, and each have received or may receive, as applicable, compensation, fees and expense reimbursements for services related to managing the Company's business. On August 8, 2017, the Company's application to list its common stock on The NASDAQ Global Select Market (“NASDAQ”) under the symbol "AFIN" (the "Listing") was approved by NASDAQ, subject to the Company being in compliance with all applicable listing standards on the date it begins trading on NASDAQ. While the Company intends to list its common stock at a time yet to be determined by its board of directors, there can be no assurance as to when or if the Company's common stock will commence trading or of the price at which the Company's common stock may trade. Note 2 — Merger Transaction On February 16, 2017 , the Company and the OP completed (a) the merger of American Realty Capital — Retail Centers of America, Inc. (“RCA”) with and into a subsidiary of the Company referred to as the "Merger Sub," with the Merger Sub surviving as a wholly owned subsidiary of the Company (the "Merger") and (b) the merger of American Realty Capital Retail Operating Partnership, L.P. (the "RCA OP") with and into the OP, with the OP as the surviving entity (the “Partnership Merger”, and together with the Merger, the “Mergers”). Pursuant to the terms and subject to the conditions set forth in the Agreement and Plan of Merger (the "Merger Agreement") entered into by the Company and the OP with RCA, the RCA OP and the Merger Sub, at the effective time of the Mergers on February 16, 2017 (the “Effective Time”), each outstanding share of common stock of RCA, $0.01 par value per share (“RCA Common Stock”) (including any restricted shares of RCA Common Stock and fractional shares), was converted into (x) 0.385 shares of the Company's common stock (the “Stock Consideration”) and (y) cash from the Company, in an amount equal to $0.95 per share (the “Cash Consideration,” and together with the Stock Consideration, the “Merger Consideration”). In addition, at the Effective Time, (i) each unit of partnership interest of the RCA OP designated as an OP unit issued and outstanding immediately prior to the Effective Time (other than those held by RCA as described in clause (ii) below) was automatically converted into 0.424 validly issued units of limited partnership interest of the OP (the “Partnership Merger Consideration”); (ii) each unit of partnership interest of the RCA OP designated as either an OP unit or a GP unit held by RCA and issued and outstanding immediately prior to the Effective Time was automatically converted into 0.385 validly issued units of limited partnership interest of the OP; (iii) each unit of partnership interest of the RCA OP designated as a Class B Unit held by RCA’s advisor and a sub-advisor issued and outstanding immediately prior to the Effective Time was converted into the Partnership Merger Consideration (the “Class B Consideration,” and together with the Partnership Merger Consideration and the Merger Consideration, the “Total Merger Consideration”), and (iv) the interest of American Realty Capital Retail Advisor, LLC, the special limited partner of the RCA OP (the “RCA Advisor”), in the RCA OP was redeemed for a cash payment, determined in accordance with the existing terms of the RCA OP’s agreement of limited partnership. 8 AMERICAN FINANCE TRUST, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) In addition, as provided in the Merger Agreement, all outstanding restricted shares of RCA Common Stock previously issued by RCA became fully vested and entitled to receive the Merger Consideration. The Company issued 38.2 million shares of its common stock as Stock Consideration and paid $94.5 million in Cash Consideration. Prior to the Mergers, the Company and RCA each were sponsored, directly or indirectly, by AR Global. AR Global and its affiliates provide investment and advisory services to the Company, and previously provided such services to RCA, pursuant to written advisory agreements. In connection with, and subject to the terms and conditions of the Merger Agreement, RCA OP units held by AR Global and its affiliates were exchanged for limited partner interests in the OP designated as OP units ("OP Units") and certain special limited partner interests in the RCA OP held by AR Global and its affiliates were, consistent with the terms of the RCA OP partnership agreement, redeemed for a cash payment of approximately $2.8 million . The Advisor has informed the Company that the Advisor has engaged Lincoln Retail REIT Services, LLC (“Lincoln”) as an independent service provider to provide real estate-related services similar to the services provided by Lincoln to the RCA Advisor prior to the Effective Time. Lincoln will continue to provide, subject to the Advisor’s or its affiliates’ oversight, asset management, property management and leasing services for those multi-tenant properties acquired by the Company from RCA in the Mergers. The Advisor has informed the Company that the Advisor has agreed to pass through to Lincoln a portion of the fees and/or other expense reimbursements otherwise payable to the Advisor or its affiliates by the Company for services rendered by Lincoln. The Company has no direct obligation to Lincoln. Accounting Treatment for the Mergers The Mergers are accounted for under the acquisition method for business combinations pursuant to accounting principles generally accepted in the United States of America ("GAAP"), with the Company as the accounting acquirer of RCA. The consideration transferred by the Company to acquire RCA establishes a new accounting basis for the assets acquired, liabilities assumed and any non-controlling interests, measured at their respective fair value as of the Effective Time. In determining the fair value of the consideration transferred, including the Stock Consideration and any non-controlling interests, the Company utilized multiple sources including real estate valuations prepared by independent valuation firms and market sales data. To the extent fair value of the Total Merger Consideration exceeds fair value of net assets acquired, any such excess represents goodwill. Alternatively, if fair value of net assets acquired exceeds fair value of the Total Merger Consideration, the transaction could result in a bargain purchase gain that is recognized immediately in earnings and attributable to the Company's common stockholders. Measurement period adjustments to the estimated fair value of identifiable assets and liabilities of RCA, as well as adjustments to the Total Merger Consideration may change the determination and amount of goodwill and/or bargain purchase gain and may impact depreciation, amortization and accretion based on revised fair value of assets acquired and liabilities assumed. 9 AMERICAN FINANCE TRUST, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) The following table summarizes the estimated fair value of the consideration transferred pursuant to the Mergers and the estimated fair values of the assets acquired and liabilities assumed as of the effective date of the Mergers. (In thousands) | RCA --------------------------------------------------------------------------------------------------------------------+---------- Total Consideration: | --------------------------------------------------------------------------------------------------------------------+---------- Fair value of the Cash Consideration, including redemption of fractional shares, as defined in the Merger Agreement | $ | 94,504 --------------------------------------------------------------------------------------------------------------------+-----------+---------- Fair value of the Stock Consideration | 917,046 | --------------------------------------------------------------------------------------------------------------------+-----------+---------- Fair value of the Partnership Merger Consideration | 2 | --------------------------------------------------------------------------------------------------------------------+-----------+---------- Fair value of the Class B Consideration | 4,882 | --------------------------------------------------------------------------------------------------------------------+-----------+---------- Fair value of the Total Merger Consideration | $ | 1,016,434 --------------------------------------------------------------------------------------------------------------------+-----------+---------- Assets Acquired at Fair Value | --------------------------------------------------------------------------------------------------------------------+---------- Land | $ | 282,063 --------------------------------------------------------------------------------------------------------------------+-----------+---------- Buildings, fixtures and improvements | 1,079,944 | --------------------------------------------------------------------------------------------------------------------+-----------+---------- Acquired intangible lease assets | 178,634 | --------------------------------------------------------------------------------------------------------------------+-----------+---------- Total real estate investments, at fair value | 1,540,641 | --------------------------------------------------------------------------------------------------------------------+-----------+---------- Cash and cash equivalents | 21,922 | --------------------------------------------------------------------------------------------------------------------+-----------+---------- Restricted cash | 4,241 | --------------------------------------------------------------------------------------------------------------------+-----------+---------- Prepaid expenses and other assets (1) | 18,959 | --------------------------------------------------------------------------------------------------------------------+-----------+---------- Goodwill (1) | 1,605 | --------------------------------------------------------------------------------------------------------------------+-----------+---------- Total assets acquired at fair value | 1,587,368 | --------------------------------------------------------------------------------------------------------------------+-----------+---------- Liabilities Assumed at Fair Value | --------------------------------------------------------------------------------------------------------------------+---------- Mortgage notes payable | 127,651 | --------------------------------------------------------------------------------------------------------------------+-----------+---------- Mortgage premiums | 4,143 | --------------------------------------------------------------------------------------------------------------------+-----------+---------- Credit facility | 304,000 | --------------------------------------------------------------------------------------------------------------------+-----------+---------- Market lease liabilities | 104,840 | --------------------------------------------------------------------------------------------------------------------+-----------+---------- Derivatives | 203 | --------------------------------------------------------------------------------------------------------------------+-----------+---------- Accounts payable and accrued expenses | 21,291 | --------------------------------------------------------------------------------------------------------------------+-----------+---------- Deferred rent and other liabilities | 8,806 | --------------------------------------------------------------------------------------------------------------------+-----------+---------- Total liabilities assumed at fair value | 570,934 | --------------------------------------------------------------------------------------------------------------------+-----------+---------- Net assets acquired | $ | 1,016,434 --------------------------------------------------------------------------------------------------------------------+-----------+---------- _________________________________ (1) | Prepaid expenses and other assets includes a measurement period adjustment of $0.5 million that was recognized during the three months ended September 30, 2017. As a result, goodwill was increased by $0.5 million. ----+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- The allocations in the table above from land, buildings, fixtures and improvements, acquired intangible lease assets and below-market lease liabilities have been provisionally allocated, and will be finalized as soon as practical within the measurement period pursuant to GAAP upon finalization of the valuation process. As a result of the Merger, the Company acquired goodwill of $1.6 million , which is primarily attributable to expected synergies from combining operations of the Company and RCA. 10 AMERICAN FINANCE TRUST, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) Note 3 — Summary of Significant Accounting Policies The accompanying unaudited consolidated financial statements of the Company included herein were prepared in accordance with GAAP for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. GAAP requires management to make estimates and assumptions that affect the reported amount of assets and liabilities as of the date of the consolidated financial statements and the reported amounts of income and expenses during the reported periods. Changes in the economic environment, financial markets and any other parameters used in determining these estimates could cause actual results to differ materially. The interim data includes all adjustments and accruals of a normal recurring nature, which, in the opinion of management, are necessary for a fair presentation of results for the interim periods. The results of operations for the nine months ended September 30, 2017 are not necessarily indicative of the results for the entire year or any subsequent interim periods. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto as of, and for the year ended December 31, 2016 , which are included in the Company's Annual Report on Form 10-K filed with the SEC on March 13, 2017 . There have been no significant changes to the Company's significant accounting policies during the nine months ended September 30, 2017 , other than the updates described below. Purchase Accounting The Company allocates the purchase price of acquired properties to tangible and identifiable intangible assets acquired, including those acquired in the Mergers, based on their respective fair values. Tangible assets include land, land improvements, buildings, fixtures and tenant improvements on an as-if vacant basis. The Company utilizes various estimates, processes and information to determine the as-if vacant property value. Estimates of value are made using customary methods, including data from appraisals, comparable sales, discounted cash flow analysis and other methods. Amounts allocated to land, land improvements, buildings and fixtures are based on cost segregation studies performed by independent third parties or on the Company's analysis of comparable properties in the Company's portfolio. Identifiable intangible assets include amounts allocated to acquire leases for above- and below-market lease rates and the value of in-place leases as applicable. Factors considered in the analysis of the in-place lease intangibles include an estimate of carrying costs during the expected lease-up period for each property, taking into account current market conditions and costs to execute similar leases. In estimating carrying costs, the Company includes real estate taxes, insurance and other operating expenses and estimates of lost rentals at contract rates during the expected lease-up period, which typically ranges from six to 24 months. The Company also estimates costs to execute similar leases including leasing commissions, legal and other related expenses. Above-market and below-market lease values for acquired properties are initially recorded based on the present value (using a discount rate which reflects the risks associated with the leases acquired) of the difference between (i) the contractual amounts to be paid pursuant to each in-place lease and (ii) management’s estimate of fair market lease rates for each corresponding in-place lease, measured over a period equal to the remaining term of the lease for above-market leases and the remaining initial term plus the term of any below-market fixed rate renewal options for below-market leases. The capitalized above-market lease values are amortized as a reduction of base rental revenue over the remaining terms of the respective leases, and the capitalized below-market lease values are amortized as an increase to base rental revenue over the remaining initial terms plus the terms of any below-market fixed rate renewal options of the respective leases. If a tenant with a below-market rent renewal does not renew, any remaining unamortized amount will be taken into income at that time. In making estimates of fair values for purposes of allocating purchase price, the Company utilizes a number of sources, including independent appraisals that may be obtained in connection with the acquisition or financing of the respective property and other market data. The Company also considers information obtained about each property as a result of the Company's pre-acquisition due diligence in estimating the fair value of the tangible and intangible assets acquired and intangible liabilities assumed. Any excess of purchase price over the fair values of assets acquired and liabilities assumed are recorded as goodwill. Alternatively, if the fair value of net assets acquired exceeds the fair value of consideration paid, the transaction results in a bargain purchase gain that the Company recognizes immediately in earnings. Derivative Instruments The Company may use derivative financial instruments to hedge all or a portion of the interest rate risk associated with its borrowings. Certain of the techniques used to hedge exposure to interest rate fluctuations may also be used to protect against declines in the market value of assets that result from general trends in debt markets. The principal objective of such agreements is to minimize the risks and costs associated with the Company's operating and financial structure as well as to hedge specific anticipated transactions. 11 AMERICAN FINANCE TRUST, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) The Company records all derivatives on the balance sheet at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether the Company has elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Derivatives may also be designated as hedges of the foreign currency exposure of a net investment in a foreign operation. Hedge accounting generally provides for the matching of the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk in a fair value hedge or the earnings effect of the hedged forecasted transactions in a cash flow hedge. The Company may enter into derivative contracts that are intended to economically hedge certain of its risk, even though hedge accounting does not apply or the Company elects not to apply hedge accounting. The accounting for subsequent changes in the fair value of these derivatives depends on whether each has been designated and qualifies for hedge accounting treatment. If the Company elects not to apply hedge accounting treatment, any change in the fair value of these derivative instruments is recognized immediately in gains (losses) on derivative instruments in the accompanying consolidated statement of operations and comprehensive loss. If the derivative is designated and qualifies for hedge accounting treatment, the change in the estimated fair value of the derivative is recorded in other comprehensive income (loss) to the extent that it is effective. Any ineffective portion of a derivative's change in fair value will be immediately recognized in earnings. Non-controlling interests The non-controlling interests represent the portion of the equity in the OP that is not owned by the Company. Non-controlling interests are presented as a separate component of equity on the consolidated balance sheets and presented as net income (loss) attributable to non-controlling interests on the consolidated statements of operations and comprehensive loss. Non-controlling interests are allocated a share of net income (loss) based on their share of equity ownership. Non-controlling interests resulted from the issuance of OP Units in conjunction with the Mergers and were recognized at fair value as of the Effective Time. In determining the fair value of the non-controlling interests, the Company utilized multiple sources including real estate valuations prepared by independent valuation firms and market sales data. Please see Note 2 — Merger Transaction for additional information on the Mergers. Recently Adopted Accounting Pronouncements In October 2016, the FASB issued guidance where a reporting entity will need to evaluate if it should consolidate a VIE. The amendments change the evaluation of whether a reporting entity is the primary beneficiary of a VIE by changing how a single decision maker of a VIE treats indirect interests in the entity held through related parties that are under common control with the reporting entity. The revised guidance is effective for reporting periods beginning after December 15, 2016. The Company has adopted the provisions of this guidance beginning January 1, 2017 and determined that there is no impact to the Company's consolidated financial position, results of operations and cash flows. Recently Issued Accounting Pronouncements In May 2014, the Financial Accounting Standards Board (“FASB”) issued an update (“ASU 2014-09”) establishing Accounting Standards Codification (“ASC”) Topic 606, Revenue from Contracts with Customers (“ASC 606”). ASU 2014-09, as amended by subsequent ASUs on the topic, establishes a comprehensive model for entities to use in accounting for revenue arising from contracts with customers. Under ASC 606, an entity is required to recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASC 606 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017. A reporting entity may apply the amendments in ASC 606 using either a modified retrospective approach, by recording a cumulative-effect adjustment to equity as of the beginning of the fiscal year of adoption or a full retrospective approach. The Company will adopt this guidance effective January 1, 2018 and currently expects to utilize the modified retrospective approach upon adoption and does not expect that this will result in a significant cumulative-effect adjustment to equity. 12 AMERICAN FINANCE TRUST, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) The Company has progressed in its project plan in evaluating our various revenue streams in order to identify any differences in the timing, measurement or presentation of revenue recognition under ASC 606 and ASC Topic 842, Leases (“ASC 842”). Based on the Company’s evaluation of its various revenue streams, the Company believes that gains on sales of real estate could be affected by adoption of ASC 606. The Company expects that this standard could have an impact on the timing of gains on certain sales of real estate as a result of more transactions generally qualifying as sales of real estate and revenue being recognized at an earlier date than under current accounting guidance. Specifically, the Company expects that this would impact partial sales of real estate in situations where the Company no longer retains a controlling financial interest. If the Company were to enter into partial sales of real estate, the Company would derecognize the real estate asset consistent with the principles outlined in ASC 606 and any retained non-controlling ownership interest would be measured at fair value consistent with the guidance on noncash consideration in ASC 606. The Company is continuing to evaluate any differences in the timing, measurement, or presentation of revenue recognition and the impact on the Company's consolidated financial statements and internal accounting processes resulting from ASC 606 as well as ASC Topic 842, Leases as discussed below. In February 2016, the FASB issued an update ASU 2016-02 establishing ASC Topic 842, Leases (“ASC 842”), which sets out the principles for the recognition, measurement, presentation and disclosure of leases for both lessees and lessors. ASC 842 supersedes previous leasing standards and is effective for reporting periods beginning after December 15, 2018. Early adoption is permitted. ASC 842 will impact the lease accounting model for both lessees and lessors. The Company will adopt this guidance effective January 1, 2019. The Company is a lessee for some properties in which it has ground leases as of September 30, 2017. For these leases, the Company will be required to record a right-of-use asset and lease liability equal to the present value of the remaining lease payments upon adoption of this update. The new standard requires lessees to apply a dual lease classification approach, classifying leases as either finance or operating leases based on the principle of whether or not the lease is effectively a financed purchase by the lessee. This classification will determine whether lease expense is recognized based on an effective interest method or on a straight line basis over the term of the lease, respectively. A lessee is also required to record a right-of-use asset and a lease liability for all leases with a term greater than 12 months regardless of their classification. Leases with a term of 12 months or less will be accounted for similar to existing guidance for operating leases today. From a lessor perspective the Company expects that the new standard will impact the presentation of lease and non-lease components of revenue such as rent, and operating expense reimbursements including common area maintenance, taxes, and insurance from leases for which the Company is a lessor. The Company does not expect this guidance to impact its existing lessor revenue recognition pattern. The Company anticipates that it will elect the following practical expedients, which must be elected as a package and applied consistently by an entity to all of its leases, which allow the Company to not have to reassess the following upon adoption: (i) whether any expired or existing contract contains a lease, (ii) lease classification related to expired or existing leases, or (iii) whether costs incurred on existing leases qualify as initial direct costs. The Company is continuing to evaluate any differences in the timing, measurement, or presentation of lessor revenues as well as the impact of the new lessee accounting model on the Company’s consolidated financial position, results of operations and disclosures. In January 2016, the FASB issued an update that amends the recognition and measurement of financial instruments. The new guidance revises an entity's accounting related to equity investments and the presentation of certain fair value changes for financial liabilities measured at fair value. Among other things, it also amends the presentation and disclosure requirements associated with the fair value of financial instruments. The Company will adopt this guidance effective January 1, 2018. The Company expects that there will be no material impact to the Company's consolidated financial position, results of operations and cash flows. In June 2016, the FASB issued guidance that changes how entities measure credit losses for financial assets carried at amortized cost. The update eliminates the requirement that a credit loss must be probable before it can be recognized and instead requires an entity to recognize the current estimate of all expected credit losses. Additionally, the update requires credit losses on available-for-sale debt securities to be carried as an allowance rather than as a direct write-down of the asset. The amendments become effective for reporting periods beginning after December 15, 2019. The amendments may be adopted early for reporting periods beginning after December 15, 2018. The company is currently evaluating the impact of this new guidance. 13 AMERICAN FINANCE TRUST, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) In August 2016, the FASB issued guidance on how certain transactions should be classified and presented in the statement of cash flows as either operating, investing or financing activities. Among other things, the update provides specific guidance on where to classify debt prepayment and extinguishment costs, payments for contingent consideration made after a business combination and distributions received from equity method investments. The Company will adopt this guidance effective January 1, 2018. The Company expects that there will be no material impact to the Company's consolidated financial position, results of operations and cash flows. In November 2016, the FASB issued guidance on the classification of restricted cash in the statement of cash flows. The amendment requires restricted cash to be included in the beginning-of-period and end-of-period total cash amounts. Therefore, transfers between cash and restricted cash will no longer be shown on the statement of cash flows. The Company will adopt this guidance effective January 1, 2018, using a retrospective transition method. As a result, the Company will restate its statements of cash flows for all periods presented to include restricted cash in the beginning and ending cash balances and remove all transfers between cash and restricted cash from operating, investing and financing activities. In January 2017, the FASB issued guidance on simplifying subsequent measurement of goodwill by eliminating Step 2 from the goodwill impairment test. The amendments in this update modify the concept of impairment from the condition that exists to when the carrying amount of a reporting unit exceeds its fair value. An entity no longer will determine goodwill impairment by calculating the implied fair value of goodwill by assigning the fair value of a reporting unit to all of its assets and liabilities as if that reporting unit had been acquired in a business combination. The revised guidance is effective for reporting periods beginning after December 15, 2019, and the amendments will be applied prospectively. Early application is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The Company is currently evaluating the impact of this new guidance. In January 2017, the FASB issued guidance that revises the definition of a business. This new guidance is applicable when evaluating whether an acquisition should be treated as either a business acquisition or an asset acquisition. Under the revised guidance, when substantially all of the fair value of gross assets acquired is concentrated in a single asset or group of similar assets, the assets acquired would not be considered a business. The Company will adopt this guidance effective January 1, 2018, and the amendments will be applied prospectively. The Company has assessed this revised guidance and expects, based on historical property acquisitions, that in most cases, a future property acquired after adoption would be treated as an asset acquisition rather than a business acquisition, which would result in the capitalization of related transaction costs. In May 2017, the FASB issued guidance that clarifies which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting. The update states that modification accounting should be used unless the fair value of the award, the vesting terms of the award and the classification of the award as either equity or liability, all do not change as a result of the modification. The Company will adopt this guidance effective January 1, 2018. The Company expects that any future modifications to its issued share-based awards will be accounted for using modification accounting, unless the modification meets all of the exception criteria noted above. As a result, the modification would be treated as an exchange of the original award for a new award, with any incremental fair value being treated as additional compensation cost. In August 2017, the FASB issued guidance to better align cash flow and fair value hedge accounting with the corresponding risk management activities. Among other things, the amendments expand which hedging strategies are eligible for hedge accounting, align the timing of recognition of hedge results with the earnings effect of the hedged item and allow companies to include the change in fair value of the derivative in the same income statement line item as the earnings effect of the hedged item. Additionally, for cash flow hedges that are highly effective, the update allows for all changes in fair value of the derivative to be recorded in other comprehensive income. The revised guidance is effective for reporting periods beginning after December 15, 2018. Early application is permitted. The Company is currently evaluating the impact of this new guidance. 14 AMERICAN FINANCE TRUST, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) Note 4 — Real Estate Investments The Company owned 517 properties, which were acquired for investment purposes, as of September 30, 2017 . The following table presents the allocation of real estate assets acquired and liabilities assumed during the nine months ended September 30, 2017 and 2016 : | Nine Months Ended September 30, ------------------------------------------------------------------------------------+-------------------------------- (Dollar amounts in thousands) | 2017 | | 2016 ------------------------------------------------------------------------------------+---------------------------------+-----------+----- Real estate investments, at cost (1): | | | ------------------------------------------------------------------------------------+---------------------------------+-----------+----- Land | $ | 303,868 | | | $ | 1,729 ------------------------------------------------------------------------------------+---------------------------------+-----------+------+--------+---+------- Buildings, fixtures and improvements | 1,150,645 | | | 29,664 | ------------------------------------------------------------------------------------+---------------------------------+-----------+------+--------+-- Total tangible assets | 1,454,513 | | | 31,393 | ------------------------------------------------------------------------------------+---------------------------------+-----------+------+--------+-- Acquired intangibles: (2) | | | ------------------------------------------------------------------------------------+---------------------------------+-----------+----- In-place leases | 170,748 | | | 3,162 | ------------------------------------------------------------------------------------+---------------------------------+-----------+------+--------+-- Above-market lease assets | 22,862 | | | 548 | ------------------------------------------------------------------------------------+---------------------------------+-----------+------+--------+-- Below-market ground lease asset | 1,233 | | | — | ------------------------------------------------------------------------------------+---------------------------------+-----------+------+--------+-- Above-market ground lease liability | — | | | (85 | ) ------------------------------------------------------------------------------------+---------------------------------+-----------+------+--------+-- Below-market lease liabilities | (106,369 | ) | | (774 | ) ------------------------------------------------------------------------------------+---------------------------------+-----------+------+--------+-- Total intangible assets, net | 88,474 | | | 2,851 | ------------------------------------------------------------------------------------+---------------------------------+-----------+------+--------+-- Credit facility assumed in the Merger | (304,000 | ) | | — | ------------------------------------------------------------------------------------+---------------------------------+-----------+------+--------+-- Mortgage notes payable assumed in the Merger | (127,651 | ) | | — | ------------------------------------------------------------------------------------+---------------------------------+-----------+------+--------+-- Premiums on mortgage notes payable assumed in the Merger | (4,143 | ) | | — | ------------------------------------------------------------------------------------+---------------------------------+-----------+------+--------+-- Other assets acquired and (liabilities assumed) in the Merger, net | 16,427 | | | — | ------------------------------------------------------------------------------------+---------------------------------+-----------+------+--------+-- Consideration paid for acquired real estate investments, net of liabilities assumed | $ | 1,123,620 | | | $ | 34,244 ------------------------------------------------------------------------------------+---------------------------------+-----------+------+--------+---+------- Number of properties purchased | 81 | | | 4 | ------------------------------------------------------------------------------------+---------------------------------+-----------+------+--------+-- _____________________________________ (1) | Real estate investments, at cost and market lease liabilities acquired during the nine months ended September 30, 2017 have been provisionally allocated pending receipt and review of final appraisals and/or other information. ----+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (2) | Weighted-average remaining amortization periods for in-place leases, above-market lease assets and below-market lease liabilities acquired during the nine months ended September 30, 2017 were 7.1 years, 9.1 years and 18.9 years, respectively, as of each property's respective acquisition date. ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ Total acquired intangible lease assets and liabilities consist of the following as of the dates presented: | September 30, 2017 | | December 31, 2016 --------------------------------------------+-----------------------+---------+------------------------- (In thousands) | Gross Carrying Amount | | Accumulated Amortization | | Net Carrying Amount | | Gross Carrying Amount | Accumulated Amortization | | Net Carrying Amount --------------------------------------------+-----------------------+---------+--------------------------+--------+---------------------+---------+-----------------------+--------------------------+---------+-------------------- Intangible assets: | | | | | | | | | | --------------------------------------------+-----------------------+---------+--------------------------+--------+---------------------+---------+-----------------------+--------------------------+---------+-------------------- In-place leases | $ | 427,467 | | | $ | 136,586 | | $ | 290,881 | | $ | 286,548 | | $ | 95,547 | $ | 191,001 --------------------------------------------+-----------------------+---------+--------------------------+--------+---------------------+---------+-----------------------+--------------------------+---------+---------------------+-------+---------+--------+---+---------+---+-------- Above-market lease assets | 32,850 | | | 10,993 | | | 21,857 | | 13,581 | | 8,106 | | 5,475 | --------------------------------------------+-----------------------+---------+--------------------------+--------+---------------------+---------+-----------------------+--------------------------+---------+---------------------+-------+---------+--------+-- Below-market ground lease asset | 1,233 | | | 20 | | | 1,213 | | — | | — | | — | --------------------------------------------+-----------------------+---------+--------------------------+--------+---------------------+---------+-----------------------+--------------------------+---------+---------------------+-------+---------+--------+-- Total acquired intangible lease assets | $ | 461,550 | | | $ | 147,599 | | $ | 313,951 | | $ | 300,129 | | $ | 103,653 | $ | 196,476 --------------------------------------------+-----------------------+---------+--------------------------+--------+---------------------+---------+-----------------------+--------------------------+---------+---------------------+-------+---------+--------+---+---------+---+-------- Intangible liabilities: | | | | | | | | | | | --------------------------------------------+-----------------------+---------+--------------------------+--------+---------------------+---------+-----------------------+--------------------------+---------+---------------------+------ Above-market ground lease liability | $ | 85 | | | $ | 2 | | $ | 83 | | $ | 85 | | $ | 1 | $ | 84 --------------------------------------------+-----------------------+---------+--------------------------+--------+---------------------+---------+-----------------------+--------------------------+---------+---------------------+-------+---------+--------+---+---------+---+-------- Below-market lease liabilities | 124,719 | | | 12,129 | | | 112,590 | | 18,443 | | 4,612 | | 13,831 | --------------------------------------------+-----------------------+---------+--------------------------+--------+---------------------+---------+-----------------------+--------------------------+---------+---------------------+-------+---------+--------+-- Total acquired intangible lease liabilities | $ | 124,804 | | | $ | 12,131 | | $ | 112,673 | | $ | 18,528 | | $ | 4,613 | $ | 13,915 --------------------------------------------+-----------------------+---------+--------------------------+--------+---------------------+---------+-----------------------+--------------------------+---------+---------------------+-------+---------+--------+---+---------+---+-------- 15 AMERICAN FINANCE TRUST, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) The following table presents amortization expense and adjustments to revenue and property operating expenses for intangible assets and liabilities for the three and nine months ended September 30, 2017 and 2016 : | Three Months Ended September 30, | | Nine Months Ended September 30, ------------------------------------------------+----------------------------------+--------+-------------------------------- (In thousands) | 2017 | | 2016 | | 2017 | | 2016 ------------------------------------------------+----------------------------------+--------+---------------------------------+-----+------+-------+------ In-place leases | $ | 18,685 | | | $ | 8,550 | | | $ | 50,149 | | $ | 25,841 | ------------------------------------------------+----------------------------------+--------+---------------------------------+-----+------+-------+-------+---+---+--------+---+---+--------+-- Total added to depreciation and amortization | $ | 18,685 | | | $ | 8,550 | | | $ | 50,149 | | $ | 25,841 | ------------------------------------------------+----------------------------------+--------+---------------------------------+-----+------+-------+-------+---+---+--------+---+---+--------+-- Above-market leases | $ | (1,607 | ) | | $ | (724 | ) | | $ | (4,387 | ) | $ | (2,220 | ) ------------------------------------------------+----------------------------------+--------+---------------------------------+-----+------+-------+-------+---+---+--------+---+---+--------+-- Below-market lease liabilities | 3,134 | | | 752 | | | 7,491 | | | 1,713 | ------------------------------------------------+----------------------------------+--------+---------------------------------+-----+------+-------+-------+---+---+--------+-- Total added to (deducted from) rental income | $ | 1,527 | | | $ | 28 | | | $ | 3,104 | | $ | (507 | ) ------------------------------------------------+----------------------------------+--------+---------------------------------+-----+------+-------+-------+---+---+--------+---+---+--------+-- Below-market ground lease asset | $ | 8 | | | $ | — | | | $ | 20 | | $ | — | ------------------------------------------------+----------------------------------+--------+---------------------------------+-----+------+-------+-------+---+---+--------+---+---+--------+-- Above-market ground lease liability | — | | | — | | | (1 | ) | | (1 | ) ------------------------------------------------+----------------------------------+--------+---------------------------------+-----+------+-------+-------+---+---+--------+-- Total deducted from property operating expenses | $ | 8 | | | $ | — | | | $ | 19 | | $ | (1 | ) ------------------------------------------------+----------------------------------+--------+---------------------------------+-----+------+-------+-------+---+---+--------+---+---+--------+-- The following table provides the projected amortization expense and adjustments to revenue and property operating expenses for intangible assets and liabilities for the next five years: (In thousands) | October 1, 2017 to December 31, 2017 | | 2018 | | 2019 | | 2020 | | 2021 ---------------------------------------------------+--------------------------------------+--------+------+-------+------+--------+-------+---+----- In-place leases | $ | 15,923 | | | $ | 54,238 | | | $ | 43,938 | | $ | 34,907 | | $ | 29,736 | ---------------------------------------------------+--------------------------------------+--------+------+-------+------+--------+-------+---+------+--------+---+-------+--------+---+---+--------+-- Total to be added to depreciation and amortization | $ | 15,923 | | | $ | 54,238 | | | $ | 43,938 | | $ | 34,907 | | $ | 29,736 | ---------------------------------------------------+--------------------------------------+--------+------+-------+------+--------+-------+---+------+--------+---+-------+--------+---+---+--------+-- Above-market leases | $ | (1,426 | ) | | $ | (4,096 | ) | | $ | (3,244 | ) | $ | (2,422 | ) | $ | (2,085 | ) ---------------------------------------------------+--------------------------------------+--------+------+-------+------+--------+-------+---+------+--------+---+-------+--------+---+---+--------+-- Below-market lease liabilities | 2,356 | | | 9,213 | | | 8,516 | | | 7,795 | | 6,936 | ---------------------------------------------------+--------------------------------------+--------+------+-------+------+--------+-------+---+------+--------+---+-------+------- Total to be added to rental income | $ | 930 | | | $ | 5,117 | | | $ | 5,272 | | $ | 5,373 | | $ | 4,851 | ---------------------------------------------------+--------------------------------------+--------+------+-------+------+--------+-------+---+------+--------+---+-------+--------+---+---+--------+-- Below-market ground lease asset | $ | 7 | | | $ | 32 | | | $ | 32 | | $ | 32 | | $ | 32 | ---------------------------------------------------+--------------------------------------+--------+------+-------+------+--------+-------+---+------+--------+---+-------+--------+---+---+--------+-- Above-market ground lease liability | — | | | (2 | ) | | (2 | ) | | (2 | ) | (2 | ) ---------------------------------------------------+--------------------------------------+--------+------+-------+------+--------+-------+---+------+--------+---+-------+------- Total to be added to property operating expenses | $ | 7 | | | $ | 30 | | | $ | 30 | | $ | 30 | | $ | 30 | ---------------------------------------------------+--------------------------------------+--------+------+-------+------+--------+-------+---+------+--------+---+-------+--------+---+---+--------+-- The following table presents unaudited pro forma information as if the acquisitions during the nine months ended September 30, 2017 had been consummated on January 1, 2016 : | Nine Months Ended September 30, -----------------------------------------------+-------------------------------- (In thousands, except per share data) | 2017 (1) | | 2016 -----------------------------------------------+---------------------------------+---------+----- Pro forma revenues | $ | 218,529 | | $ | 237,564 | -----------------------------------------------+---------------------------------+---------+------+---+---------+-- Pro forma net loss | $ | (20,062 | ) | $ | (10,084 | ) -----------------------------------------------+---------------------------------+---------+------+---+---------+-- Basic and diluted pro forma net loss per share | $ | (0.19 | ) | $ | (0.10 | ) -----------------------------------------------+---------------------------------+---------+------+---+---------+-- _____________________ (1) | For the nine months ended September 30, 2017, aggregate revenues and net income derived from the Company's 2017 acquisitions (for the Company's period of ownership) were $84.8 million and $7.6 million, respectively. ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 16 AMERICAN FINANCE TRUST, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) The following table presents future minimum base rent payments on a cash basis due to the Company over the next five years and thereafter. These amounts exclude contingent rent payments, as applicable, that may be collected from certain tenants based on provisions related to sales thresholds and increases in annual rent based on exceeding certain economic indexes among other items: (In thousands) | Future MinimumBase Rent Payments -------------------------------------+--------------------------------- October 1, 2017 to December 31, 2017 | $ | 58,208 -------------------------------------+----------------------------------+---------- 2018 | 223,642 | -------------------------------------+----------------------------------+---------- 2019 | 213,028 | -------------------------------------+----------------------------------+---------- 2020 | 196,395 | -------------------------------------+----------------------------------+---------- 2021 | 183,829 | -------------------------------------+----------------------------------+---------- Thereafter | 1,110,173 | -------------------------------------+----------------------------------+---------- | $ | 1,985,275 -------------------------------------+----------------------------------+---------- The following table lists the tenants (including, for this purpose, all affiliates of such tenants) from which the Company derives annualized rental income on a straight-line basis constituting 10.0% or more of the Company's consolidated annualized rental income on a straight-line basis for all portfolio properties as of the dates indicated: | September 30, ---------------------+-------------- Tenant | 2017 | 2016 ---------------------+---------------+------ SunTrust Bank | 11.5% | 17.8% ---------------------+---------------+------ Sanofi US | * | 11.4% ---------------------+---------------+------ C&S Wholesale Grocer | * | 10.2% ---------------------+---------------+------ _____________________ * | Tenant's annualized rental income on a straight-line basis was not greater than or equal to 10.0% of consolidated annualized rental income for all properties as of the date specified. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- The termination, delinquency or non-renewal of leases by one or more of the above tenants may have a material adverse effect on revenues. No other tenant represented 10.0% or greater of consolidated annualized rental income on a straight-line basis as of September 30, 2017 and 2016 . The following table lists the states where the Company has concentrations of properties where annualized rental income on a straight-line basis represented 10.0% or greater of consolidated annualized rental income on a straight-line basis as of the dates indicated: | September 30, -----------+-------------- State | 2017 | 2016 -----------+---------------+------ New Jersey | * | 20.0% -----------+---------------+------ Georgia | * | 11.0% -----------+---------------+------ _____________________ * | State's annualized rental income on a straight-line basis was not greater than or equal to 10.0% of consolidated annualized rental income for all properties as of the date specified. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- The Company did not own properties in any other state that in total represented 10.0% or greater of consolidated annualized rental income on a straight-line basis as of September 30, 2017 and 2016 . Real Estate Held For Sale When assets are identified by management as held for sale, the Company stops recognizing depreciation and amortization expense on the identified assets and estimates the sales price, net of costs to sell, of those assets. If the carrying amount of the assets classified as held for sale exceeds the estimated net sales price, the Company records an impairment charge equal to the amount by which the carrying amount of the assets exceeds the Company's estimate of the net sales price of the assets. 17 AMERICAN FINANCE TRUST, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) As of September 30, 2017 and December 31, 2016 , there were three and five properties, respectively, classified as held for sale. The disposal of these properties does not represent a strategic shift. Accordingly, the operating results of these properties remain classified within continuing operations for all periods presented. The following table details the major classes of assets associated with the properties that have been reclassified as held for sale as of September 30, 2017 and December 31, 2016 . (Dollar amounts in thousands) | September 30, 2017 | | December 31, 2016 -----------------------------------------------------------------------+--------------------+-------+------------------ Real estate investments held for sale, at cost: | | | -----------------------------------------------------------------------+--------------------+-------+------------------ Land | $ | 735 | | | $ | 7,225 -----------------------------------------------------------------------+--------------------+-------+-------------------+---------+---+-------- Buildings, fixtures and improvements | 2,423 | | | 142,798 | -----------------------------------------------------------------------+--------------------+-------+-------------------+---------+-- Acquired intangible lease assets | 404 | | | 18,145 | -----------------------------------------------------------------------+--------------------+-------+-------------------+---------+-- Total real estate assets held for sale, at cost | 3,562 | | | 168,168 | -----------------------------------------------------------------------+--------------------+-------+-------------------+---------+-- Less accumulated depreciation and amortization | (1,007 | ) | | (29,213 | ) -----------------------------------------------------------------------+--------------------+-------+-------------------+---------+-- Total real estate investments held for sale, net | 2,555 | | | 138,955 | -----------------------------------------------------------------------+--------------------+-------+-------------------+---------+-- Impairment charges related to properties reclassified as held for sale | (66 | ) | | (1,353 | ) -----------------------------------------------------------------------+--------------------+-------+-------------------+---------+-- Assets held for sale | $ | 2,489 | | | $ | 137,602 -----------------------------------------------------------------------+--------------------+-------+-------------------+---------+---+-------- Real Estate Sales During the nine months ended September 30, 2017 , the Company closed on the sale of 19 properties, including 13 properties operated by SunTrust Banks, Inc. ("SunTrust") (as discussed below), for an aggregate contract price of $277.9 million , exclusive of closing costs. These sales resulted in aggregate gains of $14.1 million , which is reflected in gain on sale of real estate investments on the consolidated statement of operations and comprehensive loss for the nine months ended September 30, 2017 , as well as impairment losses of $3.6 million . During the three months ended September 30, 2017 , the Company closed on the sale of seven properties operated by SunTrust (as discussed below) for an aggregate contract price of $6.0 million , exclusive of closing costs. These sales resulted in aggregate gains of $0.3 million , as well as impairment losses of $0.1 million . The disposal of these properties did not represent a strategic shift. Accordingly, the operating results of the properties sold remained classified within continuing operations for all periods presented until the date of disposal. During the nine months ended September 30, 2016 , the Company closed on the sale of nine properties, resulting in impairment charges of $0.1 million and gains on sale of real estate investments of $0.5 million . Impairment of Held for Use Real Estate Investments As of September 30, 2017 and December 31, 2016 , the Company owned 44 and 57 held for use single-tenant net lease properties operated by SunTrust, respectively, which had lease terms set to expire between December 31, 2017 and March 31, 2018. As a result, the Company reconsidered its intended holding period for these properties and evaluated the impact on its ability to recover the carrying value of such properties based on the expected cash flows over its intended holding period. The Company primarily used a market approach to estimate the future cash flows expected to be generated. This approach involved evaluating comparable sales of properties in the same geographic region as the SunTrust properties in order to generate an estimated sale price. The Company made certain assumptions in this approach including, among others, that the properties in the comparable sales used in the analysis share similar characteristics to the SunTrust properties, and that market and economic conditions at the time of any potential sales of these SunTrust properties, such as discount rates, demand for space, competition for tenants, changes in market rental rates, and costs to operate the property, would be similar to those in the comparable sales analyzed. As these factors are difficult to predict and are subject to future events that may alter management’s assumptions, the future cash flows estimated by management in its impairment analysis may not be achieved, and actual losses or impairment may be realized in the future. For some of the held for use SunTrust properties noted above, the Company has executed a non-binding letter of intent ("LOI") or a definitive purchase and sale agreement ("PSA") to sell the properties. In those instances, the Company used the sale price from the applicable LOI or PSA to estimate the future cash flows expected to be generated. The Company made certain assumptions in this approach as well, mainly that the sale of these properties would close at the terms specified in the LOI or PSA. There can be no guarantee that the sales of these properties will close under these terms or at all. 18 AMERICAN FINANCE TRUST, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) As a result of its consideration of impairment, the Company determined that as of December 31, 2016 , the carrying value of 43 of the 57 held for use SunTrust properties noted above exceeded their estimated fair values and recognized an aggregate impairment charge of $24.7 million during the year ended December 31, 2016. During the three and nine months ended September 30, 2017 , the Company recognized additional impairment charges of $7.5 million and $9.7 million , respectively, on the held for use SunTrust properties based on LOIs or PSAs entered into, which is included on the consolidated statement of operations and comprehensive loss for the three and nine months ended September 30, 2017 . No impairment was recognized on properties held for use during the three and nine months ended September 30, 2016 . The carrying value of the remaining 44 SunTrust properties noted above was $48.1 million as of September 30, 2017 . Property Damage During the three months ended September 30, 2017 , one of the Company's properties, Southroads Shopping Center, sustained roof damage from a tornado. The property is covered by insurance for property damage, subject to normal deductibles. Accordingly, damage will be covered by insurance proceeds, and the Company does not expect any significant exposure to loss related to this property. As a result of the damage, the Company wrote off the carrying value of the property's roof, which was estimated to be $5.6 million , and booked a corresponding insurance receivable on its consolidated balance sheet as of September 30, 2017 . Note 5 — Commercial Mortgage Loan The following table is a summary of the Company's commercial mortgage loan portfolio: | | September 30, 2017 | | December 31, 2016 ----------+-------------------------------+--------------------+--------+------------------ Loan Type | Property Type | Par Value | | Percentage | Par Value | | Percentage ----------+-------------------------------+--------------------+--------+-------------------+----------------+---+----------- | | (In thousands) | | | (In thousands) | | ----------+-------------------------------+--------------------+--------+-------------------+----------------+---+----------- Senior | Student Housing — Multifamily | $ | 17,200 | | 100.0 | % | | $ | 17,200 | 100 | % ----------+-------------------------------+--------------------+--------+-------------------+----------------+---+------------+---+--------+-----+-- Credit Characteristics As part of the Company's process for monitoring the credit quality of its loan, it performs a quarterly loan portfolio assessment and assigns risk ratings to each of its performing loans. The loans are scored on a scale of 1 to 5 as follows: Investment Rating | Summary Description ------------------+---------------------------------------------------------------------------------------------------------------------------------------------------------- 1 | Investment exceeding fundamental performance expectations and/or capital gain expected. Trends and risk factors since time of investment are favorable. ------------------+---------------------------------------------------------------------------------------------------------------------------------------------------------- 2 | Performing consistent with expectations and a full return of principal and interest expected. Trends and risk factors are neutral to favorable. ------------------+---------------------------------------------------------------------------------------------------------------------------------------------------------- 3 | Performing investments requiring closer monitoring. Trends and risk factors show some deterioration. ------------------+---------------------------------------------------------------------------------------------------------------------------------------------------------- 4 | Underperforming investment with some loss of interest expected but still expecting a positive return on investment. Trends and risk factors are negative. ------------------+---------------------------------------------------------------------------------------------------------------------------------------------------------- 5 | Underperforming investment with expected loss of interest and some principal. ------------------+---------------------------------------------------------------------------------------------------------------------------------------------------------- All commercial mortgage loans are assigned an initial risk rating of 2. As of September 30, 2017 , the risk rating of the Company's commercial loan held for investment was 3. As of September 30, 2017 , the Company did not have any loans that were past due on their payments, in non-accrual status or impaired. No allowance for loan losses has been recorded as of September 30, 2017 or December 31, 2016 . For the nine months ended September 30, 2017 and 2016 , the activity on the Company's commercial mortgage loans, held for investment, was as follows: | Nine Months Ended ------------------------------------------------+------------------- (In thousands) | September 30, 2017 | | September 30, 2016 ------------------------------------------------+--------------------+--------+------------------- Beginning balance | $ | 17,175 | | | $ | 17,135 ------------------------------------------------+--------------------+--------+--------------------+----+---+------- Discount accretion and premium amortization (1) | 16 | | | 15 | ------------------------------------------------+--------------------+--------+--------------------+----+-- Ending balance | $ | 17,191 | | | $ | 17,150 ------------------------------------------------+--------------------+--------+--------------------+----+---+------- _____________________________________ (1) | Includes amortization of capitalized origination fees and expenses. ----+-------------------------------------------------------------------- 19 AMERICAN FINANCE TRUST, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) Note 6 — Credit Facility On February 16, 2017, the Company, the OP, and certain other subsidiaries of the Company acting as guarantors, entered into an amendment, assumption, joinder and reaffirmation of guaranties (the “Second Amendment”) to an unsecured amended and restated credit agreement, dated December 2, 2014 (as amended by the Second Amendment, the “Credit Agreement”), by and among the RCA OP, to which the OP is successor by merger, BMO Harris Bank N.A., as administrative agent, letter of credit issuer, swingline lender and a lender, and the other parties thereto, relating to a revolving credit facility (the “Amended Credit Facility”). The Second Amendment provides for, among other things, the OP to become the borrower and principal obligor under the Credit Agreement and the Amended Credit Facility, and for the Company to become a guarantor under the Amended Credit Facility. RCA and the RCA OP were parties to the Credit Agreement prior to closing of the Merger. The Amended Credit Facility provides for aggregate revolving loan borrowings of up to $325.0 million (subject to the value and debt service coverage ratio of the unencumbered asset pool comprising the borrowing base thereunder), a swingline subfacility of $25.0 million and a $20.0 million letter of credit subfacility, subject to certain conditions. Through an uncommitted “accordion feature,” the OP, subject to lender consent and certain other conditions, may increase commitments under the Amended Credit Facility to up to $575.0 million . As of September 30, 2017 , the Company's unused borrowing capacity was $65.0 million , based on the aggregate commitments under the Amended Credit Facility. The Amended Credit Facility matures on May 1, 2018. Borrowings under the Amended Credit Facility bear interest at either (i) the base rate (which is defined in the Credit Agreement as the greatest of (a) the prime rate in effect on such day, (b) the federal funds effective rate in effect on such day plus 0.50% , and (c) LIBOR for a one month interest period plus 1.00% ) plus an applicable spread ranging from 0.35% to 1.00% , depending on the Company’s consolidated leverage ratio, or (ii) LIBOR plus an applicable spread ranging from 1.35% to 2.00% , depending on the Company’s consolidated leverage ratio. The Amended Credit Facility provides for quarterly interest payments for each base rate loan and periodic interest payments for each LIBOR loan, based upon the applicable interest period (though no longer than three months) with respect to such LIBOR loan, with all principal outstanding being due on the maturity date. The Amended Credit Facility may be prepaid at any time, in whole or in part, without premium or penalty. Upon the occurrence of an event of default, the requisite lenders have the right to terminate their obligations under the Amended Credit Facility and to accelerate the payment on any unpaid principal amount of all outstanding loans. The Company, certain of its subsidiaries and certain subsidiaries of the OP will guarantee the obligations under the Amended Credit Facility. In connection with the Mergers, the Company assumed the outstanding balance on the Amended Credit Facility of $304.0 million . During the nine months ended September 30, 2017 , the Company paid down $114.0 million , and subsequently drew $70.0 million , leaving an outstanding balance of $260.0 million as of September 30, 2017 . The Amended Credit Facility contains various customary covenants, including but not limited to financial maintenance covenants with respect to maximum consolidated leverage and consolidated secured leverage, minimum fixed charge coverage, a maximum ratio of other recourse debt to total asset value and minimum net worth. As of September 30, 2017 , the Company was in compliance with the financial covenants under the Amended Credit Facility. 20 AMERICAN FINANCE TRUST, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) Note 7 — Mortgage Notes Payable The Company's mortgage notes payable as of September 30, 2017 and December 31, 2016 consisted of the following: | | Outstanding Loan Amount as of | | Effective Interest Rate as of | | | | | | ----------------------------------------------------------+-----------------------+-------------------------------+-----------+-------------------------------+-----------+--------------------+-----------+-------------------+---+-------------- Portfolio | Encumbered Properties | September 30, 2017 | | December 31, 2016 | | September 30, 2017 | | December 31, 2016 | | Interest Rate | | Maturity | | Anticipated Repayment ----------------------------------------------------------+-----------------------+-------------------------------+-----------+-------------------------------+-----------+--------------------+-----------+-------------------+---+---------------+------+----------+------+---------------------- | | (In thousands) | | (In thousands) | | | | | | | | | | ----------------------------------------------------------+-----------------------+-------------------------------+-----------+-------------------------------+-----------+--------------------+-----------+-------------------+---+---------------+------+----------+------+---------------------- SAAB Sensis I | 1 | $ | 7,565 | | | $ | 7,841 | | | 5.93 | % | | 5.93 | % | | Fixed | Apr. 2025 | Apr. 2025 ----------------------------------------------------------+-----------------------+-------------------------------+-----------+-------------------------------+-----------+--------------------+-----------+-------------------+---+---------------+------+----------+------+-----------------------+-----+-----------+-----------+---------- SunTrust Bank II | 27 | 22,756 | | | 25,000 | | | 5.50 | % | | 5.50 | % | | Fixed | | Jul. 2031 | Jul. 2021 ----------------------------------------------------------+-----------------------+-------------------------------+-----------+-------------------------------+-----------+--------------------+-----------+-------------------+---+---------------+------+----------+------+-----------------------+-----+-----------+---------- C&S Wholesale Grocer I (1) | — | — | | | 82,313 | | | — | % | | 5.48 | % | | Fixed | | Apr. 2037 | Apr. 2017 ----------------------------------------------------------+-----------------------+-------------------------------+-----------+-------------------------------+-----------+--------------------+-----------+-------------------+---+---------------+------+----------+------+-----------------------+-----+-----------+---------- SunTrust Bank III | 104 | 82,685 | | | 88,567 | | | 5.50 | % | | 5.50 | % | | Fixed | | Jul. 2031 | Jul. 2021 ----------------------------------------------------------+-----------------------+-------------------------------+-----------+-------------------------------+-----------+--------------------+-----------+-------------------+---+---------------+------+----------+------+-----------------------+-----+-----------+---------- SunTrust Bank IV | 27 | 21,243 | | | 21,243 | | | 5.50 | % | | 5.50 | % | | Fixed | | Jul. 2031 | Jul. 2021 ----------------------------------------------------------+-----------------------+-------------------------------+-----------+-------------------------------+-----------+--------------------+-----------+-------------------+---+---------------+------+----------+------+-----------------------+-----+-----------+---------- Sanofi US I | 1 | 125,000 | | | 125,000 | | | 5.16 | % | | 5.16 | % | | Fixed | | Jul. 2026 | Jan. 2021 ----------------------------------------------------------+-----------------------+-------------------------------+-----------+-------------------------------+-----------+--------------------+-----------+-------------------+---+---------------+------+----------+------+-----------------------+-----+-----------+---------- Stop & Shop I | 4 | 37,744 | | | 38,271 | | | 5.63 | % | | 5.63 | % | | Fixed | | Jun. 2041 | Jun. 2021 ----------------------------------------------------------+-----------------------+-------------------------------+-----------+-------------------------------+-----------+--------------------+-----------+-------------------+---+---------------+------+----------+------+-----------------------+-----+-----------+---------- Multi-Tenant Mortgage Loan | 266 | 648,222 | | | 649,532 | | | 4.36 | % | | 4.36 | % | | Fixed | | Sep. 2020 | Sep. 2020 ----------------------------------------------------------+-----------------------+-------------------------------+-----------+-------------------------------+-----------+--------------------+-----------+-------------------+---+---------------+------+----------+------+-----------------------+-----+-----------+---------- Liberty Crossing | 1 | 11,000 | | | — | | | 4.66 | % | | — | % | | Fixed | | Jul. 2018 | Jul. 2018 ----------------------------------------------------------+-----------------------+-------------------------------+-----------+-------------------------------+-----------+--------------------+-----------+-------------------+---+---------------+------+----------+------+-----------------------+-----+-----------+---------- San Pedro Crossing | 1 | 17,985 | | | — | | | 3.79 | % | | — | % | | Fixed | | Jan. 2018 | Jan. 2018 ----------------------------------------------------------+-----------------------+-------------------------------+-----------+-------------------------------+-----------+--------------------+-----------+-------------------+---+---------------+------+----------+------+-----------------------+-----+-----------+---------- Tiffany Springs MarketCenter | 1 | 33,802 | | | — | | | 3.92 | % | | — | % | | Fixed | (3) | Oct. 2018 | Oct. 2018 ----------------------------------------------------------+-----------------------+-------------------------------+-----------+-------------------------------+-----------+--------------------+-----------+-------------------+---+---------------+------+----------+------+-----------------------+-----+-----------+---------- Shops at Shelby Crossing | 1 | 23,105 | | | — | | | 4.97 | % | | — | % | | Fixed | | Mar. 2024 | Mar. 2024 ----------------------------------------------------------+-----------------------+-------------------------------+-----------+-------------------------------+-----------+--------------------+-----------+-------------------+---+---------------+------+----------+------+-----------------------+-----+-----------+---------- Patton Creek | 1 | 41,060 | | | — | | | 5.76 | % | | — | % | | Fixed | | Dec. 2020 | Dec. 2020 ----------------------------------------------------------+-----------------------+-------------------------------+-----------+-------------------------------+-----------+--------------------+-----------+-------------------+---+---------------+------+----------+------+-----------------------+-----+-----------+---------- Bob Evans I | 23 | 23,950 | | | — | | | 4.71 | % | | — | % | | Fixed | | Sep. 2037 | Sep. 2027 ----------------------------------------------------------+-----------------------+-------------------------------+-----------+-------------------------------+-----------+--------------------+-----------+-------------------+---+---------------+------+----------+------+-----------------------+-----+-----------+---------- Gross mortgage notes payable | 458 | 1,096,117 | | | 1,037,767 | | | 4.69 | % | (2) | 4.75 | % | (2) | | | | ----------------------------------------------------------+-----------------------+-------------------------------+-----------+-------------------------------+-----------+--------------------+-----------+-------------------+---+---------------+------+----------+------+-----------------------+-----+-----------+---------- Deferred financing costs, net of accumulated amortization | | (13,038 | ) | | (15,492 | ) | | | | | | | | | | ----------------------------------------------------------+-----------------------+-------------------------------+-----------+-------------------------------+-----------+--------------------+-----------+-------------------+---+---------------+------+----------+------+-----------------------+-----+---------- Mortgage notes payable, net of deferred financing costs | | $ | 1,083,079 | | | $ | 1,022,275 | | | | | | | | | | ----------------------------------------------------------+-----------------------+-------------------------------+-----------+-------------------------------+-----------+--------------------+-----------+-------------------+---+---------------+------+----------+------+-----------------------+-----+-----------+---------- _____________________________________ (1) | The Company paid off the full mortgage balance secured by the C&S Wholesale Grocer properties on April 19, 2017. ----+----------------------------------------------------------------------------------------------------------------- (2) | Calculated on a weighted-average basis for all mortgages outstanding as of the dates indicated. ----+------------------------------------------------------------------------------------------------ (3) | Fixed as a result of entering into a swap agreement, which is included in derivatives, at fair value on the unaudited consolidated balance sheet as of September 30, 2017. ----+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------- As of September 30, 2017 and December 31, 2016 , the Company had pledged $2.1 billion in real estate investments as collateral for its mortgage notes payable. This real estate is not available to satisfy other debts and obligations unless first satisfying the mortgage notes payable on the properties. In addition, as of September 30, 2017 , $770.3 million in real estate investments were included in the unencumbered asset pool comprising the borrowing base under the Amended Credit Facility. Therefore, this real estate is only available to serve as collateral or satisfy other debts and obligations if it is first removed from the borrowing base under the Amended Credit Facility. During August 2015 , certain subsidiaries of the Company entered into a $655.0 million mortgage loan agreement ("Multi-Tenant Mortgage Loan") with Barclays Bank PLC, Column Financial Inc. and UBS Real Estate Securities Inc. (together, the "Lenders"). The Multi-Tenant Mortgage Loan has a stated maturity of September 6, 2020 and a stated annual interest rate of 4.30% . As of September 30, 2017 , the Multi-Tenant Mortgage Loan was secured by mortgage interests in 266 of the Company's properties. As of September 30, 2017 , the outstanding balance under the Multi-Tenant Mortgage Loan was $648.2 million . At the closing of the Multi-Tenant Mortgage Loan, the Lenders placed $42.5 million of the proceeds from the Multi-Tenant Mortgage Loan in escrow, to be released to the Company upon certain conditions, including the receipt of ground lease estoppels, performance of certain repairs and receipt of environmental insurance. As of September 30, 2017 , the Lenders had released $34.6 million of the amount originally placed in escrow to the Company. As of September 30, 2017 , $7.9 million of the proceeds from the Multi-Tenant Mortgage Loan remained in escrow and is included in restricted cash on the unaudited consolidated balance sheet as of September 30, 2017 . 21 AMERICAN FINANCE TRUST, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) The following table summarizes the scheduled aggregate principal payments on mortgage notes payable based on stated maturity dates for the five years subsequent to September 30, 2017 and thereafter: (In thousands) | Future Principal Payments -------------------------------------+-------------------------- October 1, 2017 to December 31, 2017 | $ | 582 -------------------------------------+---------------------------+---------- 2018 | 65,182 | -------------------------------------+---------------------------+---------- 2019 | 2,533 | -------------------------------------+---------------------------+---------- 2020 | 689,107 | -------------------------------------+---------------------------+---------- 2021 | 1,398 | -------------------------------------+---------------------------+---------- Thereafter | 337,315 | -------------------------------------+---------------------------+---------- | $ | 1,096,117 -------------------------------------+---------------------------+---------- The Company's mortgage notes payable agreements require the compliance of certain property-level financial covenants including debt service coverage ratios. As of September 30, 2017 , the Company was in compliance with financial covenants under its mortgage notes payable agreements. Note 8 — Fair Value Measurements GAAP establishes a hierarchy of valuation techniques based on the observability of inputs used in measuring financial instruments at fair value. GAAP establishes market-based or observable inputs as the preferred sources of values, followed by valuation models using management assumptions in the absence of market inputs. The three levels of the hierarchy are described below: Level 1 — Quoted prices in active markets for identical assets and liabilities that the reporting entity has the ability to access at the measurement date. Level 2 — Inputs other than quoted prices included within Level 1 that are observable for the asset and liability or can be corroborated with observable market data for substantially the entire contractual term of the asset or liability. Level 3 — Unobservable inputs that reflect the entity's own assumptions about the assumptions that market participants would use in the pricing of the asset or liability and are consequently not based on market activity, but rather through particular valuation techniques. The determination of where an asset or liability falls in the hierarchy requires significant judgment and considers factors specific to the asset or liability. In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company evaluates its hierarchy disclosures each quarter and depending on various factors, it is possible that an asset or liability may be classified differently from quarter to quarter. However, the Company expects that changes in classifications between levels will be rare. The Company's derivative instrument is measured at fair value on a recurring basis. Although the Company has determined that the majority of the inputs used to value its derivative fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with this derivative utilize Level 3 inputs, such as estimates of current credit spreads to evaluate the likelihood of default by the Company and its counterparty. However, as of September 30, 2017 , the Company has assessed the significance of the impact of the credit valuation adjustments on the overall valuation of its derivative position and has determined that the credit valuation adjustments are not significant to the overall valuation of the Company's derivative. As a result, the Company has determined that its derivative valuation in its entirety is classified in Level 2 of the fair value hierarchy. The valuation of derivative instruments is determined using a discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, as well as observable market-based inputs, including interest rate curves and implied volatilities. In addition, credit valuation adjustments are incorporated into the fair values to account for the Company's potential nonperformance risk and the performance risk of the counterparties. The Company had impaired real estate investments held for sale, which were carried at fair value on a non-recurring basis on the consolidated balance sheets as of September 30, 2017 and December 31, 2016 . Impaired real estate investments held for sale were valued using the sale price from the applicable LOI or PSA less costs to sell, which is an observable input. As a result, the Company's impaired real estate investments held for sale are classified in Level 2 of the fair value hierarchy. 22 AMERICAN FINANCE TRUST, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) The Company also had impaired real estate investments held for use, which were carried at fair value on a non-recurring basis on the consolidated balance sheet as of September 30, 2017 and December 31, 2016 . The Company recognized an aggregate impairment charge of $24.7 million during 2016 related to real estate investments held for use. During the three and nine months ended September 30, 2017 , the Company recognized additional impairment charges of $7.5 million and $9.7 million , respectively, related to real estate investments held for use. See Note 4 — Real Estate Investments for additional information on impairment charges incurred by the Company. The Company primarily used a market approach to estimate the future cash flows expected to be generated. This approach involved evaluating comparable sales of properties in the same geographic region as the SunTrust properties in order to generate an estimated sale price, which is an unobservable input. As a result, the impaired properties that the Company evaluated using this approach are classified in Level 3 of the fair value hierarchy. For some of the impaired properties, the Company had an executed LOI or PSA to sell the property. In those instances, the Company used the sale price from the applicable LOI or PSA to estimate the future cash flows expected to be generated, which is an observable input. As a result, the impaired properties that the Company evaluated using this approach are classified in Level 2 of the fair value hierarchy. The following table presents information about the Company's assets and liabilities measured at fair value on a recurring and non-recurring basis as of September 30, 2017 and December 31, 2016 , aggregated by the level in the fair value hierarchy within which those instruments fall. (In thousands) | Quoted Pricesin Active MarketsLevel 1 | | Significant OtherObservableInputsLevel 2 | | SignificantUnobservableInputsLevel 3 | | Total -----------------------------------------------+---------------------------------------+---+------------------------------------------+--------+--------------------------------------+--------+------- September 30, 2017 | | | | | | | | | | -----------------------------------------------+---------------------------------------+---+------------------------------------------+--------+--------------------------------------+--------+--------+---+--------+-- Impaired real estate investments held for sale | $ | — | | | $ | 573 | | $ | — | | $ | 573 -----------------------------------------------+---------------------------------------+---+------------------------------------------+--------+--------------------------------------+--------+--------+---+--------+---+---+------- Impaired real estate investments held for use | — | | | 25,457 | | | — | | 25,457 | -----------------------------------------------+---------------------------------------+---+------------------------------------------+--------+--------------------------------------+--------+--------+---+--------+-- Interest rate swap | — | | | (53 | ) | | — | | (53 | ) -----------------------------------------------+---------------------------------------+---+------------------------------------------+--------+--------------------------------------+--------+--------+---+--------+-- Total | $ | — | | | $ | 25,977 | | $ | — | | $ | 25,977 -----------------------------------------------+---------------------------------------+---+------------------------------------------+--------+--------------------------------------+--------+--------+---+--------+---+---+------- December 31, 2016 | | | | | | | -----------------------------------------------+---------------------------------------+---+------------------------------------------+--------+--------------------------------------+--------+------- Impaired real estate investments held for sale | $ | — | | | $ | 961 | | $ | — | | $ | 961 -----------------------------------------------+---------------------------------------+---+------------------------------------------+--------+--------------------------------------+--------+--------+---+--------+---+---+------- Impaired real estate Investments held for use | — | | | 6,525 | | | 45,032 | | 51,557 | -----------------------------------------------+---------------------------------------+---+------------------------------------------+--------+--------------------------------------+--------+--------+---+--------+-- Total | $ | — | | | $ | 7,486 | | $ | 45,032 | | $ | 52,518 -----------------------------------------------+---------------------------------------+---+------------------------------------------+--------+--------------------------------------+--------+--------+---+--------+---+---+------- A review of the fair value hierarchy classification is conducted on a quarterly basis. Changes in the type of inputs may result in a reclassification for certain assets and liabilities. The Company's policy with respect to transfers between levels of the fair value hierarchy is to recognize transfers into and out of each level as of the end of the reporting period. There were no transfers between levels of the fair value hierarchy during the nine months ended September 30, 2017 and 2016 . The Company is required to disclose the fair value of financial instruments for which it is practicable to estimate that value. The fair value of short-term financial instruments such as cash and cash equivalents, restricted cash, prepaid expenses and other assets, accounts payable and accrued expenses and distributions payable approximates their carrying value on the consolidated balance sheets due to their short-term nature. The fair values of the Company's remaining financial instruments that are not reported at fair value on the consolidated balance sheets as of September 30, 2017 and December 31, 2016 are reported in the following table: | | Carrying Amount at | | Fair Value at | Carrying Amount at | | Fair Value at --------------------------------------------------------+-------+--------------------+-----------+--------------------+--------------------+-----------+------------------ (In thousands) | Level | September 30, 2017 | | September 30, 2017 | December 31, 2016 | | December 31, 2016 --------------------------------------------------------+-------+--------------------+-----------+--------------------+--------------------+-----------+------------------ Commercial mortgage loan, held for investment | 3 | $ | 17,191 | | $ | 17,200 | | $ | 17,175 | $ | 17,200 --------------------------------------------------------+-------+--------------------+-----------+--------------------+--------------------+-----------+-------------------+---+-----------+---+---------- Gross mortgage notes payable and mortgage premiums, net | 3 | $ | 1,107,824 | | $ | 1,114,908 | | $ | 1,048,448 | $ | 1,076,065 --------------------------------------------------------+-------+--------------------+-----------+--------------------+--------------------+-----------+-------------------+---+-----------+---+---------- Credit facility | 3 | $ | 260,000 | | $ | 260,000 | | $ | — | $ | — --------------------------------------------------------+-------+--------------------+-----------+--------------------+--------------------+-----------+-------------------+---+-----------+---+---------- 23 AMERICAN FINANCE TRUST, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) The fair value of the commercial mortgage loan is estimated using a discounted cash flow analysis, based on the Advisor's experience with similar types of investments. The fair value of gross mortgage notes payable is based on combinations of independent third party estimates and management's estimates of market interest rates. Advances under the Amended Credit Facility are considered to be reported at fair value, because its interest rate varies with changes in LIBOR, and there has not been a significant change in credit risk of the Company or credit markets since assumption. Note 9 — Derivatives and Hedging Activities Risk Management Objective of Using Derivatives The Company may use derivative financial instruments, including interest rate swaps, caps, options, floors and other interest rate derivative contracts, to hedge all or a portion of the interest rate risk associated with its borrowings. The principal objective of such arrangements is to minimize the risks and costs associated with the Company's operating and financial structure as well as to hedge specific anticipated transactions. The Company does not intend to utilize derivatives for speculative or other purposes other than interest rate risk management. The use of derivative financial instruments carries certain risks, including the risk that the counterparties to these contractual arrangements are not able to perform under the agreements. To mitigate this risk, the Company only enters into derivative financial instruments with counterparties with high credit ratings and with major financial institutions with which the Company and its related parties may also have other financial relationships. The Company does not anticipate that any of the counterparties will fail to meet their obligations. Non-designated Hedges Changes in the fair value of derivatives not designated in hedging relationships are recorded directly in earnings. A gain of approximately $21,000 is included in interest expense on the consolidated statements of operations and comprehensive loss for the nine months ended September 30, 2017 . There was no gain or loss on non-designated hedging relationship during the three months ended September 30, 2017 . As of September 30, 2017 and December 31, 2016 , the Company did not have any derivatives that were not designated as hedges in qualifying hedging relationships. Cash Flow Hedges of Interest Rate Risk The Company's objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps and collars as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable-rate amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount. Interest rate collars designated as cash flow hedges involve the receipt of variable-rate amounts if interest rates rise above the cap strike rate on the contract and payments of variable-rate amounts if interest rates fall below the floor strike rate on the contract. The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in accumulated other comprehensive loss and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings. Amounts reported in accumulated other comprehensive loss related to derivatives will be reclassified to interest expense as interest payments are made on the Company's variable-rate debt. During the next twelve months, the Company estimates that approximately $45,000 will be reclassified from other comprehensive loss as a decrease to interest expense. As of September 30, 2017 , the Company had the following derivatives that were designated as cash flow hedges of interest rate risk. The Company had no derivatives outstanding as of December 31, 2016 : | September 30, 2017 -------------------------+--------------------- Interest Rate Derivative | Number ofInstruments | Notional Amount -------------------------+----------------------+---------------- | | (In thousands) -------------------------+----------------------+---------------- Interest Rate Swap | 1 | $ | 34,098 -------------------------+----------------------+-----------------+------- 24 AMERICAN FINANCE TRUST, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) The table below presents the fair value of the Company's derivative financial instruments as well as their classification on the accompanying consolidated balance sheet as of September 30, 2017 . The Company had no derivatives outstanding as of December 31, 2016 : (In thousands) | Balance Sheet Location | September 30, 2017 -----------------------------------------------+----------------------------+------------------- Derivatives designated as hedging instruments: | | -----------------------------------------------+----------------------------+------------------- Interest Rate Swap | Derivatives, at fair value | $ | (53 | ) -----------------------------------------------+----------------------------+--------------------+-----+-- The table below details the location in the financial statements of the gain or loss recognized on interest rate derivatives designated as cash flow hedges for the three and nine months ended September 30, 2017 . There was no gain or loss recognized on interest rate derivatives during the three and nine months ended September 30, 2016 : (In thousands) | Three Months Ended September 30, 2017 | | Nine Months Ended September 30, 2017 ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------------+----+------------------------------------- Amount of gain (loss) recognized in accumulated other comprehensive income on interest rate derivatives (effective portion) | $ | 1 | | 9 | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------------+----+--------------------------------------+---+---- Amount of gain (loss) reclassified from accumulated other comprehensive income into income as interest expense | $ | (9 | ) | $ | (35 | ) ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------------+----+--------------------------------------+---+-----+-- Amount of gain (loss) recognized in income on derivative (ineffective portion, reclassifications of missed forecasted transactions and amounts excluded from effectiveness testing) | $ | — | | $ | — | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------------------------------+----+--------------------------------------+---+-----+-- Credit-risk-related Contingent Features The Company has an agreement with its derivative counterparty that contains a provision where if the Company either defaults or is capable of being declared in default on any of its indebtedness, then the Company could also be declared in default on its derivative obligations. As of September 30, 2017 , the fair value of derivatives in a net liability position including accrued interest, but excluding any adjustment for nonperformance risk related to these agreements, was $0.1 million . As of September 30, 2017 , the Company has not posted any collateral related to these agreements and was not in breach of any agreement provisions. If the Company had breached any of these provisions, it could have been required to settle its obligations under the agreements at their aggregate termination value of $0.1 million at September 30, 2017 . Note 10 — Common Stock As of September 30, 2017 and December 31, 2016 , the Company had 104.6 million and 65.8 million shares of common stock outstanding, respectively, including unvested restricted shares and shares issued pursuant to the DRIP. In April 2013, the Company's board of directors authorized a monthly distribution equivalent to $1.65 per annum, per share of common stock. Effective July 1, 2017, the Company's board of directors authorized a decrease in the daily accrual of distributions to an annualized rate of $1.30 per annum, per share of common stock. Distributions are payable by the fifth day following each month end to stockholders of record at the close of business each day during the prior month. Distribution payments are dependent on the availability of funds. The board of directors may reduce the amount of distributions paid or suspend distribution payments at any time and therefore distributions payments are not assured. On March 17, 2017, the Company's board of directors approved an estimated net asset value per share of the Company's common stock ("Estimated Per-Share NAV") as of December 31, 2016, which was published on March 20, 2017. The Company intends to publish subsequent valuations of Estimated Per-Share NAV periodically at the discretion of the Company's board of directors, provided that such valuations will be made at least once annually. The Estimated Per-Share NAV does not represent: (1) the price at which the Company's common stock would trade on a national securities exchange or the per-share price a third party would pay to acquire the Company, (2) the amount a stockholder would obtain if he or she tried to sell his or her shares or (3) the amount stockholders would receive if the Company liquidated its assets and distributed the proceeds after paying all of its expenses and liabilities. In addition, the Estimated Per-Share NAV does not reflect events subsequent to December 31, 2016 that would have affected the Company's net asset value. In determining an Estimated Per-Share NAV as of December 31, 2016, the board of directors considered the Estimated Per-Share NAV increase from the Merger. As such, the board of directors concluded that the Estimated Per-Share NAV selected as of December 31, 2016 would not materially change as a result of the Merger. 25 AMERICAN FINANCE TRUST, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) Share Repurchase Program The Company's board of directors has authorized the Company to repurchase shares pursuant to its share repurchase program (as amended and restated, the "SRP"), which permits investors to sell their shares back to the Company after they have held them for at least one year, subject to certain conditions and limitations. The Company may repurchase shares on a semiannual basis, in its sole discretion, at each six-month period ending June 30 and December 31. On June 14, 2017, the Company announced that its board of directors had adopted an amendment and restatement of the SRP that superseded and replaced the existing SRP effective as of July 14, 2017. Under the amended and restated SRP, subject to certain conditions, only repurchase requests made following the death or qualifying disability of stockholders that purchased shares of the Company's common stock or received their shares from the Company (directly or indirectly) through one or more non-cash transactions would be considered for repurchase. Other terms and provisions of the amended and restated SRP remained consistent with the existing SRP. Under the SRP, prior to the amendment and restatement, the repurchase price per share for requests other than for death or disability was as follows: • | after one year from the purchase date — 92.5% of the then-current Estimated Per-Share NAV; --+------------------------------------------------------------------------------------------- • | after two years from the purchase date — 95.0% of the then-current Estimated Per-Share NAV; --+-------------------------------------------------------------------------------------------- • | after three years from the purchase date — 97.5% of the then-current Estimated Per-Share NAV; and --+-------------------------------------------------------------------------------------------------- • | after four years from the purchase date — 100.0% of the then-current Estimated Per-Share NAV. --+---------------------------------------------------------------------------------------------- In the case of requests for death or disability, the repurchase price per share is equal to Estimated Per-Share NAV applicable on the last day of the semiannual period, as described below. Under the SRP, repurchases at each semiannual period are limited to a maximum of 2.5% of the weighted-average number of shares of common stock outstanding during the previous fiscal year, with a maximum for any fiscal year of 5.0% of the weighted-average number of shares of common stock outstanding during the previous fiscal year. Repurchases pursuant to the SRP for any given semiannual period are funded from proceeds received during that same semiannual period through the issuance of common stock pursuant to the DRIP, as well as any funds reserved by the Company in the sole discretion of the board of directors. Repurchases are made at a price based on Estimated Per-Share NAV applicable on the last day of the semiannual period, as described above. The Company's board of directors reserves the right, in its sole discretion, at any time and from time to time, to reject any request for repurchase, change the purchase price for repurchases or otherwise amend the terms of, suspend or terminate the SRP pursuant to any applicable notice requirements under the SRP. Due to these limitations, the Company cannot guarantee that it will be able to accommodate all repurchase requests. When a stockholder requests repurchases and the repurchases are approved, the Company reclassifies such an obligation from equity to a liability based on the settlement value of the obligation. Shares repurchased have the status of authorized but unissued shares. The following table summarizes the repurchases of shares under the SRP cumulatively through September 30, 2017 : | Number of Shares | Weighted-Average Price per Share ------------------------------------------------+------------------+--------------------------------- Cumulative repurchases as of December 31, 2016 | 2,081,499 | | $ | 24.12 ------------------------------------------------+------------------+----------------------------------+-------+------ Three months ended March 31, 2017 | 848,822 | (1) | 23.85 | ------------------------------------------------+------------------+----------------------------------+-------+------ Three months ended June 30, 2017 | 6,084 | | 23.83 | ------------------------------------------------+------------------+----------------------------------+-------+------ Three months ended September 30, 2017 | 370,472 | (2) | 23.41 | ------------------------------------------------+------------------+----------------------------------+-------+------ Cumulative repurchases as of September 30, 2017 | 3,306,877 | | $ | 23.97 ------------------------------------------------+------------------+----------------------------------+-------+------ ___________________________________ (1) | Excludes rejected repurchase requests received during 2016 with respect to 5.9 million shares for $140.1 million at a weighted-average price per share of 23.65. ----+----------------------------------------------------------------------------------------------------------------------------------------------------------------- (2) | In July 2017, following the effectiveness of the amendment and restatement of the SRP, the Company's board of directors approved 100% of the repurchase requests made following the death or qualifying disability of stockholders during the period from January 1, 2017 to June 30, 2017. No repurchases have been or will be made with respect to requests received during 2017 that are not valid requests in accordance with the amended and restated SRP. ----+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 26 AMERICAN FINANCE TRUST, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) Distribution Reinvestment Plan Pursuant to the DRIP, the Company's stockholders may elect to reinvest distributions by purchasing shares of common stock. The DRIP was suspended following the payment of the Company's June 2015 distribution on July 1, 2015. On April 1, 2016, the Company reinstated the DRIP and registered an additional 7.7 million shares of common stock, offered at the then-current Estimated Per-Share NAV , for use under the DRIP pursuant to a registration statement on Form S-3 (File No. 333-210532). On August 30, 2016, in consideration of the Merger, the Company's board of directors determined to suspend the DRIP effective immediately. Following the effectiveness of the joint proxy statement/prospectus relating to the Mergers on December 16, 2016, the Company reinstated the DRIP. No dealer manager fees or selling commissions are paid with respect to shares purchased pursuant to the DRIP. Shares issued pursuant to the DRIP are recorded within equity in the accompanying consolidated balance sheets in the period distributions are declared. During the nine months ended September 30, 2017 , 1.8 million shares of common stock were issued pursuant to the DRIP. Note 11 — Commitments and Contingencies Future Minimum Ground Lease Payments The Company entered into ground lease agreements related to certain acquisitions under leasehold interest arrangements. The following table reflects the minimum base cash rental payments due from the Company over the next five years and thereafter: (In thousands) | Future Minimum Base Rent Payments -------------------------------------+---------------------------------- October 1, 2017 to December 31, 2017 | $ | 361 -------------------------------------+-----------------------------------+------- 2018 | 1,427 | -------------------------------------+-----------------------------------+------- 2019 | 1,437 | -------------------------------------+-----------------------------------+------- 2020 | 1,219 | -------------------------------------+-----------------------------------+------- 2021 | 901 | -------------------------------------+-----------------------------------+------- Thereafter | 13,450 | -------------------------------------+-----------------------------------+------- | $ | 18,795 -------------------------------------+-----------------------------------+------- Litigation and Regulatory Matters On January 13, 2017, four affiliated stockholders of RCA filed in the United States District Court for the District of Maryland a putative class action lawsuit against the Company, Edward M. Weil, Jr., Leslie D. Michelson, Edward G. Rendell (Weil, Michelson and Rendell, the “Director Defendants”), AR Global, and the Company, alleging violations of Sections 14(a) of the Securities Exchange Act of 1934 (the “Exchange Act”) by RCA and the Director Defendants, violations of Section 20(a) of the Exchange Act by AR Global and the Director Defendants, breaches of fiduciary duty by the Director Defendants, and aiding and abetting breaches of fiduciary duty by AR Global and the Company in connection with the negotiation of and proxy solicitation for a shareholder vote on the proposed merger of the Company and RCA and an amendment to RCA's charter. The complaint sought on behalf of the putative class rescission of the merger transaction, which was voted on and approved by stockholders on February 13, 2017, and closed on February 16, 2017, together with unspecified rescissory damages, unspecified actual damages, and costs and disbursements of the action. On April 26, 2017, the Court appointed a lead plaintiff. Lead plaintiff, along with other stockholders of RCA, filed an amended complaint on June 19, 2017. The Amended Complaint named additional individuals and entities as defendants (David Gong, Stanley Perla, Lisa Kabnick ("Additional Director Defendants"), Nicholas Radesca and American Realty Capital Retail Advisor, LLC), added counts under Sections 11, 12(a)(2) and 15 of the Securities Act of 1933 in connection with the Registration Statement for the proposed merger, under Section 13(e) of the Exchange Act, and counts for breach of contract and unjust enrichment, and dropped the demand for rescission (while maintaining the demand for rescissory damages). The Company, the Director Defendants, the Additional Director Defendants and Nicholas Radesca deny wrongdoing and liability and intend to vigorously defend the action. Due to the early stage of the litigation, no estimate of a probable loss or any reasonable possible losses are determinable at this time. No provisions for such losses have been recorded in the accompanying consolidated financial statements for the three and nine months ended September 30, 2017 . There are no other material legal or regulatory proceedings pending or known to be contemplated against the Company. 27 AMERICAN FINANCE TRUST, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) Environmental Matters In connection with the ownership and operation of real estate, the Company may potentially be liable for costs and damages related to environmental matters. The Company maintains environmental insurance for its properties that provides coverage for potential environmental liabilities, subject to the policy's coverage conditions and limitations. The Company has not been notified by any governmental authority of any non-compliance, liability or other claim, and is not aware of any other environmental condition that it believes will have a material adverse effect on its financial position or results of operations. Note 12 — Related Party Transactions and Arrangements As of September 30, 2017 and December 31, 2016 , American Finance Special Limited Partner, LLC (the "Special Limited Partner"), an entity controlled by the Sponsor, owned 8,888 shares of the Company's outstanding common stock and owned 30,691 and 90 units, respectively, of OP Units. After holding the OP Units for a period of one year, or upon liquidation of the OP or sale of substantially all of the assets of the OP, holders of OP Units have the right to convert OP Units for the cash value of a corresponding number of shares of the Company's common stock or, at the option of the OP, a corresponding number of shares of the Company's common stock, in accordance with the limited partnership agreement of the OP. The remaining rights of the limited partner interests are limited, however, and do not include the ability to replace the general partner or to approve the sale, purchase or refinancing of the OP's assets. Realty Capital Securities, LLC (the " Former Dealer Manager ") served as the dealer manager of the IPO. American National Stock Transfer, LLC ("ANST"), a subsidiary of the parent company of the Former Dealer Manager, provided other general professional services through January 2016. RCS Capital Corporation ("RCAP"), the parent company of the Former Dealer Manager and certain of its affiliates that provided services to the Company, filed for Chapter 11 bankruptcy protection in January 2016, prior to which it was under common control with the Sponsor. In May 2016, RCAP and its affiliated debtors emerged from bankruptcy under the new name, Aretec Group, Inc. On March 8, 2017, the creditor trust established in connection with the RCAP bankruptcy filed suit against the Sponsor, the Advisor, advisors of other entities sponsored by the Sponsor, and the Sponsor’s principals (including Edward M. Weil, Jr.). The suit alleges, among other things, certain breaches of duties to RCAP. The Company is not named in the suit, nor are there any allegations related to the services the Advisor provides to the Company. On May 26, 2017, the defendants moved to dismiss. The Advisor has informed the Company that it believes that the suit is without merit and intends to defend against it vigorously. Fees and Participations Incurred in Connection With the Operations of the Company On April 29, 2015 , the independent directors of the board of directors unanimously approved certain amendments to the Amended and Restated Advisory Agreement, as amended (the "Original A&R Advisory Agreement"), by and among the Company, the OP and the Advisor (the "Second A&R Advisory Agreement"). The Second A&R Advisory Agreement, which superseded the Original A&R Advisory Agreement, took effect on July 20, 2015 , the date on which the Company filed certain changes to the Company's charter, which were approved by the Company's stockholders on June 23, 2015 . The initial term of the Second A&R Advisory Agreement of 20 years began on April 29, 2015, and is automatically renewable for another 20-year term upon each 20-year anniversary unless terminated by the board of directors for cause. On September 6, 2016, the date of the Merger Agreement, the Company entered into an amendment and restatement of the Second A&R Advisory Agreement (the "Third A&R Advisory Agreement"), which became effective upon the Effective Time of the Mergers. Under the Third A&R Advisory Agreement, the Company has the right to internalize the services and terminate the Advisory Agreement, referred to as an “internalization,” after January 1, 2018 as long as (1) more than 67% of the Company’s independent directors approve the internalization; (2) the Company provides written notice to the Advisor; and (3) the Company pays the Advisor a fee equal to (a) $15.0 million plus (b) either (x) if the internalization occurs on or before December 31, 2028, the Subject Fees (defined below) multiplied by 4.5 or (y) if the internalization occurs on or after January 1, 2029, the Subject Fees multiplied by 3.5 plus (c)(x) 1% of the purchase price (excluding the portion of the purchase price funded with equity proceeds raised prior to the end of the fiscal quarter in which the notice of election occurs) of each acquisition or merger that occurs between the end of the fiscal quarter in which notice is given and the internalization and (y) without duplication, 1% of the amount of new equity raised by the Company between the end of the fiscal quarter in which notice is given and the internalization. Subject Fees means (I) (A) all amounts payable pursuant to the Advisory Agreement and the property management and leasing agreement (the "Property Management Agreement") with the Property Manager for the fiscal quarter in which notice occurs multiplied by (B) four plus (II) without duplication, the annual increase in the base management fee resulting from the amount of new equity raised by the Company within the fiscal quarter in which notice occurs, as described above. The initial term of the Third A&R Advisory Agreement, which commenced upon the Effective Time, extends to April 29, 2035, and is automatically renewable for another 20 -year term upon each 20 -year anniversary. 28 AMERICAN FINANCE TRUST, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) On September 6, 2016, the date of the Merger Agreement, the Company entered into an amendment and restatement of the agreement of limited partnership of the OP (the “A&R OP Agreement”), which became effective upon the Effective Time. The A&R OP Agreement makes certain changes to the provisions of the partnership agreement relating to (a) distributions of net sales proceeds and the Termination Note (as defined in the A&R OP Agreement) issuable on termination of the Third A&R Advisory Agreement to address the issuance of shares of the Company’s common stock pursuant to the Merger and in future transactions; (b) internalization of the Advisor’s services after the Effective Time pursuant to the conditions in the Third A&R Advisory Agreement; and (c) certain matters related to changes in the Third A&R Advisory Agreement. Prior to January 16, 2016 , the Advisor was paid an acquisition fee equal to 1.0% of the contract purchase price of each acquired property and 1.0% of the amount advanced for a loan or other investment. The Advisor also has been and may continue to be reimbursed for costs it incurs in providing investment-related services, or "insourced expenses." These insourced expenses may not exceed 0.5% of the contract purchase price of each acquired property and 0.5% of the amount advanced for a loan or other investment. Additionally, the Company has paid and may continue to pay third party acquisition expenses. The aggregate amount of acquisition fees and financing coordination fees (as described below) were not to exceed 1.5% of the contract purchase price and the amount advanced for a loan or other investment for all the assets acquired. The Second A&R Advisory Agreement terminated the acquisition fee and financing coordination fee (both as defined in the Second A&R Advisory Agreement) effective January 16, 2016 . As of January 16, 2016 , aggregate acquisition fees and financing coordination fees did not exceed the 1.5% threshold. Further, the total of all acquisition fees, acquisition expenses and any financing coordination fees payable was not to exceed 4.5% of the Company's total portfolio contract purchase price or 4.5% of the amount advanced for the Company's total portfolio of loans or other investments. As of January 16, 2016 , the total of all cumulative acquisition fees, acquisition expenses and financing coordination fees did not exceed the 4.5% threshold. Additionally, prior to January 16, 2016 , if the Advisor provided services in connection with the origination or refinancing of any debt that the Company obtained and used to acquire properties or to make other permitted investments, or that was assumed, directly or indirectly, in connection with the acquisition of properties, the Company paid the Advisor a financing coordination fee equal to 0.75% of the amount available and/or outstanding under such financing, subject to certain limitations. Prior to April 15, 2015, in connection with asset management services provided by the Advisor, the Company issued to the Advisor an asset management subordinated participation by causing the OP to issue (subject to periodic approval by the board of directors) to the Advisor performance-based restricted, forfeitable partnership units of the OP designated as "Class B Units." The Class B Units were intended to be profit interests that would vest, and no longer be subject to forfeiture, at such time as: (a) the value of the OP's assets plus all distributions made by the Company equals or exceeds the total amount of capital contributed by investors plus a 6.0% cumulative, pretax, non-compounded annual return thereon (the "economic hurdle"); (b) any one of the following events occurs concurrently with or subsequently to the achievement of the economic hurdle described above: (i) a listing; (ii) a transaction to which the Company or the OP is a party, as a result of which OP Units or the Company's common stock are exchanged for, or converted into, the right, or the holders of such securities are otherwise entitled, to receive cash, securities or other property or any combination thereof; or (iii) the termination of the advisory agreement without cause; and (c) the Advisor pursuant to the advisory agreement is providing services to the Company immediately prior to the occurrence of an event of the type described in clause (b) above, unless the failure to provide such services is attributable to the termination without cause of the advisory agreement by an affirmative vote of a majority of the Company's independent directors after the economic hurdle described above has been met. Unvested Class B Units will be forfeited immediately if: (x) the advisory agreement is terminated for any reason other than a termination without cause; or (y) the advisory agreement is terminated without cause by an affirmative vote of a majority of the board of directors before the economic hurdle described above has been met. As of September 30, 2017 , in aggregate, the Company's board of directors had approved the issuance of 1,052,420 Class B Units to the Advisor in connection with the arrangement described above. As of September 30, 2017 , the Company could not determine the probability of achieving the performance condition, as such, no expense was recognized in connection with this arrangement during the nine months ended September 30, 2017 and 2016 . The Advisor receives distributions on unvested Class B Units equal to the distribution amount received on the same number of shares of the Company's common stock. Such distributions on issued Class B Units are included in general and administrative expenses in the consolidated statements of operations and comprehensive loss. Pursuant to an amendment (the "Amendment") to the Original A&R Advisory Agreement entered into in April 2015, the OP will not issue any further Class B Units. The changes made pursuant to the Amendment were incorporated into the Agreement of Limited Partnership of the OP (the "OP Agreement") through a Third Amendment to the OP Agreement, which was approved by the board of directors and entered into on April 29, 2015 . 29 AMERICAN FINANCE TRUST, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) Under the Second A&R Advisory Agreement, the Company was required to pay a fixed base management fee of $18.0 million annually. Under the Third A&R Advisory Agreement, the fixed portion of the base management fee increased from $18.0 million annually to (i) $21.0 million annually for the first year following the Effective Time; (ii) $22.5 million annually for the second year following the Effective Time; and (iii) $24.0 million annually for the remainder of the term. If the Company acquires (whether by merger, consolidation or otherwise) any REIT, other than RCA, that is advised by an entity that is wholly-owned, directly or indirectly, by AR Global, other than any joint ventures, (a "Specified Transaction"), the fixed portion of the base management fee will be increased by an amount equal to the consideration paid for the acquired company's equity multiplied by 0.0031 , 0.0047 and 0.0062 for years one, two and three and thereafter, respectively, following the Specified Transaction. The variable portion of the base management fee changed from a quarterly fee equal to 0.375% of the cumulative net proceeds of any equity raised after the Company lists its common stock on a national securities exchange to a monthly fee equal to one-twelfth of 1.25% of the cumulative net proceeds of any equity raised by the Company or its subsidiaries from and after the Effective Time. Base management fees are included in asset management fees to related party on the consolidated statements of operations and comprehensive loss for the three and nine months ended September 30, 2017 and 2016 . In addition, under the Third A&R Advisory Agreement, the Company is required to pay the Advisor a variable management fee equal to (x) 15.0% of the applicable quarter's Core Earnings (as defined below) per share in excess of $0.375 per share plus (y) 10.0% of the applicable quarter's Core Earnings per share in excess of $0.50 per share, in each case as adjusted for changes in the number of shares of common stock outstanding. Core Earnings are defined as, for the applicable period, GAAP net income or loss excluding non-cash equity compensation expense, the variable management fee, acquisition and transaction related fees and expenses, financing related fees and expenses, depreciation and amortization, realized gains and losses on the sale of assets, any unrealized gains, losses or other non-cash items recorded in net loss for the period, regardless of whether such items are included in other comprehensive income or loss, or in net income, one-time events pursuant to changes in GAAP and certain non-cash charges, impairment losses on real estate related investments and other than temporary impairment of securities, amortization of deferred financing costs, amortization of tenant inducements, amortization of straight-line rent, amortization of market lease intangibles, provision for loss loans, and other non-recurring revenue and expenses. The Company did not incur a variable management fee during the three and nine months ended September 30, 2017 and 2016 . On September 6, 2016, the RCA Advisor, as RCA’s former property manager and leasing agent, assigned RCA’s existing property management agreement (the "Target Property Management Agreement") and existing leasing agreement (the "Target Leasing Agreement") to the Property Manager, in respect of (1) the properties owned by RCA prior to the Merger, and (2) any existing anchored, stabilized core retail properties, such as power centers and lifestyle centers, acquired by the Company after the Effective Time and during the term of the Target Property Management Agreement and the Target Leasing Agreement, (collectively, the "Target Properties"). The Target Property Management Agreement and the Target Leasing Agreement became effective at the Effective Time. In connection with the Merger Agreement, the Target Property Management Agreement and the Target Leasing Agreement, the Company has entered into an amended and restated the Property Management Agreement in respect of (1) the properties owned by the Company prior to the Merger and (2) any double- and triple-net leased single tenant properties acquired by the Company after the Effective Time and during the term of the Property Management Agreement (collectively, the "Company Properties" and together with the Target Properties, the "Properties"). The Property Management Agreement became effective at the Effective Time. The Target Property Management Agreement provides that the Property Manager is entitled to a management fee equal to 4% of the gross rental receipts from the Target Properties, including common area maintenance reimbursements, tax and insurance reimbursements, percentage rental payments, utility reimbursements, late fees, vending machine collections, service charges, rental interruption insurance, and a 15% administrative charge for common area expenses. In addition, the Property Manager is entitled to transition fees of up to $2,500 for each Target Property managed, a construction fee equal to 6% of construction costs incurred, if any, and reimbursement of all expenses specifically related to the operation of a Target Property, including compensation and benefits of property management, accounting, lease administration, executive and supervisory personnel of the Property Manager, and excluding expenses of the Property Manager’s corporate and general management office and excluding compensation and other expenses applicable to time spent on matters other than the Target Properties. The Target Property Management Agreement, the Target Leasing Agreement and the Property Management Agreement each have an initial term ending October 1, 2018, with automatic renewal for successive one-year terms unless terminated 60 days prior to the end of a term or terminated for cause due to material breach of the agreement, fraud, criminal conduct or willful misconduct, insolvency or bankruptcy of the Property Manager. 30 AMERICAN FINANCE TRUST, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) The Company reimburses the Advisor's costs of providing administrative services. During the three and nine months ended September 30, 2017 , the Company incurred $1.9 million and $5.4 million , respectively of reimbursement expenses from the Advisor for providing administrative services. During the three and nine months ended September 30, 2016 , the company incurred $0.8 million and $2.2 million , respectively, of reimbursement expenses from the Advisor for providing administrative services. These reimbursements are included in general and administrative expense on the consolidated statements of operations and comprehensive loss. In order to improve operating cash flows and the ability to pay distributions from operating cash flows, the Advisor may elect to forgive certain fees. Because the Advisor may forgive certain fees, cash flows from operations that would have been paid to the Advisor may be available to pay distributions to stockholders. The fees that are forgiven are not deferrals and, accordingly, will not be paid to the Advisor. In certain instances, to improve the Company's working capital, the Advisor may elect to absorb a portion of the Company's general and administrative costs or property operating costs. No such fees were forgiven or costs were absorbed by the Advisor during the three and nine months ended September 30, 2017 and 2016 . The following table details amounts incurred and payable to related parties in connection with the operations-related services described above as of and for the periods presented. Amounts below are inclusive of fees and other expense reimbursements incurred from and due to the Advisor that are passed through and ultimately paid to Lincoln as a result of the Advisor's exclusive service agreement with Lincoln: | Three Months Ended September 30, | | Nine Months Ended September 30, | | Payable as of ------------------------------------------------------+----------------------------------+-------+---------------------------------+-------+-------------- (In thousands) | 2017 | | 2016 | | 2017 | | 2016 | September 30, 2017 | | December 31, 2016 ------------------------------------------------------+----------------------------------+-------+---------------------------------+-------+---------------+-------+--------+--------------------+--------+------------------ One-time fees and reimbursements: | | | | | | | | | | ------------------------------------------------------+----------------------------------+-------+---------------------------------+-------+---------------+-------+--------+--------------------+--------+------------------ Acquisition fees and related cost reimbursements | $ | 49 | | | $ | — | | $ | 100 | | $ | — | | $ | 31 | $ | — ------------------------------------------------------+----------------------------------+-------+---------------------------------+-------+---------------+-------+--------+--------------------+--------+-------------------+-------+--------+-----+---+-------+---+---- Ongoing fees: | | | | | | | | | | ------------------------------------------------------+----------------------------------+-------+---------------------------------+-------+---------------+-------+--------+--------------------+--------+------------------ Asset management fees | 5,250 | | | 4,500 | | | 15,250 | | 13,500 | | — | | — | ------------------------------------------------------+----------------------------------+-------+---------------------------------+-------+---------------+-------+--------+--------------------+--------+-------------------+-------+--------+-----+-- Property management and leasing fees | 1,965 | | | — | | | 4,788 | | — | | 570 | | — | ------------------------------------------------------+----------------------------------+-------+---------------------------------+-------+---------------+-------+--------+--------------------+--------+-------------------+-------+--------+-----+-- Professional fees and other reimbursements (1) | 2,136 | | | 780 | | | 5,963 | | 2,303 | | 1,085 | | 763 | ------------------------------------------------------+----------------------------------+-------+---------------------------------+-------+---------------+-------+--------+--------------------+--------+-------------------+-------+--------+-----+-- Distributions on Class B Units (1) | 345 | | | 436 | | | 1,206 | | 1,300 | | 112 | | 147 | ------------------------------------------------------+----------------------------------+-------+---------------------------------+-------+---------------+-------+--------+--------------------+--------+-------------------+-------+--------+-----+-- Total related party operation fees and reimbursements | $ | 9,745 | | | $ | 5,716 | | $ | 27,307 | | $ | 17,103 | | $ | 1,798 | $ | 910 ------------------------------------------------------+----------------------------------+-------+---------------------------------+-------+---------------+-------+--------+--------------------+--------+-------------------+-------+--------+-----+---+-------+---+---- _________________________________ (1) | These costs are included in general and administrative expense on the consolidated statements of operations and comprehensive loss. ----+------------------------------------------------------------------------------------------------------------------------------------ The predecessor to AR Global was party to a services agreement with RCS Advisory Services, LLC ("RCS Advisory"), a subsidiary of RCAP, pursuant to which RCS Advisory and its affiliates provided the Company and certain other companies sponsored by AR Global with services (including, without limitation, transaction management, compliance, due diligence, event coordination and marketing services, among others) on a time and expenses incurred basis or at a flat rate based on services performed. The predecessor to AR Global instructed RCS Advisory to stop providing such services in November 2015 and no services have since been provided by RCS Advisory. The Company was also party to a transfer agency agreement with ANST, a subsidiary of RCAP, pursuant to which ANST provided the Company with transfer agency services (including broker and stockholder servicing, transaction processing, year-end IRS reporting and other services), and supervisory services overseeing the transfer agency services performed by DST Systems, Inc. ("DST"), a third-party transfer agent. The Sponsor received written notice from ANST on February 10, 2016 that it would wind down operations by the end of the month and would withdraw as the transfer agent effective February 29, 2016. On February 26, 2016, the Company entered into a definitive agreement with DST to provide the Company directly with transfer agency services (including broker and stockholder servicing, transaction processing, year-end IRS reporting and other services). 31 AMERICAN FINANCE TRUST, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) Fees Incurred in Connection with the Liquidation or Listing of the Company's Real Estate Assets In connection with the Listing, the Company, as the general partner of the OP, would cause the OP to issue a note (the "Listing Note") to the Special Limited Partner to evidence the OP's obligation to distribute to the Special Limited Partner an aggregate amount (the "Listing Amount") equal to 15.0% of the difference (to the extent the result is a positive number) between: • | the sum of (i) the "market value" (as defined in the Listing Note) of the Company's common stock plus (ii) the sum of all distributions or dividends (from any source) paid by the Company to its stockholders prior to the Listing; and --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | the sum of (i) the gross proceeds ("Gross Proceeds") of all public and private offerings, including issuance of the Company's common stock pursuant to a merger or business combination (an "Offering") plus (ii) the total amount of cash that, if distributed to those stockholders who purchased shares of common stock in an Offering, would have provided those stockholders a 6.0% cumulative, non-compounded, pre-tax annual return (based on a 365-day year) on the Gross Proceeds. --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- The "market value" used to calculate the Listing Amount will not be determinable until the end of a measurement period, the period of 30 consecutive trading days, commencing on the 180th day following the Listing, unless another liquidity event, such as a merger, occurs prior to the end of the measurement period. If another liquidity event occurs prior to the end of the measurement period, the Listing Note provides for appropriate adjustment to the calculation of the Listing Amount. The Special Limited Partner will have the right to receive distributions of "Net Sales Proceeds," as defined in the Listing Note, until the Listing Note is paid in full; provided that, the Special Limited Partner has the right, but not the obligation, to convert the entire Special Limited Partner interest into OP Units. OP Units are convertible into shares of the Company's common stock in accordance with the terms governing conversion of OP Units into shares of common stock and contained in the form of amended and restated agreement of limited partnership of the OP to be entered into in connection with the Listing, by the Company, as general partner of its OP, with the limited partners party thereto (the "Second A&R OP Agreement"). On April 29, 2015 , the board of directors authorized the execution, in conjunction with the potential Listing, the Second A&R OP Agreement to conform more closely with agreements of limited partnership of other operating partnerships controlled by real estate investment trusts whose securities are publicly traded and listed, and to add long term incentive plan units ("LTIP Units") as a new class of units of limited partnership in the OP to the existing OP Units. The Company may at any time cause the OP to issue LTIP Units pursuant to an outperformance agreement. On April 29, 2015 , the board of directors approved the general terms of a Multi-Year Outperformance Agreement to be entered into with the Company, the OP and the Advisor in connection with the Listing. Under the Original A&R Advisory Agreement, the Advisor was paid a brokerage commission on the sale of property, not to exceed the lesser of 2.0% of the contract sale price of the property and one-half of the total brokerage commission paid, if a third-party broker was also involved; provided, however, that in no event could the real estate commissions paid to the Advisor, its affiliates and unaffiliated third parties exceed the lesser of 6.0% of the contract sales price and a reasonable, customary and competitive real estate commission, in each case, payable to the Advisor if the Advisor or its affiliates, as determined by a majority of the independent directors, provided a substantial amount of services in connection with the sale. No such commissions were incurred during the three and nine months ended September 30, 2017 and 2016 . The Second A&R Advisory Agreement terminated the brokerage commission to the Advisor. Note 13 — Economic Dependency Under various agreements, the Company has engaged or will engage the Advisor, its affiliates and entities under common control with the Advisor to provide certain services that are essential to the Company, including asset management services, supervision of the management and leasing of properties owned by the Company, asset acquisition and disposition decisions, as well as other administrative responsibilities for the Company including accounting and legal services, human resources and information technology. As a result of these relationships, the Company is dependent upon the Advisor and its affiliates. In the event that these companies are unable to provide the Company with the respective services, the Company will be required to find alternative providers of these services. 32 AMERICAN FINANCE TRUST, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) Note 14 — Share-Based Compensation Restricted Share Plan The Company had an employee and director incentive restricted share plan (the "Original RSP"), which provided for the automatic grant of 1,333 restricted shares to each of the independent directors, without any further action by the Company's board of directors or the stockholders, on the date of initial election to the board of directors and on the date of each annual stockholders' meeting. Restricted shares issued to independent directors vested over a five -year period following the date of grant in increments of 20.0% per annum. The Original RSP provided the Company with the ability to grant awards of restricted shares to the Company's directors, officers and employees (if the Company ever has employees), employees of the Advisor and its affiliates, employees of entities that provide services to the Company, directors of the Advisor or of entities that provide services to the Company, certain consultants to the Company and the Advisor and its affiliates or to other entities that provide services to the Company. The total number of shares of common stock granted under the Original RSP could not exceed 5.0% of the Company's shares of common stock on a fully diluted basis at any time, and in any event could not exceed 3.4 million shares (as such number may be adjusted for stock splits, stock dividends, combinations and similar events). Restricted share awards entitle the recipient to receive shares of common stock from the Company under terms that provide for vesting over a specified period of time. For restricted share awards granted prior to 2015, such awards would typically be forfeited with respect to the unvested restricted shares upon the termination of the recipient's employment or other relationship with the Company. Restricted share awards granted during or after 2015 provide for accelerated vesting of the portion of the unvested restricted shares scheduled to vest in the year of the recipient's voluntary termination or the failure to be re-elected to the board. The Company accounts for forfeitures when they occur. Restricted shares may not, in general, be sold or otherwise transferred until restrictions are removed and the shares have vested. Holders of restricted shares may receive cash distributions prior to the time that the restrictions on the restricted shares have lapsed. Any distributions payable in shares of common stock are subject to the same restrictions as the underlying restricted shares. In April 2015 , the board of directors adopted an Amended and Restated RSP (the "A&R RSP") that replaced in its entirety the Original RSP. The A&R RSP amended the terms of the Original RSP as follows: • | it increased the number of shares of the Company's common stock, available for awards thereunder from 5.0% of the Company's outstanding shares of common stock on a fully diluted basis at any time, not to exceed 3.4 million shares of common stock, to 10.0% of the Company's outstanding shares of common stock on a fully diluted basis at any time; --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | it removes the fixed amount of shares that were automatically granted to the Company's independent directors; and --+------------------------------------------------------------------------------------------------------------------ • | it adds restricted stock units ("RSUs" and, together with restricted shares, "restricted stock") (including dividend equivalent rights thereon) as a permitted form of award. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ As of September 30, 2017 , the Company had not yet made any RSU awards. The following table reflects restricted share award activity for the nine months ended September 30, 2017 : | Number of Shares of Common Stock | | Weighted-Average Issue Price -----------------------------+----------------------------------+---+----------------------------- Unvested, December 31, 2016 | 9,367 | | | $ | 23.70 -----------------------------+----------------------------------+---+------------------------------+-------+------ Granted | 8,897 | | | 23.59 | -----------------------------+----------------------------------+---+------------------------------+-------+------ Vested | (2,556 | ) | | 23.47 | -----------------------------+----------------------------------+---+------------------------------+-------+------ Unvested, September 30, 2017 | 15,708 | | | $ | 24.00 -----------------------------+----------------------------------+---+------------------------------+-------+------ As of September 30, 2017 , the Company had $0.3 million of unrecognized compensation cost related to unvested restricted stock awards granted. That cost is expected to be recognized over a weighted-average period of 3.0 years . The fair value of the restricted shares is being expensed in accordance with the service period required. Compensation expense related to restricted shares was approximately $53,000 and $31,000 for the three months ended September 30, 2017 and 2016 , respectively. Compensation expense related to restricted shares was approximately $102,000 and $52,000 for the nine months ended September 30, 2017 and 2016 , respectively. Compensation expense related to restricted shares is included in general and administrative expense on the accompanying consolidated statements of operations and comprehensive loss. 33 AMERICAN FINANCE TRUST, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) Other Share-Based Compensation The Company may issue common stock in lieu of cash to pay fees earned by the Company's directors at each director's election. There are no restrictions on the shares issued since these payments in lieu of cash relate to fees earned for services performed. There were no shares of common stock issued to directors in lieu of cash compensation during the nine months ended September 30, 2017 and 2016 . Note 15 — Net Loss Per Share The following table sets forth the basic and diluted net loss per share computations for the three and nine months ended September 30, 2017 and 2016 : | Three Months Ended September 30, | | Nine Months Ended September 30, ------------------------------------------------------------------+----------------------------------+---------+-------------------------------- (In thousands, except share and per share amounts) | 2017 | | 2016 | | 2017 | | 2016 ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+----------- Basic and diluted net loss attributable to stockholders | $ | (15,367 | ) | | $ | (8,729 | ) | $ | (27,105 | ) | $ | (18,660 | ) ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+------------+---+------------+---+---+---------+-- Basic and diluted weighted-average shares outstanding | 104,545,591 | | | 65,741,735 | | | 97,852,337 | | 65,334,465 | ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+------------+---+------------+-- Basic and diluted net loss per share attributable to stockholders | $ | (0.15 | ) | | $ | (0.13 | ) | $ | (0.28 | ) | $ | (0.29 | ) ------------------------------------------------------------------+----------------------------------+---------+---------------------------------+------------+------+--------+------------+---+------------+---+---+---------+-- Diluted net loss per share assumes the conversion of all common stock equivalents into an equivalent number of shares of common stock, unless the effect is antidilutive. The Company considers unvested restricted stock, OP Units and Class B Units to be common share equivalents. The Company had the following common share equivalents on a weighted-average basis that were excluded from the calculation of diluted net loss per share as their effect would have been antidilutive for the periods presented: | Three Months Ended September 30, | Nine Months Ended September 30, -------------------------------------------------------------+----------------------------------+-------------------------------- | 2017 | 2016 | | 2017 | 2016 -------------------------------------------------------------+----------------------------------+---------------------------------+-----------+------+---------- Unvested restricted stock (1) | 14,404 | | 8,381 | | 12,030 | 7,521 -------------------------------------------------------------+----------------------------------+---------------------------------+-----------+------+-----------+---------- OP Units (2) | 203,612 | | 90 | | 169,319 | 90 -------------------------------------------------------------+----------------------------------+---------------------------------+-----------+------+-----------+---------- Class B Units | 1,052,420 | | 1,052,420 | | 1,052,420 | 1,052,420 -------------------------------------------------------------+----------------------------------+---------------------------------+-----------+------+-----------+---------- Total weighted-average antidilutive common share equivalents | 1,270,436 | | 1,060,891 | | 1,233,769 | 1,060,031 -------------------------------------------------------------+----------------------------------+---------------------------------+-----------+------+-----------+---------- _____________________________________ (1) | Weighted-average number of shares of unvested restricted stock outstanding for the period presented. There were 15,710 and 9,367 shares of unvested restricted stock outstanding as of September 30, 2017 and 2016, respectively. ----+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (2) | Weighted-average number of OP Units outstanding for the period presented. There were 203,612 and 90 OP Units outstanding as of September 30, 2017 and 2016, respectively. ----+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Note 16 — Subsequent Events The Company has evaluated subsequent events through the filing of this Quarterly Report on Form 10-Q , and determined that there have not been any events that have occurred that would require adjustments to, or disclosures in, the consolidated financial statements except for the following disclosures: 34 AMERICAN FINANCE TRUST, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) Election of Katie P. Kurtz as Chief Financial Officer, Secretary and Treasurer On October 5, 2017, Nicholas Radesca notified the Company's board of directors that he intends to retire and therefore resign from his positions as chief financial officer, secretary and treasurer of the Company, the Advisor and the Property Manager. Mr. Radesca's resignations will be effective on the later of (i) November 15, 2017 and (ii) the day after the Company files its Quarterly Report on Form 10-Q for the quarter ended September 30, 2017. There were no disagreements between Mr. Radesca and the Company or the Advisor. On October 9, 2017, the Company's board of directors unanimously elected Katie P. Kurtz as chief financial officer, secretary and treasurer of the Company, effective upon the effectiveness of Mr. Radesca's resignations. Ms. Kurtz has also been appointed as chief financial officer, secretary and treasurer of the Advisor and the Property Manager, effective upon the effectiveness of Mr. Radesca's resignation. Acquisitions From October 1, 2017 to November 13, 2017 , the Company acquired 28 properties with an aggregate base purchase price of $38.9 million , excluding acquisition related costs. Dispositions From October 1, 2017 to November 13, 2017 , the Company sold three properties operated by SunTrust with an aggregate contract sale price of $1.6 million . 35 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. The following discussion and analysis should be read in conjunction with the accompanying unaudited consolidated financial statements of American Finance Trust, Inc. and the notes thereto. As used herein, the terms "Company," "we," "our" and "us" refer to American Finance Trust, Inc. , a Maryland corporation, including, as required by context, American Finance Operating Partnership, L.P., a Delaware limited partnership, which we refer to as the "OP," and its subsidiaries. The Company is externally managed by American Finance Advisors, LLC (our "Advisor"), a Delaware limited liability company. Capitalized terms used herein but not otherwise defined have the meaning ascribed to those terms in "Part I — Financial Information" included in the notes to the unaudited consolidated financial statements contained herein. Forward-Looking Statements Certain statements included in this Quarterly Report on Form 10-Q are forward-looking statements. Those statements include statements regarding the intent, belief or current expectations of American Finance Trust, Inc. (the "Company," "we" "our" or "us"), our Advisor and members of our management team, as well as the assumptions on which such statements are based, and generally are identified by the use of words such as "may," "will," "seeks," "anticipates," "believes," "estimates," "expects," "plans," "intends," "should" or similar expressions. Actual results may differ materially from those contemplated by such forward-looking statements. Further, forward-looking statements speak only as of the date they are made, and we undertake no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes to future operating results over time, unless required by law. The following are some of the risks and uncertainties, although not all risks and uncertainties, that could cause our actual results to differ materially from those presented in our forward-looking statements: • | The anticipated benefits from the Mergers (as defined below) with American Realty Capital - Retail Centers of American, Inc. ("RCA") may not be realized or may take longer to realize than expected. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ • | All of our executive officers are also officers, managers, employees or holders of a direct or indirect controlling interest in the Advisor or other entities under common control with AR Global Investments, LLC (the successor business to AR Capital, LLC, "AR Global" or the "Sponsor"). As a result, our executive officers, the Advisor and its affiliates face conflicts of interest, including significant conflicts created by the Advisor's compensation arrangements with us and other investment programs advised by affiliates of the Sponsor and conflicts in allocating time among these entities and us, which could negatively impact our operating results. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Although we have announced our intention to list our common stock on an exchange at a time yet to be determined, there can be no assurance that our common stock will be listed or of the price at which our common stock may trade. No public market currently exists, or may ever exist, for shares of our common stock and shares of our common stock are, and may continue to be, illiquid. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ • | Lincoln Retail REIT Services, LLC ("Lincoln") and its affiliates, which provides services to the Advisor in connection with our stabilized core retail portfolio, faces conflicts of interest in allocating its employees' time between providing real estate-related services to the Advisor and other programs and activities in which they are presently involved or may be involved in the future. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | The performance of our retail portfolio is linked to the market for retail space generally and factors that may impact our retail tenants, such as the increasing use of the Internet by retailers and consumers. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ • | We depend on tenants for our rental revenue and, accordingly, our rental revenue is dependent upon the success and economic viability of our tenants. --+------------------------------------------------------------------------------------------------------------------------------------------------------ • | We have not generated, and in the future may not generate, operating cash flows sufficient to cover 100% of our distributions, and, as such, we may be forced to source distributions from borrowings, which may not be available, or depend on the Advisor to waive reimbursement of certain expenses or fees. There is no assurance that the Advisor will waive reimbursement of expenses or fees. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | We may be unable to pay or maintain cash distributions at the current rate or increase distributions over time. --+---------------------------------------------------------------------------------------------------------------- • | We are obligated to pay fees, which may be substantial, to the Advisor and its affiliates. --+------------------------------------------------------------------------------------------- • | We are subject to risks associated with any dislocation or liquidity disruptions that may exist or occur in the credit markets of the United States of America. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------- • | We may fail to continue to qualify to be treated as a real estate investment trust for U.S. federal income tax purposes ("REIT"), which would result in higher taxes, may adversely affect our operations and would reduce the value of an investment in our common stock and our cash available for distributions. --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 36 • | We may be deemed by regulators to be an investment company under the Investment Company Act of 1940, as amended (the "Investment Company Act"), and thus subject to regulation under the Investment Company Act. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Overview We are a diversified REIT with a retail focus. We own a diversified portfolio of commercial properties comprised primarily of freestanding single-tenant properties that are net leased to investment grade and other creditworthy tenants and a portfolio of stabilized core retail properties. consisting primarily of power centers and lifestyle centers, which were acquired in the Merger (as defined below). We intend to focus our future acquisitions primarily on net leased retail properties and stabilized core retail properties. As of September 30, 2017 , we owned 517 properties, comprised of 19.4 million rentable square feet, which were 96.0% leased, including 482 net leased commercial properties ( 443 of which are retail properties) and 35 stabilized core retail properties. Incorporated on January 22, 2013 , we are a Maryland corporation that elected and qualified to be taxed as a real estate investment trust for U.S. federal income tax purposes ("REIT") beginning with the taxable year ended December 31, 2013. Substantially all of our business is conducted through the OP and its wholly-owned subsidiaries. As of September 30, 2017 , we had 104.6 million shares of common stock outstanding, including unvested restricted shares of common stock ("restricted shares") and shares issued pursuant to our distribution reinvestment plan (the "DRIP"). On March 17, 2017, our board of directors approved an estimated net asset value per share of our common stock (" Estimated Per-Share NAV ") equal to $23.37 as of December 31, 2016, which was published on March 20, 2017. We have no employees. We have retained the Advisor to manage our affairs on a day-to-day basis. American Finance Properties, LLC (the "Property Manager") serves as our property manager. The Advisor and the Property Manager are wholly owned subsidiaries of AR Global , as a result of which, they are related parties of ours, and each have received or may receive, as applicable, compensation, fees and expense reimbursements for services related to managing our business. On August 8, 2017, our application to list our common stock on The NASDAQ Global Select Market (“NASDAQ”) under the symbol "AFIN" (the "Listing") was approved by NASDAQ, subject to our being in compliance with all applicable listing standards on the date we begin trading on NASDAQ. While we intend to list our common stock at a time yet to be determined by our board of directors, there can be no assurance as to when or if our common stock will commence trading or of the price at which our common stock may trade. Completed Mergers American Realty Capital — Retail Centers of America, Inc. Merger On February 16, 2017 , the Company and the OP completed (a) the merger of RCA with and into a subsidiary of the Company referred to as the "Merger Sub," with the Merger Sub surviving as a wholly owned subsidiary of the Company (the "Merger") and (b) the merger of American Realty Capital Retail Operating Partnership, L.P. (the "RCA OP") with and into the OP, with the OP as the surviving entity (the “Partnership Merger,” and together with the Merger, the “Mergers”). Pursuant to the terms and subject to the conditions set forth in the Agreement and Plan of Merger (the "Merger Agreement") entered into by us and the OP with RCA, the RCA OP and the Merger Sub, at the effective time of the Mergers on February 16, 2017 (the “Effective Time”), each outstanding share of common stock of RCA, $0.01 par value per share (“RCA Common Stock”) (including any restricted shares of RCA Common Stock and fractional shares), was converted into (x) 0.385 shares of our common stock (the “Stock Consideration”) and (y) cash from us, in an amount equal to $0.95 per share (the “Cash Consideration,” and together with the Stock Consideration, the “Merger Consideration”). In addition, at the Effective Time, (i) each unit of partnership interest of the RCA OP designated as an OP Unit issued and outstanding immediately prior to the Effective Time (other than those held by RCA as described in clause (ii) below) was automatically converted into 0.424 validly issued units of limited partnership interest of the OP (the “Partnership Merger Consideration”); (ii) each unit of partnership interest of the RCA OP designated as either an OP Unit or a GP Unit held by RCA and issued and outstanding immediately prior to the Effective Time was automatically converted into 0.385 validly issued units of limited partnership interest of the OP; (iii) each unit of partnership interest of the RCA OP designated as a Class B Unit held by RCA’s advisor and a sub-advisor issued and outstanding immediately prior to the Effective Time was converted into the Partnership Merger Consideration (the “Class B Consideration,” and together with the Partnership Merger Consideration and the Merger Consideration, the “Total Merger Consideration”), and (iv) the interest of American Realty Capital Retail Advisor, LLC, the special limited partner of the RCA OP (the “RCA Advisor”), in the RCA OP was redeemed for a cash payment, determined in accordance with the existing terms of the RCA OP’s agreement of limited partnership. In addition, as provided in the Merger Agreement, all outstanding shares of restricted RCA Common Stock previously issued by RCA became fully vested and entitled to receive the Merger Consideration. We issued approximately 38.2 million shares of common stock as consideration in the Merger and paid approximately $94.5 million in Cash Consideration. 37 Prior to the Mergers, the Company and RCA each were sponsored, directly or indirectly, by AR Global. AR Global and its affiliates provide investment and advisory services to the Company, and previously provided such services to RCA, pursuant to written advisory agreements. In connection with, and subject to the terms and conditions of the Merger Agreement, RCA OP units held by AR Global and its affiliates were exchanged for OP Units of the Company and certain special limited partner interests in the RCA OP held by AR Global and its affiliates were, consistent with the terms of the RCA OP partnership agreement, redeemed for a cash payment of approximately $2.8 million . The Advisor has informed us that the Advisor has engaged Lincoln as an independent service provider to provide real estate-related services similar to the services provided by Lincoln to the RCA Advisor prior to the Effective Time. Lincoln will continue to provide, subject to the Advisor’s or its affiliates’ oversight, asset management, property management and leasing services for those multi-tenant properties acquired by the Company from RCA in the Mergers. The Advisor has informed us that the Advisor has agreed to pass through to Lincoln a portion of the fees and/or other expense reimbursements otherwise payable to the Advisor or its affiliates by us for services rendered by Lincoln. We have no direct obligation to Lincoln. Significant Accounting Estimates and Critical Accounting Policies Set forth below is a summary of the significant accounting estimates and critical accounting policies that management believes are important to the preparation of our consolidated financial statements. Certain of our accounting estimates are particularly important for an understanding of our financial position and results of operations and require the application of significant judgment by our management. As a result, these estimates are subject to a degree of uncertainty. These significant accounting estimates and critical accounting policies include: Revenue Recognition Our revenues, which are derived primarily from rental income, include rents that each tenant pays in accordance with the terms of each lease reported on a straight-line basis over the initial term of the lease. Because many of our leases provide for rental increases at specified intervals, straight-line basis accounting requires us to record a receivable, and include in revenues, unbilled rents receivable that we will only receive if the tenant makes all rent payments required through the expiration of the initial term of the lease. When we acquire a property, the acquisition date is considered to be the commencement date for purposes of this calculation. For new leases after acquisition, the commencement date is considered to be the date the tenant takes control of the space. For lease modifications, the commencement date is considered to be the date the lease is executed. We defer the revenue related to lease payments received from tenants in advance of their due dates. We own certain properties with leases that include provisions for the tenant to pay contingent rental income based on a percent of the tenant's sales upon the achievement of certain sales thresholds or other targets which may be monthly, quarterly or annual targets. As the lessor to the aforementioned leases, we defer the recognition of contingent rental income, until the specified target that triggered the contingent rental income is achieved, or until such sales upon which percentage rent is based are known. Contingent rental income is included in rental income on the consolidated statements of operations and comprehensive (loss) income. We continually review receivables related to rent and unbilled rents receivable and determine collectability by taking into consideration the tenant's payment history, the financial condition of the tenant, business conditions in the industry in which the tenant operates and economic conditions in the area in which the property is located. In the event that the collectability of a receivable is in doubt, we record an increase in our allowance for uncollectible accounts or record a direct write-off of the receivable in our consolidated statements of operations and comprehensive (loss) income. Cost recoveries from tenants are included in operating expense reimbursements in our consolidated statements of operations and comprehensive (loss) income in the period the related costs are incurred, as applicable. Real Estate Investments Investments in real estate are recorded at cost. Improvements and replacements are capitalized when they extend the useful life of the asset. Costs of repairs and maintenance are expensed as incurred. We evaluate the inputs, processes and outputs of each asset acquired to determine if the transaction is a business combination or asset acquisition. If an acquisition qualifies as a business combination, the related transaction costs are recorded as an expense in the consolidated statements of operations and comprehensive (loss) income. If an acquisition qualifies as an asset acquisition, the related transaction costs are generally capitalized and subsequently amortized over the useful life of the acquired assets. In business combinations, we allocate the purchase price of acquired properties to tangible and identifiable intangible assets or liabilities based on their respective fair values. Tangible assets may include land, land improvements, buildings, fixtures and tenant improvements. Intangible assets may include the value of in-place leases and above- and below- market leases. In addition, any assumed mortgages receivable or payable and any assumed or issued noncontrolling interests are recorded at their estimated fair values. 38 The fair value of the tangible assets of an acquired property with an in-place operating lease is determined by valuing the property as if it were vacant, and the "as-if-vacant" value is then allocated to the tangible assets based on the fair value of the tangible assets. The fair value of in-place leases is determined by considering estimates of carrying costs during the expected lease-up periods, current market conditions, as well as costs to execute similar leases. The fair value of above- or below-market leases is recorded based on the present value of the difference between the contractual amount to be paid pursuant to the in-place lease and our estimate of the fair market lease rate for the corresponding in-place lease, measured over the remaining term of the lease, including any below-market fixed rate renewal options for below-market leases. In allocating the fair value to assumed mortgages, amounts are recorded to debt premiums or discounts based on the present value of the estimated cash flows, which is calculated to account for either above or below-market interest rates. In allocating non-controlling interests, amounts are recorded based on the fair value of units issued at the date of acquisition, as determined by the terms of the applicable agreement. In making estimates of fair values for purposes of allocating purchase price, we utilize a number of sources, including real estate valuations, prepared by independent valuation firms. We also consider information and other factors including: market conditions, the industry that the tenant operates in, characteristics of the real estate, i.e.: location, size, demographics, value and comparative rental rates, tenant credit profile, store profitability and the importance of the location of the real estate to the operations of the tenant's business. Real estate investments that are intended to be sold are designated as "held for sale" on the consolidated balance sheets at the lesser of carrying amount or fair value less estimated selling costs when they meet specific criteria to be presented as held for sale. Real estate investments are no longer depreciated when they are classified as held for sale. If the disposal, or intended disposal, of certain real estate investments represents a strategic shift that has had or will have a major effect on our operations and financial results, the operations of such real estate investments would be presented as discontinued operations in the consolidated statements of operations and comprehensive (loss) income for all applicable periods. Depreciation and Amortization We are required to make subjective assessments as to the useful lives of the components of our real estate investments for purposes of determining the amount of depreciation to record on an annual basis. These assessments have a direct impact on our net income because if we were to shorten the expected useful lives of our real estate investments, we would depreciate these investments over fewer years, resulting in more depreciation expense and lower net income on an annual basis. Depreciation is computed using the straight-line method over the estimated useful lives of up to 40 years for buildings, 15 years for land improvements, five years for fixtures and improvements and the shorter of the useful life or the remaining lease term for tenant improvements and leasehold interests. Capitalized above-market lease values are amortized as a reduction of rental income over the remaining terms of the respective leases. Capitalized below-market lease values are amortized as an increase to rental income over the remaining terms of the respective leases and expected below-market renewal option periods. Capitalized above-market ground lease values are amortized as a reduction of property operating expense over the remaining terms of the respective leases. Capitalized below-market ground lease values are amortized as an increase to property operating expense over the remaining terms of the respective leases and expected below-market renewal option periods. The value of in-place leases, exclusive of the value of above-market and below-market in-place leases, is amortized to expense over the remaining periods of the respective leases. Assumed mortgage premiums or discounts are amortized as an increase or reduction to interest expense over the remaining terms of the respective mortgages. Impairment of Long-Lived Assets When circumstances indicate the carrying value of a property may not be recoverable, we review the property for impairment. This review is based on an estimate of the future undiscounted cash flows, excluding interest charges, expected to result from the property's use and eventual disposition. These estimates consider factors such as expected future operating income, market and other applicable trends and residual value, as well as the effects of leasing demand, competition and other factors. If impairment exists, due to the inability to recover the carrying value of a property, an impairment loss is recorded to the extent that the carrying value exceeds the estimated fair value of the property for properties to be held and used. For properties held for sale, the impairment loss is the adjustment to fair value less estimated cost to dispose of the asset. These assessments have a direct impact on net income because recording an impairment loss results in an immediate negative adjustment to net income. 39 Commercial Mortgage Loans Commercial mortgage loans held for investment purposes are anticipated to be held until maturity, and accordingly, are carried at cost, net of unamortized acquisition fees and expenses capitalized, discounts or premiums and unfunded commitments. Commercial mortgage loans that are deemed to be impaired will be carried at amortized cost less a specific allowance for loan losses. Interest income is recorded on the accrual basis and related discounts, premiums and capitalized acquisition fees and expenses on investments are amortized over the life of the investment using the effective interest method. Amortization is reflected as an adjustment to interest income from debt investments in our consolidated statements of operations and comprehensive (loss) income. Guaranteed loan exit fees payable by the borrower upon maturity are accreted over the life of the investment using the effective interest method. The accretion of guaranteed loan exit fees is recognized in interest income from debt investments in our consolidated statements of operations and comprehensive (loss) income. Acquisition fees and expenses incurred in connection with the origination and acquisition of commercial mortgage loan investments are evaluated based on the nature of the expense to determine if they should be expensed in the period incurred or capitalized and amortized over the life of the investment. Commercial mortgage loans held for sale are carried at the lower of cost or fair value. We evaluate fair value on an individual loan basis. The amount by which cost exceeds fair value is accounted for as a valuation allowance, and changes in the valuation allowance are included in net income. Purchase discounts are no longer amortized during the period the loans are held for sale. Purchase Accounting The Company allocates the purchase price of acquired properties to tangible and identifiable intangible assets acquired, including those acquired in the Merger, based on their respective fair values. Tangible assets include land, land improvements, buildings, fixtures and tenant improvements on an as-if vacant basis. The Company utilizes various estimates, processes and information to determine the as-if vacant property value. Estimates of value are made using customary methods, including data from appraisals, comparable sales, discounted cash flow analysis and other methods. Amounts allocated to land, land improvements, buildings and fixtures are based on cost segregation studies performed by independent third parties or on the Company's analysis of comparable properties in the Company's portfolio. Identifiable intangible assets include amounts allocated to acquire leases for above- and below-market lease rates and the value of in-place leases as applicable. Factors considered in the analysis of the in-place lease intangibles include an estimate of carrying costs during the expected lease-up period for each property, taking into account current market conditions and costs to execute similar leases. In estimating carrying costs, the Company includes real estate taxes, insurance and other operating expenses and estimates of lost rentals at contract rates during the expected lease-up period, which typically ranges from six to 24 months. The Company also estimates costs to execute similar leases including leasing commissions, legal and other related expenses. Above-market and below-market lease values for acquired properties are initially recorded based on the present value (using a discount rate which reflects the risks associated with the leases acquired) of the difference between (i) the contractual amounts to be paid pursuant to each in-place lease and (ii) management’s estimate of fair market lease rates for each corresponding in-place lease, measured over a period equal to the remaining term of the lease for above-market leases and the remaining initial term plus the term of any below-market fixed rate renewal options for below-market leases. The capitalized above-market lease values are amortized as a reduction of base rental revenue over the remaining terms of the respective leases, and the capitalized below-market lease values are amortized as an increase to base rental revenue over the remaining initial terms plus the terms of any below-market fixed rate renewal options of the respective leases. If a tenant with a below-market rent renewal does not renew, any remaining unamortized amount will be taken into income at that time. In making estimates of fair values for purposes of allocating purchase price, the Company utilizes a number of sources, including independent appraisals that may be obtained in connection with the acquisition or financing of the respective property and other market data. The Company also considers information obtained about each property as a result of the Company's pre-acquisition due diligence in estimating the fair value of the tangible and intangible assets acquired and intangible liabilities assumed. Any excess of purchase price over the fair values of assets acquired and liabilities assumed are recorded as goodwill. Alternatively, if the fair value of net assets acquired exceeds the fair value of consideration paid, the transaction results in a bargain purchase gain that the Company recognizes immediately in earnings. Recently Adopted Accounting Pronouncements In October 2016, the FASB issued guidance where a reporting entity will need to evaluate if it should consolidate a VIE. The amendments change the evaluation of whether a reporting entity is the primary beneficiary of a VIE by changing how a single decision maker of a VIE treats indirect interests in the entity held through related parties that are under common control with the reporting entity. The revised guidance is effective for reporting periods beginning after December 15, 2016. We have adopted the provisions of this guidance beginning January 1, 2017 and determined that there is no impact to our consolidated financial position, results of operations and cash flows. 40 Recently Issued Accounting Pronouncements See Note 3 — Summary of Significant Accounting Policies to our unaudited consolidated financial statements in this Quarterly Report on Form 10-Q for further discussion. 41 Properties As of September 30, 2017 , we owned 517 properties, which were acquired for investment purposes, comprised of 19.4 million rentable square feet and located in 40 states. Our properties consist of freestanding, single-tenant properties and stabilized core retail properties, which are 96.0% leased based on rentable square feet with a weighted-average remaining lease term of 8.1 years as of September 30, 2017 . The following table represents certain additional information about the properties we own at September 30, 2017 : Portfolio | Acquisition Date | Number ofProperties | Rentable Square Feet | Remaining Lease Term (1) | | Percentage Leased -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+------------------ Dollar General I | Apr. & May 2013 | 2 | 18,126 | | 10.6 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Walgreens I | Jul. 2013 | 1 | 10,500 | | 20.0 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Dollar General II | Jul. 2013 | 2 | 18,052 | | 10.7 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Auto Zone I | Jul. 2013 | 1 | 7,370 | | 9.8 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Dollar General III | Jul. 2013 | 5 | 45,989 | | 10.6 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- BSFS I | Jul. 2013 | 1 | 8,934 | | 6.3 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Dollar General IV | Jul. 2013 | 2 | 18,126 | | 8.4 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Tractor Supply I | Aug. 2013 | 1 | 19,097 | | 10.2 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Dollar General V | Aug. 2013 | 1 | 12,480 | | 10.3 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Mattress Firm I | Aug. & Nov. 2013; Feb., Mar. & Apr. 2014 | 5 | 23,612 | | 7.9 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Family Dollar I | Aug. 2013 | 1 | 8,050 | | 3.8 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Lowe's I | Aug. 2013 | 5 | 671,313 | | 11.8 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- O'Reilly Auto Parts I | Aug. 2013 | 1 | 10,692 | | 12.8 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Food Lion I | Aug. 2013 | 1 | 44,549 | | 12.1 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Family Dollar II | Aug. 2013 | 1 | 8,028 | | 5.8 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Walgreens II | Aug. 2013 | 1 | 14,490 | | 15.5 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Dollar General VI | Aug. 2013 | 1 | 9,014 | | 8.4 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Dollar General VII | Aug. 2013 | 1 | 9,100 | | 10.5 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Family Dollar III | Aug. 2013 | 1 | 8,000 | | 5.0 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Chili's I | Aug. 2013 | 2 | 12,700 | | 8.2 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- CVS I | Aug. 2013 | 1 | 10,055 | | 8.3 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Joe's Crab Shack I | Aug. 2013 | 2 | 16,012 | | 9.5 | | 48.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Dollar General VIII | Sep. 2013 | 1 | 9,100 | | 10.8 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Tire Kingdom I | Sep. 2013 | 1 | 6,635 | | 7.5 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Auto Zone II | Sep. 2013 | 1 | 7,370 | | 5.7 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Family Dollar IV | Sep. 2013 | 1 | 8,320 | | 5.8 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Fresenius I | Sep. 2013 | 1 | 5,800 | | 7.8 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Dollar General IX | Sep. 2013 | 1 | 9,014 | | 7.6 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Advance Auto I | Sep. 2013 | 1 | 10,500 | | 5.8 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Walgreens III | Sep. 2013 | 1 | 15,120 | | 8.5 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Walgreens IV | Sep. 2013 | 1 | 13,500 | | 7.0 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- CVS II | Sep. 2013 | 1 | 13,905 | | 19.4 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Arby's I | Sep. 2013 | 1 | 3,000 | | 10.8 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Dollar General X | Sep. 2013 | 1 | 9,100 | | 10.5 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- AmeriCold I | Sep. 2013 | 9 | 1,407,166 | | 10.0 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Home Depot I | Sep. 2013 | 2 | 1,315,200 | | 9.3 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- New Breed Logistics I | Sep. 2013 | 1 | 390,486 | | 4.1 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- American Express Travel Related Services I | Sep. 2013 | 2 | 785,164 | | 2.4 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- L.A. Fitness I | Sep. 2013 | 1 | 45,000 | | 6.4 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- SunTrust Bank I (2) | Sep. 2013 | 30 | 179,400 | | 6.3 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- National Tire & Battery I | Sep. 2013 | 1 | 10,795 | | 6.2 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Circle K I | Sep. 2013 | 19 | 54,521 | | 11.1 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Walgreens V | Sep. 2013 | 1 | 14,490 | | 9.9 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Walgreens VI | Sep. 2013 | 1 | 14,560 | | 11.6 | | 100.0% -------------------------------------------+------------------------------------------+---------------------+----------------------+--------------------------+------+-------------------+------- 42 Portfolio | Acquisition Date | Number ofProperties | Rentable Square Feet | Remaining Lease Term (1) | | Percentage Leased ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+------------------ FedEx Ground I | Sep. 2013 | 1 | 21,662 | | 5.7 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Walgreens VII | Sep. 2013 | 10 | 142,140 | | 12.1 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- O'Charley's I | Sep. 2013 | 20 | 135,973 | | 14.1 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Krystal Burgers Corporation I | Sep. 2013 | 6 | 12,730 | | 12.0 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- 1st Constitution Bancorp I | Sep. 2013 | 1 | 4,500 | | 6.3 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- American Tire Distributors I | Sep. 2013 | 1 | 125,060 | | 6.3 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Tractor Supply II | Oct. 2013 | 1 | 23,500 | | 6.0 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- United Healthcare I | Oct. 2013 | 1 | 400,000 | | 3.8 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- National Tire & Battery II | Oct. 2013 | 1 | 7,368 | | 14.7 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Tractor Supply III | Oct. 2013 | 1 | 19,097 | | 10.6 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Mattress Firm II | Oct. 2013 | 1 | 4,304 | | 5.9 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Dollar General XI | Oct. 2013 | 1 | 9,026 | | 9.6 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Academy Sports I | Oct. 2013 | 1 | 71,640 | | 10.8 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Talecris Plasma Resources I | Oct. 2013 | 1 | 22,262 | | 5.5 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Amazon I | Oct. 2013 | 1 | 79,105 | | 5.8 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Fresenius II | Oct. 2013 | 2 | 16,047 | | 9.9 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Dollar General XII | Nov. 2013 & Jan. 2014 | 2 | 18,126 | | 11.2 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Dollar General XIII | Nov. 2013 | 1 | 9,169 | | 8.5 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Advance Auto II | Nov. 2013 | 2 | 13,887 | | 5.6 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- FedEx Ground II | Nov. 2013 | 1 | 48,897 | | 5.8 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Burger King I | Nov. 2013 | 41 | 168,192 | | 16.2 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Dollar General XIV | Nov. 2013 | 3 | 27,078 | | 10.7 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Dollar General XV | Nov. 2013 | 1 | 9,026 | | 11.1 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- FedEx Ground III | Nov. 2013 | 1 | 24,310 | | 5.9 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Dollar General XVI | Nov. 2013 | 1 | 9,014 | | 8.2 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Family Dollar V | Nov. 2013 | 1 | 8,400 | | 5.5 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Walgreens VIII | Dec. 2013 | 1 | 14,490 | | 6.3 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- CVS III | Dec. 2013 | 1 | 10,880 | | 6.3 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Mattress Firm III | Dec. 2013 | 1 | 5,057 | | 5.8 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Arby's II | Dec. 2013 | 1 | 3,494 | | 10.6 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Family Dollar VI | Dec. 2013 | 2 | 17,484 | | 6.3 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- SAAB Sensis I | Dec. 2013 | 1 | 90,822 | | 7.5 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Citizens Bank I | Dec. 2013 | 9 | 34,777 | | 6.3 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Walgreens IX | Jan. 2014 | 1 | 14,490 | | 5.3 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- SunTrust Bank II (2) | Jan. 2014 | 27 | 136,997 | | 10.3 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Mattress Firm IV | Jan. 2014 | 1 | 5,040 | | 6.9 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- FedEx Ground IV | Jan. 2014 | 1 | 59,167 | | 5.8 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Mattress Firm V | Jan. 2014 | 1 | 5,548 | | 6.1 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Family Dollar VII | Feb. 2014 | 1 | 8,320 | | 6.8 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Aaron's I | Feb. 2014 | 1 | 7,964 | | 5.9 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Auto Zone III | Feb. 2014 | 1 | 6,786 | | 5.5 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- C&S Wholesale Grocer I | Feb. 2014 | 2 | 1,671,233 | | 5.5 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Advance Auto III | Feb. 2014 | 1 | 6,124 | | 6.9 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Family Dollar VIII | Mar. 2014 | 3 | 24,960 | | 5.8 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Dollar General XVII | Mar. & May 2014 | 3 | 27,078 | | 10.5 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- SunTrust Bank III (2) | Mar. 2014 | 104 | 576,617 | | 9.6 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- SunTrust Bank IV (2) | Mar. 2014 | 27 | 142,625 | | 9.6 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Dollar General XVIII | Mar. 2014 | 1 | 9,026 | | 10.5 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Sanofi US I | Mar. 2014 | 1 | 736,572 | | 15.3 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Family Dollar IX | Apr. 2014 | 1 | 8,320 | | 6.5 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Stop & Shop I | May 2014 | 8 | 544,112 | | 9.1 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Bi-Lo I | May 2014 | 1 | 55,718 | | 8.3 | | 100.0% ------------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- 43 Portfolio | Acquisition Date | Number ofProperties | Rentable Square Feet | Remaining Lease Term (1) | | Percentage Leased -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+------------------ Dollar General XIX | May 2014 | 1 | 12,480 | | 10.9 | | 100.0% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Dollar General XX | May 2014 | 5 | 48,584 | | 9.6 | | 100.0% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Dollar General XXI | May 2014 | 1 | 9,238 | | 10.9 | | 100.0% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Dollar General XXII | May 2014 | 1 | 10,566 | | 9.6 | | 100.0% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- FedEx Ground V | Feb. 2016 | 1 | 45,755 | | 7.8 | | 100.0% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- FedEx Ground VI | Feb. 2016 | 1 | 120,731 | | 7.9 | | 100.0% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- FedEx Ground VII | Feb. 2016 | 1 | 42,299 | | 8.0 | | 100.0% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- FedEx Ground VIII | Feb. 2016 | 1 | 78,673 | | 8.1 | | 100.0% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Liberty Crossing | Feb. 2017 | 1 | 105,779 | | 2.2 | | 90.9% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- San Pedro Crossing | Feb. 2017 | 1 | 201,965 | | 4.1 | | 96.7% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Tiffany Springs MarketCenter | Feb. 2017 | 1 | 264,952 | | 4.9 | | 84.9% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- The Streets of West Chester | Feb. 2017 | 1 | 236,842 | | 10.9 | | 92.1% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Prairie Towne Center | Feb. 2017 | 1 | 289,277 | | 6.7 | | 95.3% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Southway Shopping Center | Feb. 2017 | 1 | 181,809 | | 4.5 | | 98.6% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Stirling Slidell Centre | Feb. 2017 | 1 | 134,276 | | 2.9 | | 77.5% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Northwoods Marketplace | Feb. 2017 | 1 | 236,078 | | 3.3 | | 97.1% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Centennial Plaza | Feb. 2017 | 1 | 233,797 | | 3.1 | | 78.6% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Northlake Commons | Feb. 2017 | 1 | 109,112 | | 4.0 | | 96.5% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Shops at Shelby Crossing | Feb. 2017 | 1 | 236,107 | | 4.8 | | 97.0% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Shoppes of West Melbourne | Feb. 2017 | 1 | 144,484 | | 4.3 | | 98.3% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- The Centrum | Feb. 2017 | 1 | 270,747 | | 3.4 | | 93.5% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Shoppes at Wyomissing | Feb. 2017 | 1 | 103,064 | | 3.5 | | 91.3% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Southroads Shopping Center | Feb. 2017 | 1 | 437,515 | | 4.7 | | 71.2% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Parkside Shopping Center | Feb. 2017 | 1 | 181,620 | | 5.2 | | 94.6% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- West Lake Crossing | Feb. 2017 | 1 | 75,928 | | 4.2 | | 100.0% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Colonial Landing | Feb. 2017 | 1 | 263,559 | | 4.6 | | 70.0% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- The Shops at West End | Feb. 2017 | 1 | 381,831 | | 10.6 | | 82.2% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Township Marketplace | Feb. 2017 | 1 | 298,630 | | 3.7 | | 94.8% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Cross Pointe Centre | Feb. 2017 | 1 | 226,089 | | 9.5 | | 100.0% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Towne Center Plaza | Feb. 2017 | 1 | 94,096 | | 5.3 | | 100.0% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Harlingen Corners | Feb. 2017 | 1 | 228,208 | | 4.8 | | 97.6% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Village at Quail Springs | Feb. 2017 | 1 | 100,404 | | 2.3 | | 45.1% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Pine Ridge Plaza | Feb. 2017 | 1 | 239,492 | | 2.7 | | 96.9% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Bison Hollow | Feb. 2017 | 1 | 134,798 | | 5.1 | | 100.0% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Jefferson Commons | Feb. 2017 | 1 | 205,918 | | 8.4 | | 83.5% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Northpark Center | Feb. 2017 | 1 | 318,327 | | 3.8 | | 99.2% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Anderson Station | Feb. 2017 | 1 | 243,550 | | 3.8 | | 84.5% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Patton Creek | Feb. 2017 | 1 | 491,294 | | 4.2 | | 92.6% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- North Lakeland Plaza | Feb. 2017 | 1 | 171,397 | | 2.9 | | 96.3% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Riverbend Marketplace | Feb. 2017 | 1 | 142,617 | | 6.1 | | 90.5% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Montecito Crossing | Feb. 2017 | 1 | 179,721 | | 4.6 | | 97.4% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Best on the Boulevard | Feb. 2017 | 1 | 204,568 | | 4.3 | | 100.0% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Shops at Rivergate South | Feb. 2017 | 1 | 140,703 | | 6.4 | | 65.4% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Dollar General XXIII | Mar., May & Jun. 2017 | 8 | 72,480 | | 11.9 | | 100.0% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Jo-Ann Fabrics I | Apr. 2017 | 1 | 18,018 | | 7.3 | | 100.0% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Bob Evans I | Apr. 2017 | 23 | 116,899 | | 19.6 | | 100.0% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- FedEx Ground IX | May 2017 | 1 | 53,739 | | 8.7 | | 100.0% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Chili's II | May 2017 | 1 | 6,039 | | 10.1 | | 100.0% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Sonic Drive In I | Jun. 2017 | 2 | 2,745 | | 14.8 | | 100.0% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Bridgestone HOSEPower I | Jun. 2017 | 2 | 41,131 | | 11.9 | | 100.0% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Bridgestone HOSEPower II | Jul. 2017 | 1 | 25,125 | | 12.1 | | 100.0% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- FedEx Ground X | Jul. 2017 | 1 | 141,803 | | 9.8 | | 100.0% -----------------------------+-----------------------+---------------------+----------------------+--------------------------+------+-------------------+------- 44 Portfolio | Acquisition Date | Number ofProperties | Rentable Square Feet | Remaining Lease Term (1) | | Percentage Leased ----------------+------------------+---------------------+----------------------+--------------------------+------+------------------ Chili's III | Aug. 2017 | 1 | 5,742 | | 10.1 | | 100.0% ----------------+------------------+---------------------+----------------------+--------------------------+------+-------------------+------- FedEx Ground XI | Sep. 2017 | 1 | 29,246 | | 9.8 | | 100.0% ----------------+------------------+---------------------+----------------------+--------------------------+------+-------------------+------- Hardee's I | Sep. 2017 | 4 | 13,455 | | 20.0 | | 100.0% ----------------+------------------+---------------------+----------------------+--------------------------+------+-------------------+------- | | 517 | 19,389,951 | | 8.1 | | 96.0% ----------------+------------------+---------------------+----------------------+--------------------------+------+-------------------+------- _____________________ (1) | Remaining lease term in years as of September 30, 2017. If the portfolio has multiple properties with varying lease expirations, remaining lease term is calculated on a weighted-average basis. ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (2) | Includes certain of the 44 properties operated by SunTrust Banks, Inc. ("SunTrust") which had lease terms set to expire between December 31, 2017 and March 31, 2018, comprising 0.3 million rentable square feet. As of September 30, 2017, these properties were either being marketed for sale, subject to a non-binding letter of intent ("LOI") or subject to a definitive purchase and sale agreement ("PSA"). There can be no guarantee that these properties will be sold on the terms contemplated by any applicable LOI or PSA, or at all. See Note 4 — Real Estate Investments of the accompanying consolidated financial statements for further details. ----+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Property Damage During the three months ended September 30, 2017 , one of the Company's properties, Southroads Shopping Center, sustained roof damage from a tornado. The property is covered by insurance for property damage, subject to normal deductibles. Accordingly, damage will be covered by insurance proceeds, and the Company does not expect any significant exposure to loss related to this property. As a result of the damage, the Company wrote off the carrying value of the property's roof, which was estimated to be $5.6 million , and booked a corresponding insurance receivable on its consolidated balance sheet as of September 30, 2017 . CRE Debt Investments As of September 30, 2017 , we had one commercial real estate loan investment. The following table shows selected data from our investment portfolio as of September 30, 2017 : Deal Name | Par Value | | Carrying Value | Interest Rate | | Effective Yield | Loan to Value (1) ------------+----------------+--------+----------------+---------------+--------+-----------------+------------------ | (In thousands) | | (In thousands) | | | | ------------+----------------+--------+----------------+---------------+--------+-----------------+------------------ Senior Loan | $ | 17,200 | | $ | 17,191 | | 4.50% + 1M LIBOR | 5.8 | % | 66.0 | % ------------+----------------+--------+----------------+---------------+--------+-----------------+-------------------+-----+---+------+-- | $ | 17,200 | | $ | 17,191 | | | 5.8 | % | 66.0 | % ------------+----------------+--------+----------------+---------------+--------+-----------------+-------------------+-----+---+------+-- _____________________ (1) | Loan to value percentage is from metrics at origination. ----+--------------------------------------------------------- Results of Operations As of September 30, 2017 , we owned 517 properties, comprised of 19.4 million rentable square feet that were 96.0% leased. Comparison of the Three Months Ended September 30, 2017 to the Three Months Ended September 30, 2016 There were 436 properties that we owned for the entirety of both the three months ended September 30, 2017 and the three months ended September 30, 2016 (our "Three Month Same Store"), comprised of 11.4 million rentable square feet that were 99.9% leased as of September 30, 2017 . We acquired 35 stabilized core retail properties in the Merger (the "Merger Acquisitions"), comprised of 7.5 million rentable square feet that were 89.8% leased as of September 30, 2017 . Additionally, from July 1, 2016 through September 30, 2017 , excluding properties acquired in the Merger, we acquired 46 properties (our "Acquisitions Since July 1, 2016 "), comprised of 0.5 million rentable square feet that were 100.0% leased as of September 30, 2017 . From July 1, 2016 through September 30, 2017 , we sold 31 properties (our "Disposals Since July 1, 2016 "), comprised of 2.0 million rentable square feet. 45 The following table summarizes our leasing activity during the three months ended September 30, 2017 : | Three Months Ended September 30, 2017 ------------------------------+-------------------------------------- | | | | | (In thousands) | ------------------------------+---------------------------------------+---+----------------------+-----------+----------------------------------------------------+------------------------------------------ | Number of Leases | | Rentable Square Feet | | Annualized SLR(1) prior to Lease Execution/Renewal | Annualized SLR(1) after Execution/Renewal | | Costs to execute lease | | Costs to execute lease per square foot ------------------------------+---------------------------------------+---+----------------------+-----------+----------------------------------------------------+-------------------------------------------+---+------------------------+--------+--------------------------------------- New leases (2) | 7 | | | 46,451 | | $ | — | | | $ | 687 | | $ | 399 | | $ | 8.59 ------------------------------+---------------------------------------+---+----------------------+-----------+----------------------------------------------------+-------------------------------------------+---+------------------------+--------+----------------------------------------+-----+-------+---+-----+------+---+----- Lease renewals/amendments (2) | 27 | | | 1,064,728 | | 23,258 | | | 21,742 | | | 6,513 | | $ | 6.12 ------------------------------+---------------------------------------+---+----------------------+-----------+----------------------------------------------------+-------------------------------------------+---+------------------------+--------+----------------------------------------+-----+-------+---+-----+----- Lease terminations | (4 | ) | | (121,158 | ) | (1,188 | ) | | — | | | — | | $ | — ------------------------------+---------------------------------------+---+----------------------+-----------+----------------------------------------------------+-------------------------------------------+---+------------------------+--------+----------------------------------------+-----+-------+---+-----+----- _____________________________________ (1) | Straight-line rental income ----+---------------------------- (2) | New leases reflect leases in which a new tenant took possession of the space during the three months ended September 30, 2017, excluding new property acquisitions. Lease renewals/amendments reflect leases in which an existing tenant executed terms to extend the life or change the rental terms of the lease during the three months ended September 30, 2017. ----+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Lease renewals/amendments in the table above includes an amendment to our lease with Sanofi US, which extended its remaining lease term from 9.0 years as of June 30, 2017 to 15.3 years as of September 30, 2017 . In connection with the amendment, we paid a $6.1 million leasing commission, which has been capitalized to deferred costs, net on the accompanying consolidated balance sheet as of September 30, 2017 and will be amortized over the term of the lease. As of September 30, 2017 , Sanofi US is our second largest tenant, representing 7.1% of total annualized straight-line rental income. Rental Income Rental income increased $20.9 million to $62.3 million for the three months ended September 30, 2017 , compared to $41.4 million for the three months ended September 30, 2016 . This increase in rental income was primarily due to $25.7 million of incremental rental income from the Merger Acquisitions, as well as $1.9 million of incremental rental income from our Acquisitions Since July 1, 2016 . These increases were partially offset by a decrease in rental income of $6.1 million from our Disposals Since July 1, 2016 . Our Three Month Same Store rental income remained relatively consistent at $34.6 million. Operating Expense Reimbursements Pursuant to certain of our lease agreements, tenants are required to reimburse us for certain property operating expenses, in addition to paying base rent, whereas under certain other lease agreements, the tenants are directly responsible for all operating costs of the respective properties. Operating expense reimbursement revenue increased $4.0 million to $7.2 million for the three months ended September 30, 2017 compared to $3.2 million for the three months ended September 30, 2016 . This increase was primarily driven by $6.1 million of operating expense reimbursements from the Merger Acquisitions. This increase was partially offset by a decrease in operating expense reimbursements of $2.2 million from our Disposals Since July 1, 2016 . Our Three Month Same Store operating expense reimbursements remained relatively consistent at $0.7 million. Interest Income from Debt Investments Interest income from debt investments increased $0.1 million to $0.3 million for the three months ended September 30, 2017 compared to $0.2 million for the three months ended September 30, 2016 . Interest income from debt investments relates to our commercial real estate loan investments. For the three months ended September 30, 2017 , the weighted-average carrying value of our one commercial mortgage loan was $17.2 million , with a weighted-average yield of 5.80% . For the three months ended September 30, 2016 , we had commercial mortgage loans with a weighted-average balance of $17.2 million and a weighted-average yield of 5.1% . Asset Management Fees to Related Party Asset management fees paid to the Advisor increased $0.8 million to $5.3 million for the three months ended September 30, 2017 , compared to $4.5 million for the three months ended September 30, 2016 . We pay these fees to the Advisor for managing our day-to-day operations. Prior to the Effective Time of the Merger, we paid the Advisor (i) a base management fee with a fixed portion of $1.5 million payable monthly and a variable portion, if applicable, payable quarterly in arrears, and (ii) a variable management fee, if applicable, payable quarterly in arrears. Following the Effective Time of the Merger, the fixed portion of the base management fee increased from $18.0 million annually to (i) $21.0 million annually for the first year following the Effective Time; (ii) $22.5 million annually for the second year following the Effective Time; and (iii) $24.0 million annually for the remainder of the term. We did not incur any variable management fees during the three months ended September 30, 2017 and 2016 . Please see Note 12 — Related Party Transactions and Arrangements of the accompanying consolidated financial statements for more information on fees incurred from the Advisor. 46 Property Operating Expense Property operating expense increased $7.3 million to $10.8 million for the three months ended September 30, 2017 compared to $3.5 million for the three months ended September 30, 2016 . This increase was primarily driven by property operating expense of $9.5 million from the Merger Acquisitions, partially offset by a decrease of $2.4 million from our Disposals Since July 1, 2016 . Our Three Month Same Store property operating expense remained relatively consistent at $1.2 million. Property operating expenses primarily consist of the costs associated with maintaining our properties including real estate taxes, utilities, and repairs and maintenance. Most of these expenses are passed through and reimbursed by our tenants. Impairment charges We incurred $7.6 million of impairment charges during the three months ended September 30, 2017 , $0.2 million of which related to properties sold or reclassified as held for sale, as the carrying amount of the long-lived assets associated with these properties was greater than our estimate of their fair value less estimated costs to sell. The remaining $7.4 million of impairment charges were taken on certain of the 44 held for use properties we owned as of September 30, 2017 . These properties are operated by SunTrust and had lease terms set to expire between December 31, 2017 and March 31, 2018. As of September 30, 2017 , these properties were either being marketed for sale or were subject to a LOI or a PSA. There can be no guarantee that these properties will be sold on the terms contemplated by any applicable LOI or PSA, or at all. See Note 4 — Real Estate Investments of the accompanying consolidated financial statements for further details. We determined, based on LOIs or PSAs entered into, that the carrying value of these properties exceeded their estimated fair values less costs to sell as of September 30, 2017 . The carrying value of the remaining 44 SunTrust properties noted above was $48.1 million as of September 30, 2017 , and we may experience further impairment losses with respect to these properties in future periods. We recognized $0.1 million of impairment charges during the three months ended September 30, 2016 , which related to the loss on sale of a single-tenant net lease property operated by SunTrust. Acquisition and Transaction Related Expense Acquisition and transaction related expense decreased $3.2 million to $1.2 million for the three months ended September 30, 2017 , compared to $4.4 million for the three months ended September 30, 2016 . Acquisition and transaction related expenses for the three months ended September 30, 2017 were primarily incurred in connection with our acquisition of eight properties. Acquisition and transaction related expenses for the three months ended September 30, 2016 were primarily due to costs incurred in connection with the Merger. These costs include fees to the special committee of the board of directors for their review of the Merger, as well as fees to the special committee's outside financial advisor and legal counsel. General and Administrative Expense General and administrative expense increased $2.0 million to $5.0 million for the three months ended September 30, 2017 , compared to $3.0 million for the three months ended September 30, 2016 . This increase primarily related to an increase in the amount of expenses incurred from the Advisor and its affiliates that we are required to reimburse resulting from incremental personnel costs from the Merger, as well as an increase in audit fees and legal fees paid to third parties. Depreciation and Amortization Expense Depreciation and amortization expense increased $15.7 million to $41.1 million for the three months ended September 30, 2017 compared to $25.4 million for the three months ended September 30, 2016 . We incurred depreciation and amortization expense of $18.8 million related to the properties acquired from RCA in the Merger and $0.8 million related to our Acquisitions Since July 1, 2016 . Additionally, depreciation and amortization expense decreased $3.9 million on our Disposals Since July 1, 2016 . The purchase price of acquired properties is allocated to tangible and identifiable intangible assets and depreciated or amortized over their estimated useful lives. 47 Interest Expense Interest expense increased $1.9 million to $14.5 million for the three months ended September 30, 2017 , compared to $12.6 million for the three months ended September 30, 2016 . This increase is primarily related to the debt we assumed from RCA in the Merger. In connection with the Merger, we assumed mortgage notes payable with a total principal balance of $127.7 million, as well as a revolving credit facility which was assumed from RCA and amended and restated in connection with the closing of the Merger (the "Amended Credit Facility") with an outstanding balance of $304.0 million. We subsequently paid down a portion of the Amended Credit Facility, which had an outstanding balance as of September 30, 2017 of $260.0 million . Additionally, we took out a $24.0 million mortgage, with an interest rate of 4.71% , during the third quarter of 2017 encumbering 23 Bob Evans properties. This increase was partially offset by the repayment of an $82.3 million mortgage, with an interest rate of 5.48% , secured by properties operated by C&S Wholesale Grocer that we sold during the period. During the three months ended September 30, 2017 , the weighted-average interest rate on the Amended Credit Facility and total mortgage notes payable was 2.65% and 4.69%, respectively, as compared to a weighted-average interest rate of 4.76% on our mortgage debt during the three months ended September 30, 2016 . Gain on Sale of Real Estate Investments During the three months ended September 30, 2017 , we sold seven properties leased to SunTrust, three of which resulted in gains on sale. These three properties sold for an aggregate contract price of $1.8 million, resulting in aggregate gains on sale of $0.3 million. Comparison of the Nine Months Ended September 30, 2017 to the Nine Months Ended September 30, 2016 There were 432 properties that we owned for the entirety of both the nine months ended September 30, 2017 and the nine months ended September 30, 2016 (our "Nine Month Same Store"), comprised of 11.1 million rentable square feet that were 99.9% leased as of September 30, 2017 . We acquired 35 stabilized core retail properties in the Merger (the "Merger Acquisitions"), comprised of 7.5 million rentable square feet that were 89.8% leased as of September 30, 2017 . Additionally, during 2016 and the first three quarters of 2017, excluding properties acquired in the Merger, we acquired 50 properties (our "Acquisitions Since January 1, 2016 "), comprised of 0.8 million rentable square feet that were 100.0% leased as of September 30, 2017 . During 2016 and the first three quarters of 2017, we sold 31 properties (our "Disposals Since January 1, 2016 "), comprised of 2.0 million rentable square feet. The following table summarizes our leasing activity during the nine months ended September 30, 2017 : | Nine Months Ended September 30, 2017 ------------------------------+------------------------------------- | | | | | (In thousands) | ------------------------------+--------------------------------------+---+----------------------+-----------+-----------------------------------------------------+------------------------------------------- | Number of Leases | | Rentable Square Feet | | Annualized SLR (1) prior to Lease Execution/Renewal | Annualized SLR (1) after Execution/Renewal | | Costs to execute lease | | Costs to execute lease per square foot ------------------------------+--------------------------------------+---+----------------------+-----------+-----------------------------------------------------+--------------------------------------------+---+------------------------+--------+--------------------------------------- New leases (2) | 13 | | | 69,611 | | $ | — | | | $ | 1,130 | | $ | 1,117 | | $ | 16.05 ------------------------------+--------------------------------------+---+----------------------+-----------+-----------------------------------------------------+--------------------------------------------+---+------------------------+--------+----------------------------------------+-------+-------+---+-------+------+---+------ Lease renewals/amendments (2) | 63 | | | 1,450,034 | | 27,814 | | | 26,459 | | | 7,023 | | $ | 4.84 ------------------------------+--------------------------------------+---+----------------------+-----------+-----------------------------------------------------+--------------------------------------------+---+------------------------+--------+----------------------------------------+-------+-------+---+-------+----- Lease terminations | (8 | ) | | (134,711 | ) | (1,423 | ) | | — | | | — | | $ | — ------------------------------+--------------------------------------+---+----------------------+-----------+-----------------------------------------------------+--------------------------------------------+---+------------------------+--------+----------------------------------------+-------+-------+---+-------+----- _____________________________________ (1) | Straight-line rental income ----+---------------------------- (2) | New leases reflect leases in which a new tenant took possession of the space during the nine months ended September 30, 2017, excluding new property acquisitions. Lease renewals/amendments reflect leases in which an existing tenant executed terms to extend the life or change the rental terms of the lease during the nine months ended September 30, 2017. ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Lease renewals/amendments in the table above includes an amendment to our lease with Sanofi US, which extended its remaining lease term from 9.5 years as of December 31, 2016 to 15.3 years as of September 30, 2017 . In connection with the amendment, we paid a $6.1 million leasing commission, which has been capitalized to deferred costs, net on the accompanying consolidated balance sheet as of September 30, 2017 and will be amortized over the term of the lease. As of September 30, 2017 , Sanofi US is our second largest tenant, representing 7.1% of total annualized straight-line rental income. Rental Income Rental income increased $53.9 million to $176.9 million for the nine months ended September 30, 2017 , compared to $123.0 million for the nine months ended September 30, 2016 . This increase in rental income was primarily due to $64.3 million of incremental rental income from the Merger Acquisitions, as well as $3.3 million of incremental rental income from our Acquisitions Since January 1, 2016 . These increases were partially offset by a decrease in rental income of $14.3 million from our Disposals Since January 1, 2016 . 48 Operating Expense Reimbursements Pursuant to certain of our lease agreements, tenants are required to reimburse us for certain property operating expenses, in addition to paying base rent, whereas under certain other lease agreements, the tenants are directly responsible for all operating costs of the respective properties. Operating expense reimbursement revenue increased $11.9 million to $20.9 million for the nine months ended September 30, 2017 compared to $9.0 million for the nine months ended September 30, 2016 . This increase was primarily driven by $17.5 million of operating expense reimbursements from the Merger Acquisitions. This increase was partially offset by a decrease in operating expense reimbursements of $5.8 million from our Disposals Since January 1, 2016 . Our Nine Month Same Store operating expense reimbursements remained relatively consistent at $1.8 million. Interest Income from Debt Investments Interest income from debt investments remained consistent at $0.8 million for the nine months ended September 30, 2017 and the nine months ended September 30, 2016 . Interest income from debt investments related to our commercial real estate loan investments. For the nine months ended September 30, 2017 , the average carrying value of our one commercial mortgage loan was $17.2 million , with a weighted-average yield of 5.60% . For the nine months ended September 30, 2016 , we had commercial mortgage loans with a weighted-average balance of $22.8 million and a weighted-average yield of 4.4% . Asset Management Fees to Related Party Asset management fees paid to the Advisor increased $1.8 million to $15.3 million for the nine months ended September 30, 2017 , compared to $13.5 million for the nine months ended September 30, 2016 . Prior to the Effective Time of the Merger, we paid the Advisor (i) a base management fee with a fixed portion of $1.5 million payable monthly and a variable portion, if applicable, payable quarterly in arrears, and (ii) a variable management fee, if applicable, payable quarterly in arrears. Following the Effective Time of the Merger, the fixed portion of the base management fee increased from $18.0 million annually to (i) $21.0 million annually for the first year following the Effective Time; (ii) $22.5 million annually for the second year following the Effective Time; and (iii) $24.0 million annually for the remainder of the term. We did not incur any variable management fees during the nine months ended September 30, 2017 and 2016 . Please see Note 12 — Related Party Transactions and Arrangements for more information on fees incurred from the Advisor. Property Operating Expense Property operating expense increased $19.9 million to $30.0 million for the nine months ended September 30, 2017 , compared to $10.1 million for the nine months ended September 30, 2016 . This increase was primarily driven by property operating expense of $25.9 million from the Merger Acquisitions, partially offset by a decrease of $6.4 million from our Disposals Since January 1, 2016 . Our Nine Month Same Store property operating expense remained relatively consistent at $3.1 million. Property operating expenses primarily consist of the costs associated with maintaining our properties including real estate taxes, utilities, and repairs and maintenance. Most of these expenses are passed through and reimbursed by our tenants. Impairment Charges We incurred $14.2 million of impairment charges during the nine months ended September 30, 2017 , $4.5 million of which related to properties sold or reclassified as held for sale, as the carrying amount of the long-lived assets associated with these properties was greater than our estimate of their fair value less estimated costs to sell. The remaining $9.7 million of impairment charges were taken on held for use properties we sold during the nine months ended September 30, 2017 or that we owned as of September 30, 2017 . These properties are operated by SunTrust and had lease terms set to expire between December 31, 2017 and March 31, 2018. As of September 30, 2017 , 44 of these properties were either being marketed for sale or were subject to a LOI or a PSA. There can be no guarantee that these properties will be sold on the terms contemplated by any applicable LOI or PSA, or at all. See Note 4 — Real Estate Investments of the accompanying consolidated financial statements for further details. We determined, based on LOIs or PSAs entered into, that the carrying value of these properties exceeded their estimated fair values less costs to sell as of September 30, 2017 . The carrying value of the remaining 44 SunTrust properties noted above was $48.1 million as of September 30, 2017 , and we may experience further impairment losses with respect to these properties in future periods. We recognized $0.1 million of impairment charges during the nine months ended September 30, 2016 , which related to the loss on sale of a single-tenant net lease property operated by SunTrust. 49 Acquisition and Transaction Related Expense Acquisition and transaction related expense increased $2.1 million to $7.6 million for the nine months ended September 30, 2017 , compared to $5.5 million for the nine months ended September 30, 2016 . Acquisition and transaction related expenses for the nine months ended September 30, 2017 were primarily in connection with the Mergers. These costs include fees to the special committee's financial advisor and legal counsel of $4.1 million, fees to transfer RCA's mortgages and credit facility of $0.8 million and legal and other fees related to the Mergers of $0.5 million. Additionally, we incurred $2.2 million of costs related to our acquisition of 46 properties. Acquisition and transaction related expenses for the nine months ended September 30, 2016 were primarily in connection with the Merger. General and Administrative Expense General and administrative expense increased $6.3 million to $15.1 million for the nine months ended September 30, 2017 , compared to $8.8 million for the nine months ended September 30, 2016 . This increase primarily related to an increase in the amount of expenses incurred by the Advisor and its affiliates that we are required to reimburse resulting from incremental personnel costs from the Merger, as well as an increase in legal and audit fees. Depreciation and Amortization Expense Depreciation and amortization expense increased $36.5 million to $113.0 million for the nine months ended September 30, 2017 , compared to $76.5 million for the nine months ended September 30, 2016 . We incurred depreciation and amortization expense of $46.7 million for the approximately 7.5 months that we owned the properties acquired from RCA in the Merger and $1.4 million on our Acquisitions Since January 1, 2016 . Additionally, depreciation and amortization expense decreased $11.0 million on our Disposals Since January 1, 2016 . The purchase price of acquired properties is allocated to tangible and identifiable intangible assets and depreciated or amortized over their estimated useful lives. Interest Expense Interest expense increased $7.4 million to $44.9 million for the nine months ended September 30, 2017 , compared to $37.5 million for the nine months ended September 30, 2016 . This increase is primarily related to the debt we assumed from RCA in the Merger. In connection with the Merger, we assumed mortgage notes payable with a total principal balance of $127.7 million, as well as the Amended Credit Facility with an outstanding balance of $304.0 million. The Amended Credit Facility had an outstanding balance as of September 30, 2017 of $260.0 million . Additionally, we took out a $24.0 million mortgage during the third quarter of 2017 encumbering 23 Bob Evans properties. This increase was partially offset by the repayment of an $82.3 million mortgage secured by certain properties operated by C&S Wholesale Grocer that we sold during the period. During the nine months ended September 30, 2017 , the weighted-average interest rate on the Amended Credit Facility and total mortgage notes payable was 2.48% and 4.72%, respectively, as compared to a weighted-average interest rate of 4.77% on our mortgage debt during the nine months ended September 30, 2016 . Gain on Sale of Real Estate Investments During the nine months ended September 30, 2017 , we sold three properties leased to Merrill Lynch, Pierce, Fenner & Smith for a contract price of $145.5 million, net of closing costs. These properties had a net carrying value at the date of disposition of $140.3 million, resulting in a gain on sale of $5.2 million. Additionally, we sold three properties leased to C&S Wholesale Grocer for a contract price of $44.2 million, net of closing costs. The property had a net carrying value at the date of disposition of $35.6 million, resulting in a gain on sale of $8.6 million. We also sold 13 properties leased to SunTrust for an aggregate contract price of $8.9 million, resulting in aggregate gains on sale of $0.3 million. Cash Flows for the Nine Months Ended September 30, 2017 Cash flows from operating activities was $64.5 million during the nine months ended September 30, 2017 and consisted of a net loss of $27.2 million , adjusted for non-cash items of $112.5 million , including depreciation and amortization of tangible and intangible real estate assets, amortization of deferred financing costs, impairment charges, share-based compensation, amortization of mortgage premiums, discount accretion and premium amortization on investments, net and gain on sale of real estate investments, as well as changes in restricted cash of $0.7 million . These operating cash inflows were partially offset by an increase in prepaid expenses and other assets of $7.9 million , a decrease in accounts payable and accrued expenses of $5.3 million , and a decrease in deferred rent and other liabilities of $8.3 million . The net cash used in investing activities during the nine months ended September 30, 2017 of $6.9 million consisted of cash paid to acquire RCA in the Merger of $94.5 million , amounts invested in real estate and other assets of $107.1 million , deposits for real estate acquisitions of $0.8 million , changes in restricted cash of $1.0 million and capital expenditures of $4.3 million , partially offset by the sale of real estate investments of $179.0 million and cash acquired in the Merger of $21.9 million . 50 The net cash used in financing activities of $120.3 million during the nine months ended September 30, 2017 consisted primarily of payments on the Amended Credit Facility of $114.0 million , common stock repurchases of $29.1 million , cash distributions of $66.0 million , payments of deferred financing costs of $1.6 million and payments of mortgage notes payable of $3.4 million . These financing cash outflows were partially offset by proceeds from the Amended Credit Facility of $70.0 million and proceeds from mortgage notes payable of $24.0 million . Cash Flows for the Nine Months Ended September 30, 2016 Cash flows provided from operating activities was $55.8 million during the nine months ended September 30, 2016 and consisted of a net loss of $18.7 million, adjusted for non-cash items of $76.9 million, including depreciation and amortization of tangible and intangible real estate assets, amortization of deferred financing costs, impairment charges, share-based compensation, amortization of mortgage premiums, discount accretion and premium amortization on investments, net and gain on sale of real estate investments, as well as an increase in accounts payable and accrued expenses of $6.1 million. These operating cash inflows were partially offset by an increase in prepaid expenses and other assets of $6.6 million and a decrease in deferred rent and other liabilities of $1.9 million. The net cash provided by investing activities during the nine months ended September 30, 2016 of $38.2 million was generated from the proceeds from the sale of commercial mortgage loans of $56.9 million and the sale of real estate investments of $15.5 million, partially offset by amounts invested in real estate and other assets of $34.2 million. The net cash used in financing activities of $81.0 million during the nine months ended September 30, 2016 consisted primarily of cash distributions of $60.5 million, common stock repurchases of $16.3 million, payments of deferred financing costs of $3.5 million and payments of mortgage notes payable of $0.8 million. Liquidity and Capital Resources We expect to fund our future short-term operating liquidity requirements through a combination of cash on hand, net cash provided by our current property operations, proceeds from shares issued through the DRIP and proceeds from the Amended Credit Facility. We may also generate additional liquidity through property dispositions and, to the extent available, secured or unsecured borrowings. As of September 30, 2017 , we had cash and cash equivalents of $68.5 million , includi ng $7.2 million of re maining cash proceeds received from common stock issued under the DRIP. Our principal demands for funds are for payment of our operating and administrative expenses, property acquisitions, capital expenditures, debt service obligations, cash distributions to our stockholders and repurchases of our common stock pursuant to the share repurchase program (as amended and restated, the "SRP"). On February 16, 2017, we, the OP, and certain other subsidiaries of ours acting as guarantors, entered into an amendment, assumption, joinder and reaffirmation of guaranties (the “Second Amendment”) to an unsecured amended and restated credit agreement, dated December 2, 2014 (as amended by the Second Amendment, the “Credit Agreement”), by and among the RCA OP to which the OP is successor by merger, BMO Harris Bank N.A., as administrative agent, letter of credit issuer, swingline lender and a lender, and the other parties thereto, relating to the Amended Credit Facility. The Second Amendment provides for, among other things, the OP to become the borrower and principal obligor under the Credit Agreement and the Amended Credit Facility, and for the Company to become a guarantor under the Amended Credit Facility. RCA and the RCA OP were parties to the Credit Agreement prior to closing of the Merger. The Amended Credit Facility permits aggregate revolving loan borrowings of up to $325.0 million (subject to the value and debt service coverage ratio of the unencumbered asset pool comprising the borrowing base thereunder), a swingline subfacility of $25.0 million and a $20.0 million letter of credit subfacility, subject to certain conditions. Through an uncommitted “accordion feature,” the OP, subject to lender consent and certain other conditions, may increase commitments under the Amended Credit Facility to up to $575.0 million . As of September 30, 2017 , our unused borrowing c apacity was $65.0 million , base d on the aggregate commitments under the Amended Credit Facility. The Amended Credit Facility matures on May 1, 2018. Borrowings under the Amended Credit Facility bear interest at either (i) the base rate (which is defined in the Credit Agreement as the greatest of (a) the prime rate in effect on such day, (b) the federal funds effective rate in effect on such day plus 0.50% , and (c) LIBOR for a one month interest period plus 1.00% ) plus an applicable spread ranging from 0.35% to 1.00% , depending on the Company’s consolidated leverage ratio, or (ii) LIBOR plus an applicable spread ranging from 1.35% to 2.00% , depending on the Company’s consolidated leverage ratio. The Amended Credit Facility requires us to pay interest quarterly for each base rate loan and periodically for each LIBOR loan, based upon the applicable interest period (though no longer than three months) with respect to such LIBOR loan, with all principal outstanding being due on the maturity date. The Amended Credit Facility may be prepaid at any time, in whole or in part, without premium or penalty. Upon the occurrence of an event of default, the requisite lenders have the right to terminate their obligations under the Amended Credit Facility and to accelerate the payment on any unpaid principal amount of all outstanding loans. The Company, certain of its subsidiaries and certain subsidiaries of the OP will guarantee the obligations under the Amended Credit Facility. 51 As of September 30, 2017 , we had $1.1 billion of mortgage notes payable outstanding and $260.0 million outstanding under the Amended Credit Facility, with a leverage ratio (total debt divided by total assets) of 41.0% . During the three months ended September 30, 2017 , the weighted-average interest rate on the Amended Credit Facility and mortgage notes payable was 2.65% and 4.69%, respectively. As of December 31, 2016 , we had $1.0 billion of mortgage notes payable outstanding, with a leverage ratio of 50.0% and a weighted-average interest rate of 4.75% . Using debt balances as of September 30, 2017 , we had approximately $289.0 million of mortgage debt and borrowings under the Amended Credit Facility that matures between September 30, 2017 and September 30, 2018. As of September 30, 2017 , we had pledged $2.1 billion in real estate investments as collateral for our mortgage notes payable and $770.3 million in real estate investments were included in the unencumbered asset pool comprising the borrowing base under the Amended Credit Facility. Accordingly, as of September 30, 2017 , we had $0.5 million in real estate investments available to serve as collateral under new mortgage loans or to be added to the unencumbered asset pool comprising the borrowing base under the Amended Credit Facility or another similar facility. One of our primary uses of cash during the nine months ended September 30, 2017 has been for acquisitions of properties. At the closing of the Merger, we paid $94.5 million in Cash Consideration, as well as $917.0 million in Stock Consideration, in order to acquire all of the assets and liabilities of RCA, including 35 stabilized core retail properties comprised of 7.5 million rentable square feet. In addition to the Merger, we have acquired 46 net leased commercial properties during the nine months ended September 30, 2017 for an aggregate contract price of $107.0 million , comprised of 0.5 million rentable square feet. These acquisitions were funded through a combination of mortgage debt, draws on the Amended Credit Facility, proceeds from dispositions of properties and available cash on hand. In addition to the acquisitions noted above, we purchased an additional 28 properties subsequent to September 30, 2017 with an aggregate base purchase price of $38.9 million , excluding acquisition related costs. We also have entered into PSAs to acquire an additional four properties for an aggregate contract purchase price of approximately $12.3 million . We anticipate using available cash on hand, proceeds from dispositions of properties and proceeds from the Amended Credit Facility, to pay the consideration required to complete these acquisitions. These acquisitions are subject to conditions, and there can be no assurance they will be completed on their current terms, or at all. During the nine months ended September 30, 2017 , we closed on the sale of 19 properties, including 13 properties operated by SunTrust, for an aggregate contract price of $277.9 million , excluding acquisition related costs. In connection with these sales, we repaid $90.0 million of mortgage debt, leaving net proceeds available for property acquisitions of $187.9 million . In addition, we have sold three properties operated by SunTrust subsequent to September 30, 2017 , with an aggregate contract sale price of $1.6 million . In connection with these sales, we repaid $1.9 million of mortgage debt. We also have entered into PSAs to dispose of an additional eight properties, including seven properties operated by SunTrust, for an aggregate contract sale price of approximately $25.8 million . In connection with these sales, we expect to repay approximately $18.0 million of mortgage debt. These dispositions are subject to conditions, and there can be no assurance they will be completed on their current terms, or at all. Non-GAAP Financial Measures This section reports on non-GAAP financial measures, including funds from operations and modified funds from operations. A description of these non-GAAP measures and reconciliations to the most directly comparable GAAP measure, which is net income, is provided below. Funds from Operations and Modified Funds from Operations The historical accounting convention used for real estate assets requires straight-line depreciation of buildings, improvements, and straight-line amortization of intangibles, which implies that the value of a real estate asset diminishes predictably over time. We believe that, because real estate values historically rise and fall with market conditions, including, but not limited to, inflation, interest rates, the business cycle, unemployment and consumer spending, presentations of operating results for a REIT using the historical accounting convention for depreciation and certain other items may be less informative. Because of these factors, the National Association of Real Estate Investment Trusts ("NAREIT"), an industry trade group, has published a standardized measure of performance known as funds from operations ("FFO"), which is used in the REIT industry as a supplemental performance measure. We believe FFO, which excludes certain items such as real estate-related depreciation and amortization, is an appropriate supplemental measure of a REIT's operating performance. FFO is not equivalent to our net income or loss as determined under GAAP. We define FFO, a non-GAAP measure, consistent with the standards set forth in the White Paper on FFO approved by the Board of Governors of NAREIT, as revised in February 2004 (the "White Paper"). The White Paper defines FFO as net income or loss computed in accordance with GAAP, but excluding gains or losses from sales of property and real estate related impairments, plus real estate related depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures. 52 We believe that the use of FFO provides a more complete understanding of our performance to investors and to management, and reflects the impact on our operations from trends in occupancy rates, rental rates, operating costs, general and administrative expenses, and interest costs, which may not be immediately apparent from net income. Changes in the accounting and reporting promulgations under GAAP that were put into effect in 2009 subsequent to the establishment of NAREIT's definition of FFO, such as the change to expense as incurred rather than capitalize and depreciate acquisition fees and expenses incurred for business combinations, have prompted an increase in cash-settled expenses, specifically acquisition fees and expenses, as items that are expensed under GAAP across all industries. These changes had a particularly significant impact on publicly registered, non-listed REITs, which typically have a significant amount of acquisition activity in the early part of their existence, particularly during the period when they are raising capital through ongoing initial public offerings. Because of these factors, the Investment Program Association (the "IPA"), an industry trade group, published a standardized measure of performance known as modified funds from operations ("MFFO"), which the IPA has recommended as a supplemental measure for publicly registered, non-listed REITs. MFFO is designed to be reflective of the ongoing operating performance of publicly registered, non-listed REITs by adjusting for those costs that are more reflective of acquisitions and investment activity, along with other items the IPA believes are not indicative of the ongoing operating performance of a publicly registered, non-listed REIT, such as straight-lining of rents as required by GAAP. We believe it is appropriate to use MFFO as a supplemental measure of operating performance because we believe that both before and after we have deployed all of our offering proceeds and are no longer incurring a significant amount of acquisitions fees or other related costs, it reflects the impact on our operations from trends in occupancy rates, rental rates, operating costs, general and administrative expenses, and interest costs, which may not be immediately apparent from net income. MFFO is not equivalent to our net income or loss as determined under GAAP. We define MFFO, a non-GAAP measure, consistent with the IPA's Guideline 2010-01, Supplemental Performance Measure for Publicly Registered, Non-Listed REITs: Modified Funds from Operations (the "Practice Guideline") issued by the IPA in November 2010. The Practice Guideline defines MFFO as FFO further adjusted for acquisition and transaction related fees and expenses and other items. In calculating MFFO, we follow the Practice Guideline and exclude acquisition and transaction-related fees and expenses (which includes costs incurred in connection with strategic alternatives), amounts relating to deferred rent receivables and amortization of market lease and other intangibles, net (which are adjusted in order to reflect such payments from a GAAP accrual basis to a cash basis of disclosing the rent and lease payments), accretion of discounts and amortization of premiums on debt investments and borrowings, mark-to-market adjustments included in net income (including gains or losses incurred on assets held for sale), gains or losses included in net income from the extinguishment or sale of debt, hedges, foreign exchange, derivatives or securities holdings where trading of such holdings is not a fundamental attribute of the business plan, unrealized gains or losses resulting from consolidation from, or deconsolidation to, equity accounting, and after adjustments for consolidated and unconsolidated partnerships and joint ventures, with such adjustments calculated to reflect MFFO on the same basis. We believe that, because MFFO excludes costs that we consider more reflective of acquisition activities and other non-operating items, MFFO can provide, on a going-forward basis, an indication of the sustainability (that is, the capacity to continue to be maintained) of our operating performance after the period in which we are acquiring properties and once our portfolio is stabilized. We also believe that MFFO is a recognized measure of sustainable operating performance by the non-listed REIT industry and allows for an evaluation of our performance against other publicly registered, non-listed REITs. Not all REITs, including publicly registered, non-listed REITs, calculate FFO and MFFO the same way. Accordingly, comparisons with other REITs, including publicly registered, non-listed REITs, may not be meaningful. Furthermore, FFO and MFFO are not indicative of cash flow available to fund cash needs and should not be considered as an alternative to net income (loss) or income (loss) from continuing operations as determined under GAAP as an indication of our performance, as an alternative to cash flows from operations, as an indication of our liquidity, or indicative of funds available to fund our cash needs including our ability to make distributions to our stockholders. FFO and MFFO should be reviewed in conjunction with other GAAP measurements as an indication of our performance. FFO and MFFO should not be construed to be more relevant or accurate than the current GAAP methodology in calculating net income or in its applicability in evaluating our operating performance. The methods utilized to evaluate the performance of a publicly registered, non-listed REIT under GAAP should be construed as more relevant measures of operational performance and considered more prominently than the non-GAAP measures, FFO and MFFO, and the adjustments to GAAP in calculating FFO and MFFO. Neither the SEC, NAREIT, the IPA nor any other regulatory body or industry trade group has passed judgment on the acceptability of the adjustments that we use to calculate FFO or MFFO. In the future, NAREIT, the IPA or another industry trade group may publish updates to the White Paper or the Practice Guidelines or the SEC or another regulatory body could standardize the allowable adjustments across the publicly registered, non-listed REIT industry, and we would have to adjust our calculation and characterization of FFO or MFFO accordingly. 53 The table below reflects the items deducted from or added to net loss in our calculation of FFO and MFFO for the periods presented: | Three Months Ended | Nine Months Ended September 30, 2017 -----------------------------------------------------------------------------------+--------------------+------------------------------------- (In thousands) | March 31, 2017 | | June 30, 2017 | | September 30, 2017 | -----------------------------------------------------------------------------------+--------------------+--------------------------------------+---------------+--------+--------------------+------- Net loss attributable to stockholders (in accordance with GAAP) | $ | (10,717 | ) | | $ | (1,021 | ) | | $ | (15,367 | ) | $ | (27,105 | ) -----------------------------------------------------------------------------------+--------------------+--------------------------------------+---------------+--------+--------------------+--------+--------+---+---+---------+---+---+---------+-- Gain on sale of real estate investments | (5,222 | ) | | (8,609 | ) | | (264 | ) | | (14,095 | ) -----------------------------------------------------------------------------------+--------------------+--------------------------------------+---------------+--------+--------------------+--------+--------+---+---+---------+-- Impairment charges | 3,929 | | | 2,649 | | | 7,605 | | | 14,183 | -----------------------------------------------------------------------------------+--------------------+--------------------------------------+---------------+--------+--------------------+--------+--------+---+---+---------+-- Depreciation and amortization | 31,478 | | | 40,438 | | | 41,132 | | | 113,048 | -----------------------------------------------------------------------------------+--------------------+--------------------------------------+---------------+--------+--------------------+--------+--------+---+---+---------+-- Proportionate share of adjustments for non-controlling interests to arrive at FFO | (31 | ) | | (68 | ) | | (94 | ) | | (193 | ) -----------------------------------------------------------------------------------+--------------------+--------------------------------------+---------------+--------+--------------------+--------+--------+---+---+---------+-- FFO attributable to stockholders | 19,437 | | | 33,389 | | | 33,012 | | | 85,838 | -----------------------------------------------------------------------------------+--------------------+--------------------------------------+---------------+--------+--------------------+--------+--------+---+---+---------+-- Acquisition and transaction related fees and expenses | 5,436 | | | 947 | | | 1,173 | | | 7,556 | -----------------------------------------------------------------------------------+--------------------+--------------------------------------+---------------+--------+--------------------+--------+--------+---+---+---------+-- Amortization of market lease and other intangibles, net | (453 | ) | | (1,113 | ) | | (1,519 | ) | | (3,085 | ) -----------------------------------------------------------------------------------+--------------------+--------------------------------------+---------------+--------+--------------------+--------+--------+---+---+---------+-- Straight-line rent | (1,572 | ) | | (1,882 | ) | | (2,077 | ) | | (5,531 | ) -----------------------------------------------------------------------------------+--------------------+--------------------------------------+---------------+--------+--------------------+--------+--------+---+---+---------+-- Amortization of mortgage premiums on borrowings | (1,126 | ) | | (928 | ) | | (1,063 | ) | | (3,117 | ) -----------------------------------------------------------------------------------+--------------------+--------------------------------------+---------------+--------+--------------------+--------+--------+---+---+---------+-- Discount accretion on investment | (6 | ) | | (7 | ) | | (3 | ) | | (16 | ) -----------------------------------------------------------------------------------+--------------------+--------------------------------------+---------------+--------+--------------------+--------+--------+---+---+---------+-- Mark-to-market adjustments | (73 | ) | | (7 | ) | | (25 | ) | | (105 | ) -----------------------------------------------------------------------------------+--------------------+--------------------------------------+---------------+--------+--------------------+--------+--------+---+---+---------+-- Proportionate share of adjustments for non-controlling interests to arrive at MFFO | 4 | | | 6 | | | 7 | | | 17 | -----------------------------------------------------------------------------------+--------------------+--------------------------------------+---------------+--------+--------------------+--------+--------+---+---+---------+-- MFFO attributable to stockholders | $ | 21,647 | | | $ | 30,405 | | | $ | 29,505 | | $ | 81,557 | -----------------------------------------------------------------------------------+--------------------+--------------------------------------+---------------+--------+--------------------+--------+--------+---+---+---------+---+---+---------+-- Distributions In April 2013, our board of directors authorized distributions payable on a monthly basis to stockholders of record on each day at a rate equal to $1.65 per annum, per share of common stock. On June 14, 2017, we announced that our board of directors authorized a decrease in the daily accrual of distributions to an annualized rate of $1.30 per annum, per share of common stock, effective July 1, 2017. This represents a change in the annualized distribution yield, based on the original purchase price of $25.00 per share, from 6.6% to 5.2%, or a change from 7.1% to 5.6% based on our most recent Estimated Per Share NAV as of December 31, 2016 of $23.37 per share. The first distributions under the new rate were paid on or about August 5, 2017. Distributions are payable by the 5th day following each month end to stockholders of record at the close of business each day during the prior month. The amount of distributions payable to our stockholders is determined by our board of directors and is dependent on a number of factors, including funds available for distribution, our financial condition, capital expenditure requirements, as applicable, requirements of Maryland law and annual distribution requirements needed to maintain our status as a REIT under the Internal Revenue Code of 1986, as amended (the "Code"). Our board of directors may reduce the amount of distributions paid or suspend distribution payments at any time prior to distributions being declared. Therefore, distribution payments are not assured. During the nine months ended September 30, 2017 , distributions paid to common stockholders totaled $109.5 million , inclusive of $43.5 million of distributions that were reinvested in additional shares of our common stock through our DRIP. During the nine months ended September 30, 2017 , cash used to pay distributions was generated from cash flows provided from operations, and cash available on hand. 54 The following table shows the sources for the payment of distributions to common stockholders, including distributions on unvested restricted shares, for the periods indicated: | Three Months Ended | | Nine Months Ended September 30, 2017 -----------------------------------------------------------------------+--------------------+---------+------------------------------------- | March 31, 2017 | | June 30, 2017 | | September 30, 2017 | -----------------------------------------------------------------------+--------------------+---------+--------------------------------------+------+--------------------+------- (In thousands) | | | Percentage of Distributions | | | | Percentage of Distributions | | | | Percentage of Distributions | | | | Percentage of Distributions -----------------------------------------------------------------------+--------------------+---------+--------------------------------------+------+--------------------+--------+-----------------------------+--------+--------+------+-----------------------------+-------+--------+---------+---------------------------- Cash distributions paid to stockholders not reinvested in common stock | $ | 17,167 | | | | | $ | 25,827 | | | | | $ | 23,016 | | | | $ | 66,010 | | | -----------------------------------------------------------------------+--------------------+---------+--------------------------------------+------+--------------------+--------+-----------------------------+--------+--------+------+-----------------------------+-------+--------+---------+-----------------------------+--------+---+--------+---------+---+------+-------- Cash distributions reinvested in common stock issued under the DRIP | 11,887 | | | | | 17,449 | | | | | 14,188 | | | | | 43,524 | | -----------------------------------------------------------------------+--------------------+---------+--------------------------------------+------+--------------------+--------+-----------------------------+--------+--------+------+-----------------------------+-------+--------+---------+-----------------------------+--------+---+------- Total distributions paid | $ | 29,054 | | | | | $ | 43,276 | | | | | $ | 37,204 | | | | $ | 109,534 | | | -----------------------------------------------------------------------+--------------------+---------+--------------------------------------+------+--------------------+--------+-----------------------------+--------+--------+------+-----------------------------+-------+--------+---------+-----------------------------+--------+---+--------+---------+---+------+-------- Source of distribution coverage: | | | | | | | | | | | | | | | -----------------------------------------------------------------------+--------------------+---------+--------------------------------------+------+--------------------+--------+-----------------------------+--------+--------+------+-----------------------------+-------+--------+---------+---------------------------- Cash flows provided by operations | $ | 8,409 | | | 28.9 | % | | $ | 33,017 | | | 76.3 | % | | $ | 23,048 | | 62.0 | % | | $ | 64,474 | 58.9 | % -----------------------------------------------------------------------+--------------------+---------+--------------------------------------+------+--------------------+--------+-----------------------------+--------+--------+------+-----------------------------+-------+--------+---------+-----------------------------+--------+---+--------+---------+---+------+---------+-------+-- Cash proceeds received from common stock issued under the DRIP | — | | | — | % | | 10,259 | | | 23.7 | % | | 14,156 | | | 38.0 | % | 24,415 | | | 22.3 | % -----------------------------------------------------------------------+--------------------+---------+--------------------------------------+------+--------------------+--------+-----------------------------+--------+--------+------+-----------------------------+-------+--------+---------+-----------------------------+--------+---+--------+---------+---+------+-------- Available cash on hand (1) | 20,645 | | | 71.1 | % | | — | | | — | % | | — | | | — | % | 20,645 | | | 18.8 | % -----------------------------------------------------------------------+--------------------+---------+--------------------------------------+------+--------------------+--------+-----------------------------+--------+--------+------+-----------------------------+-------+--------+---------+-----------------------------+--------+---+--------+---------+---+------+-------- Total source of distribution coverage | $ | 29,054 | | | 100.0 | % | | $ | 43,276 | | | 100.0 | % | | $ | 37,204 | | 100.0 | % | | $ | 109,534 | 100.0 | % -----------------------------------------------------------------------+--------------------+---------+--------------------------------------+------+--------------------+--------+-----------------------------+--------+--------+------+-----------------------------+-------+--------+---------+-----------------------------+--------+---+--------+---------+---+------+---------+-------+-- Cash flows provided by operations (GAAP basis) | $ | 8,409 | | | | | $ | 33,017 | | | | | $ | 23,048 | | | | $ | 64,474 | | | -----------------------------------------------------------------------+--------------------+---------+--------------------------------------+------+--------------------+--------+-----------------------------+--------+--------+------+-----------------------------+-------+--------+---------+-----------------------------+--------+---+--------+---------+---+------+-------- Net loss (in accordance with GAAP) | $ | (10,730 | ) | | | | $ | (1,023 | ) | | | | $ | (15,397 | ) | | | $ | (27,150 | ) | | -----------------------------------------------------------------------+--------------------+---------+--------------------------------------+------+--------------------+--------+-----------------------------+--------+--------+------+-----------------------------+-------+--------+---------+-----------------------------+--------+---+--------+---------+---+------+-------- _____________________________________ (1) | Consists of proceeds from sale of real estate investments and proceeds from financings. See Note 4 — Real Estate Investments of the accompanying consolidated financial statements for information on our sales of real estate investments, Note 7 — Mortgage Notes Payable of the accompanying consolidated financial statements for information on our mortgage loans outstanding and Note 6 — Credit Facility of the accompanying consolidated financial statements for information on amounts outstanding and availability under the Amended Credit Facility. ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ Because we do not generate sufficient cash flows from our operations to fund distributions, we have used and expect to continue to use, a portion of our cash on hand to pay distributions, which could cause our stockholders' investment to be adversely impacted. Loan Obligations The payment terms of certain of our mortgage loan obligations require principal and interest payments monthly, with all unpaid principal and interest due at maturity. Our loan agreements stipulate that we comply with specific reporting covenants. As of September 30, 2017 , we were in compliance with the debt covenants under our loan agreements. The Advisor may, with approval from our board of directors, seek to borrow short-term capital that, combined with secured mortgage financing, exceeds our targeted leverage ratio. As of September 30, 2017 , our leverage ratio (total debt divided by total assets) was 41.0% . 55 Contractual Obligations The following table reflects contractual debt obligations under our mortgage notes payable based on anticipated repayment dates, as well as minimum base rental cash payments due for leasehold interests over the next five years and thereafter as of September 30, 2017 . These minimum base rental cash payments due for leasehold interests amounts exclude contingent rent payments, as applicable, that may be payable based on provisions related to increases in annual rent based on exceeding certain economic indexes among other items: | | | | | Years Ended December 31, | | ------------------------------------+---------+-----------+--------------------------------------+-------+--------------------------+--------+---------- (In thousands) | Total | | October 1, 2017 to December 31, 2017 | | 2018-2019 | | 2020-2021 | Thereafter ------------------------------------+---------+-----------+--------------------------------------+-------+--------------------------+--------+-----------+----------- Principal on mortgage notes payable | $ | 1,096,117 | | | $ | 582 | | $ | 67,715 | $ | 976,932 | $ | 50,888 ------------------------------------+---------+-----------+--------------------------------------+-------+--------------------------+--------+-----------+------------+---------+--------+-----------+---+------- Interest on mortgage notes payable | 166,701 | | | 8,585 | | | 98,859 | | 49,704 | 9,553 | ------------------------------------+---------+-----------+--------------------------------------+-------+--------------------------+--------+-----------+------------+---------+--------+---------- Credit Facility | 260,000 | | | — | | | 260,000 | | — | — | ------------------------------------+---------+-----------+--------------------------------------+-------+--------------------------+--------+-----------+------------+---------+--------+---------- Interest on Credit Facility | 7,963 | | | 1,712 | | | 6,251 | | — | — | ------------------------------------+---------+-----------+--------------------------------------+-------+--------------------------+--------+-----------+------------+---------+--------+---------- Ground lease rental payments due | 18,795 | | | 361 | | | 2,864 | | 2,120 | 13,450 | ------------------------------------+---------+-----------+--------------------------------------+-------+--------------------------+--------+-----------+------------+---------+--------+---------- | $ | 1,549,576 | | | $ | 11,240 | | $ | 435,689 | $ | 1,028,756 | $ | 73,891 ------------------------------------+---------+-----------+--------------------------------------+-------+--------------------------+--------+-----------+------------+---------+--------+-----------+---+------- Several of the loan agreements on our mortgage notes payable feature anticipated repayment dates in advance of the stated maturity dates. Please see table below: Portfolio | Maturity | Anticipated Repayment -----------------------------+-----------+---------------------- SAAB Sensis I | Apr. 2025 | Apr. 2025 -----------------------------+-----------+---------------------- SunTrust Bank II | Jul. 2031 | Jul. 2021 -----------------------------+-----------+---------------------- SunTrust Bank III | Jul. 2031 | Jul. 2021 -----------------------------+-----------+---------------------- SunTrust Bank IV | Jul. 2031 | Jul. 2021 -----------------------------+-----------+---------------------- Sanofi US I - New Loan | Jul. 2026 | Jan. 2021 -----------------------------+-----------+---------------------- Stop & Shop I | Jun. 2041 | Jun. 2021 -----------------------------+-----------+---------------------- Multi-Tenant Mortgage Loan | Sep. 2020 | Sep. 2020 -----------------------------+-----------+---------------------- Liberty Crossing | Jul. 2018 | Jul. 2018 -----------------------------+-----------+---------------------- San Pedro Crossing | Jan. 2018 | Jan. 2018 -----------------------------+-----------+---------------------- Tiffany Springs MarketCenter | Oct. 2018 | Oct. 2018 -----------------------------+-----------+---------------------- Shops at Shelby Crossing | Mar. 2024 | Mar. 2024 -----------------------------+-----------+---------------------- Patton Creek | Dec. 2020 | Dec. 2020 -----------------------------+-----------+---------------------- Bob Evans I | Sep. 2037 | Sep. 2027 -----------------------------+-----------+---------------------- Election as a REIT We elected to be taxed as a REIT under Sections 856 through 860 of the Code, effective for our taxable year ended December 31, 2013. We believe that, commencing with such taxable year, we have been organized and have operated in a manner so that we qualify for taxation as a REIT under the Code. We intend to continue to operate in such a manner, but no assurance can be given that we will operate in a manner so as to remain qualified as a REIT. In order to continue to qualify for taxation as a REIT, we must distribute annually at least 90% of our REIT taxable income (which does not equal net income as calculated in accordance with GAAP), determined without regard for the deduction for dividends paid and excluding net capital gains, and must comply with a number of other organizational and operational requirements. If we continue to qualify for taxation as a REIT, we generally will not be subject to federal corporate income tax on that portion of our REIT taxable income that we distribute to our stockholders. Even if we qualify for taxation as a REIT, we may be subject to certain state and local taxes on our income and properties, as well as federal income and excise taxes on our undistributed income. 56 Inflation Some of our leases with our tenants contain provisions designed to mitigate the adverse impact of inflation. These provisions generally increase rental rates during the terms of the leases either at fixed rates or indexed escalations (based on the Consumer Price Index or other measures). We may be adversely impacted by inflation on the leases that do not contain indexed escalation provisions. However, our net leases require the tenant to pay its allocable share of operating expenses, which may include common area maintenance costs, real estate taxes and insurance. This may reduce our exposure to increases in costs and operating expenses resulting from inflation. Related-Party Transactions and Agreements Please see Note 12 — Related Party Transactions and Arrangements of the accompanying consolidated financial statements. Off-Balance Sheet Arrangements We have no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors. Item 3. Quantitative and Qualitative Disclosures About Market Risk. The market risk associated with financial instruments and derivative financial instruments is the risk of loss from adverse changes in market prices or interest rates. Our long-term debt, which consists of secured financings, bears interest at fixed rates. Our interest rate risk management objectives are to limit the impact of interest rate changes on earnings and cash flows and to lower our overall borrowing costs. To achieve these objectives, from time to time, we may enter into interest rate hedge contracts such as swaps, collars and treasury lock agreements in order to mitigate our interest rate risk with respect to various debt instruments. We would not hold or issue these derivative contracts for trading or speculative purposes. We do not have any foreign operations and thus are not exposed to foreign currency fluctuations. As of September 30, 2017 , our fixed rate debt consisted of secured mortgage financings with a gross carrying value of $1.1 billion and a fair value of $1.1 billion . Changes in market interest rates on our fixed-rate debt impact its fair value, but it has no impact on interest expense incurred or cash flow. For instance, if interest rates rise 100 basis points and our fixed-rate debt balance remains constant, we expect the fair value of our obligation to decrease, the same way the price of a bond declines as interest rates rise. The sensitivity analysis related to our fixed–rate debt assumes an immediate 100 basis point move in interest rates from their September 30, 2017 levels, with all other variables held constant. A 100 basis point increase in market interest rates would result in a decrease in the fair value of our fixed-rate debt by $30.4 million . A 100 basis point decrease in market interest rates would result in an increase in the fair value of our fixed-rate debt by $31.6 million . As of September 30, 2017 , our variable-rate debt consisted of our Amended Credit Facility, which had a carrying and fair value of $260.0 million . In terest rate volatility associated with the Amended Credit Facility affects interest expense incurred and cash flow. The sensitivity analysis related to our variable-rate debt assumes an immediate 100 basis point move in interest rates from September 30, 2017 levels with all other variables held constant. A 100 basis point increase or decrease in variable rates on the Amended Credit Facility would increase or decrease our interest expense by $2.6 million . These amounts were determined by considering the impact of hypothetical interest rate changes on our borrowing costs, and, assuming no other changes in our capital structure. The information presented above includes only those exposures that existed as of September 30, 2017 and does not consider exposures or positions arising after that date. The information represented herein has limited predictive value. Future actual realized gains or losses with respect to interest rate fluctuations will depend on cumulative exposures, hedging strategies employed and the magnitude of the fluctuations. Item 4. Controls and Procedures. Evaluation of Disclosure Controls and Procedures In accordance with Rules 13a-15(b) and 15d-15(b) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), we, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, carried out an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) of the Exchange Act) as of the end of the period covered by this Quarterly Report on Form 10-Q and determined that our disclosure controls and procedures are effective. Changes in Internal Control Over Financial Reporting No change occurred in our internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) of the Exchange Act) during the three months ended September 30, 2017 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. 57 PART II — OTHER INFORMATION Item 1. Legal Proceedings. On January 13, 2017, four affiliated stockholders of RCA filed in the United States District Court for the District of Maryland a putative class action lawsuit against the Company, Edward M. Weil, Jr., Leslie D. Michelson, Edward G. Rendell (Weil, Michelson and Rendell, the “Director Defendants”), AR Global, and the Company, alleging violations of Sections 14(a) of the Securities Exchange Act of 1934 (the “Exchange Act”) by RCA and the Director Defendants, violations of Section 20(a) of the Exchange Act by AR Global and the Director Defendants, breaches of fiduciary duty by the Director Defendants, and aiding and abetting breaches of fiduciary duty by AR Global and the Company in connection with the negotiation of and proxy solicitation for a shareholder vote on the proposed merger of the Company and RCA and an amendment to RCA's charter. The complaint sought on behalf of the putative class rescission of the merger transaction, which was voted on and approved by stockholders on February 13, 2017, and closed on February 16, 2017, together with unspecified rescissory damages, unspecified actual damages, and costs and disbursements of the action. On April 26, 2017, the Court appointed a lead plaintiff. Lead plaintiff, along with other stockholders of RCA, filed an amended complaint on June 19, 2017. The Amended Complaint named additional individuals and entities as defendants (David Gong, Stanley Perla, Lisa Kabnick ("Additional Director Defendants"), Nicholas Radesca and American Realty Capital Retail Advisor, LLC), added counts under Sections 11, 12(a)(2) and 15 of the Securities Act of 1933 in connection with the Registration Statement for the proposed merger, under Section 13(e) of the Exchange Act, and counts for breach of contract and unjust enrichment, and dropped the demand for rescission (while maintaining the demand for rescissory damages). The Company, the Director Defendants, the Additional Director Defendants and Nicholas Radesca deny wrongdoing and liability and intend to vigorously defend the action. Due to the early stage of the litigation, no estimate of a probable loss or any reasonable possible losses are determinable at this time. No provisions for such losses have been recorded in the accompanying consolidated financial statements for the three and nine months ended September 30, 2017 . We are not a party to, and none of our properties are subject to, any material pending legal proceedings. Item 1A. Risk Factors. The following risk factors supplement the risk factors set forth in our Annual Report on Form 10-K for the year ended December 31, 2016 . The Estimated Per-Share NAV may be lower or higher than the price of our shares of common stock on a national securities exchange. Our Estimated Per-Share NAV does not represent, and we can give no assurance as to, (1) the price at which our shares will trade on a national securities exchange or the per share price a third party would pay to acquire the Company, (2) the amount a stockholder would obtain if he or she tried to sell his or her shares, or (3) the amount stockholders would receive if we liquidated our assets and distributed the proceeds after paying all of its expenses and liabilities. In addition, our Estimated Per-Share NAV does not reflect events subsequent to the date as of which the Estimated Per-Share NAV is determined that may have affected the value of our shares. Our common stock has never been traded on a national securities exchange and as such has no trading history, and there can be no assurance that the trading price of our common stock will equal or exceed Estimated Per-Share NAV. Presently there is not an established market for our shares. On August 8, 2017, our application to list our common stock on NASDAQ under the symbol "AFIN" was approved by NASDAQ, subject to our being in compliance with all applicable listing standards on the date we begin trading on NASDAQ. Our board of directors has not yet determined when it will request that our common stock be listed and commence trading and any decision with respect to the timing of listing will be based on market conditions and other factors. There can be no assurance as to when or if our common stock will commence trading or as to the price at which our common stock will trade. There can be no assurance that the trading price of our common stock will equal or exceed our Estimated Per-Share NAV as of December 31, 2016 of $23.37 and may differ significantly from our Estimated Per-Share NAV. The current lack of liquidity for shares of our common stock could adversely affect the market price of our common stock upon listing. Because there is no established market for our shares of common stock, any stockholders wishing to exit their investment have not had the opportunity to do so. Once our common stock is listed on a national securities exchange, these stockholders and others will have the ability to sell their shares of common stock. Sales of substantial amounts of shares of our common stock, or the perception that such sales might occur could result in downward pressure on the price of our common stock. 58 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds. Recent Sale of Unregistered Equity Securities On July 21, 2017, we awarded each of our five independent directors 1,283 restricted shares of common stock ("restricted shares") under our employee and director incentive restricted share plan. All of these awards of restricted shares were exempt from registration under Section 4(a)(2) of the Securities Act of 1933, as amended. Purchases of Equity Securities by the Issuer and Affiliated Purchasers Our board of directors has adopted the SRP that enables our stockholders to sell their shares to us under limited circumstances. At the time a stockholder requests a repurchase, we may, subject to certain conditions, repurchase the shares presented for repurchase for cash to the extent we have sufficient funds available. The following table summarizes the repurchases of shares under the SRP cumulatively through September 30, 2017 : | Number of Shares | Weighted-Average Price per Share ------------------------------------------------+------------------+--------------------------------- Cumulative repurchases as of December 31, 2016 | 2,081,499 | | $ | 24.12 ------------------------------------------------+------------------+----------------------------------+-------+------ Three months ended March 31, 2017 | 848,822 | (1) | 23.85 | ------------------------------------------------+------------------+----------------------------------+-------+------ Three months ended June 30, 2017 | 6,084 | | 23.83 | ------------------------------------------------+------------------+----------------------------------+-------+------ Three months ended September 30, 2017 | 370,472 | (2) | 23.41 | ------------------------------------------------+------------------+----------------------------------+-------+------ Cumulative repurchases as of September 30, 2017 | 3,306,877 | | $ | 23.97 ------------------------------------------------+------------------+----------------------------------+-------+------ ___________________________________ (1) | Excludes rejected repurchase requests received during 2016 with respect to 5.9 million shares for $140.1 million at a weighted-average price per share of 23.65. ----+----------------------------------------------------------------------------------------------------------------------------------------------------------------- (2) | In July 2017, following the effectiveness of the amendment and restatement of the SRP, our board of directors approved 100% of the repurchase requests made following the death or qualifying disability of stockholders during the period from January 1, 2017 to June 30, 2017. No repurchases have been or will be made with respect to requests received during 2017 that are not valid requests in accordance with the amended and restated SRP. ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ Item 3. Defaults Upon Senior Securities. None. Item 4. Mine Safety Disclosures. Not applicable. Item 5. Other Information. Articles Supplementary On November 9, 2017, the Company’s board of directors, upon recommendation of its nominating and corporate governance committee (which is comprised entirely of independent directors), unanimously approved a resolution electing to be subject to Section 3-803 of the Maryland General Corporation Law (“MGCL”), so that the board of directors will be classified into three classes each initially comprised of no more than two directors. The initial members of each class will be determined by the Company’s board of directors in advance of the Company’s 2018 annual stockholder meeting. As a result of the change, approximately one-third of the board of directors will be elected at each annual meeting of the Company’s stockholders for three year terms and until their successors are duly elected and qualify. On November 9, 2017, the Company filed Articles Supplementary with the State Department of Assessments and Taxation of Maryland to implement this change (the "Articles Supplementary"). The Articles Supplementary were effective upon the acceptance for record of the filing. The number of directors in each class may be changed from time to time by the board of directors to reflect an increase or decrease in the total number of directors so that each class, to the extent possible, will have the same number of directors. The decision by the Company’s board of directors to adopt a classified board was not taken in response to any known takeover attempt or threat, but rather because the Company’s board of directors, in considering various arguments for and against having a classified board, believed it is in the best interest of the Company to promote its operating stability and the implementation of the Company’s long-term business strategy. The foregoing description of the Articles Supplementary does not purport to be complete and is qualified in its entirety by reference to the full text of the Articles Supplementary, which is filed as an exhibit to this Quarterly Report on Form 10-Q. 59 Indemnification Agreement On November 13, 2017, in connection with the election of Katie P. Kurtz as our chief financial officer, secretary and treasurer, effective upon the resignation of Nicholas Radesca from the same role, we entered into an indemnification agreement (the “Indemnification Agreement”) with Ms. Kurtz in the same form as the indemnification agreements we have entered into with our other directors and officers. Under the Indemnification Agreement, Ms. Kurtz will be indemnified by us to the maximum extent permitted by Maryland law for certain liabilities and will be advanced certain expenses that have been incurred as a result of actions brought, or threatened to be brought, against her as our officer as a result of her service, subject to the limitations set forth in the Indemnification Agreement. The Indemnification Agreement will become effective on November 15, 2017, the date Mr. Radesca’s resignation will become effective. The foregoing description of the Indemnification Agreement does not purport to be complete and is qualified in its entirety by reference to the full text of the Indemnification Agreement, which is filed as an exhibit to this Quarterly Report on Form 10-Q. Item 6. Exhibits. The exhibits listed on the Exhibit Index (following the signatures section of this report) are included, or incorporated by reference, in this Quarterly Report on Form 10-Q. 60 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. AMERICAN FINANCE TRUST, INC. ---------------------------- By: | /s/ Edward M. Weil, Jr. -----------------------------+--------------------------------------------------------------------------------------------------------------- | Edward M. Weil, Jr. -----------------------------+--------------------------------------------------------------------------------------------------------------- | Chief Executive Officer and President(Principal Executive Officer) -----------------------------+--------------------------------------------------------------------------------------------------------------- By: | /s/ Nicholas Radesca -----------------------------+--------------------------------------------------------------------------------------------------------------- | Nicholas Radesca -----------------------------+--------------------------------------------------------------------------------------------------------------- | Chief Financial Officer, Treasurer and Secretary(Principal Financial Officer and Principal Accounting Officer) -----------------------------+--------------------------------------------------------------------------------------------------------------- Dated: November 13, 2017 61 EXHIBITS INDEX The following exhibits are included, or incorporated by reference, in this Quarterly Report on Form 10-Q for the quarter ended September 30, 2017 (and are numbered in accordance with Item 601 of Regulation S-K). Exhibit No. | Description ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3.1 * | Articles Supplementary relating to election to be subject to Section 3-803 of the MGCL ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.1 * | Indemnification Agreement between American Finance Trust, Inc. and Katie P. Kurtz, dated as of November 13, 2017 ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.1 * | Certification of the Principal Executive Officer of the Company pursuant to Securities Exchange Act Rule 13a-14(a) or 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.2 * | Certification of the Principal Financial Officer of the Company pursuant to Securities Exchange Act Rule 13a-14(a) or 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 32 * | Written statements of the Principal Executive Officer and Principal Financial Officer of the Company pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101 * | XBRL (eXtensible Business Reporting Language). The following materials from American Finance Trust, Inc.'s Quarterly Report on Form 10-Q for the three and nine months ended September 30, 2017, formatted in XBRL: (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Operations and Comprehensive Loss, (iii) the Consolidated Statement of Changes in Equity, (iv) the Consolidated Statements of Cash Flows and (v) the Notes to the Consolidated Financial Statements. ------------+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ____________________ * Filed herewith. 62

American Realty Capital Healthcare Trust III, Inc.

1609234

10-Q

0001609234-17-000012

Document UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) ---------- x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 -----------+---------------------------------------------------------------------------------------- For the quarterly period ended September 30, 2017 | OR --+----------------------------------------------------------------------------------------- o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 --+----------------------------------------------------------------------------------------- For the transition period from _________ to __________ Commission file number: 000-55625 American Realty Capital Healthcare Trust III, Inc. (Exact name of registrant as specified in its charter) Maryland | 38-3930747 ---------------------------------------------------------------+------------------------------------- (State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) ---------------------------------------------------------------+------------------------------------- 405 Park Ave., 4th Floor, New York, NY | 10022 ---------------------------------------------------------------+------------------------------------- (Address of principal executive offices) | (Zip Code) ---------------------------------------------------------------+------------------------------------- (212) 415-6500 -------------------------------------------------------------- (Registrant's telephone number, including area code) -------------------------------------------------------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o Indicate by check mark whether the registrant submitted electronically and posted on its corporate Web Site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of "large accelerated filer," "accelerated filer," "smaller reporting company" and "emerging growth company" in Rule 12b-2 of the Exchange Act. Large accelerated filer o | | Accelerated filer o --------------------------+-----------------------------------------------+---------------------------- Non-accelerated filer o | (Do not check if a smaller reporting company) | Smaller reporting company x --------------------------+-----------------------------------------------+---------------------------- | | Emerging growth company x --------------------------+-----------------------------------------------+---------------------------- If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. x Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). o Yes x No Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: As of October 31, 2017 , the registrant had 6,956,304 shares of common stock outstanding. AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS | Page -----------------------------------------------------------------------------------------------------------------------------------------+----- PART I — FINANCIAL INFORMATION | -----------------------------------------------------------------------------------------------------------------------------------------+----- Item 1. Financial Statements. | -----------------------------------------------------------------------------------------------------------------------------------------+----- Consolidated Balance Sheets as of September 30, 2017 (Unaudited) and December 31, 2016 | 3 -----------------------------------------------------------------------------------------------------------------------------------------+----- Consolidated Statements of Operations and Comprehensive Loss for the Three and Nine Months Ended September 30, 2017 and 2016 (Unaudited) | 4 -----------------------------------------------------------------------------------------------------------------------------------------+----- Consolidated Statement of Equity for the Nine Months Ended September 30, 2017 (Unaudited) | 5 -----------------------------------------------------------------------------------------------------------------------------------------+----- Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2017 and 2016 (Unaudited) | 6 -----------------------------------------------------------------------------------------------------------------------------------------+----- Notes to Consolidated Financial Statements (Unaudited) | 7 -----------------------------------------------------------------------------------------------------------------------------------------+----- Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. | 33 -----------------------------------------------------------------------------------------------------------------------------------------+----- Item 3. Quantitative and Qualitative Disclosures About Market Risk. | 46 -----------------------------------------------------------------------------------------------------------------------------------------+----- Item 4. Controls and Procedures. | 47 -----------------------------------------------------------------------------------------------------------------------------------------+----- PART II — OTHER INFORMATION | 48 -----------------------------------------------------------------------------------------------------------------------------------------+----- Item 1. Legal Proceedings. | 48 -----------------------------------------------------------------------------------------------------------------------------------------+----- Item 1A. Risk Factors. | 48 -----------------------------------------------------------------------------------------------------------------------------------------+----- Item 2. Unregistered Sales of Equity Securities and Use of Proceeds of Registered Securities. | 53 -----------------------------------------------------------------------------------------------------------------------------------------+----- Item 3. Defaults Upon Senior Securities. | 54 -----------------------------------------------------------------------------------------------------------------------------------------+----- Item 4. Mine Safety Disclosures. | 54 -----------------------------------------------------------------------------------------------------------------------------------------+----- Item 5. Other Information. | 54 -----------------------------------------------------------------------------------------------------------------------------------------+----- Item 6. Exhibits. | 54 -----------------------------------------------------------------------------------------------------------------------------------------+----- Signatures. | 55 -----------------------------------------------------------------------------------------------------------------------------------------+----- 2 Part I — FINANCIAL INFORMATION Item 1. Financial Statements. AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (In thousands, except share and per share data) | September 30, | | December 31, -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+------------- | 2017 | | 2016 -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+------------- | (Unaudited) | | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+------------- ASSETS | | | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+------------- Real estate investments, at cost: | | | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+------------- Land | $ | 10,225 | | | $ | 10,225 -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+--------------+---------+---+-------- Buildings, fixtures and improvements | 101,226 | | | 101,197 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+--------------+---------+-- Acquired intangible lease assets | 18,450 | | | 18,450 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+--------------+---------+-- Total real estate investments, at cost | 129,901 | | | 129,872 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+--------------+---------+-- Less: accumulated depreciation and amortization | (12,326 | ) | | (8,137 | ) -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+--------------+---------+-- Total real estate investments, net | 117,575 | | | 121,735 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+--------------+---------+-- Cash | 12,970 | | | 16,371 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+--------------+---------+-- Restricted cash | 114 | | | 37 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+--------------+---------+-- Straight-line rent receivable | 812 | | | 662 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+--------------+---------+-- Prepaid expenses and other assets | 937 | | | 1,242 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+--------------+---------+-- Deferred costs, net | 14 | | | 9 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+--------------+---------+-- Total assets | $ | 132,422 | | | $ | 140,056 -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+--------------+---------+---+-------- LIABILITIES AND EQUITY | | | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+------------- Mortgage note payable, net of deferred financing costs | $ | 4,866 | | | $ | 4,919 -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+--------------+---------+---+-------- Mortgage premium, net | 81 | | | 113 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+--------------+---------+-- Market lease intangible liabilities, net | 1,590 | | | 1,701 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+--------------+---------+-- Accounts payable and accrued expenses (including $721 and $130 due to related parties as of September 30, 2017 and December 31, 2016, respectively) | 3,326 | | | 1,904 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+--------------+---------+-- Deferred rent | 453 | | | 472 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+--------------+---------+-- Distributions payable | 1 | | | 925 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+--------------+---------+-- Total liabilities | 10,317 | | | 10,034 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+--------------+---------+-- Preferred stock, $0.01 par value, 50,000,000 shares authorized, none issued and outstanding as of September 30, 2017 and December 31, 2016 | — | | | — | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+--------------+---------+-- Common stock, $0.01 par value, 300,000,000 shares authorized, 6,956,304 and 6,978,303 shares of common stock issued and outstanding as of September 30, 2017 and December 31, 2016, respectively | 70 | | | 70 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+--------------+---------+-- Additional paid-in capital | 149,693 | | | 150,109 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+--------------+---------+-- Accumulated deficit | (28,119 | ) | | (20,621 | ) -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+--------------+---------+-- Total stockholders' equity | 121,644 | | | 129,558 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+--------------+---------+-- Non-controlling interests | 461 | | | 464 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+--------------+---------+-- Total equity | 122,105 | | | 130,022 | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+--------------+---------+-- Total liabilities and equity | $ | 132,422 | | | $ | 140,056 -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------+---------------+---------+--------------+---------+---+-------- The accompanying notes are an integral part of these consolidated financial statements. 3 AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS) (In thousands, except share and per share data) (Unaudited) | Three Months Ended September 30, | | Nine Months Ended September 30, ---------------------------------------------------------+----------------------------------+-------+-------------------------------- | 2017 | | 2016 | | 2017 | | 2016 ---------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+-------+---------- Revenues: | | | | | | | ---------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+-------+---------- Rental income | $ | 2,277 | | | $ | 2,272 | | | $ | 6,830 | | | $ | 6,817 ---------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+-------+-----------+-----------+---+-----------+---+-----------+---+------ Operating expense reimbursements | 651 | | | 652 | | | 1,950 | | | 1,903 | ---------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+-------+-----------+-----------+---+-----------+-- Resident services and fee income | 670 | | | 749 | | | 2,081 | | | 2,156 | ---------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+-------+-----------+-----------+---+-----------+-- Total revenues | 3,598 | | | 3,673 | | | 10,861 | | | 10,876 | ---------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+-------+-----------+-----------+---+-----------+-- Expenses: | | | | | | | ---------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+-------+---------- Property operating and maintenance | 1,374 | | | 1,306 | | | 4,144 | | | 3,847 | ---------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+-------+-----------+-----------+---+-----------+-- Operating fees to related party | 15 | | | 41 | | | 42 | | | 120 | ---------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+-------+-----------+-----------+---+-----------+-- Acquisition and transaction related | 568 | | | 104 | | | 1,727 | | | 237 | ---------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+-------+-----------+-----------+---+-----------+-- General and administrative | 740 | | | 363 | | | 2,087 | | | 1,584 | ---------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+-------+-----------+-----------+---+-----------+-- Depreciation and amortization | 1,304 | | | 1,502 | | | 3,939 | | | 4,660 | ---------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+-------+-----------+-----------+---+-----------+-- Total expenses | 4,001 | | | 3,316 | | | 11,939 | | | 10,448 | ---------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+-------+-----------+-----------+---+-----------+-- Operating income (loss) | (403 | ) | | 357 | | | (1,078 | ) | | 428 | ---------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+-------+-----------+-----------+---+-----------+-- Other income (expense): | | | | | | | ---------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+-------+---------- Interest expense | (46 | ) | | (47 | ) | | (139 | ) | | (142 | ) ---------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+-------+-----------+-----------+---+-----------+-- Interest and other income | — | | | — | | | — | | | 1 | ---------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+-------+-----------+-----------+---+-----------+-- Total other expense | (46 | ) | | (47 | ) | | (139 | ) | | (141 | ) ---------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+-------+-----------+-----------+---+-----------+-- Income (loss) before income taxes | (449 | ) | | 310 | | | (1,217 | ) | | 287 | ---------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+-------+-----------+-----------+---+-----------+-- Income tax benefit (expense) | 58 | | | (74 | ) | | 32 | | | (147 | ) ---------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+-------+-----------+-----------+---+-----------+-- Net income (loss) | (391 | ) | | 236 | | | (1,185 | ) | | 140 | ---------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+-------+-----------+-----------+---+-----------+-- Net loss attributable to non-controlling interests | (5 | ) | | (4 | ) | | (12 | ) | | (13 | ) ---------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+-------+-----------+-----------+---+-----------+-- Net income (loss) attributable to stockholders | (396 | ) | | 232 | | | (1,197 | ) | | 127 | ---------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+-------+-----------+-----------+---+-----------+-- Comprehensive income (loss) attributable to stockholders | $ | (396 | ) | | $ | 232 | | | $ | (1,197 | ) | | $ | 127 ---------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+-------+-----------+-----------+---+-----------+---+-----------+---+------ Basic net income (loss) per share | $ | (0.06 | ) | | $ | 0.03 | | | $ | (0.17 | ) | | $ | 0.02 ---------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+-------+-----------+-----------+---+-----------+---+-----------+---+------ Basic weighted-average shares outstanding | 6,951,111 | | | 6,908,297 | | | $ | 6,948,884 | | | $ | 6,857,513 | ---------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+-------+-----------+-----------+---+-----------+---+-----------+-- Diluted net income (loss) per share | $ | (0.06 | ) | | $ | 0.02 | | | $ | (0.17 | ) | | $ | — ---------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+-------+-----------+-----------+---+-----------+---+-----------+---+------ Diluted weighted-average shares outstanding | 6,951,111 | | | 6,914,287 | | | 6,948,884 | | | 6,862,756 | ---------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+-------+-----------+-----------+---+-----------+-- Distributions declared per share | $ | 0.13 | | | $ | 0.39 | | | $ | 0.91 | | | $ | 1.17 ---------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+-------+-----------+-----------+---+-----------+---+-----------+---+------ The accompanying notes are an integral part of these unaudited consolidated financial statements. 4 AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF EQUITY For the Nine Months Ended September 30, 2017 (In thousands, except share data) (Unaudited) | Common Stock | | | | | | | | | -----------------------------------------------------------+-----------------+---+-----------+----+---------------------------+---------------------+---+----------------------------+--------+-------------------------- | Number ofShares | | Par Value | | Additional Paid-inCapital | Accumulated Deficit | | Total Stockholders' Equity | | Non-controlling Interests | | Total Equity -----------------------------------------------------------+-----------------+---+-----------+----+---------------------------+---------------------+---+----------------------------+--------+---------------------------+---+------------- Balance, December 31, 2016 | 6,978,303 | | | $ | 70 | | $ | 150,109 | | | $ | (20,621 | ) | $ | 129,558 | | $ | 464 | $ | 130,022 -----------------------------------------------------------+-----------------+---+-----------+----+---------------------------+---------------------+---+----------------------------+--------+---------------------------+---+--------------+---+-----+---------+--------+---+-----+---+-------- Common stock issued through distribution reinvestment plan | 60,495 | | | 1 | | 1,436 | | | — | | | 1,437 | | — | | 1,437 | -----------------------------------------------------------+-----------------+---+-----------+----+---------------------------+---------------------+---+----------------------------+--------+---------------------------+---+--------------+---+-----+---------+--------+-- Common stock repurchases | (82,494 | ) | | (1 | ) | (1,879 | ) | | — | | | (1,880 | ) | — | | (1,880 | ) -----------------------------------------------------------+-----------------+---+-----------+----+---------------------------+---------------------+---+----------------------------+--------+---------------------------+---+--------------+---+-----+---------+--------+-- Share-based compensation | — | | | — | | 27 | | | — | | | 27 | | — | | 27 | -----------------------------------------------------------+-----------------+---+-----------+----+---------------------------+---------------------+---+----------------------------+--------+---------------------------+---+--------------+---+-----+---------+--------+-- Distributions declared | — | | | — | | — | | | (6,301 | ) | | (6,301 | ) | (15 | ) | (6,316 | ) -----------------------------------------------------------+-----------------+---+-----------+----+---------------------------+---------------------+---+----------------------------+--------+---------------------------+---+--------------+---+-----+---------+--------+-- Net income (loss) | — | | | — | | — | | | (1,197 | ) | | (1,197 | ) | 12 | | (1,185 | ) -----------------------------------------------------------+-----------------+---+-----------+----+---------------------------+---------------------+---+----------------------------+--------+---------------------------+---+--------------+---+-----+---------+--------+-- Balance, September 30, 2017 | 6,956,304 | | | $ | 70 | | $ | 149,693 | | | $ | (28,119 | ) | $ | 121,644 | | $ | 461 | $ | 122,105 -----------------------------------------------------------+-----------------+---+-----------+----+---------------------------+---------------------+---+----------------------------+--------+---------------------------+---+--------------+---+-----+---------+--------+---+-----+---+-------- The accompanying notes are an integral part of this unaudited consolidated financial statement. 5 AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) (Unaudited) | Nine Months Ended September 30, --------------------------------------------------------------------------------+-------------------------------- | 2017 | | 2016 --------------------------------------------------------------------------------+---------------------------------+--------+----- Cash flows from operating activities: | | | --------------------------------------------------------------------------------+---------------------------------+--------+----- Net income (loss) | $ | (1,185 | ) | | $ | 140 --------------------------------------------------------------------------------+---------------------------------+--------+------+--------+---+------- Adjustments to reconcile net loss to net cash provided by operating activities: | | | --------------------------------------------------------------------------------+---------------------------------+--------+----- Depreciation and amortization | 3,939 | | | 4,660 | --------------------------------------------------------------------------------+---------------------------------+--------+------+--------+-- Amortization of deferred financing costs | 22 | | | 22 | --------------------------------------------------------------------------------+---------------------------------+--------+------+--------+-- Amortization of mortgage premium | (32 | ) | | (32 | ) --------------------------------------------------------------------------------+---------------------------------+--------+------+--------+-- Amortization of market lease and other intangibles | 154 | | | 154 | --------------------------------------------------------------------------------+---------------------------------+--------+------+--------+-- Share-based compensation | 27 | | | 32 | --------------------------------------------------------------------------------+---------------------------------+--------+------+--------+-- Changes in assets and liabilities: | | | --------------------------------------------------------------------------------+---------------------------------+--------+----- Straight-line rent receivable | (150 | ) | | (392 | ) --------------------------------------------------------------------------------+---------------------------------+--------+------+--------+-- Prepaid expenses and other assets | 318 | | | (186 | ) --------------------------------------------------------------------------------+---------------------------------+--------+------+--------+-- Accounts payable and accrued expenses | 1,422 | | | 116 | --------------------------------------------------------------------------------+---------------------------------+--------+------+--------+-- Deferred rent | (19 | ) | | 233 | --------------------------------------------------------------------------------+---------------------------------+--------+------+--------+-- Restricted cash | (77 | ) | | 51 | --------------------------------------------------------------------------------+---------------------------------+--------+------+--------+-- Net cash provided by operating activities | 4,419 | | | 4,798 | --------------------------------------------------------------------------------+---------------------------------+--------+------+--------+-- Cash flows from investing activities: | | | --------------------------------------------------------------------------------+---------------------------------+--------+----- Capital expenditures | (62 | ) | | (120 | ) --------------------------------------------------------------------------------+---------------------------------+--------+------+--------+-- Net cash used in investing activities | (62 | ) | | (120 | ) --------------------------------------------------------------------------------+---------------------------------+--------+------+--------+-- Cash flows from financing activities: | | | | --------------------------------------------------------------------------------+---------------------------------+--------+------+------- Payments on mortgage note payable | (75 | ) | | (71 | ) --------------------------------------------------------------------------------+---------------------------------+--------+------+--------+-- Common stock repurchases | (1,880 | ) | | — | --------------------------------------------------------------------------------+---------------------------------+--------+------+--------+-- Payments of offering costs and fees related to common stock issuances | — | | | (212 | ) --------------------------------------------------------------------------------+---------------------------------+--------+------+--------+-- Distributions paid | (5,788 | ) | | (4,810 | ) --------------------------------------------------------------------------------+---------------------------------+--------+------+--------+-- Distributions to non-controlling interest holders | (15 | ) | | (17 | ) --------------------------------------------------------------------------------+---------------------------------+--------+------+--------+-- Net cash used in financing activities | (7,758 | ) | | (5,110 | ) --------------------------------------------------------------------------------+---------------------------------+--------+------+--------+-- Net change in cash | (3,401 | ) | | (432 | ) --------------------------------------------------------------------------------+---------------------------------+--------+------+--------+-- Cash, beginning of period | 16,371 | | | 16,808 | --------------------------------------------------------------------------------+---------------------------------+--------+------+--------+-- Cash, end of period | $ | 12,970 | | | $ | 16,376 --------------------------------------------------------------------------------+---------------------------------+--------+------+--------+---+------- Supplemental disclosure of cash flow information: | | -----------------------------------------------------------+-------+---- Cash paid for interest | $ | 150 | | $ | 152 -----------------------------------------------------------+-------+-----+-------+---+---- Cash paid for income taxes | 155 | | 129 | -----------------------------------------------------------+-------+-----+-------+-- Non-cash investing and financing activities: | | -----------------------------------------------------------+-------+---- Payable and accrued offering costs | $ | 228 | | $ | 228 -----------------------------------------------------------+-------+-----+-------+---+---- Common stock issued through distribution reinvestment plan | 1,437 | | 3,232 | -----------------------------------------------------------+-------+-----+-------+-- The accompanying notes are an integral part of these unaudited consolidated financial statements. 6 AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) Note 1 — Organization American Realty Capital Healthcare Trust III, Inc. (including, as required by context, American Realty Capital Healthcare III Operating Partnership, L.P. (the "OP") and its subsidiaries, the "Company") was incorporated on April 24, 2014 as a Maryland corporation that elected and qualified to be taxed as a real estate investment trust for U.S. federal income tax purposes ("REIT") beginning with its taxable year ended December 31, 2015. The Company was formed to primarily acquire a diversified portfolio of healthcare-related assets, including medical office buildings ("MOBs"), seniors housing communities and other healthcare-related facilities. The Company purchased its first property and commenced real estate operations in March 2015. As of September 30, 2017 , the Company owned 19 properties located in 10 states, comprised of 0.5 million rentable square feet. On August 20, 2014, the Company commenced its initial public offering (the "IPO") on a "reasonable best efforts" basis of up to 125.0 million shares of common stock, $0.01 par value per share, at a price of $25.00 per share, subject to certain volume and other discounts, for total gross proceeds of up to $3.1 billion , plus up to 26.3 million shares of common stock available pursuant to a distribution reinvestment plan (the "DRIP"). On November 15, 2015, the Company announced the suspension of its IPO, effective December 31, 2015, and in August 2016, the IPO lapsed in accordance with its terms, having raised significantly less capital than expected. As of September 30, 2017 , the Company had approximately 7.0 million shares of common stock outstanding, including unvested restricted shares of common stock ("restricted shares") and shares issued pursuant to the DRIP, and had received total proceeds from the IPO and the DRIP, net of share repurchases, of $171.1 million . Substantially all of the Company's business is conducted through the OP. The Company has no employees. American Realty Capital Healthcare III Advisors, LLC (the "Advisor") has been retained to manage the Company's affairs on a day-to-day basis. The Company also has retained American Realty Capital Healthcare III Properties, LLC (the "Property Manager") to serve as the Company's property manager. The Advisor and the Property Manager are under common control with AR Global Investments, LLC (the successor business to AR Capital, LLC, "AR Global"), the parent of the American Realty Capital VII, LLC, the Company's sponsor, (the "Sponsor"), as a result of which they are related parties, and each of which have received or will receive compensation, fees and other expense reimbursements from the Company for services related to managing the Company's business. The Advisor, the Property Manager and Realty Capital Securities, LLC (the "Former Dealer Manager") have received or may receive fees during the Company's offering, acquisition, operational and liquidation stages. On June 16, 2017, the Company, the OP and ARHC TRS Holdco III, LLC, a subsidiary of the OP (“HT III Holdco”) entered into a purchase agreement (the “Purchase Agreement”) with Healthcare Trust, Inc. (“HTI”), Healthcare Trust Operating Partnership, L.P. (“HTI OP”) and ARHC TRS Holdco II, LLC (“HTI Holdco”), pursuant to which HTI, the HTI OP and HTI Holdco have agreed to purchase membership interests in the Company’s indirect subsidiaries which collectively own all 19 properties owned by the Company and comprise substantially all of the Company’s assets (together with the other transactions contemplated by the Purchase Agreement, the “Asset Sale”). Also on June 16, 2017, the American Realty Capital Healthcare Trust III, Inc. board of directors (the "Board of Directors") approved a plan of liquidation and dissolution of the Company (the “Plan of Liquidation”), which becomes effective if the Asset Sale closes. In connection with the Purchase Agreement, the Company entered into a letter agreement on the same date (as amended on September 28, 2017, the “Letter Agreement”) governing, if the Asset Sale closes, the fees and expenses that had become or would become payable by or to the Advisor and its affiliates or the Company. See Note 2 — Purchase Agreement and Plan of Liquidation and Note 8 — Related Party Transactions and Arrangements. Note 2 — Purchase Agreement and Plan of Liquidation Purchase Agreement On June 16, 2017, the Company, the OP and HT III Holdco entered into the Purchase Agreement with HTI, HTI OP and HTI Holdco. HTI is sponsored and advised by affiliates of the Advisor. Pursuant to the Purchase Agreement, HTI, HTI OP, and HTI Holdco have agreed to purchase membership interests in the Company’s indirect subsidiaries which collectively own all 19 properties owned by the Company and comprise substantially all of the Company’s assets for a purchase price of $120.0 million (the “Purchase Price”). 7 AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) The Purchase Price is subject to customary prorations and closing adjustments in accordance with the terms of the Purchase Agreement and will be payable on the date the Asset Sale is consummated (the “Closing Date”) less $4.9 million , the principal amount of the loan secured by the Company’s Philip Center property (the “Philip Center Loan”) which will be assumed by HTI, or repaid by the Company, and associated costs. Pursuant to the terms of the Purchase Agreement, HTI has agreed to use commercially reasonable efforts (including paying early termination fees not to exceed $200,000 ) to assume the Philip Center Loan and to cause the Company to be released from the guaranty associated with the Philip Center Loan. If HTI does not assume the Philip Center Loan on the Closing Date or if the Company is not released from the guaranty associated with the Philip Center Loan, the Philip Center Loan will be repaid in full by the Company on the Closing Date and any early termination fee in excess of $200,000 will be subtracted from the Purchase Price. HTI will deposit $6.0 million (the “Escrow Amount”) of the Purchase Price payable into an escrow account for the benefit of the Company on the Closing Date, and this amount, less any amounts paid or reserved for pending or unsatisfied indemnification claims of HTI made pursuant to the Purchase Agreement, will be released in installments thereafter over a period of 14 months following the Closing Date. In connection with its approval of the Purchase Agreement, the Board of Directors also approved the Plan of Liquidation, which is subject to stockholder approval. On October 23, 2017, the Company filed a definitive proxy statement related to its 2017 annual meeting of stockholders (the "Annual Meeting") at which stockholder approval of the Asset Sale and the Plan of Liquidation will be sought. The Annual Meeting is scheduled to be held on December 21, 2017. The closing of the Asset Sale is conditioned upon stockholder approval of both the Asset Sale and the Plan of Liquidation. Thus, if stockholders do not approve the Plan of Liquidation, the Asset Sale will not be completed even if stockholders approve the Asset Sale. Likewise, the effectiveness of the Plan of Liquidation is conditioned upon stockholder approval of the Plan of Liquidation and the closing of the Asset Sale. If the Asset Sale is not approved and does not close, the Plan of Liquidation will not become effective regardless of whether or not it has been approved. The Company expects that effectiveness of the Plan of Liquidation will cause the Company’s basis of accounting to change from the going-concern basis to the liquidation basis of accounting, which requires the Company’s assets to be measured at the estimated amounts of consideration the entity expects to collect in settling and disposing of its assets and liabilities are to be measured at the estimated amounts at which the liabilities are expected to be settled. Pursuant to the terms of the Purchase Agreement, HTI has agreed to use commercially reasonable efforts (including paying early termination fees not to exceed $200,000 ) to assume the Philip Center Loan and to cause the Company to be released from the guaranty associated with the Philip Center Loan. If HTI does not assume the Philip Center Loan on the Closing Date or if the Company is not released from the guaranty associated with the Philip Center Loan, the Philip Center Loan will be repaid in full by the Company on the Closing Date and any early termination fee in excess of $200,000 will be subtracted from the Purchase Price. The Purchase Agreement contains a number of customary representations and warranties for transactions of this type made by HTI, HTI OP and HTI Holdco (the "Purchaser Parties"), on the one hand, and the Company, the OP and HT III Holdco (the "Seller Parties"), on the other hand. The representations and warranties were made by the parties as of the date of the Purchase Agreement and generally survive (along with related indemnification obligations described below) for a period of 14 months following the Closing Date. Certain of these representations and warranties are subject to specified exceptions and qualifications contained in the Purchase Agreement and are qualified by the disclosure letters delivered in connection therewith. The Seller Parties have agreed to pay in full or cause to be cancelled or discharged all liens and encumbrances against the Properties at or prior to the Closing Date. If the Seller Parties fail to pay any liens or encumbrances at or prior to the Closing Date, Purchaser Parties may pay those amounts and credit the amount paid against the Purchase Price. The Seller Parties and the Purchaser Parties have agreed to jointly and severally indemnify, hold harmless and defend the other parties from losses in connection with certain matters, including, among others: (i) breaches of representations and warranties and failures of covenants by the other parties; (ii) with respect to indemnification by the Seller Parties only, taxes payable by the Company, its subsidiaries or any of their respective affiliates in connection with any taxable period prior to the Closing Date, and any interest and penalties thereon; and (iii) with respect to indemnification by the Seller Parties only, any stockholder litigation brought by the Company’s stockholders directly or derivatively in connection with the transactions contemplated by the Purchase Agreement, subject to certain limitations. A party will not become liable for indemnification with respect to breaches of representations and warranties and failures of covenants unless and until the aggregate amount of indemnifiable claims by the other party exceeds $500,000 and this liability may not exceed 10% of the Purchase Price. Indemnifiable losses for which the Seller Parties are liable are recoverable by the Purchaser Parties first out of the Escrow 8 AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) Amount and then, to the extent the indemnifiable losses exceed the Escrow Amount, from the Seller Parties, jointly and severally. The Purchase Agreement prohibits the Company from initiating, soliciting, knowingly encouraging or facilitating any inquiries or the making of any proposal, offer or other action that constitutes, or may reasonably be expected to lead to, any Acquisition Proposal (as defined in the Purchase Agreement). However, prior to receipt of the stockholder approval of the Asset Sale and the Plan of Liquidation, if the Company receives a bona fide written Acquisition Proposal that did not result from a breach of these exclusivity provisions and which the Special Committee determines in good faith, after consultation with its legal and financial advisors, is or is reasonably expected to lead to a Superior Proposal (as defined in the Purchase Agreement), the Company may furnish, make available or provide access to non-public information with respect to the Company to the person who made the Acquisition Proposal, participate in negotiations regarding the Acquisition Proposal and disclose to the Company’s stockholders any information required to be disclosed under applicable law. The Purchase Agreement provides that the Board of Directors may, if it determines in good faith after consultation with its legal advisor (and based on the recommendation of the Special Committee) that the failure of the Board of Directors to take certain actions related to changing its recommendation to the Company’s stockholders with respect to its approval of the Asset Sale or the Plan of Liquidation or entering into an agreement related to an Acquisition Proposal (any such action, a “Change in Recommendation”) would be reasonably likely to be inconsistent with the standard of conduct applicable to the Company’s directors under applicable law, subject to certain conditions, (i) make a Change in Recommendation upon receipt by the Company of an Acquisition Proposal that constitutes a Superior Proposal or (ii) otherwise, under certain circumstances, make a Change in Recommendation in response to certain material events, circumstances, changes or developments that were not known to the Board of Directors prior to signing the Purchase Agreement. The Purchase Agreement provides for certain termination rights of the Company and HTI, including HTI’s right to terminate the Purchase Agreement upon the occurrence of a Change in Recommendation or a material violation by the Company of its exclusivity obligations under the Purchase Agreement, in which event the Company will be required to pay HTI a termination fee of $3.6 million . In addition, the Company has agreed to reimburse HTI for up to $850,000 for certain transaction-related expenses (excluding HTI’s advisor expenses) if the Purchase Agreement is terminated by either party due to the Company’s failure to obtain stockholder approval of the Asset Sale and the Plan of Liquidation. If the Company terminates the Purchase Agreement due to HTI’s failure to pay the Purchase Price at closing, HTI is required to reimburse the Company for up to $750,000 in actual third party expenses incurred in connection with the Asset Sale (without excluding Advisor expenses). Similarly, if the Company has not fulfilled certain necessary conditions to close the Asset Sale, other than obtaining stockholder approval of the Asset Sale and the Plan of Liquidation at the Annual Meeting, the Company is required to reimburse HTI for up to $750,000 in actual third party expenses incurred in connection with the Asset Sale (excluding HTI’s advisor’s expenses). The Plan of Liquidation Pursuant to the Plan of Liquidation, the Company will be required to pay or provide for its liabilities and expenses, distribute the remaining proceeds of the liquidation of the Company’s assets to its stockholders, wind up the Company’s operations, and dissolve. The Company’s common stock is registered under the Securities Exchange Act of 1934, as amended (the "Exchange Act"). While implementing the Plan of Liquidation, the Company will remain subject to the reporting requirements under the Exchange Act. The Company may seek relief from the Securities and Exchange Commission (the "SEC") from these reporting requirements after the Company files its articles of dissolution, but there can be no assurance that this relief will be granted. Pursuant to the Plan of Liquidation, the Company will, among other things: • | pay or provide for the Company’s liabilities, obligations and expenses, which may include establishing a reserve fund to provide for payment of contingent or unknown liabilities; --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | liquidate and dissolve the OP and the indirect subsidiaries of the Company and the OP, and distribute the net proceeds of the liquidation in accordance with the provisions of the organizational documents of those entities and the laws of the States of Maryland and Delaware, as applicable; --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | distribute cash and the remaining proceeds of the Asset Sale and the Company’s liquidation to stockholders in one or more distributions after paying or providing for liabilities, obligations and expenses and taking all necessary or advisable actions to wind up the Company’s affairs; and --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 9 AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) • | wind up the Company’s operations and dissolve the Company, all in accordance with the Plan of Liquidation. --+----------------------------------------------------------------------------------------------------------- The Plan of Liquidation requires the Company to use commercially reasonable efforts to liquidate and dissolve the Company and to distribute all of the Company’s assets to the holders of outstanding shares of common stock no later than the second anniversary of the effective date of the Plan of Liquidation. The Plan of Liquidation also provides, however, that this final distribution will not occur earlier than the end of the 14-month survival period of the representations and warranties under the Purchase Agreement and will not occur prior to final resolution of any unsatisfied indemnification claims or other claims that are first made prior to the end of that period. Note 3 — Summary of Significant Accounting Policies The accompanying unaudited consolidated financial statements of the Company included herein were prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP") for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. The information furnished includes all adjustments and accruals of a normal recurring nature, which, in the opinion of management, are necessary for a fair presentation of results for the interim periods. The results of operations for the three and nine months ended September 30, 2017 are not necessarily indicative of the results for the entire year or any subsequent interim period. These financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto as of and for the year ended December 31, 2016 , which are included in the Company's Annual Report on Form 10-K filed with the SEC on March 9, 2017 . There have been no significant changes to the Company's significant accounting policies during the nine months ended September 30, 2017 other than the updates described below. Principles of Consolidation and Basis of Presentation The accompanying consolidated financial statements include the accounts of the Company, the OP and its subsidiaries. All intercompany accounts and transactions are eliminated in consolidation. In determining whether the Company has a controlling financial interest in a joint venture and the requirement to consolidate the accounts of that entity, management considers factors such as ownership interest, authority to make decisions and contractual and substantive participating rights of the other partners or members as well as whether the entity is a variable interest entity ("VIE") for which the Company is the primary beneficiary. The Company has determined the OP is a VIE of which the Company is the primary beneficiary. Substantially all of the Company's assets and liabilities are held by the OP. Recently Issued Accounting Pronouncements In May 2014, the Financial Accounting Standards Board (“FASB”) issued an update (“ASU 2014-09”) establishing Accounting Standards Codification (“ASC”) Topic 606, Revenue from Contracts with Customers (“ASC 606”). ASU 2014-09, as amended by subsequent ASUs on the topic, establishes a comprehensive model for entities to use in accounting for revenue arising from contracts with customers. Under ASC 606, an entity is required to recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASC 606 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017. A reporting entity may apply the amendments in ASC 606 using either a modified retrospective approach, by recording a cumulative-effect adjustment to equity as of the beginning of the fiscal year of adoption or a full retrospective approach. The Company will adopt this guidance effective January 1, 2018 and currently expects to utilize the modified retrospective approach upon adoption and does not expect that this will result in a significant cumulative-effect adjustment to equity. If stockholder approval of the Asset Sale and the Plan of Liquidation is obtained, the Company anticipates that the provisions of this guidance will no longer apply. The Company has progressed in its project plan in evaluating its various revenue streams in order to identify any differences in the timing, measurement or presentation of revenue recognition under ASC 606 and ASC Topic 842, Leases (“ASC 842”). Based on the Company’s evaluation of its various revenue streams, the Company believes that certain elements of resident services and fee income in its seniors housing - operating properties segment as well as gains on the sale of real estate could be impacted by the adoption of ASC 606. Resident services and fee income that may be affected by ASC 606 is generated through services the Company provides to residents of its seniors housing communities that are in addition to the residents’ contractual rights to occupy living and common-area space at the communities, such as care, meals, transportation, and activities. ASC 606 requires an entity to recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. While these revenue streams may be subject to the application of ASC 606, 10 AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) the Company believes that the timing of revenue recognition will be consistent with the current accounting model because the revenues associated with these services are generally recognized on a monthly basis. As it relates to gains on the sale of real estate, the Company expects that this standard could have an impact on the timing of gains on certain sales of real estate as a result of more transactions generally qualifying as sales of real estate and revenue being recognized at an earlier date than under current accounting guidance. Specifically, the Company expects that this would impact partial sales of real estate in situations where the Company no longer retains a controlling financial interest. If the Company were to enter into partial sales of real estate, the Company would derecognize the real estate asset consistent with the principles outlined in ASC 606 and any retained non-controlling ownership interest would be measured at fair value consistent with the guidance on noncash consideration in ASC 606. Lastly, upon adoption of ASC 606, the Company believes that it will likely have to separately disclose the components of its total revenue between lease revenue accounted for under existing lease guidance and service revenue accounted for under ASC 606. The Company is continuing to evaluate any differences in the timing, measurement, or presentation of revenue recognition and the impact on the Company's consolidated financial statements and internal accounting processes resulting from ASC 606 as well as ASC Topic 842, as discussed below. In February 2016, the FASB issued an update ASU 2016-02 establishing ASC Topic 842, which sets out the principles for the recognition, measurement, presentation and disclosure of leases for both lessees and lessors. ASC 842 supersedes previous leasing standards and is effective for reporting periods beginning after December 15, 2018. Early adoption is permitted. ASC 842 will impact the lease accounting model for both lessees and lessors. The Company will adopt this guidance effective January 1, 2019. If stockholder approval of the Asset Sale and the Plan of Liquidation is obtained, the Company anticipates that the provisions of this guidance will no longer apply. The Company is a lessee for two of its properties for which it has ground leases as of September 30, 2017. For these leases, the Company will be required to record a right-of-use asset and lease liability equal to the present value of the remaining lease payments upon adoption of this update. The new standard requires lessees to apply a dual lease classification approach, classifying leases as either finance or operating leases based on the principle of whether or not the lease is effectively a financed purchase by the lessee. This classification will determine whether lease expense is recognized based on an effective interest method or on a straight line basis over the term of the lease, respectively. A lessee is also required to record a right-of-use asset and a lease liability for all leases with a term greater than 12 months regardless of their classification. Leases with a term of 12 months or less will be accounted for similar to existing guidance for operating leases today. From a lessor perspective the Company expects that the new standard will impact the presentation of lease and non-lease components of revenue such as rent, and operating expense reimbursements including common area maintenance, taxes, and insurance from leases for which the Company is a lessor. The Company does not expect this guidance to impact its existing lessor revenue recognition pattern. The Company anticipates that it will elect the following practical expedients, which must be elected as a package and applied consistently by an entity to all of its leases, which allow the Company to not have to reassess the following upon adoption: (i) whether any expired or existing contract contains a lease, (ii) lease classification related to expired or existing leases, or (iii) whether costs incurred on existing leases qualify as initial direct costs. The Company is continuing to evaluate any differences in the timing, measurement, or presentation of lessor revenues as well as the impact of the new lessee accounting model on the Company’s consolidated financial position, results of operations and disclosures. In January 2016, the FASB issued an update that amends the recognition and measurement of financial instruments. The new guidance revises an entity's accounting related to equity investments and the presentation of certain fair value changes for financial liabilities measured at fair value. Among other things, it also amends the presentation and disclosure requirements associated with the fair value of financial instruments. The Company will adopt this guidance effective January 1, 2018. The Company expects that there will be no impact to the Company's consolidated financial position, results of operations and cash flows. In March 2016, the FASB issued guidance which requires an entity to determine whether the nature of its promise to provide goods or services to a customer is performed in a principal or agent capacity and to recognize revenue in a gross or net manner based on its principal/agent designation. The Company will adopt this guidance effective January 1, 2018. The Company expects that there will be no impact to the Company's consolidated financial position, results of operations and cash flows. 11 AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) In August 2016, the FASB issued guidance on how certain transactions should be classified and presented in the statement of cash flows as either operating, investing or financing activities. Among other things, the update provides specific guidance on where to classify debt prepayment and extinguishment costs, payments for contingent consideration made after a business combination and distributions received from equity method investments. The Company will adopt this guidance effective January 1, 2018. The Company expects that there will be no impact to the Company's consolidated financial position, results of operations and cash flows. In November 2016, the FASB issued guidance on the classification of restricted cash in the statement of cash flows. The amendment requires restricted cash to be included in the beginning-of-period and end-of-period total cash amounts. Therefore, transfers between cash and restricted cash will no longer be shown on the statement of cash flows. The Company will adopt this guidance effective January 1, 2018, using a retrospective transition method. As a result, the Company will restate its statements of cash flows for all periods presented to include restricted cash in the beginning and ending cash balances and remove all transfers between cash and restricted cash from operating, investing and financing activities. In February 2017, the FASB issued guidance on the derecognition of nonfinancial assets. The guidance clarifies the definition of in substance non-financial assets, unifies guidance related to partial sales of non-financial assets, eliminates rules specifically addressing the sales of real estate, removes the exception to the financial asset derecognition model and clarifies the accounting for contributions of non-financial assets to joint ventures. The Company will adopt this guidance effective January 1, 2018. The Company expects that any future sales of real estate in which the Company retains a non-controlling interest in the property would result in the full gain amount being recognized at the time of the partial sale. Historically, the Company has not retained any interest in properties it has sold. If stockholder approval of the Asset Sale and the Plan of Liquidation is obtained, the Company anticipates that the provisions of this guidance will no longer apply. In May 2017, the FASB issued guidance that clarifies which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting. The update states that modification accounting should be used unless the fair value of the award, the vesting terms of the award and the classification of the award as either equity or liability, all do not change as a result of the modification. The Company will adopt this guidance effective January 1, 2018. The Company expects that any future modifications to its issued share-based awards will be accounted for using modification accounting, unless the modification meets all of the exception criteria noted above. As a result, the modification would be treated as an exchange of the original award for a new award, with any incremental fair value being treated as additional compensation cost. Recently Adopted Accounting Pronouncements In October 2016, the FASB issued guidance where a reporting entity will need to evaluate if it should consolidate a VIE. The amendments change the evaluation of whether a reporting entity is the primary beneficiary of a VIE by changing how a single decision maker of a VIE treats indirect interests in the entity held through related parties that are under common control with the reporting entity. The revised guidance is effective for reporting periods beginning after December 15, 2016. Early adoption is permitted. The Company has adopted the provisions of this guidance beginning January 1, 2017 and determined that there is no impact to the Company's consolidated financial position, results of operations and cash flows. In January 2017, the FASB issued guidance that revises the definition of a business. This new guidance is applicable when evaluating whether an acquisition should be treated as either a business acquisition or an asset acquisition. Under the revised guidance, when, among other things, substantially all of the fair value of gross assets acquired is concentrated in a single asset or group of similar assets, the assets acquired would not be considered a business. The revised guidance is effective for reporting periods beginning after December 15, 2017, and the amendments will be applied prospectively. Early application is permitted only for transactions that have not previously been reported in issued financial statements. The Company has assessed this revised guidance and expects, based on historical acquisitions, that, in most cases, a future property acquisition would be treated as an asset acquisition rather than a business acquisition, which would result in the capitalization of related transaction costs. The Company has adopted the provisions of this guidance beginning January 1, 2017. 12 AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) Note 4 — Real Estate Investments The following table presents future minimum base rental cash payments due to the Company over the next five years and thereafter as of September 30, 2017 . These amounts exclude contingent rent payments, as applicable, that may be collected from certain tenants based on provisions related to sales thresholds and increases in annual rent based on exceeding certain economic indexes, among other items. (In thousands) | Future Minimum Base Rent Payments ------------------------------------+---------------------------------- October 1, 2017 — December 31, 2017 | $ | 2,251 ------------------------------------+-----------------------------------+------- 2018 | 8,801 | ------------------------------------+-----------------------------------+------- 2019 | 8,349 | ------------------------------------+-----------------------------------+------- 2020 | 7,860 | ------------------------------------+-----------------------------------+------- 2021 | 6,431 | ------------------------------------+-----------------------------------+------- Thereafter | 18,846 | ------------------------------------+-----------------------------------+------- Total | $ | 52,538 ------------------------------------+-----------------------------------+------- As of September 30, 2017 and 2016 , the Company had no tenants (including, for this purpose, all affiliates of such tenants) whose annualized rental income on a straight-line basis represented 10% or more of consolidated annualized rental income on a straight-line basis for all properties. The following table lists the states where the Company has a concentration of properties where annualized rental income on a straight-line basis represented 10% or more of consolidated annualized rental income on a straight-line basis as of September 30, 2017 and 2016 : | September 30, ---------+-------------- State | 2017 | 2016 ---------+---------------+------ Illinois | 41.7% | 42.2% ---------+---------------+------ Georgia | 11.9% | 11.9% ---------+---------------+------ Intangible Assets and Liabilities Acquired intangible assets and liabilities consisted of the following as of the periods presented: | September 30, 2017 | | December 31, 2016 --------------------------------------+-----------------------+--------+------------------------- (In thousands) | Gross Carrying Amount | | Accumulated Amortization | | Net Carrying Amount | | Gross Carrying Amount | Accumulated Amortization | | Net Carrying Amount --------------------------------------+-----------------------+--------+--------------------------+-----+---------------------+-------+-----------------------+--------------------------+--------+-------------------- Intangible assets: | | | | | | | | | | --------------------------------------+-----------------------+--------+--------------------------+-----+---------------------+-------+-----------------------+--------------------------+--------+-------------------- In-place leases | $ | 16,023 | | | $ | 5,848 | | $ | 10,175 | | $ | 16,023 | | $ | 4,058 | $ | 11,965 --------------------------------------+-----------------------+--------+--------------------------+-----+---------------------+-------+-----------------------+--------------------------+--------+---------------------+-----+--------+-------+---+-------+---+------- Intangible market lease assets | 2,427 | | | 699 | | | 1,728 | | 2,427 | | 434 | | 1,993 | --------------------------------------+-----------------------+--------+--------------------------+-----+---------------------+-------+-----------------------+--------------------------+--------+---------------------+-----+--------+-------+-- Total acquired intangible assets | $ | 18,450 | | | $ | 6,547 | | $ | 11,903 | | $ | 18,450 | | $ | 4,492 | $ | 13,958 --------------------------------------+-----------------------+--------+--------------------------+-----+---------------------+-------+-----------------------+--------------------------+--------+---------------------+-----+--------+-------+---+-------+---+------- Intangible liabilities: | | | | | | | | | | --------------------------------------+-----------------------+--------+--------------------------+-----+---------------------+-------+-----------------------+--------------------------+--------+-------------------- Above-market ground lease liabilities | $ | 180 | | | $ | 34 | | $ | 146 | | $ | 180 | | $ | 22 | $ | 158 --------------------------------------+-----------------------+--------+--------------------------+-----+---------------------+-------+-----------------------+--------------------------+--------+---------------------+-----+--------+-------+---+-------+---+------- Intangible market lease liabilities | 1,721 | | | 277 | | | 1,444 | | 1,722 | | 179 | | 1,543 | --------------------------------------+-----------------------+--------+--------------------------+-----+---------------------+-------+-----------------------+--------------------------+--------+---------------------+-----+--------+-------+-- Total acquired intangible liabilities | $ | 1,901 | | | $ | 311 | | $ | 1,590 | | $ | 1,902 | | $ | 201 | $ | 1,701 --------------------------------------+-----------------------+--------+--------------------------+-----+---------------------+-------+-----------------------+--------------------------+--------+---------------------+-----+--------+-------+---+-------+---+------- 13 AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) The following table discloses amounts recognized within the consolidated statements of operations and comprehensive loss related to amortization of in-place lease assets, amortization and accretion of above- and below-market lease assets and liabilities, net and the accretion of above-market ground leases, for the periods presented: | Three Months Ended September 30, | | Nine Months Ended September 30, -------------------------------------------------------------------+----------------------------------+-----+-------------------------------- (In thousands) | 2017 | | 2016 | 2017 | | 2016 -------------------------------------------------------------------+----------------------------------+-----+---------------------------------+------+-----+----- Amortization of in-place leases(1) | $ | 587 | | $ | 788 | | $ | 1,790 | | $ | 2,525 | -------------------------------------------------------------------+----------------------------------+-----+---------------------------------+------+-----+------+---+-------+---+---+-------+-- Amortization (accretion) of above- and below-market leases, net(2) | $ | 55 | | $ | 55 | | $ | 166 | | $ | 166 | -------------------------------------------------------------------+----------------------------------+-----+---------------------------------+------+-----+------+---+-------+---+---+-------+-- Accretion of above-market ground leases(3) | $ | (4 | ) | $ | (4 | ) | $ | (12 | ) | $ | (12 | ) -------------------------------------------------------------------+----------------------------------+-----+---------------------------------+------+-----+------+---+-------+---+---+-------+-- _______________ (1) | Reflected within depreciation and amortization expense ----+------------------------------------------------------- (2) | Reflected within rental income ----+------------------------------- (3) | Reflected within property operating and maintenance expense ----+------------------------------------------------------------ The following table provides the projected amortization expense and adjustments to revenues for the next five years: (In thousands) | October 1, 2017 — December 31, 2017 | | 2018 | | 2019 | | 2020 | | 2021 ---------------------------------------------------------------------+-------------------------------------+-----+------+------+------+-------+------+---+----- In-place lease assets | $ | 572 | | | $ | 2,197 | | | $ | 2,022 | | $ | 1,794 | | $ | 1,285 | ---------------------------------------------------------------------+-------------------------------------+-----+------+------+------+-------+------+---+------+-------+---+------+-------+---+---+-------+-- Total to be added to amortization expense | $ | 572 | | | $ | 2,197 | | | $ | 2,022 | | $ | 1,794 | | $ | 1,285 | ---------------------------------------------------------------------+-------------------------------------+-----+------+------+------+-------+------+---+------+-------+---+------+-------+---+---+-------+-- Above-market lease assets | $ | 86 | | | $ | 318 | | | $ | 309 | | $ | 301 | | $ | 224 | ---------------------------------------------------------------------+-------------------------------------+-----+------+------+------+-------+------+---+------+-------+---+------+-------+---+---+-------+-- Below-market lease liabilities | (33 | ) | | (132 | ) | | (131 | ) | | (127 | ) | (120 | ) ---------------------------------------------------------------------+-------------------------------------+-----+------+------+------+-------+------+---+------+-------+---+------+------ Total to be deducted from rental income | $ | 53 | | | $ | 186 | | | $ | 178 | | $ | 174 | | $ | 104 | ---------------------------------------------------------------------+-------------------------------------+-----+------+------+------+-------+------+---+------+-------+---+------+-------+---+---+-------+-- Above-market ground lease liabilities | $ | (4 | ) | | $ | (16 | ) | | $ | (16 | ) | $ | (16 | ) | $ | (16 | ) ---------------------------------------------------------------------+-------------------------------------+-----+------+------+------+-------+------+---+------+-------+---+------+-------+---+---+-------+-- Total to be deducted from property operating and maintenance expense | $ | (4 | ) | | $ | (16 | ) | | $ | (16 | ) | $ | (16 | ) | $ | (16 | ) ---------------------------------------------------------------------+-------------------------------------+-----+------+------+------+-------+------+---+------+-------+---+------+-------+---+---+-------+-- Non-Recurring Fair Value Measurement Assessment As a result of the Board of Directors' approval of the Asset Sale and Plan of Liquidation, the Company reconsidered its intended holding period for all of its operating properties and evaluated the impact on its ability to recover the carrying value of such properties based on the expected cash flows over its intended holding period. The Company's estimated future cash flows expected to be generated are based on management’s experience in its real estate market and the effects of current market conditions. The assumptions are subject to economic and market uncertainties including, among others, market capitalization rates, discount rates, demand for space, competition for tenants, changes in market rental rates, and costs to operate the property. Additionally, the Company made assumptions as to the costs associated with the consummation of the Asset Sale. Such costs would have an impact on the estimated future cash flows expected to be received for the properties. As the estimates used by management are difficult to predict and are subject to alteration through future events, the cash flows estimated by management in its impairment analysis may not be achieved, and actual losses or impairment may be realized in the future. Based on the terms of the Purchase Agreement, the Company performed its analysis at the portfolio level and grouped all 19 properties together. The aggregate carrying value of the portfolio did not exceed the aggregate estimated fair value less costs to sell. 14 AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) Note 5 — Mortgage Note Payable The following table reflects the Company's mortgage note payable as of September 30, 2017 and December 31, 2016 : | | Outstanding Loan Amount as of | | Effective Interest Rate | | | ----------------------------------------------------------+-----------------------+-------------------------------+-------+-------------------------+-----+---+-------------- Portfolio | Encumbered Properties | September 30, 2017 | | December 31, 2016 | | | Interest Rate | Maturity ----------------------------------------------------------+-----------------------+-------------------------------+-------+-------------------------+-----+---+---------------+--------- | | (In thousands) | | (In thousands) | | | | | ----------------------------------------------------------+-----------------------+-------------------------------+-------+-------------------------+-----+---+---------------+----------+---- Philip Professional Center — Lawrenceville, GA | 2 | $ | 4,922 | | | $ | 4,997 | | 4.0 | % | Fixed | Oct. 2019 ----------------------------------------------------------+-----------------------+-------------------------------+-------+-------------------------+-----+---+---------------+----------+-----+---+-------+---------- Deferred financing costs, net of accumulated amortization | | (56 | ) | | (78 | ) | | | | ----------------------------------------------------------+-----------------------+-------------------------------+-------+-------------------------+-----+---+---------------+----------+-----+-- Mortgage note payable, net of deferred financing costs | | $ | 4,866 | | | $ | 4,919 | | | | ----------------------------------------------------------+-----------------------+-------------------------------+-------+-------------------------+-----+---+---------------+----------+-----+---+------ As of September 30, 2017 , the Company had pledged $9.0 million of total real estate investments, net as collateral for the mortgage note payable. This real estate is not available to satisfy other debts and obligations unless first satisfying the mortgage note payable on the property. The Company makes payments of principal and interest on its mortgage note payable on a monthly basis. The following table summarizes the scheduled aggregate principal payments on the Company's mortgage note payable for the five years subsequent to September 30, 2017 and thereafter: (In thousands) | Future PrincipalPayments ------------------------------------+------------------------- October 1, 2017 — December 31, 2017 | $ | 25 ------------------------------------+--------------------------+------ 2018 | 104 | ------------------------------------+--------------------------+------ 2019 | 4,793 | ------------------------------------+--------------------------+------ 2020 | — | ------------------------------------+--------------------------+------ 2021 | — | ------------------------------------+--------------------------+------ Thereafter | — | ------------------------------------+--------------------------+------ Total | $ | 4,922 ------------------------------------+--------------------------+------ Note 6 — Fair Value of Financial Instruments GAAP establishes a hierarchy of valuation techniques based on the observability of inputs used in measuring financial instruments at fair value. GAAP establishes market-based or observable inputs as the preferred source of values, followed by valuation models using management assumptions in the absence of market inputs. The three levels of the hierarchy are described below: Level 1 — Quoted prices in active markets for identical assets and liabilities that the reporting entity has the ability to access at the measurement date. Level 2 — Inputs other than quoted prices included within Level 1 that are observable for the asset and liability or can be corroborated with observable market data for substantially the entire contractual term of the asset or liability. Level 3 — Unobservable inputs that reflect the entity's own assumptions that market participants would use in the pricing of the asset or liability and are consequently not based on market activity, but rather through particular valuation techniques. The determination of where an asset or liability falls in the hierarchy requires significant judgment and considers factors specific to the asset or liability. In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company evaluates its hierarchy disclosures each quarter and depending on various factors, it is possible that an asset or liability may be classified differently from quarter to quarter. However, the Company expects that changes in classifications between levels will be rare. 15 AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) The Company is required to disclose the fair value of financial instruments for which it is practicable to estimate that value. The fair value of short-term financial instruments such as cash, restricted cash, straight-line rent receivable, prepaid expenses and other assets, deferred costs, net, accounts payable and accrued expenses, deferred rent and distributions payable approximates their carrying value on the consolidated balance sheets due to their short-term nature. The fair value of the Company's remaining financial instrument that is not reported at fair value on the consolidated balance sheet is reported below. | | Carrying Amount at | | Fair Value at | Carrying Amount at | | Fair Value at ------------------------------------------------+-------+--------------------+-------+--------------------+--------------------+-------+------------------ (In thousands) | Level | September 30, 2017 | | September 30, 2017 | December 31, 2016 | | December 31, 2016 ------------------------------------------------+-------+--------------------+-------+--------------------+--------------------+-------+------------------ Mortgage note payable and mortgage premium, net | 3 | $ | 5,003 | | $ | 5,002 | | $ | 5,110 | $ | 5,085 ------------------------------------------------+-------+--------------------+-------+--------------------+--------------------+-------+-------------------+---+-------+---+------ The fair value of the mortgage note payable is estimated using a discounted cash flow analysis, based on the Advisor's experience with similar types of borrowing arrangements. Note 7 — Common Stock The Company had approximately 7.0 million shares of common stock outstanding, including unvested restricted shares and shares issued pursuant to the DRIP, net of shares repurchased under the share repurchase program (as amended, the “SRP”), as of September 30, 2017 and December 31, 2016 . The Company had received total proceeds from the IPO and the DRIP, net of share repurchases, of $171.1 million and $171.5 million as of September 30, 2017 and December 31, 2016 , respectively. The Company had paid distributions on a monthly basis to stockholders of record at a rate equivalent to $1.56 per annum, per share of common stock, beginning on March 15, 2015. Distributions were payable by the 5th day following each month end to stockholders of record at the close of business each day during the prior month. On July 18, 2017, in light of the pending Asset Sale and Plan of Liquidation, the Board of Directors determined that the Company will cease declaring and paying regular distributions to its stockholders following the distributions to stockholders of record with respect to each day during the month of July 2017. Distribution payments are dependent on the availability of funds. The Board of Directors may reduce the amount of distributions paid or suspend distribution payments at any time and therefore distribution payments are not assured. Distribution Reinvestment Plan Pursuant to the DRIP, stockholders may elect to reinvest distributions by purchasing shares of common stock in lieu of receiving cash. No dealer manager fees or selling commissions are paid with respect to shares purchased under the DRIP. The shares purchased pursuant to the DRIP have the same rights and are treated in the same manner as the shares issued pursuant to the IPO. The Board of Directors may designate that certain cash or other distributions be excluded from reinvestment pursuant to the DRIP. On June 29, 2016, the Board of Directors amended the DRIP to provide that any amendment, suspension or termination of the DRIP will become effective immediately upon (i) the Company’s public announcement of such amendment, suspension or termination and (ii) the Company’s mailing of a notice regarding the amendment, suspension or termination to each DRIP participant. Shares issued under the DRIP are recorded to equity in the accompanying consolidated balance sheets in the period distributions are declared. The Company announced on April 28, 2017 that it had determined to temporarily suspend its DRIP, in contemplation of the Asset Sale. Furthermore, on June 16, 2017, the Company’s Board of Directors determined it most appropriate to suspend the DRIP indefinitely. The suspension became effective on June 19, 2017. As a result, no re-investment pursuant to the DRIP occurred subsequent to the distributions to stockholders of record with respect to each day during the month of March 2017. During the three months ended March 31, 2017, the per share purchase price of shares issued pursuant to the DRIP was $23.75 per share which was equal to 95% of the offering price in the IPO, and the Company issued approximately 60,000 shares of common stock pursuant to the DRIP during that period, generating aggregate proceeds of $1.4 million . On July 18, 2017, the independent directors of the Board of Directors, who comprise a majority of the Board of Directors unanimously approved an Estimated Per-Share NAV as of July 18, 2017 of $17.64 . Beginning on July 19, 2017, the date the Estimated-Per Share NAV was first published (the “NAV Pricing Date”), the per share price for shares pursuant to the DRIP, if any, will be issued at the Estimated-Per Share NAV. 16 AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) Share Repurchase Program The Board of Directors has adopted a SRP that enables stockholders to sell their shares to the Company in limited circumstances. On June 16, 2017, in furtherance of the Asset Sale, the Board of Directors determined to suspend the Company’s SRP indefinitely and, as authorized by the terms of the SRP, to reject any repurchase requests that the Company has received or will receive during calendar year 2017. The suspension of the SRP became effective as of July 19, 2017. Prior to this suspension, the SRP permitted investors to sell their shares back to the Company after they have held them for at least one year, subject to significant conditions and limitations described below. Prior to the time that the Company’s shares are listed on a national securities exchange and until the Company began to calculate Estimated Per-Share NAV (other than with respect to a repurchase request that is made in connection with a stockholder’s death or disability), the repurchase price per share depended on the length of time investors held such shares as follows: after one year from the purchase date — the lower of $23.13 or 92.5% of the amount they actually paid for each share, and after two years from the purchase date — the lower of $23.75 or 95.0% of the amount they actually paid for each share (in each case, as adjusted for any stock distributions, combinations, splits and recapitalizations). In cases of requests for death and disability, the repurchase prices were equal to the price actually paid for each such share. Beginning with the NAV Pricing Date, the price per share that the Company would have paid to repurchase its shares would have been equal to its Estimated Per-Share NAV at the time of repurchase multiplied by a percentage equal to (i) 92.5% , if the person seeking repurchase has held his or her shares for a period greater than one year and less than two years; (ii) 95.0% , if the person seeking repurchase has held his or her shares for a period greater than two years and less than three years; (iii) 97.5% , if the person seeking repurchase has held his or her shares for a period greater than three years and less than four years; or (iv) 100.0% , if the person seeking repurchase has held his or her shares for a period greater than four years. In cases of requests for death and disability, the repurchase prices would have been equal to Estimated Per-Share NAV at the time of repurchase. Subject to limited exceptions, stockholders who redeem their shares of the Company's common stock within the first four months from the date of purchase would have been subject to a short-term trading fee of 2% of the aggregate Estimated Per-Share NAV of the shares of common stock received. If the SRP remained effective beyond the NAV Pricing Date, which occurred after the SRP was indefinitely suspended, the price per share that the Company would have paid to repurchase its shares would have been based on Estimated Per-Share NAV. Repurchases of shares of the Company's common stock, when requested, were at the sole discretion of the Board of Directors. Until the SRP Amendment (described below), the Company limited the number of shares repurchased during any calendar year to 5% of the weighted average number of shares of common stock outstanding on December 31st of the previous calendar year. In addition, the Company was only authorized to repurchase shares in a given quarter up to the amount of proceeds received from its DRIP in that same quarter. On January 25, 2016, the Company's Board of Directors approved and amended the SRP (the "SRP Amendment") to supersede and replace the existing SRP. Under the SRP Amendment, repurchases of shares of the Company's common stock, when requested, were at the sole discretion of the Board of Directors and generally will be made semiannually (each six-month period ending June 30 or December 31, a “fiscal semester”). Repurchases for any fiscal semester were limited to a maximum of 2.5% of the weighted average number of shares of common stock outstanding during the previous fiscal year (the "Prior Year Outstanding Shares"), with a maximum for any fiscal year of 5.0% of the Prior Year Outstanding Shares. In addition, the Company was only authorized to repurchase shares in a given fiscal semester up to the amount of proceeds received from its DRIP in that same fiscal semester. Any repurchase requests received during such fiscal semester were paid at the applicable Estimated Per-Share NAV then in effect. On September 21, 2016, the Board of Directors further amended the Company’s SRP (the "Special 2016 SRP Amendment") to provide, solely for calendar year 2016, for one twelve-month repurchase period ending December 31, 2016. The annual limit on repurchases under the SRP remained unchanged and continued to be limited to a maximum of 5.0% of the Prior Year Outstanding Shares and was subject to the terms and limitations set forth in the SRP. Following calendar year 2016, the repurchase periods returned to two semi-annual periods and applicable limitations set forth in the SRP. The Special 2016 SRP Amendment became effective on September 22, 2016 and only applied to repurchase periods in calendar year 2016. The SRP will immediately terminate if the Company's shares are listed on any national securities exchange. In addition, the Board of Directors may amend, suspend (in whole or in part) or terminate the SRP at any time, with effect the day following announcement of the amendment, suspension or termination upon 30 days’ prior written notice to the Company's stockholders. 17 AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) If a stockholder requests a repurchase and the repurchase is approved by the Board of Directors, the Company will reclassify such obligation from equity to a liability based on the value of the obligation. Shares purchased under the SRP will have the status of authorized but unissued shares. The following table reflects the number of shares repurchased cumulatively through September 30, 2017 : | Number of Shares Repurchased | Weighted-Average Price per Share ------------------------------------------------+------------------------------+--------------------------------- Cumulative repurchases as of December 31, 2016 | 1,021 | | $ | 24.97 ------------------------------------------------+------------------------------+----------------------------------+-------+------ Nine months ended September 30, 2017 (1) | 82,494 | | 22.79 | ------------------------------------------------+------------------------------+----------------------------------+-------+------ Cumulative repurchases as of September 30, 2017 | 83,515 | | $ | 22.82 ------------------------------------------------+------------------------------+----------------------------------+-------+------ _______________ (1) | Represents repurchases related to repurchase requests received during 2016, including 82,494 shares repurchased during the nine months ended September 30, 2017 for approximately $1.9 million at a weighted average price per share of $22.79, net of 1,110 share repurchase requests that were canceled. Excludes rejected repurchase requests received during 2016 with respect to 181,389 shares for $4.0 million at a weighted average price per share of $22.29, which were unfulfilled. On June 16, 2017, in furtherance of the Asset Sale, the Board of Directors determined to suspend the SRP indefinitely and, as authorized by the terms of the SRP, to reject any repurchase requests that the Company has received or will receive during calendar year 2017. The suspension of the SRP became effective as of July 19, 2017 and no shares have been, or will be, repurchased in connection with requests made during 2017. ----+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 18 AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) Note 8 — Related Party Transactions and Arrangements As of September 30, 2017 and December 31, 2016 , American Realty Capital Healthcare III Special Limited Partnership, LLC (the "Special Limited Partner"), an entity controlled by the Sponsor, owned 8,888 shares of the Company's outstanding common stock. As of September 30, 2017 and December 31, 2016 , the Advisor held 90 units of limited partner interests in the OP ("OP Units"). The Former Dealer Manager served as the dealer manager of the IPO. SK Research, LLC ("SK Research") and American National Stock Transfer, LLC ("ANST"), both subsidiaries of the parent company of the Former Dealer Manager, provided other general professional services through December 2015 and January 2016, respectively. RCS Capital Corporation ("RCAP"), the parent company of the Former Dealer Manager and certain of its affiliates that provided the Company with services, filed for Chapter 11 bankruptcy protection in January 2016, prior to which it was also under common control with AR Global, the parent of the Sponsor. In May 2016, RCAP and its affiliated debtors emerged from bankruptcy under the new name Aretec Group, Inc. On March 8, 2017, the creditor trust established in connection with the RCAP bankruptcy filed suit against AR Global, the Advisor, advisors of other entities sponsored by AR Global, and AR Global’s principals (including Mr. Weil, the executive chairman of the Board of Directors). The suit alleges, among other things, certain breaches of duties to RCAP. The Company is not named in the suit, nor are there allegations related to the services the Advisor provides to the Company. On May 26, 2017, the defendants moved to dismiss. The Advisor has informed the Company that it believes the suit is without merit and intends to defend against it vigorously. Purchase Agreement On June 16, 2017, the Company, the OP and HT III Holdco entered into the Purchase Agreement with HTI, HTI OP and HTI Holdco. HTI is sponsored and advised by affiliates of the Advisor. Pursuant to the Purchase Agreement, the Purchaser Parties have agreed to purchase membership interests in the Company’s indirect subsidiaries which collectively own all 19 properties owned by the Company and comprise substantially all of the Company’s assets for the Purchase Price, subject to reductions for debt assumed or repaid and customary prorations and closing adjustments. See Note 2 — Purchase Agreement and Plan of Liquidation. AR Global Arrangements In connection with the execution of the Purchase Agreement, the Company, the Advisor, the Property Manager and AR Global, as guarantor, entered into the Letter Agreement, pursuant to which, subject to the completion of the Asset Sale, the parties resolved matters related to expense reimbursements or fees previously paid by the Company to the Advisor and its affiliates (the “Excess Amount”) and made certain agreements with respect to all fees and other amounts that would be payable to the Advisor and its affiliates pursuant to the Company's advisory agreement with the Advisor (the "Advisory Agreement"), the Company's property management agreement with the Property Manager (the "Property Management Agreement") and the limited partnership agreement of the OP (the “LPA”) if the Asset Sale is completed. Letter Agreement Pursuant to the Letter Agreement, as satisfaction of the Excess Amount, the Advisor and the Property Manager will pay, tender, waive or assume certain fees, expenses and obligations, as applicable. The Excess Amount aggregates to $3.68 million consisting of the “Excess O&O Amount” and the “Excess Oversight Amount” as described below. • | Pursuant to the Advisory Agreement, the Company reimbursed the Advisor and its affiliates, including subsidiaries of RCAP up to 2.0% of gross offering proceeds for organization and offering expenses, which included reimbursements to the Advisor for other organization and offering expenses that it incurred for due diligence fees included in detailed and itemized invoices. The Advisor was responsible for offering costs, excluding selling commissions and dealer manager fees, in excess of the 2.0% cap as of the end of the IPO. As of the end of the IPO, offering and related costs, excluding commissions and dealer manager fees, exceeded 2.0% of gross proceeds received from the IPO by $3.77 million. This amount includes $3.54 million already paid by the Company to the Advisor and its affiliates (the “Excess O&O Amount”) and $228 thousand of unpaid disputed fees payable to affiliates of AR Global, including subsidiaries of RCAP (the “Disputed Amount”). Pursuant to the Letter Agreement, to the extent any portion of the Disputed Amount is found to be payable, it will be paid by the Advisor (with this obligation guaranteed by AR Global) and will not be the responsibility of the Company. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 19 AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) • | Pursuant to the Property Management Agreement, the Company was responsible for paying the Property Manager an oversight fee of 1.0% of gross revenues ("Oversight Fees") for the Property Manager’s supervision of third parties managing certain of the Properties, which the Company had previously overpaid to the Property Manager in an amount equal to approximately $141 thousand (the “Excess Oversight Amount”). --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- The parties have agreed, as partial satisfaction of the Excess Amount, that the Advisor and Property Manager, as applicable, will: • | surrender 83,018 limited partnership units of the OP designated as "Class B Units" (the "Class B Units") previously issued to the Advisor and the additional 12,624 Class B Units issued in November 2017 with respect to the quarter ended September 30, 2017 in accordance with the terms of the Advisory Agreement and the LPA, with the value of the Class B Units so surrendered calculated in accordance with the Letter Agreement, at the fair market value thereof as reasonably determined by the Board of Directors as of the Closing Date, which per-unit amount will be based on the per-share value as implied from the Purchase Agreement; --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | waive amounts that would have been payable by the Company with respect to certain transition services provided by the Advisor beginning as of January 1, 2018 and through the later of (1) dissolution of the Company and (2) 30 days following the expiration of the 14 month survival period of the representation and warranties under the Purchase Agreement, valued at $0.24 million in the aggregate; --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ • | waive amounts with respect to certain administrative expense reimbursements that would be payable to the Advisor by the Company for expenses incurred during the nine months ending December 31, 2017, valued at $0.10 million per month and $0.87 million in the aggregate; --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | waive amounts that would have been payable to the Property Manager by the Company as Oversight Fees in accordance with the terms of the Property Management Agreement; --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | waive amounts that would have been payable to the Advisor by the Company in accordance with the terms of the Advisory Agreement and the LPA (as amended by the contemplated amendments to the Advisory Agreement and the LPA (the "Contemplated Amendments”), which have not yet been executed and will not become effective if the Asset Sale does not close), with respect to cash asset management and oversight fees for the period commencing October 1, 2017 and ending on the Closing Date; and --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | waive fees valued at approximately $24,000 potentially payable by the Company to one of the subsidiaries of RCAP in addition to the Disputed Amount. --+----------------------------------------------------------------------------------------------------------------------------------------------------- Following the Closing Date, the Advisor will pay to the Company any Excess Amount in excess of the value of the foregoing bullet points in two equal installments, the first of which will be due within three days following the Closing Date and the second of which will be due within six months following the Closing Date. These payments are guaranteed by AR Global. The Letter Agreement will be null and void if the Purchase Agreement is terminated. Other than as contemplated by the Letter Agreement, if the Asset Sale is completed, no fees or other amounts are or will become due or otherwise payable under the Advisory Agreement, the Property Management Agreement, the LPA or any other agreement between the Company and the Advisor and its affiliates. Advisory Agreement and Property Management Agreement Amendments As contemplated by the Letter Agreement, concurrently with the execution of the Purchase Agreement, the Company, the OP and the Advisor entered into an amendment to the Advisory Agreement (the “Advisory Agreement Amendment”) and the Company and the Property Manager also entered into an amendment to the Property Management Agreement (the “Property Management Amendment”). Pursuant to the Advisory Agreement Amendment, the Advisor has agreed to provide the Company services required to implement the Plan of Liquidation following the Closing Date. Pursuant to the Advisory Agreement Amendment, the amounts payable by the Company to Advisor for these services will be automatically waived in partial satisfaction of the Excess Amount in accordance with the terms of the Letter Agreement, and no other amounts will be payable to the Advisor following the Closing Date. Pursuant to the Property Management Amendment, the Property Manager agreed to continue to provide any property management or wind-down services under the Property Management Agreement at no cost or charge. The Property Management Amendment will be null and void if the Purchase Agreement is terminated. The Advisory Agreement Amendment will only become effective at the Closing Date and will be of no force or effect in the event the Purchase Agreement is terminated prior to the Closing Date. 20 AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) Contemplated Amendments to Advisory Agreement and LPA Pursuant to the Letter Agreement, prior to the Closing Date, the Company and the Advisor agreed to enter into the Contemplated Amendments, an amendment to the Advisory Agreement and an amendment to the LPA, effective as of October 1, 2017, to facilitate the establishment of a value for Class B Units consistent with the applicable provisions of the Letter Agreement and certain of the other payments contemplated by the Letter Agreement. The Contemplated Amendments have not yet been executed. Notwithstanding the date the Contemplated Amendments are executed, they will be effective as of October 1, 2017 and only if the Asset Sale and the Plan of Liquidation are approved and the Asset Sale closes. They will be of no force or effect in the event the Purchase Agreement is terminated prior to the Closing Date. Fees Incurred in Connection with the IPO The Advisor, Sponsor and Former Dealer Manager and their affiliates received compensation and reimbursement for services relating to the IPO. All offering costs incurred by the Company and the Advisor, Sponsor and Former Dealer Manager and their affiliates on behalf of the Company are charged to additional paid-in capital on the accompanying consolidated balance sheets. No offering costs were incurred during the three and nine months ended September 30, 2017 or 2016 . As of September 30, 2017 and December 31, 2016 , the Company had $0.2 million payable to the Former Dealer Manager and its affiliates for services relating to the IPO. Fees Incurred and Participations Paid in Connection With the Operations of the Company The Advisor receives an acquisition fee of 1.5% of the contract purchase price of each property acquired and 1.5% of the amount advanced for a loan or other investment. The Advisor is also reimbursed for services provided for which it incurs investment-related expense, or insourced expenses. Such insourced expenses may not exceed 0.5% of the contract purchase price of each acquired property and 0.5% of the amount advanced for a loan or other investment. Additionally, the Company reimburses the Advisor for third party acquisition expenses. The Company also reimburses the Advisor for legal expenses it or its affiliates incur in connection with the selection, evaluation and acquisition of assets, in an amount not to exceed 0.1% of the contract purchase price of each property or 0.1% of the amount advanced for each loan or other investment. Once the proceeds from the IPO have been fully invested, the aggregate amount of acquisition fees and any financing coordination fees (as described below) for any new acquisitions may not exceed 2.0% of the contract purchase price and the amount advanced for a loan or other investment for all the assets acquired. In no event will the total of all acquisition fees, acquisition expenses and any financing coordination fees payable with respect to a particular investment exceed 4.5% of the contract purchase price of the Company's portfolio to be measured at the close of the acquisition phase or 4.5% of the amount advanced for all loans or other investments. Pursuant to the Letter Agreement, no acquisitions fees or related expense reimbursements will be payable following the closing of the Asset Sale. If the Advisor provides services in connection with the origination or refinancing of any debt that the Company obtains and uses to acquire properties or to make other permitted investments, or that is assumed, directly or indirectly, in connection with the acquisition of properties, the Company will pay the Advisor a financing coordination fee equal to 0.75% of the amount available and/or outstanding under such financing, subject to certain limitations. Pursuant to the Letter Agreement, no financing coordination fees will be payable following the closing of the Asset Sale pursuant to the Letter Agreement. The Advisor manages the Company’s day-to-day operations. Since the Company’s inception, in lieu of paying the Advisor in cash for its asset management services, the Company has compensated the Advisor by causing the OP to issue Class B Units to the Advisor (subject to periodic approval by the Board of Directors). The Class B Units are intended to be profit interests that will vest, and no longer be subject to forfeiture, at such time as any one of the following events occur: (1) the termination of the Advisory Agreement by an affirmative vote of a majority of the Company's independent directors without cause; (2) a listing of the Company's common stock on a national securities exchange; or (3) a transaction to which the Company or the OP is a party, as a result of which OP Units or the Company's common stock are or will be exchanged for or converted into the right, or the holders of such securities will otherwise be entitled, to receive cash, securities or other property or any combination thereof; provided that the Advisor, pursuant to the Advisory Agreement, is providing services to the Company immediately prior to the occurrence of an event of the type described therein (the "performance condition"). Such Class B Units will be forfeited immediately if the Advisory Agreement is terminated for any reason other than a termination without cause. 21 AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) When and if approved by the Board of Directors, the Class B Units are issued to the Advisor quarterly in arrears pursuant to the terms of the limited partnership agreement of the OP. The number of Class B Units issued in any quarter is an amount equal to: (i) the excess of (A) the product of (y) 0.1875% multiplied by (z) either the cost of the Company's assets (through the quarter ended June 30, 2017) or the lower of the cost of assets and the fair value of the Company’s assets (for all subsequent quarters in light of the Company publishing an Estimated Per-Share NAV on July 19, 2017) over (B) any amounts payable as the oversight fee under the Property Management Agreement for the quarter; divided by (ii) the value of one share of common stock as of the last day of the quarter, which was equal to $22.50 (the price at which the Company sold shares in the IPO, minus the selling commissions and dealer manager fees paid in that offering) through the quarter ended June 30, 2017 and is equal to Estimated Per-Share NAV for all subsequent quarters in light of the Company publishing an Estimated Per-Share NAV on July 19, 2017. The value of issued Class B Units will be determined and expensed when the Company deems the achievement of the performance condition to be probable. The Advisor receives distributions in cash on unvested Class B Units equal to the per share distribution paid on the Company's common stock. Such distributions on Class B Units are included in general and administrative expenses in the consolidated statements of operations and comprehensive loss until the performance condition is considered probable to occur. During the three and nine months ended September 30, 2017 , the Board of Directors approved the issuance of 10,665 and 37,096 Class B Units to the Advisor in connection with this arrangement, respectively. As of September 30, 2017 , the Board of Directors had approved the issuance of 83,018 Class B Units to the Advisor in connection with this arrangement. Pursuant to the Letter Agreement, the Company and the Advisor parties resolved matters related to expense reimbursements or fees previously paid by the Company to the Advisor and its affiliates and made certain agreements with respect to all fees and other amounts that would be payable to the Advisor and its affiliates pursuant to the Advisory Agreement, the Property Management Agreement and the LPA if the Asset Sale is completed, including that the Advisor would surrender all Class B Units previously issued to the Advisor. Pursuant to the Contemplated Amendments to be entered into pursuant to the Letter Agreement prior to the Closing Date, effective as of October 1, 2017, with respect to quarter ended September 30, 2017, the OP was required to, as it has already done, issue 12,624 Class B Units, which is the number of Class B Units equal to: (i) the excess of (A) the product of (y) 0.1875% multiplied by (z) the lower of the Company’s cost of assets and the fair market value of the Company’s assets over (B) any amounts payable as the oversight fee under the Property Management Agreement for the quarter; divided by (ii) Estimated Per-Share NAV. With respect to all subsequent quarters, the Advisor would be entitled to receive a cash asset management fee equal to the excess of (A) the product of (y) 0.1875% multiplied by (z) the lower of the Company’s cost of assets and the fair market value of the Company’s assets over (B) any amounts payable as the oversight fee under the Property Management Agreement for the quarter. Any payments with respect to this cash asset management fee, if it ever becomes payable, have been waived pursuant to the Letter Agreement. Unless the Company contracts with a third party, the Company pays the Property Manager a property management fee of 1.5% of gross revenues from the Company's single-tenant net leased properties and 2.5% of gross revenues from all other types of properties. The Company also reimburses the Property Manager for property level expenses. If the Company contracts directly with third parties for such services, the Company pays them customary market fees and pays the Property Manager an oversight fee of up to 1.0% of the gross revenues of the property managed. In no event is the Property Manager or any affiliates of the Property Manager entitled to an oversight fee if any third party receives market fees greater than the property management fee, as explained above. Further, in no event does the Company pay the Property Manager or any affiliates of the Property Manager both a property management fee and an oversight fee with respect to any particular property. Property management fees are recorded to operating fees to related party in the accompanying consolidated statements of operations and comprehensive loss. The Advisor pays general and administrative expenses on behalf of the Company, for which, the Company subsequently reimburses the Advisor. These fees and reimbursements are included in general and administrative expenses in the accompanying consolidated statements of operations and comprehensive loss. As acknowledged in the Letter Agreement, the Company had previously overpaid property management and oversight fees to the Property Manager in an amount equal to approximately $141 thousand . Pursuant to the Letter Agreement, any obligation the Advisor has to repay this amount will be satisfied if the Asset Sale is consummated. Since May 1, 2017, in lieu of paying the Property Manager property management fees, including oversight fees, the Company has applied all property management fees otherwise due and payable to the Property Manager against the overpaid amount. Concurrent with the Letter Agreement, the 22 AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) Property Manager agreed pursuant to the Property Management Amendment to continue to provide any property management or wind-down services at no cost or charge. The following table details amounts incurred, forgiven and payable or receivable in connection with the Company's operations-related services described above as of and for the periods presented: | Three Months Ended September 30, | | Nine Months Ended September 30, | | | | ------------------------------------------------------+----------------------------------+-----+---------------------------------+---+----------+---+--------- | 2017 | | 2016 | | 2017 | | 2016 | Payable (Receivable) as of ------------------------------------------------------+----------------------------------+-----+---------------------------------+---+----------+---+----------+--------------------------- (In thousands) | Incurred | | Forgiven | | Incurred | | Forgiven | Incurred | | Forgiven | Incurred | | Forgiven | | September 30, 2017 | | December 31, 2016 ------------------------------------------------------+----------------------------------+-----+---------------------------------+---+----------+---+----------+----------------------------+-----+----------+----------+---+----------+---+--------------------+-----+------------------ Ongoing fees and reimbursements: | | | | | | | | | | | | | | | | | ------------------------------------------------------+----------------------------------+-----+---------------------------------+---+----------+---+----------+----------------------------+-----+----------+----------+---+----------+---+--------------------+-----+------------------ Property management fees | $ | 15 | | | $ | — | | $ | 41 | | $ | — | | | $ | 42 | | $ | — | $ | 120 | | $ | — | $ | (114 | ) | $ | (129 | ) ------------------------------------------------------+----------------------------------+-----+---------------------------------+---+----------+---+----------+----------------------------+-----+----------+----------+---+----------+---+--------------------+-----+-------------------+---+---+-----+-----+----+---+---+---+------+---+---+------+-- Professional fees and reimbursements | 326 | | | — | | | 66 | | — | | 706 | | | — | | | 224 | | — | 607 | | 29 | ------------------------------------------------------+----------------------------------+-----+---------------------------------+---+----------+---+----------+----------------------------+-----+----------+----------+---+----------+---+--------------------+-----+-------------------+---+---+-----+-----+----+-- Distributions on Class B Units | 31 | | | — | | | 13 | | — | | 75 | | | — | | | 26 | | — | — | | 2 | ------------------------------------------------------+----------------------------------+-----+---------------------------------+---+----------+---+----------+----------------------------+-----+----------+----------+---+----------+---+--------------------+-----+-------------------+---+---+-----+-----+----+-- Total related party operating fees and reimbursements | $ | 372 | | | $ | — | | $ | 120 | | $ | — | | | $ | 823 | | $ | — | $ | 370 | | $ | — | $ | 493 | | $ | (98 | ) ------------------------------------------------------+----------------------------------+-----+---------------------------------+---+----------+---+----------+----------------------------+-----+----------+----------+---+----------+---+--------------------+-----+-------------------+---+---+-----+-----+----+---+---+---+------+---+---+------+-- The Company reimburses the Advisor's costs of providing administrative services, subject to the limitation that the Company will not reimburse the Advisor for any amount by which the Company's operating expenses at the end of the four preceding fiscal quarters exceeds the greater of (a) 2.0% of average invested assets and (b) 25.0% of net income other than any additions to reserves for depreciation, bad debt, impairments or other similar non-cash expenses and excluding any gain from the sale of assets for that period (the "2%/25% Limitation"), unless the Company's independent directors determine that such excess was justified based on unusual and nonrecurring factors which they deem sufficient, in which case the excess amount may be reimbursed to the Advisor in subsequent periods. Additionally, the Company will reimburse the Advisor for personnel costs in connection with other services during the operational stage; however, the Company may not reimburse the Advisor for personnel costs in connection with services for which the Advisor receives acquisition fees, acquisition expense reimbursements or real estate commissions. The Advisor incurred $0.3 million and $0.6 million for providing such services during the three and nine months ended September 30, 2017 , respectively. No such reimbursements were payable during the three and nine months ended September 30, 2016 . Following the closing of the Asset Sale pursuant to the Letter Agreement, no such reimbursements will be payable. Pursuant to the Letter Agreement, as partial satisfaction of the Excess Amount the Advisor has agreed to waive amounts with respect to these administrative expense reimbursements that would be payable to the Advisor by the Company for expenses incurred during the nine months ending December 31, 2017, starting April 1, 2017, valued at approximately $0.1 million per month and $0.9 million in the aggregate. In order to improve operating cash flows and the ability to pay distributions from operating cash flows, the Advisor may elect to forgive and absorb certain fees. No such fees or expenses were forgiven or absorbed by the Advisor during the three and nine months ended September 30, 2017 or 2016 . The predecessor to AR Global was party to a services agreement with RCS Advisory Services, LLC ( "RCS Advisory"), a subsidiary of the parent company of the Former Dealer Manager, pursuant to which RCS Advisory and its affiliates provided the Company and certain other companies sponsored by AR Global with services (including, without limitation, transaction management, compliance, due diligence, event coordination and marketing services, among others) on a time and expenses incurred basis or at a flat rate based on services performed. The predecessor to AR Global instructed RCS Advisory to stop providing such services in November 2015 and no services have since been provided by RCS Advisory. 23 AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) The Company was also party to a transfer agency agreement with ANST, a subsidiary of RCAP, pursuant to which ANST provided the Company with transfer agency services (including broker and stockholder servicing, transaction processing, year-end Internal Revenue Service ("IRS") reporting and other services), and supervisory services overseeing the transfer agency services performed by DST Systems, Inc. ("DST"), a third-party transfer agent. AR Global received written notice from ANST on February 10, 2016 that it would wind down operations by the end of the month and would withdraw as the transfer agent effective February 29, 2016. On February 26, 2016, the Company entered into a definitive agreement with DST to provide the Company directly with transfer agency services (including broker and stockholder servicing, transaction processing, year-end IRS reporting and other services). Fees and Participations Incurred in Connection with a Listing or the Liquidation of the Company's Real Estate Assets The Company will pay the Advisor an annual subordinated performance fee calculated on the basis of the Company's total return to stockholders, payable annually in arrears, such that for any year in which the Company's total return on stockholder's capital exceeds 6.0% per annum, the Advisor will be entitled to 15.0% of the excess total return but not to exceed 10.0% of the aggregate total return for such year. This fee will be payable only upon the sale of assets, distributions or other event which results in the return on stockholder's capital exceeding 6.0% per annum. No subordinated performance fees were incurred during the three and nine months ended September 30, 2017 or 2016 . The Company will pay the Advisor a real estate commission on the sale of property, not to exceed the lesser of 2.0% of the contract sale price of the property and 50.0% of the total brokerage commission paid if a third party broker is also involved; provided, however, that in no event may the real estate commissions paid to the Advisor, its affiliates and agents and unaffiliated third parties exceed the lesser of 6.0% of the contract sales price and a reasonable, customary and competitive real estate commission. Real estate commissions will only be payable to the Advisor if the Advisor or its affiliates, as determined by a majority of the independent directors, provided a substantial amount of services in connection with the sale. No such fees were incurred during the three and nine months ended September 30, 2017 or 2016 . Under the terms of the Letter Agreement, the Company will no longer be obligated to pay a real estate commission to the Advisor following the closing of the Asset Sale. The Company will pay the Special Limited Partner a subordinated participation in the net sales proceeds of the sale of real estate assets of 15.0% of remaining net sale proceeds after return of capital contributions to investors plus payment to investors of a 6.0% cumulative, pre-tax non-compounded annual return on the capital contributed by investors. The Special Limited Partner will not be entitled to the subordinated participation in the net sales proceeds unless investors have received a return of their capital plus a return equal to a 6.0% cumulative non-compounded annual return on their capital contributions. No participation in net sales proceeds was incurred during the three and nine months ended September 30, 2017 or 2016 . If the Company's shares of common stock are listed on a national securities exchange, the Special Limited Partner will receive a subordinated incentive listing distribution from the OP equal to 15.0% of the amount by which the Company's market value plus distributions exceeds the aggregate capital contributed by investors plus an amount equal to a 6.0% cumulative, pre-tax non-compounded annual return to investors. The Company cannot assure that it will provide this 6.0% annual return but the Special Limited Partner will not be entitled to the subordinated incentive listing distribution unless investors have received a 6.0% cumulative, pre-tax non-compounded annual return on their capital contributions. The Asset Sale will not generate net proceeds in excess of this 6.0% hurdle. Thus, the Special Limited Partner will not receive a payment in respect of this subordinated participation in net sales proceeds if the Asset Sale and the Plan of Liquidation are approved and the Asset Sale closes. No such distribution was incurred or paid during the three and nine months ended September 30, 2017 or 2016 . Neither the Special Limited Partner nor any of its affiliates can earn both the subordinated participation in the net sales proceeds and the subordinated listing distribution. Upon termination or non-renewal of the Advisory Agreement with the Advisor, with or without cause, the Special Limited Partner will be entitled to receive distributions from the OP equal to 15% of the amount by which the sum of the Company's market value plus distributions exceeds the sum of the aggregate capital contributed by investors plus an amount equal to an annual 6.0% cumulative, pre-tax, non-compounded annual return to investors. The Special Limited Partner may elect to defer its right to receive a subordinated distribution upon termination until either a listing on a national securities exchange or other liquidity event occurs. 24 AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) Note 9 — Economic Dependency Under various agreements, the Company has engaged or will engage the Advisor, its affiliates and entities under common ownership with the Advisor to provide certain services that are essential to the Company, including asset management services, supervision of the management and leasing of properties owned by the Company, asset acquisition and disposition decisions, as well as other administrative responsibilities for the Company including accounting and legal services, human resources and information technology. Pursuant to the Advisory Agreement Amendment, the Advisor has agreed to provide the Company services required to implement the Plan of Liquidation following the Closing Date. The amounts payable by the Company to Advisor for these services will be automatically waived in partial satisfaction of the Excess Amount in accordance with the terms of the Letter Agreement, and no other amounts will be payable to the Advisor following the Closing Date. See Note 8 — Related Party Transactions and Arrangements — AR Global Arrangements. As a result of these relationships, the Company is dependent upon the Advisor and its affiliates. In the event that the Advisor and its affiliates are unable to provide the Company with the respective services, the Company will be required to find alternative providers of these services. Note 10 — Share-Based Compensation Restricted Share Plan The Company has an employee and director incentive restricted share plan (the "RSP"), which provides for the automatic grant of 1,333 restricted shares to each of the independent directors, without any further action by the Board of Directors or the stockholders, after initial election to the Board of Directors and after each annual stockholder's meeting, with such shares vesting annually beginning with the one year anniversary of initial election to the Board of Directors and the date of the next annual meeting, respectively. Restricted shares issued to independent directors vest over a five -year period following the date of grant in increments of 20.0% per annum. The RSP provides the Company with the ability to grant awards of restricted shares to the Company's directors, officers and employees (if the Company ever has employees), employees of the Advisor and its affiliates, employees of entities that provide services to the Company, directors of the Advisor or of entities that provide services to the Company, certain consultants to the Company and the Advisor and its affiliates or to entities that provide services to the Company. The total number of shares of common stock granted as awards under the RSP may not exceed 5.0% of the Company's outstanding shares of common stock on a fully diluted basis at any time and in any event will not exceed 6.3 million shares (as such number may be adjusted for stock splits, stock dividends, combinations and similar events). Restricted share awards entitle the recipient to receive common shares from the Company under terms that provide for vesting over a specified period of time or upon attainment of pre-established performance objectives. Such awards would typically be forfeited with respect to the unvested shares upon the termination of the recipient's employment or other relationship with the Company. Restricted shares may not, in general, be sold or otherwise transferred until restrictions are removed and the shares have vested. Holders of restricted shares may receive cash distributions prior to the time that the restrictions on the restricted shares have lapsed. Any distributions payable in common shares shall be subject to the same restrictions as the underlying restricted shares. The following table reflects restricted share award activity for the period presented: | Number of Shares ofCommon Stock | | Weighted-Average Issue Price -----------------------------+---------------------------------+---+----------------------------- Unvested, December 31, 2016 | 6,398 | | | $ | 22.50 -----------------------------+---------------------------------+---+------------------------------+-------+------ Granted | — | | | — | -----------------------------+---------------------------------+---+------------------------------+-------+------ Vested | (1,600 | ) | | 22.50 | -----------------------------+---------------------------------+---+------------------------------+-------+------ Forfeitures | — | | | — | -----------------------------+---------------------------------+---+------------------------------+-------+------ Unvested, September 30, 2017 | 4,798 | | | $ | 22.50 -----------------------------+---------------------------------+---+------------------------------+-------+------ 25 AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) As of September 30, 2017 , the Company had $0.1 million of unrecognized compensation cost related to unvested restricted share award grants under the Company's RSP. That cost is expected to be recognized over a weighted average period of 2.9 years. The fair value of the restricted shares is being expensed on a straight-line basis over the service period of five years. Compensation expense related to restricted shares was approximately $9,000 and $27,000 for the three and nine months ended September 30, 2017 , respectively. Compensation expense related to restricted shares was approximately $20,000 and $32,000 for the three and nine months ended September 30, 2016 , respectively. Compensation expense related to restricted shares is recorded as general and administrative expense in the accompanying consolidated statements of operations and comprehensive loss. Note 11 — Non-controlling Interests The Company is the sole general partner and holds substantially all of the OP Units. As of September 30, 2017 and December 31, 2016 , the Advisor held 90 OP Units, which represents a nominal percentage of the aggregate OP ownership. After holding the OP Units for a period of one year, or such lesser time as determined by the Company in its sole and absolute discretion, a holder of OP Units has the right to convert OP Units for the cash value of a corresponding number of shares of the Company's common stock or, at the option of the OP, a corresponding number of shares of the Company's common stock, as allowed by the LPA. The remaining rights of limited partner interests in the OP are limited, however, and do not include the ability to replace the general partner or to approve the sale, purchase or refinancing of the OP's assets. No distributions were paid to OP Unit holders during the three and nine months ended September 30, 2017 and September 30, 2016 . The Company has an investment arrangement with unaffiliated third parties whereby such investors receive an ownership interest in certain of the Company's property owning subsidiaries and are entitled to receive a proportionate share of the net operating cash flow derived from the subsidiaries' property. Upon disposition of a property subject to this investment arrangement, the investors will receive a proportionate share of the net proceeds from the sale of the property. The investors have no recourse to any other assets of the Company. Due to the nature of the Company's involvement with the arrangement and the significance of its investment in relation to the investment of the third parties, the Company has determined that it controls each entity in this arrangement and therefore the entities related to this arrangement are consolidated within the Company's financial statements. A non-controlling interest is recorded for the investor's ownership interest in the properties. The following table summarizes the activity related to investment arrangements with the unaffiliated third party. | | | | | | As of September 30, 2017 | | As of December 31, 2016 | | Distributions for the Three Months Ended September 30, --------------------------------------------+-----------------+------------------------------------------------------------+-----+---------------------------------------------------------------+---+-----------------------------------------------------------+---+----------------------------------------------------------+---+---------------------------------------------------------- Property Name (Dollar amounts in thousands) | Investment Date | Third Party Net Investment Amount as of September 30, 2017 | | Non-Controlling Ownership Percentage as of September 30, 2017 | | Net Real Estate Assets Subject to Investment Arrangement | | Mortgage Notes Payable Subject to Investment Arrangement | | Net Real Estate Assets Subject to Investment Arrangement | | Mortgage Notes Payable Subject to Investment Arrangement | | 2017 | 2016 --------------------------------------------+-----------------+------------------------------------------------------------+-----+---------------------------------------------------------------+---+-----------------------------------------------------------+---+----------------------------------------------------------+---+-----------------------------------------------------------+---+----------------------------------------------------------+---+-------+----- UnityPoint Clinic - Muscatine, IA | Dec. 2015 | $ | 281 | | | 5 | % | | $ | 5,615 | | | $ | — | | $ | 5,790 | | $ | — | | $ | 9 | $ | 10 --------------------------------------------+-----------------+------------------------------------------------------------+-----+---------------------------------------------------------------+---+-----------------------------------------------------------+---+----------------------------------------------------------+---+-----------------------------------------------------------+---+----------------------------------------------------------+---+-------+------+---+-------+---+---+---+---+---+---+---+--- UnityPoint Clinic - Moline, IL | Dec. 2015 | 179 | | | 5 | % | | 3,575 | | | — | | | 3,691 | | — | | 6 | | | 7 --------------------------------------------+-----------------+------------------------------------------------------------+-----+---------------------------------------------------------------+---+-----------------------------------------------------------+---+----------------------------------------------------------+---+-----------------------------------------------------------+---+----------------------------------------------------------+---+-------+------+---+-------+---+---+---+-- 26 AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) Note 12 — Net Loss Per Share The following is a summary of the basic and diluted net loss per share computation for the three and nine months ended September 30, 2017 and 2016 : | Three Months Ended September 30, | | Nine Months Ended September 30, --------------------------------------------------------------+----------------------------------+-------+-------------------------------- (In thousands, except share and per share amounts) | 2017 | | 2016 | | 2017 | | 2016 --------------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+------+---------- Computation of Basic Net Income (Loss) Per Share: | | | | | | | --------------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+------+---------- Net income (loss) attributable to stockholders | $ | (396 | ) | | $ | 232 | | $ | (1,197 | ) | $ | 127 --------------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+------+-----------+---+-----------+---+---+----- Basic weighted-average shares outstanding | 6,951,111 | | | 6,908,297 | | | 6,948,884 | | 6,857,513 | --------------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+------+-----------+---+-----------+-- Basic net income (loss) per share | $ | (0.06 | ) | | $ | 0.03 | | $ | (0.17 | ) | $ | 0.02 --------------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+------+-----------+---+-----------+---+---+----- Computation of Diluted Net Income (Loss) Per Share: | | | | | | | --------------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+------+---------- Net income (loss) attributable to stockholders | $ | (396 | ) | | $ | 232 | | $ | (1,197 | ) | $ | 127 --------------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+------+-----------+---+-----------+---+---+----- Adjustments to net income (loss) for common share equivalents | — | | | (114 | ) | | — | | (114 | ) --------------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+------+-----------+---+-----------+-- Diluted net income (loss) | $ | (396 | ) | | $ | 118 | | $ | (1,197 | ) | $ | 13 --------------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+------+-----------+---+-----------+---+---+----- Basic weighted average shares outstanding | 6,951,111 | | | 6,908,297 | | | 6,948,884 | | 6,857,513 | --------------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+------+-----------+---+-----------+-- Unvested restricted shares (1) | — | | | 5,900 | | | — | | 5,153 | --------------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+------+-----------+---+-----------+-- OP Units | — | | | 90 | | | — | | 90 | --------------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+------+-----------+---+-----------+-- Diluted weighted-average shares outstanding | 6,951,111 | | | 6,914,287 | | | 6,948,884 | | 6,862,756 | --------------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+------+-----------+---+-----------+-- Diluted net income (loss) per share | $ | (0.06 | ) | | $ | 0.02 | | $ | (0.17 | ) | $ | — --------------------------------------------------------------+----------------------------------+-------+---------------------------------+-----------+------+------+-----------+---+-----------+---+---+----- _______________ (1) | Weighted-average number of unvested restricted shares outstanding for the periods presented. ----+--------------------------------------------------------------------------------------------- Diluted net income per share assumes the conversion of all common stock equivalents into an equivalent number of common shares, unless the effect is antidilutive. The Company considers unvested restricted shares, OP Units and Class B Units to be common share equivalents. The Company had the following common share equivalents on a weighted-average basis that were excluded from the calculation of diluted net loss per share as their effect would have been antidilutive for the periods presented: | Three Months Ended September 30, | Nine Months Ended September 30, -------------------------------------------------------------+----------------------------------+-------------------------------- | 2017 | 2016 | | 2017 | 2016 -------------------------------------------------------------+----------------------------------+---------------------------------+--------+------+------- Unvested restricted shares (1) | 5,193 | | — | | 5,975 | — -------------------------------------------------------------+----------------------------------+---------------------------------+--------+------+--------+------- OP Units (2) | 90 | | — | | 90 | — -------------------------------------------------------------+----------------------------------+---------------------------------+--------+------+--------+------- Class B Units (3) | 78,381 | | 32,723 | | 64,340 | 22,212 -------------------------------------------------------------+----------------------------------+---------------------------------+--------+------+--------+------- Total weighted-average antidilutive common stock equivalents | 83,664 | | 32,723 | | 70,405 | 22,212 -------------------------------------------------------------+----------------------------------+---------------------------------+--------+------+--------+------- _______________ (1) | Weighted average number of antidilutive unvested restricted shares outstanding for the periods presented. There were 4,798 and 6,398 unvested restricted shares outstanding as of September 30, 2017 and 2016, respectively. ----+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (2) | Weighted average number of antidilutive OP Units outstanding for the periods presented. There were 90 OP Units outstanding as of September 30, 2017 and 2016. ----+-------------------------------------------------------------------------------------------------------------------------------------------------------------- (3) | Weighted average number of antidilutive Class B Units outstanding for the periods presented. There were 83,018 and 36,370 Class B Units outstanding as of September 30, 2017 and 2016, respectively. ----+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 27 AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) Note 13 — Segment Reporting During the three and nine months ended September 30, 2017 and 2016 , the Company operated in three reportable business segments for management and internal financial reporting purposes: medical office buildings, triple-net leased healthcare facilities and seniors housing — operating properties. The Company evaluates performance and makes resource allocations based on its three business segments. The medical office building segment primarily consists of MOBs leased to healthcare-related tenants under long-term leases, which may require such tenants to pay a pro rata share of property-related expenses. The triple-net leased healthcare facilities segment primarily consists of investments in seniors housing communities, hospitals, inpatient rehabilitation facilities and skilled nursing facilities under long-term leases, under which tenants are generally responsible to directly pay property-related expenses. The seniors housing — operating property segment consists of direct investments in seniors housing communities, primarily providing assisted living, independent living and memory care services, which are operated through engaging independent third-party managers. There were no intersegment sales or transfers during the periods presented. The Company evaluates the performance of the combined properties in each segment based on net operating income ("NOI"). NOI is defined as total revenues, excluding contingent purchase price consideration, less property operating and maintenance expense. NOI excludes all other items of expense and income included in the financial statements in calculating net income (loss). The Company uses NOI to assess and compare property level performance and to make decisions concerning the operation of the properties. The Company believes that NOI is useful as a performance measure because, when compared across periods, NOI reflects the impact on operations from trends in occupancy rates, rental rates, operating expenses and acquisition activity on an unleveraged basis, providing perspective not immediately apparent from net income (loss). NOI excludes certain components from net income (loss) in order to provide results that are more closely related to a property's results of operations. For example, interest expense is not necessarily linked to the operating performance of a real estate asset and is often incurred at the corporate level. In addition, depreciation and amortization, because of historical cost accounting and useful life estimates, may distort operating performance at the property level. NOI presented by the Company may not be comparable to NOI reported by other REITs that define NOI differently. The Company believes that in order to facilitate a clear understanding of the Company's operating results, NOI should be examined in conjunction with net income (loss) as presented in the Company's consolidated financial statements. NOI should not be considered as an alternative to net income (loss) as an indication of the Company's performance or to cash flows as a measure of the Company's liquidity or ability to make distributions. 28 AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) The following tables reconcile the segment activity to consolidated net loss for the three and nine months ended September 30, 2017 and 2016 : | Three Months Ended September 30, 2017 | | Nine Months Ended September 30, 2017 ---------------------------------------------------+---------------------------------------+-------+---------------------------------------- (In thousands) | Medical Office Buildings | | Triple-Net Leased Healthcare Facilities | | Seniors Housing — Operating Properties | | Consolidated | | Medical Office Buildings | | Triple-Net Leased Healthcare Facilities | Seniors Housing — Operating Properties | | Consolidated ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+------+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+------------- Revenues: | | | | | | | | | | | | | | ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+------+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+------------- Rental income | $ | 2,172 | | | $ | 105 | | | $ | — | | $ | 2,277 | | | $ | 6,517 | | | $ | 313 | | $ | — | | $ | 6,830 ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+------+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+-------+--------+-------+---+----+--------+---+-----+---+-------+---+------ Operating expense reimbursements | 651 | | | — | | | — | | | 651 | | 1,950 | | | — | | | — | | | 1,950 ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+------+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+-------+--------+-------+---+----+------- Resident services and fee income | — | | | — | | | 670 | | | 670 | | — | | | — | | | 2,081 | | | 2,081 ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+------+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+-------+--------+-------+---+----+------- Total revenues | 2,823 | | | 105 | | | 670 | | | 3,598 | | 8,467 | | | 313 | | | 2,081 | | | 10,861 ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+------+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+-------+--------+-------+---+----+------- Property operating and maintenance | 806 | | | 81 | | | 487 | | | 1,374 | | 2,438 | | | 266 | | | 1,440 | | | 4,144 ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+------+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+-------+--------+-------+---+----+------- NOI | $ | 2,017 | | | $ | 24 | | | $ | 183 | | 2,224 | | | $ | 6,029 | | | $ | 47 | | $ | 641 | | 6,717 | ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+------+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+-------+--------+-------+---+----+--------+---+-----+---+-------+-- Operating fees to related party | | | | | | | (15 | ) | | | | | | | (42 | ) ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+------+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+------ Acquisition and transaction related | | | | | | | (568 | ) | | | | | | | (1,727 | ) ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+------+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+------ General and administrative | | | | | | | (740 | ) | | | | | | | (2,087 | ) ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+------+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+------ Depreciation and amortization | | | | | | | (1,304 | ) | | | | | | | (3,939 | ) ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+------+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+------ Interest expense | | | | | | | (46 | ) | | | | | | | (139 | ) ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+------+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+------ Interest and other income | | | | | | | — | | | | | | | | — | ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+------+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+------ Income tax benefit (expense) | | | | | | | 58 | | | | | | | | 32 | ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+------+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+------ Net loss attributable to non-controlling interests | | | | | | | (5 | ) | | | | | | | (12 | ) ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+------+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+------ Net income (loss) attributable to stockholders | | | | | | | $ | (396 | ) | | | | | | | $ | (1,197 | ) ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+------+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+-------+--------+------ 29 AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) | Three Months Ended September 30, 2016 | | Nine Months Ended September 30, 2016 ---------------------------------------------------+---------------------------------------+-------+---------------------------------------- (In thousands) | Medical Office Buildings | | Triple-Net Leased Healthcare Facilities | | Seniors Housing — Operating Properties | | Consolidated | | Medical Office Buildings | | Triple-Net Leased Healthcare Facilities | Seniors Housing — Operating Properties | | Consolidated ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+-----+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+------------- Revenues: | | | | | | | | | | | | | | ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+-----+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+------------- Rental income | $ | 2,168 | | | $ | 104 | | | $ | — | | $ | 2,272 | | | $ | 6,504 | | | $ | 313 | | $ | — | | $ | 6,817 ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+-----+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+-------+-------+-------+---+-----+--------+---+-----+---+-------+---+------ Operating expense reimbursements | 652 | | | — | | | — | | | 652 | | 1,903 | | | — | | | — | | | 1,903 ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+-----+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+-------+-------+-------+---+-----+------- Resident services and fee income | — | | | — | | | 749 | | | 749 | | — | | | — | | | 2,156 | | | 2,156 ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+-----+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+-------+-------+-------+---+-----+------- Total revenues | 2,820 | | | 104 | | | 749 | | | 3,673 | | 8,407 | | | 313 | | | 2,156 | | | 10,876 ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+-----+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+-------+-------+-------+---+-----+------- Property operating and maintenance | 822 | | | 1 | | | 483 | | | 1,306 | | 2,417 | | | 1 | | | 1,429 | | | 3,847 ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+-----+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+-------+-------+-------+---+-----+------- NOI | $ | 1,998 | | | $ | 103 | | | $ | 266 | | 2,367 | | | $ | 5,990 | | | $ | 312 | | $ | 727 | | 7,029 | ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+-----+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+-------+-------+-------+---+-----+--------+---+-----+---+-------+-- Operating fees to related party | | | | | | | (41 | ) | | | | | | | (120 | ) ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+-----+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+------ Acquisition and transaction related | | | | | | | (104 | ) | | | | | | | (237 | ) ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+-----+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+------ General and administrative | | | | | | | (363 | ) | | | | | | | (1,584 | ) ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+-----+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+------ Depreciation and amortization | | | | | | | (1,502 | ) | | | | | | | (4,660 | ) ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+-----+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+------ Interest expense | | | | | | | (47 | ) | | | | | | | (142 | ) ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+-----+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+------ Interest and other income | | | | | | | — | | | | | | | | 1 | ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+-----+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+------ Income tax benefit (expense) | | | | | | | (74 | ) | | | | | | | (147 | ) ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+-----+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+------ Net loss attributable to non-controlling interests | | | | | | | (4 | ) | | | | | | | (13 | ) ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+-----+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+------ Net income (loss) attributable to stockholders | | | | | | | $ | 232 | | | | | | | | $ | 127 | ---------------------------------------------------+---------------------------------------+-------+-----------------------------------------+-----+----------------------------------------+-----+--------------+-----+--------------------------+-------+-----------------------------------------+----------------------------------------+-------+--------------+--------+-------+-------+------ The following table reconciles the segment activity to consolidated total assets as of the periods presented: | September 30, | | December 31, ----------------------------------------+---------------+---------+------------- (In thousands) | 2017 | | 2016 ----------------------------------------+---------------+---------+------------- ASSETS | | | ----------------------------------------+---------------+---------+------------- Investments in real estate, net: | | | ----------------------------------------+---------------+---------+------------- Medical office buildings | $ | 103,143 | | | $ | 106,968 ----------------------------------------+---------------+---------+--------------+---------+---+-------- Triple-net leased healthcare facilities | 4,430 | | | 4,554 | ----------------------------------------+---------------+---------+--------------+---------+-- Seniors housing — operating properties | 10,002 | | | 10,213 | ----------------------------------------+---------------+---------+--------------+---------+-- Total investments in real estate, net | 117,575 | | | 121,735 | ----------------------------------------+---------------+---------+--------------+---------+-- Cash | 12,970 | | | 16,371 | ----------------------------------------+---------------+---------+--------------+---------+-- Restricted cash | 114 | | | 37 | ----------------------------------------+---------------+---------+--------------+---------+-- Straight-line rent receivable | 812 | | | 662 | ----------------------------------------+---------------+---------+--------------+---------+-- Prepaid expenses and other assets | 937 | | | 1,242 | ----------------------------------------+---------------+---------+--------------+---------+-- Deferred costs, net | 14 | | | 9 | ----------------------------------------+---------------+---------+--------------+---------+-- Total assets | $ | 132,422 | | | $ | 140,056 ----------------------------------------+---------------+---------+--------------+---------+---+-------- 30 AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) The following table reconciles capital expenditures by reportable business segment for the periods presented: | Three Months Ended September 30, | | Nine Months Ended September 30, ----------------------------------------+----------------------------------+----+-------------------------------- (In thousands) | 2017 | | 2016 | | 2017 | | 2016 ----------------------------------------+----------------------------------+----+---------------------------------+---+------+----+----- Medical office buildings | $ | — | | | $ | 16 | | $ | — | $ | 55 ----------------------------------------+----------------------------------+----+---------------------------------+---+------+----+------+---+----+---+---- Triple-net leased healthcare facilities | — | | | — | | | — | | — ----------------------------------------+----------------------------------+----+---------------------------------+---+------+----+------+---+--- Seniors housing — operating properties | 18 | | | 4 | | | 62 | | 65 ----------------------------------------+----------------------------------+----+---------------------------------+---+------+----+------+---+--- Total capital expenditures | $ | 18 | | | $ | 20 | | $ | 62 | $ | 120 ----------------------------------------+----------------------------------+----+---------------------------------+---+------+----+------+---+----+---+---- Note 14 — Commitments and Contingencies The Company has entered into operating lease agreements related to certain acquisitions under leasehold interest arrangements. The following table reflects the minimum base cash rental payments due from the Company over the next five years and thereafter under these arrangements. These amounts exclude contingent rent payments, as applicable, that may be payable based on provisions related to increases in annual rent based on exceeding certain economic indexes among other items. (In thousands) | Future Minimum Base Rental Payments ------------------------------------+------------------------------------ October 1, 2017 — December 31, 2017 | $ | 26 ------------------------------------+-------------------------------------+------ 2018 | 105 | ------------------------------------+-------------------------------------+------ 2019 | 106 | ------------------------------------+-------------------------------------+------ 2020 | 109 | ------------------------------------+-------------------------------------+------ 2021 | 116 | ------------------------------------+-------------------------------------+------ Thereafter | 3,323 | ------------------------------------+-------------------------------------+------ Total | $ | 3,785 ------------------------------------+-------------------------------------+------ Total rental expense from the Company's operating leases was approximately $34,000 during the three ended September 30, 2017 and 2016 and $0.1 million for the nine months ended September 30, 2017 and 2016 . Litigation and Regulatory Matters In the ordinary course of business, the Company may become subject to litigation, claims and regulatory matters. There are no material legal or regulatory proceedings pending or known to be contemplated against the Company. Environmental Matters In connection with the ownership and operation of real estate, the Company may potentially be liable for costs and damages related to environmental matters. The Company has not been notified by any governmental authority of any non-compliance, liability or other claim, and is not aware of any other environmental condition that it believes will have a material adverse effect on the results of operations. Purchase Agreement In connection with its approval of the Purchase Agreement, the Board of Directors also approved the Plan of Liquidation, which will become effective if the Company obtains stockholder approval of the Asset Sale and the Plan of Liquidation and the Asset Sale is consummated. The consummation of the Asset Sale is also subject to the Company obtaining stockholder approval of the Asset Sale and the Plan of Liquidation as well as other conditions, and there can be no assurance the Asset Sale will be consummated on the terms contained in the Purchase Agreement, or at all. Pursuant to the Plan of Liquidation, the Company anticipates winding up its affairs and distributing the net cash proceeds available for distribution after satisfying the Company’s liabilities to the holders of its common stock in one or more liquidating distributions. See Note 2 — Purchase Agreement and Plan of Liquidation. 31 AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2017 (Unaudited) Note 15 — Subsequent Events The Company has evaluated subsequent events through the filing of this Quarterly Report on Form 10-Q and determined that there have not been any events that have occurred that would require adjustments to disclosures in the consolidated financial statements, except for the following disclosures: On October 23, 2017, the Company filed a definitive proxy statement related to the Annual Meeting at which stockholder approval of the Asset Sale and the Plan of Liquidation will be sought. The Annual Meeting is scheduled to be held on December 21, 2017. 32 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. The following discussion and analysis should be read in conjunction with the accompanying unaudited consolidated financial statements of American Realty Capital Healthcare Trust III, Inc. and the notes thereto. As used herein, the terms the "Company," "we," "our" and "us" refer to American Realty Capital Healthcare Trust III, Inc., a Maryland corporation, including, as required by context, American Realty Capital Healthcare III Operating Partnership, L.P., a Delaware limited partnership, which we refer to as the "OP," and its subsidiaries. The Company is externally managed by American Realty Capital Healthcare III Advisors, LLC (our "Advisor"), a Delaware limited liability company. Capitalized terms used herein, but not otherwise defined, have the meaning ascribed to those terms in "Part I — Financial Information" included in the notes to the unaudited consolidated financial statements and contained herein. Forward-Looking Statements Certain statements included in this Quarterly Report on Form 10-Q are forward-looking statements. Those statements include statements regarding the intent, belief or current expectations of the Company and members of our management team, as well as the assumptions on which such statements are based, and generally are identified by the use of words such as "may," "will," "seeks," "anticipates," "believes," "estimates," "expects," "plans," "intends," "should" or similar expressions. Actual results may differ materially from those contemplated by such forward-looking statements. Further, forward-looking statements speak only as of the date they are made, and we undertake no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes to future operating results over time, unless required by law. The following are some of the risks and uncertainties, although not all risks and uncertainties, that could cause our actual results to differ materially from those presented in our forward-looking statements: • | We have agreed to sell substantially all of our assets (the "Asset Sale") to Healthcare Trust, Inc. (“HTI”) pursuant to and on the terms set forth in a purchase agreement, dated as of June 16, 2017 (the “Purchase Agreement”). The Asset Sale is subject to conditions, and there can be no assurance when or whether the Asset Sale will be completed. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Failure to complete the Asset Sale, which is subject to conditions, would prevent the complete liquidation and dissolution of the Company, as contemplated by a plan of liquidation approved by American Realty Capital Healthcare Trust III, Inc.'s board of directors (our "Board of Directors) on June 16, 2017 (the “Plan of Liquidation”) and could have adverse consequences for the Company. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | We cannot determine the amount or timing of any liquidating distributions to our stockholders. --+----------------------------------------------------------------------------------------------- • | All of our executive officers and certain directors are also officers, managers or holders of a direct or indirect controlling interest in the Advisor and other entities affiliated with AR Global Investments, LLC (the successor business to AR Capital, LLC, "AR Global"), the parent of our sponsor, American Realty Capital VII, LLC (the "Sponsor"). As a result, our executive officers and certain directors, our Advisor and its affiliates face conflicts of interest. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | HTI is sponsored and advised by affiliates of the Advisor. Our directors and officers (including all our executive officers and one of our directors, in their capacities as executives or members of the Advisor, HTI’s advisor (the "HTI Advisor") and their affiliates) may have interests in the Asset Sale that may be different from, or in addition to, those of our other stockholders. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ • | The Purchase Agreement contains provisions that could discourage a potential competing acquirer or could result in any competing proposal being at a lower price than it might otherwise be. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | In some circumstances, our stockholders could be held liable for amounts they received from us in connection with our dissolution. --+----------------------------------------------------------------------------------------------------------------------------------- • | No public market currently exists, or may ever exist, for shares of our common stock which are, and may continue to be, illiquid. --+---------------------------------------------------------------------------------------------------------------------------------- • | Any adverse judgment in a lawsuit challenging the Asset Sale or the Plan of Liquidation may prevent the Asset Sale from closing or from closing within the expected timeframe, if at all. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ • | The healthcare industry is heavily regulated, and new laws or regulations, changes to existing laws or regulations, loss of licensure or failure to obtain licensure could result in the inability of tenants to make lease payments to us. --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | We are depending on our Advisor to conduct our operations. Adverse changes in the financial condition of our Advisor or our relationship with our Advisor could adversely affect us. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 33 • | During July 2017, in light of the pending Asset Sale and Plan of Liquidation, our Board of Directors determined that the Company will cease declaring and paying regular distributions to its stockholders. There can be no assurance we will resume paying distributions, or at what rate. --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | We are obligated to pay fees, which may be substantial, to our Advisor and its affiliates. --+------------------------------------------------------------------------------------------- • | Our revenue is dependent upon the success and economic viability of our tenants. --+--------------------------------------------------------------------------------- • | Increases in interest rates could increase the amount of our debt payments. --+---------------------------------------------------------------------------- • | We are subject to risks associated with any dislocations or liquidity disruptions that may exist or occur in the credit markets of the United States from time to time. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------ • | We may fail to continue to qualify to be treated as a real estate investment trust for U.S. federal income tax purposes ("REIT"), which would result in higher taxes and dramatically lower the amount of liquidating distributions to our stockholders. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Pursuing the Plan of Liquidation may increase the risk that we will be liable for U.S. federal income and excise taxes, which would reduce the amount of liquidating distributions. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ • | The sale of our assets in the Asset Sale may cause us to be subject to a 100% excise tax on the net income from “prohibited transactions,” which would reduce the amount of our liquidating distributions to stockholders. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | We may be deemed to be an investment company under the Investment Company Act of 1940, as amended (the "Investment Company Act"), and thus subject to regulation under the Investment Company Act. --+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Overview We were incorporated on April 24, 2014 as a Maryland corporation that elected and qualified to be taxed as a REIT beginning with our taxable year ended December 31, 2015. We were formed to primarily acquire a diversified portfolio of healthcare-related assets, including medical office buildings ("MOBs"), seniors housing communities and other healthcare-related facilities. We purchased our first property and commenced real estate operations in March 2015. As of September 30, 2017 , we owned 19 properties consisting of 0.5 million rentable square feet. On August 20, 2014, we commenced our initial public offering ("IPO") on a "reasonable best efforts" basis of up to 125.0 million shares of common stock, $0.01 par value per share, at a price of $25.00 per share, subject to certain volume and other discounts, for total gross proceeds of up to $3.1 billion plus up to 26.3 million shares of common stock available pursuant to our distribution reinvestment plan (the "DRIP"). On November 15, 2015, we announced the suspension of our IPO, effective December 31, 2015, and in August 2016, the IPO lapsed in accordance with its terms, having raised significantly less capital than expected. As of September 30, 2017 , we had received total proceeds from the IPO and the DRIP, net of share repurchases, of $171.1 million . Beginning in late January 2016, our Board of Directors began receiving inquiries from potential bidders regarding possible strategic transactions. In order to review, examine and consider the range of strategic alternatives available to us, our Board of Directors initiated a strategic review process. As part of the strategic review process, our Board of Directors established a special committee, consisting solely of independent directors on our Board of Directors, to evaluate and negotiate the various strategic alternatives (the “Special Committee”). In connection with the strategic review, the Special Committee engaged SunTrust Robinson Humphrey, Inc. as financial advisor and retained Shapiro Sher Guinot & Sandler, P.A. as special legal counsel. During the strategic review process, the Special Committee and its advisors contacted 23 potential partners and entered into 20 nondisclosure agreements. On June 16, 2017, we entered into the Purchase Agreement to sell substantially all of our assets to HTI for a purchase price of $120.0 million (the “Purchase Price”). The Purchase Price is subject to customary prorations and closing adjustments in accordance with the terms of the Purchase Agreement and will be payable on the date the Asset Sale is consummated (the “Closing Date”) less $4.9 million , the principal amount of the loan secured by our Philip Center property, which will be assumed by HTI or repaid by us, and associated costs. HTI will deposit $6.0 million (the "Escrow Amount") of the Purchase Price payable into an escrow account for our benefit on the Closing Date, and this amount, less any amounts paid or reserved for pending or unsatisfied indemnification claims of HTI made pursuant to the Purchase Agreement, will be released in installments thereafter over a period of 14 months following the Closing Date. In connection with its approval of the Purchase Agreement, the Board of Directors also approved the Plan of Liquidation, which is subject to stockholder approval. On October 23, 2017, we filed a definitive proxy statement related to our 2017 annual meeting of stockholders (the “Annual Meeting”) at which stockholder approval of the Asset Sale and the Plan of Liquidation will be sought. The Annual Meeting is scheduled to be held on December 21, 2017. The closing of the Asset Sale is conditioned upon stockholder approval of both the Asset Sale and the Plan of Liquidation. Thus, if stockholders do not approve the Plan of 34 Liquidation, the Asset Sale will not be completed even if stockholders approve the Asset Sale. Likewise, the effectiveness of the Plan of Liquidation is conditioned upon stockholder approval of the Plan of Liquidation and the closing of the Asset Sale. If the Asset Sale is not approved and does not close, the Plan of Liquidation will not become effective regardless of whether or not it has been approved. The Company expects that effectiveness of the Plan of Liquidation will cause the Company’s basis of accounting to change from the going-concern basis to the liquidation basis of accounting, which requires the Company's assets to be measured at the estimated amounts of consideration the entity expects to collect in settling and disposing of its assets and liabilities are to be measured at the estimated amounts at which the liabilities are expected to be settled. We believe that the net cash proceeds generated by the Asset Sale will be sufficient to pay our expenses, including the expenses of liquidating, and to satisfy our liabilities and obligations. After paying or providing for these amounts, we estimate the net cash proceeds available for distribution pursuant to the Plan of Liquidation to our stockholders will aggregate $17.67 to $17.81 per outstanding share of common stock. This estimate is based on certain assumptions and there can be no guarantee at this time as to the exact amount that our stockholders will receive. During the course of liquidating and dissolving, we may incur unanticipated expenses and liabilities all of which are likely to reduce the cash available for distribution to our stockholders. This is the first time that the Board of Directors has determined an estimated per-share net asset value of our common stock. We anticipate publishing an update to the Estimated Per-Share NAV by July 18, 2018 or earlier, at the discretion of the Board of Directors, in connection with material changes including, among others, material liquidating distributions paid pursuant to the Plan of Liquidation. Estimated Per-Share NAV is based on certain assumptions and estimates. There can be no guarantee as to the exact amount of net liquidation proceeds that will be available for distribution to our stockholders pursuant to the Plan of Liquidation. Moreover, shares of our common stock are not listed on a national securities exchange, and Estimated Per-Share NAV does not represent the amount a stockholder would obtain if a stockholder sold his or her shares. Substantially all of our business is conducted through the OP. We have no employees. The Advisor has been retained to manage our affairs on a day-to-day basis. We also have retained American Realty Capital Healthcare III Properties, LLC (the “Property Manager”) to serve as our property manager. The Advisor and the Property Manager are under common control with AR Global, the parent of our Sponsor, as a result of which they are related parties, and each of which have received or will receive compensation, fees and other expense reimbursements from us for services related to managing our business. The Advisor and Property Manager have received or may receive fees during our offering, acquisition, operational and liquidation stages. In connection with the Purchase Agreement, we entered into a letter agreement on the same date (as amended on September 28, 2017, the "Letter Agreement") governing, if the Asset Sale closes, the fees and expenses that had become or would become payable by and to the Advisor and its affiliates, on the one hand, and us, on the other hand. Pursuant to the Letter Agreement, the Advisor and the Property Manager will pay, tender, waive or assume certain fees, expenses and obligations, as applicable, as partial satisfaction of the amounts related to expense reimbursements or fees previously paid by the Company to the Advisor and its affiliates. Prior to entering into the Purchase Agreement, our principal investments objectives were: • | to acquire a diversified portfolio of healthcare-related assets including MOBs, seniors housing communities and other healthcare-related facilities that generate sustainable growth in cash flow from operations to pay monthly cash distributions; --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • to preserve, protect and return our investors’ capital contributions; • to realize growth in the value of our investments upon our ultimate sale of such investments; and • to be prudent, patient and deliberate, taking into account current real estate markets. Healthcare-related facilities include MOBs and outpatient facilities, seniors housing communities, such as assisted and independent living and memory care facilities, as well as hospitals, inpatient rehabilitation hospitals, long-term acute care centers, surgery centers, skilled nursing facilities, specialty medical and diagnostic facilities, research laboratories, and pharmaceutical buildings. In light of the pending Asset Sale and the Plan of Liquidation, the Company does not intend to conduct future investment activities. 35 Significant Accounting Estimates and Critical Accounting Policies Our Annual Report on Form 10-K for the year ended December 31, 2016 contains a discussion of our significant accounting estimates and critical accounting policies. There have been no significant changes in our significant accounting estimates and critical accounting policies since December 31, 2016. See also Note 3 — Summary of Significant Accounting Policies to our unaudited consolidated financial statements for the nine-month period ended September 30, 2017, set forth herein. Properties The following table presents certain additional information about the properties we owned as of September 30, 2017 : Property/Portfolio | Acquisition Date | Number of Properties | Rentable Square Feet | Occupancy | | Weighted Average Remaining Lease Term | | Base Purchase Price (1) --------------------------------------------------------------+------------------+----------------------+----------------------+-----------+--------+---------------------------------------+------+------------------------ | | | | | | (In years) | | (In thousands) --------------------------------------------------------------+------------------+----------------------+----------------------+-----------+--------+---------------------------------------+------+------------------------ Medical Office Buildings: | | | | | | | | --------------------------------------------------------------+------------------+----------------------+----------------------+-----------+--------+---------------------------------------+------+------------------------ DaVita Bay Breeze — Largo, FL | Mar. 2015 | 1 | 7,247 | | 100.0% | | 9.7 | | $ | 1,650 --------------------------------------------------------------+------------------+----------------------+----------------------+-----------+--------+---------------------------------------+------+-------------------------+---------+-------- RAI Clearwater — Clearwater, FL | Apr. 2015 | 1 | 14,936 | | 100.0% | | 7.2 | | 4,750 | --------------------------------------------------------------+------------------+----------------------+----------------------+-----------+--------+---------------------------------------+------+-------------------------+---------+-------- DaVita Hudson — Hudson, FL | May 2015 | 1 | 8,984 | | 100.0% | | 7.0 | | 2,725 | --------------------------------------------------------------+------------------+----------------------+----------------------+-----------+--------+---------------------------------------+------+-------------------------+---------+-------- Rockwall Medical Plaza — Rockwall, TX | Jun. 2015 | 1 | 18,176 | | 100.0% | | 2.5 | | 6,639 | --------------------------------------------------------------+------------------+----------------------+----------------------+-----------+--------+---------------------------------------+------+-------------------------+---------+-------- Decatur Medical Office Building — Decatur, GA | Jul. 2015 | 1 | 20,800 | | 100.0% | | 5.1 | | 5,100 | --------------------------------------------------------------+------------------+----------------------+----------------------+-----------+--------+---------------------------------------+------+-------------------------+---------+-------- Buckeye Health Center — Cleveland, OH | Aug. 2015 | 1 | 25,070 | | 100.0% | | 2.6 | | 5,550 | --------------------------------------------------------------+------------------+----------------------+----------------------+-----------+--------+---------------------------------------+------+-------------------------+---------+-------- Philip Professional Center — Lawrenceville, GA | Aug. 2015 | 2 | 31,483 | | 93.9% | | 10.9 | | 9,000 | --------------------------------------------------------------+------------------+----------------------+----------------------+-----------+--------+---------------------------------------+------+-------------------------+---------+-------- Illinois CancerCare Clinic — Galesburg, IL | Aug. 2015 | 1 | 9,211 | | 100.0% | | 6.9 | | 3,400 | --------------------------------------------------------------+------------------+----------------------+----------------------+-----------+--------+---------------------------------------+------+-------------------------+---------+-------- Galesburg VA Outpatient Clinic — Galesburg, IL | Aug. 2015 | 1 | 9,979 | | 100.0% | | 5.8 | | 2,630 | --------------------------------------------------------------+------------------+----------------------+----------------------+-----------+--------+---------------------------------------+------+-------------------------+---------+-------- Woodlake Office Center — Woodbury, MN | Sep. 2015 | 1 | 36,375 | | 100.0% | | 5.0 | | 14,900 | --------------------------------------------------------------+------------------+----------------------+----------------------+-----------+--------+---------------------------------------+------+-------------------------+---------+-------- Greenfield Medical Center — Gilbert, AZ | Oct. 2015 | 1 | 28,489 | | 100.0% | | 3.1 | | 7,000 | --------------------------------------------------------------+------------------+----------------------+----------------------+-----------+--------+---------------------------------------+------+-------------------------+---------+-------- Lee Memorial Health System Outpatient Center — Ft. Meyers, FL | Oct. 2015 | 1 | 24,174 | | 100.0% | | 1.0 | | 5,275 | --------------------------------------------------------------+------------------+----------------------+----------------------+-----------+--------+---------------------------------------+------+-------------------------+---------+-------- Beaumont Medical Center — Warren, MI | Dec. 2015 | 1 | 35,219 | | 95.2% | | 4.3 | | 13,650 | --------------------------------------------------------------+------------------+----------------------+----------------------+-----------+--------+---------------------------------------+------+-------------------------+---------+-------- Madison Medical Plaza — Joliet, IL | Dec. 2015 | 1 | 70,023 | | 89.4% | | 3.9 | | 19,500 | --------------------------------------------------------------+------------------+----------------------+----------------------+-----------+--------+---------------------------------------+------+-------------------------+---------+-------- UnityPoint Clinic — Muscatine, IA | Dec. 2015 | 1 | 21,767 | | 100.0% | | 7.5 | | 5,887 | --------------------------------------------------------------+------------------+----------------------+----------------------+-----------+--------+---------------------------------------+------+-------------------------+---------+-------- UnityPoint Clinic — Moline, IL | Dec. 2015 | 1 | 14,640 | | 100.0% | | 6.3 | | 3,767 | --------------------------------------------------------------+------------------+----------------------+----------------------+-----------+--------+---------------------------------------+------+-------------------------+---------+-------- Total Medical Office Buildings: | | 17 | 376,573 | | 97.1% | | 5.2 | | 111,423 | --------------------------------------------------------------+------------------+----------------------+----------------------+-----------+--------+---------------------------------------+------+-------------------------+---------+-------- Triple-Net Leased Healthcare Facility(2): | | | | | | | | --------------------------------------------------------------+------------------+----------------------+----------------------+-----------+--------+---------------------------------------+------+------------------------ Arcadian Cove Assisted Living — Richmond, KY | Aug. 2015 | 1 | 34,659 | | 100.0% | | 12.9 | | 4,775 | --------------------------------------------------------------+------------------+----------------------+----------------------+-----------+--------+---------------------------------------+------+-------------------------+---------+-------- Seniors Housing — Operating Property: | | | | | | | | --------------------------------------------------------------+------------------+----------------------+----------------------+-----------+--------+---------------------------------------+------+------------------------ Cedarhurst of Collinsville — Collinsville, IL | Aug. 2015 | 1 | 56,700 | | 75.0% | | N/A | | 11,600 | --------------------------------------------------------------+------------------+----------------------+----------------------+-----------+--------+---------------------------------------+------+-------------------------+---------+-------- Portfolio, September 30, 2017 | | 19 | 467,932 | | | | | | $ | 127,798 --------------------------------------------------------------+------------------+----------------------+----------------------+-----------+--------+---------------------------------------+------+-------------------------+---------+-------- _______________ (1) | Contract purchase price, excluding acquisition related costs. ----+-------------------------------------------------------------- (2) | Revenues for our triple-net leased healthcare facility generally consist of fixed rental amounts (subject to annual contractual escalations) received from our tenants in accordance with the applicable lease terms and does not vary based on the underlying operating performance of the property. As of September 30, 2017, the property leased to our seniors housing — triple net leased tenant had operating occupancy of approximately 88.7%. While operating occupancy rates may affect the profitability of our tenants’ operations, they do not have a direct impact on our revenues or financial results. Operating occupancy statistics for our triple-net leased healthcare facility are compiled through reports from tenants and have not been independently validated by us. ----+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- N/A | Not applicable ----+--------------- Results of Operations Comparison of the Three Months Ended September 30, 2017 to the Three Months Ended September 30, 2016 As of September 30, 2017 , we owned 19 properties and real estate-related assets, all of which we have owned since January 1, 2016. Net income (loss) attributable to stockholders was $(0.4) million and approximately $0.2 million for the three months ended September 30, 2017 and 2016 , respectively. 36 Rental Income Rental income was consistent at $2.3 million for the three months ended September 30, 2017 and 2016 . Rental income relates to our 17 MOBs and one triple-net leased healthcare facility. Operating Expense Reimbursements Operating expense reimbursements was consistent at $0.7 million for the three months ended September 30, 2017 and 2016 , respectively. Pursuant to many of our lease agreements, tenants are required to pay their pro rata share of reimbursable property operating expenses, which may be subject to exclusions and expense floors, in addition to base rent, whereas under certain other lease agreements, the tenants are generally directly responsible for all operating costs of the respective properties. Resident Services and Fee Income Resident services and fee income remained consistent at $0.7 million for the three months ended September 30, 2017 and 2016 . Resident services and fee income is generated in connection with rent and services offered to residents in our seniors housing - operating properties ("SHOPs") depending on the level of care required, as well as fees associated with other ancillary services. Property Operating and Maintenance Expenses Property operating and maintenance expenses increased $0.1 million to $1.4 million for the three months ended September 30, 2017 from $1.3 million for the three months ended September 30, 2016 . These costs primarily relate to the costs associated with our properties, including real estate taxes, property insurance, utilities, repairs, maintenance, and unaffiliated third party property management fees and costs relating to caring for the residents of our SHOP, as well as bad debt expense. The $0.1 million increase for the three months ended September 30, 2017 relates to bad debt expense recorded on our triple-net leased healthcare facility. Operating Fees to Related Party Operating fees to related party decreased approximately $26 thousand to approximately $15 thousand for the three months ended September 30, 2017 from approximately $41 thousand for the three months ended September 30, 2016 . Operating fees to related party relates to fees incurred from our Property Manager for property management services for managing our properties on a day-to-day basis, as well as oversight fees that may apply on properties under contract with unaffiliated third parties for such services, subject to exclusions. Typically, property management fees increase in direct correlation with gross revenues. As acknowledged in the Letter Agreement, prior to 2017, our property management and oversight fees had been overpaid to the Property Manager in an amount equal to approximately $141 thousand . Pursuant to the Letter Agreement, any obligation the Advisor has to repay this amount will be satisfied if the Asset Sale is consummated. During the period from May 1, 2017, the beginning of the applicable period on the Letter Agreement, through September 30, 2017, in lieu of paying the Property Manager property management fees, including oversight fees, this overpayment was applied to all property management fees otherwise due and payable to the Property Manager. Acquisition and Transaction Related Expenses Acquisition and transaction related expenses of $0.6 million for the three months ended September 30, 2017 primarily related to costs associated with our preparation and filing of the preliminary and definitive proxy statements related to the Annual Meeting. Acquisition and transaction related expenses of $0.1 million for the three months ended September 30, 2016 primarily related to fees incurred from the strategic review process initiated by the Special Committee earlier in the year. Acquisition and transaction related expenses generally increase or decrease in direct correlation with the number and contract purchase price of the properties acquired during the period and the level of activity surrounding any contemplated transaction. General and Administrative Expenses General and administrative expenses increased $0.3 million from $0.4 million for the three months ended September 30, 2016 to $0.7 million for the three months ended September 30, 2017 , which related to administrative expense reimbursements to our related parties. Depreciation and Amortization Expens e Depreciation and amortization expense decreased $0.2 million to $1.3 million for the three months ended September 30, 2017 from $1.5 million for the three months ended September 30, 2016 . The purchase price of acquired properties is allocated to tangible and identifiable intangible assets and liabilities and depreciated or amortized over their estimated useful lives. The decrease in depreciation and amortization expense was due to the expiration of an in-place lease asset recorded at acquisition in a previous period. 37 Interest Expense Interest expense decreased approximately $1 thousand to approximately $46 thousand for the three months ended September 30, 2017 from approximately $47 thousand for the three months ended September 30, 2016 . Interest expense related to our mortgage note payable that had an average monthly balance of $5.0 million during the three months ended September 30, 2017 compared to an average monthly balance of $5.1 million during the three months ended September 30, 2016 . Interest and Other Income No interest and other income was received during the three months ended September 30, 2017 and 2016. Income Tax Benefit (Expense) We incurred income tax benefit (expense) of approximately $58 thousand and $(74) thousand , respectively, for the three months ended September 30, 2017 and 2016 related to our SHOP using a structure permitted by RIDEA, under which a REIT may lease qualified healthcare properties on an arm's length basis to a taxable REIT subsidiary ("TRS") if the property is operated on behalf of such subsidiary by an eligible third-party independent contractor. Net Loss Attributable to Non-Controlling Interests Net loss attributable to non-controlling interest holders was approximately $5 thousand and $4 thousand , respectively, for the three months ended September 30, 2017 and 2016 , which represents the portion of net income allocated to an unaffiliated third party that owns an interest in certain of our property owning subsidiaries and is entitled to receive a proportionate share of net operating cash flow derived from the subsidiaries' properties. Comparison of the Nine Months Ended September 30, 2017 to the Nine Months Ended September 30, 2016 As of September 30, 2017 , we owned 19 properties and real estate-related assets, all of which we have owned since January 1, 2016. Net income (loss) attributable to stockholders was $(1.2) million and $0.1 million for the nine months ended September 30, 2017 and 2016 , respectively. Rental Income Rental income remained consistent at approximately $6.8 million for the nine months ended September 30, 2017 and 2016 . Operating Expense Reimbursements Operating expense reimbursements increased $0.1 million to $2.0 million for the nine months ended September 30, 2017 , compared to $1.9 million for the nine months ended September 30, 2016 . Pursuant to many of our lease agreements, tenants are required to pay their pro rata share of reimbursable property operating expenses, which may be subject to exclusions and expense floors, in addition to base rent, whereas under certain other lease agreements, the tenants are generally directly responsible for all operating costs of the respective properties. Resident Services and Fee Income Resident services and fee income decreased $0.1 million to $2.1 million for the nine months ended September 30, 2017 when compared to $2.2 million for the nine months ended September 30, 2016 . Resident services and fee income is generated in connection with rent and services offered to residents in our SHOP depending on the level of care required, as well as fees associated with other ancillary services. The decrease is related to lower occupancy during the nine months ended September 30, 2017 , compared to occupancy during the nine months ended September 30, 2016 . Property Operating and Maintenance Expenses Property operating and maintenance expenses increased $0.3 million to $4.1 million for the nine months ended September 30, 2017 from $3.8 million for the nine months ended September 30, 2016 . These costs primarily relate to the costs associated with our properties, including real estate taxes, property insurance, utilities, repairs, maintenance, and unaffiliated third party property management fees and costs relating to caring for the residents of our SHOP, as well as bad debt expense. The increase in property operating and maintenance expenses was primarily attributable to bad debt expense recorded on our triple-net healthcare facility. Operating Fees to Related Party Operating fees to related party decreased $78 thousand to $42 thousand for the nine months ended September 30, 2017 from $120 thousand for the nine months ended September 30, 2016 . Operating fees to related party relates to fees incurred from our Property Manager for property management services for managing our properties on a day-to-day basis, as well as oversight fees that may apply on properties under contract with unaffiliated third parties for such services, subject to exclusions. Typically, property management fees increase in direct correlation with gross revenues. As acknowledged in the Letter Agreement, prior to 2017, our property management and oversight fees had been overpaid to the Property Manager in an amount equal to approximately $141 thousand . Pursuant to the Letter Agreement, any obligation 38 the Advisor has to repay this amount will be satisfied if the Asset Sale is consummated. During the period from May 1, 2017 to September 30, 2017, in lieu of paying the Property Manager property management fees, including oversight fees, this overpayment was applied to all property management fees otherwise due and payable to the Property Manager. Acquisition and Transaction Related Expenses Acquisition and transaction related expenses of $1.7 million for the nine months ended September 30, 2017 primarily related to costs associated with our entry into the Purchase Agreement and our preparation and filing of the preliminary and definitive proxy statements related to the Annual Meeting. Acquisition and transaction related expenses of $0.2 million for the nine months ended September 30, 2016 primarily related to fees incurred in connection with the strategic review process initiated by the Special Committee. General and Administrative Expenses General and administrative expenses increased $0.5 million to $2.1 million for the nine months ended September 30, 2017 from $1.6 million , which relates to an increase of $0.6 million related to administrative expense reimbursements to our related parties, which includes administrative expense reimbursements and distribution expense paid on limited partnership units of the OP designated as "Class B Units" ("Class B Units") to the Advisor. This increase offsets with a decrease of $0.1 million due to higher annual proxy solicitation costs incurred during the nine months ended September 30, 2016 , since our annual stockholder meeting had taken place, whereas the annual stockholder meeting for 2017 is scheduled to occur later in the year and proxy solicitation had not yet commenced on September 30, 2017. Depreciation and Amortization Expense Depreciation and amortization expense decreased $0.8 million to $3.9 million for the nine months ended September 30, 2017 from $4.7 million for the nine months ended September 30, 2016 . The purchase price of acquired properties is allocated to tangible and identifiable intangible assets and liabilities and depreciated or amortized over their estimated useful lives. The decrease in depreciation and amortization expense was due to the expiration of an in-place lease asset recorded at acquisition in a previous period. Interest Expense Interest expense was unchanged at $0.1 million for the nine months ended September 30, 2017 and 2016 , related to our mortgage note payable with an average monthly balance of $5.0 million during the nine months ended September 30, 2017 and 2016 . Interest and Other Income Interest income of approximately $1 thousand for the nine months ended September 30, 2016 related to interest income on cash balances and other miscellaneous income. No interest income was received during the nine months ended September 30, 2017 . Income Tax Benefit (Expense) Income tax benefit (expense) of approximately $32 thousand and $(147) thousand for the nine months ended September 30, 2017 and 2016 , respectively, related to our SHOP using a structure permitted by RIDEA, under which a REIT may lease qualified healthcare properties on an arm's length basis to a taxable REIT subsidiary ("TRS") if the property is operated on behalf of such subsidiary by an eligible third-party independent contractor. Net Loss Attributable to Non-Controlling Interest Holders Net loss attributable to non-controlling interest holders was approximately $12 thousand and approximately $13 thousand for the nine months ended September 30, 2017 and 2016 , respectively which represents the portion of net income allocated to an unaffiliated third party that owns an interest in certain of our property owning subsidiaries and is entitled to receive a proportionate share of net operating cash flow derived from the subsidiaries' properties. 39 Cash Flows for the Nine Months Ended September 30, 2017 During the nine months ended September 30, 2017 , net cash provided by operating activities was $4.4 million . The level of cash flows used in or provided by operating activities is affected by the number of properties owned, the performance of those properties, the timing of interest payments and the amount of borrowings outstanding during the period, as well as the receipt of scheduled rent payments and the level of operating expenses. Cash inflows related to a net loss adjusted for non-cash items of approximately $2.9 million (net loss of $1.2 million adjusted for non-cash items including depreciation and amortization of tangible and identifiable intangible real estate assets, amortization of deferred financing costs, amortization of mortgage premiums and equity-based compensation of $4.1 million ), a decrease in prepaid expenses and other assets of $0.3 million due to tenant receivables and prepaid expenses, an increase in accounts payable and accrued expenses of $1.4 million due to legal fees related to the pending Asset Sale and Plan of Liquidation, as well as related party expense reimbursements. These cash inflows offset against cash outflows of $0.2 million related to an increase in straight-line rent receivables and an increase of $0.1 million in restricted cash and approximately $19 thousand in deferred rent. The net cash used in investing activities during the nine months ended September 30, 2017 of approximately $0.1 million related to capital expenditures. Net cash used in financing activities of $7.8 million during the nine months ended September 30, 2017 consisted primarily of repurchases of our common stock of $1.9 million , distributions to stockholders of $5.8 million , principal payments made on mortgage notes payable of approximately $75 thousand and distributions paid to non-controlling interest holders of approximately $15 thousand . Cash Flows for the Nine Months Ended September 30, 2016 During the nine months ended September 30, 2016 , net cash provided by operating activities was $4.8 million . The level of cash flows used in or provided by operating activities is affected by the timing of interest payments, the receipt of scheduled rent payments, and the level of operating expenses. Cash inflows related to a net loss adjusted for non-cash items of $5.0 million (net income of $0.1 million adjusted for non-cash items including depreciation and amortization of tangible and identifiable intangible real estate assets, amortization of deferred financing costs, amortization of mortgage premiums and equity-based compensation of $4.8 million ), increase in prepaid expenses and other assets of $0.2 million due to rent receivables and prepaid expenses, increase in accounts payable and accrued expenses of $0.1 million related to professional fees, real estate taxes and property operating expenses for our MOBs and SHOP and a $0.2 million increase in deferred rent. These cash inflows were partially offset by an increase in unbilled rent receivables recorded in accordance with straight-line basis accounting of $0.4 million and a decrease in restricted cash of approximately $51 thousand . The net cash used in investing activities during the nine months ended September 30, 2016 of $0.1 million related to capital expenditures. Net cash used in financing activities of $5.1 million during the nine months ended September 30, 2016 consisted primarily of distributions to stockholders of $4.8 million , payments of offering costs of $0.2 million and principal payments made on mortgage notes payable of approximately $71 thousand . Liquidity and Capital Resources As of September 30, 2017 , we had cash on hand of $13.0 million and expect to fund liquidity requirements over the next 12 months through a combination of cash on hand and operating cash flows. Cash on hand mainly consists of proceeds from our IPO and distributions reinvested per our DRIP. While we temporarily suspended our DRIP in April 2017 and indefinitely suspended it in June 2017, we had received total proceeds from our IPO and DRIP, net of share repurchases, of $171.1 million as of September 30, 2017 . Additionally, in light of the pending Asset Sale and Plan of Liquidation, our Board of Directors determined that we will cease declaring and paying regular distributions to our stockholders following the distributions to stockholders of record with respect to each day during the month of July 2017. On June 16, 2017, we entered into the Purchase Agreement pursuant to which we agreed to sell substantially all of our assets to HTI. The closing of the Asset Sale is conditioned upon stockholder approval of both the Asset Sale and the Plan of Liquidation. Subject to the Asset Sale being completed, we intend to wind up our affairs and distribute our assets, which are expected to consist primarily of cash after satisfying our liabilities, to the holders of our common stock in accordance with the Plan of Liquidation. We believe that the net cash proceeds generated by the Asset Sale will be sufficient to pay our expenses, including the expenses of liquidating, and to satisfy our liabilities and obligations. After paying or providing for these amounts, we estimate the net cash proceeds available for distribution pursuant to the Plan of Liquidation to our stockholders will aggregate $17.67 to $17.81 per outstanding share of common stock. We anticipate paying periodic liquidating distributions, including an initial liquidating distribution of $15.75 expected to be paid within two weeks following the closing of the Asset Sale. The amount of distributions associated with the Plan of Liquidation is an estimate based on certain assumptions and there can be no 40 guarantee as to the exact amount that our stockholders will receive. During the course of liquidating and dissolving, we may incur unanticipated expenses and liabilities all of which are likely to reduce the cash available for distribution. If the Asset Sale and Plan of Liquidation are not approved by stockholders and therefore do not occur or become effective, we will make no liquidating distributions to stockholders pursuant to the Plan of Liquidation and our current cash on hand in addition to cash flows from operations will be used to pay our operating and administrative expenses as well as to maintain the properties in our portfolio. Additionally, in light of the pending Asset Sale and Plan of Liquidation, the Board of Directors determined to cease the declaration and payment of regular distributions to stockholders following those declared and paid with respect to each day during the month of July 2017. If the Asset Sale and Plan of Liquidation are not approved by stockholders, the Board of Directors will further evaluate our distribution policy. There can be no assurances that regular distributions will be reinstituted at the same level or at all. Our total cash demands described herein coupled with the lack of funds received if the Asset Sale is not consummated could have a material impact on our liquidity and cause our stockholders’ investment to be adversely impacted. We may borrow if we need funds to satisfy the REIT tax qualification requirement that we generally distribute annually to our stockholders at least 90% of our REIT taxable income (which does not equal net income, as calculated in accordance with GAAP, determined without regard to the deduction for dividends paid and excluding net capital gain). We also may borrow if we otherwise deem it necessary or advisable to assure that we maintain our qualification as a REIT. Under our charter, the maximum amount of our total indebtedness may not exceed 300% of our total "net assets" as defined in our charter as of the date of any borrowing, which is generally expected to be approximately 75% of the cost of our investments. However, we may exceed that limit if approved by a majority of our independent directors and disclosed to stockholders in our next quarterly report following such borrowing along with justification for exceeding such limit. In addition, it is currently our intention to limit our aggregate borrowings to 45% of the aggregate fair market value of our assets, unless borrowing a greater amount is approved by a majority of our independent directors and disclosed to stockholders in our next quarterly report following such borrowing along with justification for borrowing such a greater amount. This limitation will not apply to individual real estate assets or investments. As of September 30, 2017 , our secured debt leverage ratio (total secured debt divided by total assets) was approximately 3.7% and we did not have any unsecured borrowings. At the date of acquisition of each asset, we anticipate that the cost of investment for such asset will be substantially similar to its fair market value, which will enable us to satisfy the requirements under our charter. However, subsequent events, including changes in the fair market value of our assets, could result in our exceeding these limits. Our Board of Directors adopted a Share Repurchase Program (as amended, the "SRP"), which enabled our stockholders to sell their shares to us under limited circumstances. On June 16, 2017, in furtherance of the Asset Sale, our Board of Directors suspended the SRP indefinitely and, as authorized by the terms of the SRP, authorized us to reject any repurchase requests that we received or will receive during calendar year 2017. The suspension of the SRP became effective as of July 19, 2017. The following table reflects the number of shares repurchased cumulatively through September 30, 2017 : | Number of Shares Repurchased | Weighted-Average Price per Share ------------------------------------------------+------------------------------+--------------------------------- Cumulative repurchases as of December 31, 2016 | 1,021 | | $ | 24.97 ------------------------------------------------+------------------------------+----------------------------------+-------+------ Nine months ended September 30, 2017 (1) | 82,494 | | 22.79 | ------------------------------------------------+------------------------------+----------------------------------+-------+------ Cumulative repurchases as of September 30, 2017 | 83,515 | | $ | 22.82 ------------------------------------------------+------------------------------+----------------------------------+-------+------ _______________ (1) | Represents repurchases related to repurchase requests received during 2016, including 82,494 shares repurchased during the nine months ended September 30, 2017 for approximately $1.9 million at a weighted average price per share of $22.79, net of 1,110 share repurchase requests that were canceled. Excludes rejected repurchase requests received during 2016 with respect to 181,389 shares for $4.0 million at a weighted average price per share of $22.29, which were unfulfilled. On June 16, 2017, in furtherance of the Asset Sale, our Board of Directors determined to suspend the SRP indefinitely and, as authorized by the terms of the SRP, to reject any repurchase requests that we had received or will receive during calendar year 2017. The suspension of the SRP became effective as of July 19, 2017 and no shares have been, or will be, repurchased in connection with requests made during 2017. ----+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Non-GAAP Financial Measures This section includes non-GAAP financial measures including Funds from Operations, Modified Funds from Operations and Net Operating Income ("NOI"). A description of these non-GAAP financial measures and reconciliations to the most directly comparable GAAP measure, which is net income, are provided below: 41 Funds from Operations and Modified Funds from Operations The historical accounting convention used for real estate assets requires straight-line depreciation of buildings, improvements, and straight-line amortization of intangibles, which implies that the value of a real estate asset diminishes predictably over time. We believe that, because real estate values historically rise and fall with market conditions, including, but not limited to, inflation, interest rates, the business cycle, unemployment and consumer spending, presentations of operating results for a REIT using the historical accounting convention for depreciation and certain other items may be less informative. Because of these factors, the National Association of Real Estate Investment Trusts ("NAREIT"), an industry trade group, has published a standardized measure of performance known as funds from operations ("FFO"), which is used in the REIT industry as a supplemental performance measure. We believe FFO, which excludes certain items such as real estate-related depreciation and amortization, is an appropriate supplemental measure of a REIT's operating performance. FFO is not equivalent to our net income or loss as determined under GAAP. We define FFO, a non-GAAP measure, consistent with the standards set forth in the White Paper on FFO approved by the Board of Governors of NAREIT, as revised in February 2004 (the "White Paper"). The White Paper defines FFO as net income or loss computed in accordance with GAAP, but excluding gains or losses from sales of property and real estate related impairments, plus real estate-related depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures. Adjustments for unconsolidated partnerships and joint ventures, if any, are calculated to reflect FFO on the same basis. We believe that the use of FFO provides a more complete understanding of our performance to investors and to management, and reflects the impact on our operations from trends in occupancy rates, rental rates, operating costs, general and administrative expenses, and interest costs, which may not be immediately apparent from net income. Changes in the accounting and reporting promulgations under GAAP that were put into effect in 2009 subsequent to the establishment of NAREIT's definition of FFO, such as the change to expense as incurred rather than capitalize and depreciate acquisition fees and expenses incurred for business combinations, have prompted an increase in cash-settled expenses, specifically acquisition fees and expenses, as items that are expensed under GAAP across all industries. These changes had a particularly significant impact on publicly registered, non-listed REITs, which typically have a significant amount of acquisition activity in the early part of their existence, particularly during the period when they are raising capital through ongoing initial public offerings. Because of these factors, the Investment Program Association (the "IPA"), an industry trade group, has published a standardized measure of performance known as modified funds from operations ("MFFO"), which the IPA has recommended as a supplemental measure for publicly registered, non-listed REITs. MFFO is designed to be reflective of the ongoing operating performance of publicly registered, non-listed REITs by adjusting for those costs that are more reflective of acquisitions and investment activity, along with other items the IPA believes are not indicative of the ongoing operating performance of a publicly registered, non-listed REIT, such as straight-lining of rents as required by GAAP. We believe it is appropriate to use MFFO as a supplemental measure of operating performance because we believe that, when compared year over year, both before and after we have deployed all of our offering proceeds and are no longer incurring a significant amount of acquisition fees or other related costs, it reflects the impact on our operations from trends in occupancy rates, rental rates, operating costs, general and administrative expenses, and interest costs, which may not be immediately apparent from net income. MFFO is not equivalent to our net income or loss as determined under GAAP. We define MFFO, a non-GAAP measure, consistent with the IPA's Guideline 2010-01, Supplemental Performance Measure for Publicly Registered, Non-Listed REITs: Modified Funds from Operations (the "Practice Guideline") issued by the IPA in November 2010. The Practice Guideline defines MFFO as FFO further adjusted for acquisition and transaction related fees and expenses and other items. In calculating MFFO, we follow the Practice Guideline and exclude acquisition fees and expenses, amortization of above and below and other market intangible lease assets and liabilities, amounts relating to straight line rent adjustments (in order to reflect such payments from a GAAP accrual basis to a cash basis), accretion of discounts and amortization of premiums on debt investments and adjustments for unconsolidated partnerships and joint ventures, with such adjustments calculated to reflect MFFO on the same basis. We also exclude other non-operating items in calculating MFFO, such as transaction-related fees and expenses (which include costs associated with the strategic review process that led to our entry into the Purchase Agreement). We believe that, because MFFO excludes costs that we consider more reflective of acquisition activities and other non-operating items, MFFO can provide, on a going-forward basis, an indication of the sustainability (that is, the capacity to continue to be maintained) of our operating performance once our portfolio is stabilized. We also believe that MFFO is a recognized measure of sustainable operating performance by the non-listed REIT industry and allows for an evaluation of our performance against other publicly registered, non-listed REITs. 42 Not all REITs, including publicly registered, non-listed REITs, calculate FFO and MFFO the same way. Accordingly, comparisons with other REITs, including publicly registered, non-listed REITs, may not be meaningful. Furthermore, FFO and MFFO are not indicative of cash flow available to fund cash needs and should not be considered as an alternative to net income (loss) or income (loss) from continuing operations as determined under GAAP as an indication of our performance, as an alternative to cash flows from operations as an indication of our liquidity, or indicative of funds available to fund our cash needs including our ability to make distributions to our stockholders. FFO and MFFO should be reviewed in conjunction with GAAP measurements as an indication of our performance. The methods utilized to evaluate the performance of a publicly registered, non-listed REIT under GAAP should be construed as more relevant and accurate measures of operational performance and considered more prominently than the non-GAAP measures, FFO and MFFO, and the adjustments to GAAP in calculating FFO and MFFO. Neither the SEC, NAREIT, the IPA nor any other regulatory body or industry trade group has passed judgment on the acceptability of the adjustments that we use to calculate FFO or MFFO. In the future, NAREIT, the IPA or another industry trade group may publish updates to the White Paper or the Practice Guideline or the SEC or another regulatory body could standardize the allowable adjustments across the publicly registered, non-listed REIT industry and we would have to adjust our calculation and characterization of FFO or MFFO accordingly. The table below reflects the items deducted from or added to net income attributable to stockholders in our calculation of FFO and MFFO for the periods indicated. In calculating our FFO and MFFO, we exclude the impact of amounts attributable to our non-controlling interests. | Three Months Ended | | Nine Months Ended -------------------------------------------------------------------------+--------------------+-------+------------------ (In thousands) | March 31, 2017 | | June 30, 2017 | | September 30, 2017 | | September 30, 2017 -------------------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+------------------- Net income (loss) attributable to stockholders (in accordance with GAAP) | $ | 162 | | | $ | (963 | ) | | $ | (396 | ) | $ | (1,197 | ) -------------------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+---+-------+---+---+--------+-- Depreciation and amortization (1) | 1,313 | | | 1,313 | | | 1,300 | | | 3,926 | -------------------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+---+-------+-- Adjustments for non-controlling interests (2) | (1 | ) | | (9 | ) | | (5 | ) | | (15 | ) -------------------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+---+-------+-- FFO attributable to stockholders | 1,474 | | | 341 | | | 899 | | | 2,714 | -------------------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+---+-------+-- Acquisition and transaction related | 46 | | | 1,113 | | | 568 | | | 1,727 | -------------------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+---+-------+-- Amortization of market lease and other intangibles | 51 | | | 52 | | | 51 | | | 154 | -------------------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+---+-------+-- Straight-line rent adjustments | 12 | | | (73 | ) | | (67 | ) | | (128 | ) -------------------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+---+-------+-- Amortization of mortgage premium | (11 | ) | | (10 | ) | | (10 | ) | | (31 | ) -------------------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+---+-------+-- Adjustments for non-controlling interests (2) | (1 | ) | | (1 | ) | | 4 | | | 2 | -------------------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+---+-------+-- MFFO attributable to stockholders | $ | 1,571 | | | $ | 1,422 | | | $ | 1,445 | | $ | 4,438 | -------------------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+---+-------+---+---+--------+-- _______________ (1) | Net of non-real estate depreciation and amortization. ----+------------------------------------------------------ (2) | Represents the portion of the adjustments allocable to non-controlling interests. ----+---------------------------------------------------------------------------------- Net Operating Income NOI is a non-GAAP financial measure used by us to evaluate the operating performance of our real estate. NOI is equal to total revenues, excluding contingent purchase price consideration, less property operating and maintenance expense. NOI excludes all other items of expense and income included in the financial statements in calculating net income (loss). We believe NOI provides useful and relevant information because it reflects only those income and expense items that are incurred at the property level and presents such items on an unlevered basis. We use NOI to assess and compare property level performance and to make decisions concerning the operation of the properties. Further, we believe NOI is useful to investors as a performance measure because, when compared across periods, NOI reflects the impact on operations from trends in occupancy rates, rental rates, operating expenses and acquisition activity on an unleveraged basis, providing perspective not immediately apparent from net income (loss). NOI excludes certain components from net income (loss) in order to provide results that are more closely related to a property's results of operations. For example, depreciation and amortization, because of historical cost accounting and useful life estimates, may distort operating performance at the property level. NOI presented by us may not be comparable to NOI reported by other REITs that define NOI differently. NOI should not be considered as an alternative to net income (loss) as an indication of our performance or to cash flows as a measure of our liquidity or ability to make distributions. 43 The following table reflects the items deducted from or added to net income (loss attributable to stockholders in our calculation of NOI for the periods indicated: | Three Months Ended | | Nine Months Ended -------------------------------------------------------------------------+--------------------+-------+------------------ | March 31, 2017 | | June 30, 2017 | | September 30, 2017 | | September 30, 2017 -------------------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+------------------- Net income (loss) attributable to stockholders (in accordance with GAAP) | $ | 162 | | | $ | (963 | ) | | $ | (396 | ) | $ | (1,197 | ) -------------------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+---+-------+---+---+--------+-- Impairment on sale of real estate investments | — | | | — | | | | | — | -------------------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+---+------ Operating fees to related party | 13 | | | 14 | | | 15 | | | 42 | -------------------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+---+-------+-- Acquisition and transaction related | 46 | | | 1,113 | | | 568 | | | 1,727 | -------------------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+---+-------+-- General and administrative | 604 | | | 743 | | | 740 | | | 2,087 | -------------------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+---+-------+-- Depreciation and amortization | 1,316 | | | 1,318 | | | 1,304 | | | 3,939 | -------------------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+---+-------+-- Interest expense | 46 | | | 46 | | | 46 | | | 139 | -------------------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+---+-------+-- Interest and other income | — | | | — | | | — | | | — | -------------------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+---+-------+-- Income tax expense | 55 | | | (29 | ) | | (58 | ) | | (32 | ) -------------------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+---+-------+-- Net income attributable to non-controlling interests | 3 | | | 4 | | | 5 | | | 12 | -------------------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+---+-------+-- NOI | $ | 2,245 | | | $ | 2,246 | | | $ | 2,224 | | $ | 6,717 | -------------------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+---+-------+---+---+--------+-- | Three Months Ended | | Nine Months Ended ----------------------------------------------------------------+--------------------+-------+------------------ | March 31, 2016 | | June 30, 2016 | | September 30, 2016 | | September 30, 2016 ----------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+------------------- Net loss attributable to stockholders (in accordance with GAAP) | $ | (85 | ) | | $ | (20 | ) | $ | 232 | | $ | 127 ----------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+-------+---+---+------ Operating fees to related party | 40 | | | 39 | | | 41 | | 120 | ----------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+-------+-- Acquisition and transaction related | 30 | | | 103 | | | 104 | | 237 | ----------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+-------+-- General and administrative | 676 | | | 545 | | | 363 | | 1,584 | ----------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+-------+-- Depreciation and amortization | 1,577 | | | 1,581 | | | 1,502 | | 4,660 | ----------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+-------+-- Interest expense | 48 | | | 47 | | | 47 | | 142 | ----------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+-------+-- Interest and other income | — | | | (1 | ) | | — | | (1 | ) ----------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+-------+-- Income tax expense | 45 | | | 28 | | | 74 | | 147 | ----------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+-------+-- Net income attributable to non-controlling interests | 4 | | | 5 | | | 4 | | 13 | ----------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+-------+-- NOI | $ | 2,335 | | | $ | 2,327 | | $ | 2,367 | | $ | 7,029 ----------------------------------------------------------------+--------------------+-------+-------------------+-------+--------------------+-------+--------------------+---+-------+---+---+------ Refer to Note 13 — Segment Reporting for a reconciliation of NOI to net income (loss) attributable to stockholders by reportable segment. Distributions On January 29, 2015, our Board of Directors authorized, and we began paying, monthly distributions payable to stockholders of record each day during the applicable period at a rate equivalent to $1.56 per annum per share of common stock, beginning March 15, 2015. During July 2017, in light of the pending Asset Sale and Plan of Liquidation, we ceased declaring and paying regular distributions to our stockholders following the distributions to stockholders of record with respect to each day during the month of July 2017. The amount of distributions payable to our stockholders is determined by our Board of Directors and is dependent on a number of factors, including funds available for distribution, our financial condition, capital expenditure requirements, as applicable, requirements of Maryland law and annual distribution requirements needed to qualify and maintain our status as a REIT under the Internal Revenue Code of 1986, as amended (the "Code"). Distribution payments are dependent on the availability of funds. Our Board of Directors may reduce the amount of distributions paid or suspend distribution payments at any time and therefore distribution payments are not assured. 44 During the nine months ended September 30, 2017 , distributions paid to common stockholders totaled $7.2 million , including distributions to non-controlling interest holders of $15 thousand , and $1.4 million which was reinvested into additional shares of common stock through our DRIP. During the nine months ended September 30, 2017 , cash used to pay distributions was generated from cash flows provided by operations and available cash on hand, which includes proceeds from our IPO. The following table shows the sources for the payment of distributions to common stockholders, including distributions on unvested restricted shares, for the periods indicated: | Three Months Ended | | Nine Months Ended -------------------------------------------------------------------------+--------------------+-------+---------------------------- | March 31, 2017 | | June 30, 2017 | | September 30, 2017 (3) | | September 30, 2017 -------------------------------------------------------------------------+--------------------+-------+-----------------------------+------+------------------------+-----+---------------------------- (In thousands) | | | Percentage of Distributions | | | | Percentage of Distributions | | | | Percentage of Distributions | | | | Percentage of Distributions -------------------------------------------------------------------------+--------------------+-------+-----------------------------+------+------------------------+-----+-----------------------------+-------+-------+------+-----------------------------+-------+-----+-------+---------------------------- Cash distributions paid to stockholders (1) | $ | 1,595 | | | | | $ | 2,391 | | | | | $ | 1,802 | | | | $ | 5,788 | | | -------------------------------------------------------------------------+--------------------+-------+-----------------------------+------+------------------------+-----+-----------------------------+-------+-------+------+-----------------------------+-------+-----+-------+-----------------------------+-------+---+-------+--------+---+------+------ Distributions reinvested in common stock issued under the DRIP | 1,075 | | | | | 362 | | | | | — | | | | | 1,437 | | -------------------------------------------------------------------------+--------------------+-------+-----------------------------+------+------------------------+-----+-----------------------------+-------+-------+------+-----------------------------+-------+-----+-------+-----------------------------+-------+---+------ Total distributions paid | $ | 2,670 | | | | | $ | 2,753 | | | | | $ | 1,802 | | | | $ | 7,225 | | | -------------------------------------------------------------------------+--------------------+-------+-----------------------------+------+------------------------+-----+-----------------------------+-------+-------+------+-----------------------------+-------+-----+-------+-----------------------------+-------+---+-------+--------+---+------+------ Source of distribution coverage: | | | | | | | | | | | | | | | -------------------------------------------------------------------------+--------------------+-------+-----------------------------+------+------------------------+-----+-----------------------------+-------+-------+------+-----------------------------+-------+-----+-------+---------------------------- Cash flows provided by operations | $ | 2,029 | | | 76.0 | % | | $ | 1,227 | | | 44.6 | % | | $ | 1,163 | | 64.5 | % | | $ | 4,419 | 61.2 | % -------------------------------------------------------------------------+--------------------+-------+-----------------------------+------+------------------------+-----+-----------------------------+-------+-------+------+-----------------------------+-------+-----+-------+-----------------------------+-------+---+-------+--------+---+------+-------+-------+-- Available cash on hand (2) | 641 | | | 24.0 | % | | 1,526 | | | 55.4 | % | | 639 | | | 35.5 | % | 2,806 | | | 38.8 | % -------------------------------------------------------------------------+--------------------+-------+-----------------------------+------+------------------------+-----+-----------------------------+-------+-------+------+-----------------------------+-------+-----+-------+-----------------------------+-------+---+-------+--------+---+------+------ Total source of distribution coverage | $ | 2,670 | | | 100.0 | % | | $ | 2,753 | | | 100.0 | % | | $ | 1,802 | | 100.0 | % | | $ | 7,225 | 100.0 | % -------------------------------------------------------------------------+--------------------+-------+-----------------------------+------+------------------------+-----+-----------------------------+-------+-------+------+-----------------------------+-------+-----+-------+-----------------------------+-------+---+-------+--------+---+------+-------+-------+-- Cash flows provided by operations (in accordance with GAAP) | $ | 2,029 | | | | | $ | 1,227 | | | | | $ | 1,163 | | | | $ | 4,419 | | | -------------------------------------------------------------------------+--------------------+-------+-----------------------------+------+------------------------+-----+-----------------------------+-------+-------+------+-----------------------------+-------+-----+-------+-----------------------------+-------+---+-------+--------+---+------+------ Net income (loss) attributable to stockholders (in accordance with GAAP) | $ | 162 | | | | | $ | (963 | ) | | | | $ | (396 | ) | | | $ | (1,197 | ) | | -------------------------------------------------------------------------+--------------------+-------+-----------------------------+------+------------------------+-----+-----------------------------+-------+-------+------+-----------------------------+-------+-----+-------+-----------------------------+-------+---+-------+--------+---+------+------ _______________ (1) | Includes distributions paid to non-controlling interest stockholders. ----+---------------------------------------------------------------------- (2) | Includes proceeds received from our IPO. ----+----------------------------------------- (3) | During July 2017, in light of the pending Asset Sale and Plan of Liquidation, we ceased declaring and paying regular distributions to our stockholders following the distributions to stockholders of record with respect to each day during the month of July 2017. ----+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- For the nine months ended September 30, 2017 , cash flows provided by operations were $4.4 million . As shown in the table above, we funded distributions with cash flows provided by operations and available cash on hand. To the extent we pay distributions in excess of cash flows provided by operations and use our available cash on hand, our stockholders' investment may be adversely impacted. If, for some reason, we do not obtain stockholder approval of the Asset Sale and the Plan of Liquidation, our Board of Directors will further evaluate our distribution policy. We may not generate sufficient cash flows from operations to pay future distributions. The amount of cash available for distributions is affected by many factors, such as rental income from acquired properties and our operating expense levels, as well as many other variables. Actual cash available for distributions may vary substantially from estimates. Our actual results may differ significantly from the assumptions used by our Board of Directors in establishing a distribution rate to stockholders. Loan Obligations The payment terms of our loan obligation requires principal and interest amounts to be paid monthly with all unpaid principal and interest due at maturity. Our Advisor may, with approval from our independent directors, seek to borrow short-term capital that, combined with secured mortgage financing, exceeds our targeted leverage ratio. Such short-term borrowings may be obtained from third-parties on a case-by-case basis as acquisition opportunities present themselves. We view the use of short-term borrowings, including advances under a line of credit, if a line of credit is ever obtained, as an efficient and accretive means of acquiring real estate. 45 Contractual Obligations The following table reflects contractual debt obligations under our mortgage notes payable and minimum base rental cash payments due for leasehold interests over the next five years and thereafter as of September 30, 2017 . The minimum base rental cash payments due for leasehold interests exclude contingent rent payments, as applicable, that may be payable based on provisions related to increases in annual rent based on exceeding certain economic indexes, among other items. As of September 30, 2017 , the outstanding mortgage note payable had a weighted average effective interest rate of 4.0% . | | | | | Years Ended December 31, | | -----------------------------------+-------+-------+-------------------------------------+----+--------------------------+-----+------------ (In thousands) | Total | | October 1, 2017 — December 31, 2017 | | 2018 — 2019 | | 2020 — 2021 | Thereafter -----------------------------------+-------+-------+-------------------------------------+----+--------------------------+-----+-------------+----------- Principal on mortgage note payable | $ | 4,922 | | | $ | 25 | | $ | 4,897 | $ | — | $ | — -----------------------------------+-------+-------+-------------------------------------+----+--------------------------+-----+-------------+------------+-------+-------+-----+---+------ Interest on mortgage note payable | 401 | | | 49 | | | 352 | | — | — | -----------------------------------+-------+-------+-------------------------------------+----+--------------------------+-----+-------------+------------+-------+-------+---- Lease rental payments due | 3,785 | | | 26 | | | 211 | | 225 | 3,323 | -----------------------------------+-------+-------+-------------------------------------+----+--------------------------+-----+-------------+------------+-------+-------+---- | $ | 9,108 | | | $ | 100 | | $ | 5,460 | $ | 225 | $ | 3,323 -----------------------------------+-------+-------+-------------------------------------+----+--------------------------+-----+-------------+------------+-------+-------+-----+---+------ Election as a REIT We elected and qualified to be taxed as a REIT under Sections 856 through 860 of the Code, effective for our taxable year ended December 31, 2015. Commencing with such taxable year, we were organized and operated in a manner so that we qualify for taxation as a REIT under the Code. We intend to continue to operate in such a manner but no assurance can be given that we will operate in a manner so as to remain qualified for taxation as a REIT. In order continue to qualify for taxation as a REIT, we must, among other things, distribute annually at least 90% of our REIT taxable income (which does not equal net income as calculated in accordance with GAAP) determined without regard to the deduction for dividends paid and excluding net capital gains, and must comply with a number of other organizational and operational requirements. If we continue to qualify for taxation as a REIT, we generally will not be subject to federal corporate income tax on that portion of our REIT taxable income that we distribute to our stockholders. Even if we continue to qualify for taxation as a REIT, we may be subject to certain state and local taxes on our income and properties as well as federal income and excise taxes on our undistributed income. Inflation We may be adversely impacted by inflation on any leases that do not contain indexed escalation provisions. In addition, we may be required to pay costs for maintenance and operation of properties, which may adversely impact our results of operations due to potential increases in costs and operating expenses resulting from inflation. Related-Party Transactions and Agreements Please see Note 8 — Related Party Transactions and Arrangements of the accompanying consolidated financial statements. Off-Balance Sheet Arrangements We have no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors. Item 3. Quantitative and Qualitative Disclosures About Market Risk. The market risk associated with financial instruments and derivative financial instruments is the risk of loss from adverse changes in market prices or interest rates. Our long-term debt, which consists of secured financings, bears interest at a fixed rate. As of September 30, 2017 , we did not have any derivative financial instruments. Our interest rate risk management objectives are to limit the impact of interest rate changes on earnings and cash flows and to lower our overall borrowing costs. To achieve these objectives, from time to time, we may enter into interest rate hedge contracts such as swaps, collars, and treasury lock agreements in order to mitigate our interest rate risk with respect to various debt instruments. We do not hold or issue these derivative contracts for trading or speculative purposes. We do not have any foreign operations and thus we are not exposed to foreign currency fluctuations. 46 As of September 30, 2017 , our debt included a fixed-rate secured mortgage financing with a carrying value of $5.0 million and a fair value of $5.0 million . Changes in market interest rates on our fixed-rate debt impact the fair value of the note, but it has no impact on interest due on the note. For instance, if interest rates rise 100 basis points and our fixed rate debt balance remains constant, we expect the fair value of our obligation to decrease, the same way the price of a bond declines as interest rates rise. The sensitivity analysis related to our fixed-rate debt assumes an immediate 100 basis point move in interest rates from their September 30, 2017 levels, with all other variables held constant. A 100 basis point increase in market interest rates would result in a decrease in the fair value of our fixed-rate debt by $0.1 million . A 100 basis point decrease in market interest rates would result in an increase in the fair value of our fixed-rate debt by $0.1 million . These amounts were determined by considering the impact of hypothetical interest rate changes on our borrowing costs, and assuming no other changes in our capital structure. The information presented above includes only those exposures that existed as of September 30, 2017 and does not consider exposures or positions arising after that date. The information represented herein has limited predictive value. Future actual realized gains or losses with respect to interest rate fluctuations will depend on cumulative exposures, hedging strategies employed and the magnitude of the fluctuations. Item 4. Controls and Procedures. Evaluation of Disclosure Controls and Procedures In accordance with Rules 13a-15(b) and 15d-15(b) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), management, under the supervision and with the participation of our Interim Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act) as of the end of the period covered by this Quarterly Report on Form 10-Q . Based on such evaluation, our Interim Chief Executive Officer and Chief Financial Officer have concluded, as of the end of such period, that our disclosure controls and procedures are effective. Changes in Internal Control Over Financial Reporting No change occurred in our internal controls over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) of the Exchange Act) during the three months ended September 30, 2017 that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting. 47 PART II — OTHER INFORMATION Item 1. Legal Proceedings. We are not a party to, and none of our properties are subject to, any material pending legal proceedings. Item 1A. Risk Factors. There have been no material changes to the risk factors disclosed in our Annual Report on Form 10-K for the year ended December 31, 2016, other than the risk factors noted below: Failure to complete the Asset Sale, which is subject to conditions and also may not close due to uncertainties regarding HTI’s ability to finance the payment of the Purchase Price at closing, would prevent the Plan of Liquidation from becoming effective and could have adverse consequences for the Company. The Asset Sale is subject to certain conditions, some of which are out of the Company’s control, including, among other things stockholder approval of the Asset Sale and the Plan of Liquidation by the Company’s stockholders, which will be sought at the Annual Meeting. There can be no assurance when or whether these conditions will be satisfied or, to the extent waivable, waived or the occurrence of any effect, event, development or change will not transpire. If these conditions are not satisfied or waived, if permitted, by the March 16, 2018 outside date, the Purchase Agreement may be terminated and the Asset Sale would not be completed. At the closing of the Asset Sale, HTI plans to simultaneously add qualifying properties it is acquiring from us to the borrowing base of its existing revolving credit facility, thereby increasing the borrowing capacity thereunder, and draw down approximately $50.0 million to pay a portion of the Purchase Price and other costs associated with the closing of the Asset Sale. HTI intends to fund the remaining amounts payable through a combination of additional borrowings made possible by adding additional unencumbered assets it currently owns to the borrowing base of the HTI’s existing revolving credit facility as well as cash on hand. Although the Asset Sale is not subject to any financing condition, adding any property to the borrowing base of the HTI’s existing revolving credit facility requires satisfying certain conditions, including approval of the agent thereunder. There can be no assurance these conditions will be satisfied or waived when all the other conditions to the closing of the Asset Sale have been satisfied or waived and that HTI will be able pay the Purchase Price when it is required to do so under the Purchase Agreement. HTI has not made alternative financing arrangements and, if sufficient financing is not available through the HTI’s existing revolving credit facility on the Closing Date, HTI may not have sufficient cash on hand available to fund the entire Purchase Price and any other costs payable in connection with the closing of the Asset Sale. As of September 1, 2017, HTI had approximately $81.5 million in cash and cash equivalents. HTI’s cash and cash equivalents may decline between the date of this Quarterly Report on Form 10-Q and the Closing Date. HTI is subject to a covenant requiring the aggregate amount of all HTI’s unrestricted cash and cash equivalents to be equal to at least $30.0 million at all times. If the Company terminates the Purchase Agreement due to HTI’s failure to pay the Purchase Price at closing, HTI is required to reimburse the Company for up to $750,000 in actual third party expenses incurred in connection with the Asset Sale (without excluding Advisor expenses). However, after those reimbursements have been paid, HTI will have no further liability to the Company (including for any punitive, speculative or consequential damages) except with respect to surviving indemnification obligations. Moreover, the Company has waived any right to recover the balance of the Purchase Price, or any part thereof, and the right to pursue any other remedy permitted at law or in equity against HTI. There can be no assurance with respect to the timing of the completion of the Asset Sale or whether the Asset Sale will be completed on its current terms, or at all. If the Asset Sale is not completed for any reason, the Company would be subject to a number of other material risks, including that: • | the Plan of Liquidation will not become effective and the Company may continue to consider entering into a strategic transaction, which could result in our Board of Directors and management devoting time to that process instead of the Company’s operations, and there can be no assurance that an alternative strategic transaction would be available on equal or better terms and conditions than the Asset Sale, if at all; --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ • | the Company would be required to pay expenses incurred in connection with the Asset Sale, including financial advisory, legal and accounting fees,; --+---------------------------------------------------------------------------------------------------------------------------------------------------- • | if the Purchase Agreement is terminated under certain circumstances related to our Board of Directors changing its recommendation to the Company’s stockholders with respect to its approval of the Asset Sale or the Plan of Liquidation or the Company entering into an agreement related to a competing third-party proposal to acquire all or a significant part of the Company, the Company will be required to pay HTI a termination fee of $3.6 million; and --+-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 48 • | if the Purchase Agreement is terminated by either party due to the Company’s failure to obtain stockholder approval of the Asset Sale and the Plan of Liquidation at the Annual Meeting, the Company will be responsible for reimbursing HTI for up to $850,000 in actual third party, non-HTI Advisor expenses, including non-HTI Advisor legal fees and any fee paid to HTI’s financial advisor, incurred in connection with the transactions contemplated by the Purchase Agreement. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- The pendency of the Asset Sale could adversely affect the business and operations of the Company. In connection with the pending Asset Sale, some tenants or vendors of the Company may delay or defer decisions because of uncertainty concerning the outcome of the Asset Sale, which could negatively impact the revenues, earnings, cash flows and expenses of the Company, regardless of whether the Asset Sale is completed. In addition, due to operating covenants in the Purchase Agreement, the Company may be unable, during the pendency of the Asset Sale, to pursue certain strategic transactions, undertake certain significant capital projects, undertake certain significant financing transactions and otherwise pursue other actions that are not in the ordinary course of business, even if these actions would prove beneficial. The Company’s directors and officers (including all of the Company’s executive officers and one of the Company’s directors, in their capacities as executives or members of the Advisor, the HTI Advisor and their affiliates) may have interests in the Asset Sale that may be different from, or in addition to, those of the Company’s other stockholders. The Company’s directors and officers (including all of the Company’s executive officers and one of the Company’s directors, in their capacitates as executives or members of the Advisor, the HTI Advisor and their affiliates) may have interests in the Asset Sale and the Plan of Liquidation that are different from, or in addition to, the interests of stockholders. The Advisor and the HTI Advisor, as well as their respective property managers, are indirectly owned and controlled by AR Global. Edward M. Weil, Jr., the executive chairman of our Board of Directors, is also a member of the HTI board of directors. Mr. Weil owns a non-controlling interest in the parent of AR Global and is also the chief executive officer of AR Global. In addition, the Company, HTI, the Advisor, the Property Manager and HTI's property manager have the same executive officers, W. Todd Jensen and Katie P. Kurtz. These interests also include the following: • | Under the Letter Agreement, subject to completing the Asset Sale, the obligation of the Advisor and its affiliates to pay the Company approximately $3.68 million with respect to certain expense reimbursements or fees previously paid by the Company to the Advisor or its affiliates will be satisfied in exchange for the surrender of certain Class B Units issued to the Advisor, an agreement to waive or assume certain fees and expense reimbursements that are payable or that become payable by the Company to the Advisor and an agreement by the Advisor to pay the Company any remaining amounts in cash following the Closing Date. --+---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | Pursuant to the Letter Agreement, prior to the Closing Date and subject to completing the Asset Sale, the Company and the Advisor have agreed to enter into amendments to the Company's advisory agreement with the Advisor and the limited partnership agreement of the OP effective as of October 1, 2017 to facilitate the establishment of a value for Class B Units consistent with the applicable provisions of the Letter Agreement and certain of the other payments contemplated by the Letter Agreement, even though, without these amendments, the Advisor would not be entitled to receive liquidating distributions in connection with the Plan of Liquidation. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | HTI acquiring our properties could result in an increase in the fees payable by HTI to its advisor and property manager and their affiliates under HTI's agreements with its advisor and property manager. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | All outstanding and unvested restricted shares of the Company, including 4,798 unvested restricted shares held by the Company’s directors and executive officers in the aggregate as of June 30, 2017 and the 1,333 restricted shares automatically granted to each of the Company’s independent directors in connection with the Annual Meeting, will vest upon the sale of all or substantially all of the Company’s assets, which would occur if the Asset Sale is consummated. --+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- • | HTI may be required to reimburse the HTI Advisor for insourced acquisition expenses up to a maximum of $0.6 million, representing 0.5% of the contract purchase price (as defined in HTI’s charter) being paid to acquire our properties. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ • | HTI common stock may increase in value as a result of the Asset Sale, which may benefit HTI’s stockholders generally as well as AR Global, which directly or indirectly beneficially owns 8,888 shares of HTI common stock and 359,340 shares of HTI common stock issuable in exchange for certain performance-based restricted, forfeitable interests in HTI OP. --+------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 49 The Purchase Agreement contains provisions that could discourage a potential competing acquiror or could result in any competing proposal being at a lower price than it might otherwise be. The Purchase Agreement contains “no shop” provisions that, subject to limited exceptions, restrict the Company from initiating, soliciting, knowingly encouraging or facilitating any inquiries or the making of any proposal, offer or other action that constitutes, or may reasonably be expected to lead to, any competing third-party proposals to acquire all or a significant part of the Company. In addition, if the Purchase Agreement is terminated under certain circumstances related to our Board of Directors changing its recommendation to the Company’s stockholders with respect to its approval of the Asset Sale or the Plan of Liquidation or the Company entering into an agreement related to a competing third-party proposals to acquire all or a significant part of the Company, the Company will be required to pay HTI a termination fee of $3.6 million. These provisions could discourage a potential acquiror that might have an interest in acquiring all or a significant part of the Company or its assets from considering or proposing an acquisition, even if the potential acquiror were prepared to pay consideration with a higher per share value than the Purchase Price agreed to by HTI, or might result in a potential competing acquiror proposing to pay a lower amount than it might otherwise have proposed to pay because of the added expense of the termination fee that may become payable in certain circumstances. The Company cannot determine at this time the amount or timing of any liquidating distributions to its stockholders. The Company anticipates paying periodic liquidating distributions, including an initial liquidating distribution of $15.75 expected to be paid within two weeks following the closing of the Asset Sale, but the Company cannot determine at this time when it will be able to pay liquidating distributions to its stockholders or the amount of any liquidating distributions. The amount of net cash proceeds available for distribution pursuant to the Plan of Liquidation depends on a variety of factors, including, but not limited to, the timing of the closing of the Asset Sale; the amount required to pay both existing liabilities and obligations as well as any contingent liabilities; the cost of operating the Company through the date of its final dissolution; general business and economic conditions; and other matters. Under the Purchase Agreement, the Company is obligated to indemnify HTI in certain circumstances, including with respect to any stockholder litigation brought by the Company’s stockholders directly or derivatively in connection with the transactions contemplated by the Purchase Agreement. Indemnifiable losses incurred by HTI, if any, for which the Company is liable are recoverable by HTI first out of the Escrow Amount and then, to the extent the indemnifiable losses exceed the Escrow Amount, from the Company. Moreover, the Plan of Liquidation states that the final liquidating distribution will not occur earlier than the end of the 14-month survival period of the representations and warranties under the Purchase Agreement and will not occur prior to final resolution of any unsatisfied indemnification claims or other claims that are first made prior to the end of that period. Funding indemnity claims or other contingent liabilities could delay and reduce distributions to stockholders. The Company will also continue to incur liabilities and expenses from operations prior to closing the Asset Sale and prior to the dissolution of the Company. The Company’s estimates regarding its expense levels may be inaccurate. Any unexpected claims, liabilities or expenses that arise between the date of this proxy statement and the consummation of the Company’s proposed liquidation and final dissolution, or any claims, liabilities or expenses that exceed the Company’s estimates, will delay the timing of and reduce the amount of cash available for distribution to stockholders. In some circumstances, the Company’s stockholders could be held liable for amounts they received from the Company in connection with the dissolution. If the Company fails to create an adequate reserve to pay its expenses and liabilities, or if the Company transfers its assets to a liquidating trust and the reserve and the assets held by the liquidating trust are less than the amount ultimately required to pay expenses and liabilities, each stockholder or holder of a beneficial interest in the liquidating trust could be held liable to creditors for the holder’s pro rata portion of any excess amounts owed to the creditor, albeit limited to the amounts previously received by the stockholder in distributions from the Company or the liquidating trust, as applicable. Accordingly, a stockholder could be required to return all liquidating distributions received from the Company or the liquidating trust. If a stockholder has paid taxes on distributions previously received, a repayment of all or a portion of the amount of a distribution could result in a stockholder incurring a net tax cost if the stockholder’s repayment does not cause a commensurate reduction in taxes payable. If the Company fails to adequately provide for its expenses and liabilities or if the amount ultimately required to be paid in respect of the liabilities exceeds the amount available from the contingency reserve and the assets of the liquidating trust, the Company’s creditors could seek an injunction to prevent the Company or liquidating trust, as applicable, from paying distributions under the Plan of Liquidation on the grounds that the amounts to be distributed are needed to provide for the payment of expenses and liabilities. Any such action could delay or substantially diminish the cash distributions that the Company pays to its stockholders or holders of beneficial interests of any liquidating trust. 50 The Company will continue to incur the expenses of complying with public company reporting requirements. Following the Asset Sale and through the Company’s subsequent liquidation and dissolution, the Company will be required to continue to comply with the applicable reporting requirements of the Exchange Act. The Company will continue to incur costs to comply with these reporting requirements, which will reduce the amount of cash available for distribution to stockholders. The Board of Directors may abandon or delay implementation of the Plan of Liquidation even if it is approved by the Company’s stockholders. The Board of Directors has adopted and approved the Plan of Liquidation, but may terminate the Plan of Liquidation for any reason until the time that the articles of dissolution have been filed with, and accepted for record by, the State Department of Assessments and Taxation of Maryland. Our Board of Directors may modify or amend the Plan of Liquidation without further action by the stockholders to the extent permitted under then current law. The Plan of Liquidation will only become effective if the Asset Sale is completed, following which the Company’s assets will consist primarily of cash. Although our Board of Directors has no present intention to pursue any alternative to the Plan of Liquidation, the members of our Board of Directors may conclude that abandoning the Plan of Liquidation is otherwise in the best interests of the Company and its stockholders. If our Board of Directors elects to pursue any alternative to the Plan of Liquidation, stockholders may not receive any of the distributions of net proceeds from the Asset Sale currently estimated to be available for distribution to stockholders. An adverse judgment in a lawsuit challenging the Asset Sale or the Plan of Liquidation may prevent the Asset Sale from closing or from closing within the expected timeframe, if at all. There may be lawsuits filed challenging the Asset Sale or the Plan of Liquidation, which could, among other things, result in the Company incurring costs associated with defending these claims or any other liabilities that may be incurred in connection with these claims. Further, an injunction could be issued, prohibiting the Company from completing the Asset Sale in the expected time frame, may prevent it from being completed altogether and may prevent the Company from paying liquidating distributions. Pursuing the Plan of Liquidation may cause the Company to fail to qualify as a REIT, which would dramatically lower the amount of liquidating distributions. For so long as the Company qualifies as a REIT and distributes all of its taxable income, the Company generally is not subject to federal income tax. Although our Board of Directors does not presently intend to terminate the Company’s REIT status prior to the final distribution of its assets and dissolution, our Board of Directors may take actions pursuant to the Plan of Liquidation that would result in a loss of REIT status. Upon the final distribution of the Company’s assets and dissolution, the Company’s existence and REIT status will terminate. However, there is a risk that the Company’s actions in pursuit of the Plan of Liquidation may cause the Company to fail to meet one or more of the requirements that must be met in order to qualify as a REIT prior to completion of the Plan of Liquidation. For example, to qualify as a REIT, at least 75% of the Company’s gross income must come from real estate sources and 95% of the Company’s gross income must come from real estate sources and certain other sources that are itemized in the REIT tax laws, mainly interest and dividends. The Company may encounter difficulties satisfying these requirements as part of the liquidation process. In addition, in connection with that process, the Company may recognize ordinary income in excess of the cash received. The REIT rules require the Company to pay out a large portion of its ordinary income in the form of a dividend to its stockholders. However, to the extent that the Company recognizes ordinary income without any cash available for distribution, and if the Company were unable to borrow to fund the required dividend or find another way to meet the REIT distribution requirements, the Company may cease to qualify as a REIT. While the Company expects to comply with the requirements necessary to qualify as a REIT in any taxable year, if it is unable to do so, the Company will, among other things (unless entitled to relief under certain statutory provisions): • | not be allowed a deduction for dividends paid to stockholders in computing the Company’s taxable income --+-------------------------------------------------------------------------------------------------------- • | be subject to federal income tax, including any applicable alternative minimum tax, on the Company’s taxable income at regular corporate rates; --+------------------------------------------------------------------------------------------------------------------------------------------------ • | be subject to increased state and local taxes; and --+--------------------------------------------------- • | be disqualified from treatment as a REIT for the taxable year in which the Company loses its qualification and for the four following taxable years. --+----------------------------------------------------------------------------------------------------------------------------------------------------- As a result of these consequences, the Company’s failure to qualify as a REIT could substantially reduce the funds available for distribution to the Company’s stockholders. 51 Pursuing the Plan of Liquidation may increase the risk that the Company will be liable for U.S. federal income and excise taxes, which would reduce the amount of liquidating distributions. The Company generally is not subject to U.S. federal income tax to the extent that the Company distributes to stockholders during each taxable year (or, under certain circumstances, during the subsequent taxable year) dividends equal to the Company’s taxable income for the year (determined without regard to the deduction for dividends paid and by excluding any net capital gain). However, the Company is subject to U.S. federal income tax to the extent that its taxable income exceeds the amount of dividends paid to stockholders for the taxable year. In addition, the Company is subject to a 4% nondeductible excise tax on the amount, if any, by which certain distributions paid by the Company with respect to any calendar year are less than the sum of 85% of its ordinary income for that year, plus 95% of the Company’s capital gain net income for that year, plus 100% of the Company’s undistributed taxable income from prior years. While the Company intends to make distributions to its stockholders sufficient to avoid the imposition of any U.S federal income tax on the Company’s taxable income and the imposition of the excise tax, differences in timing between the Company’s actual cash flow and the recognition of its taxable income, could cause the Company to have to either borrow funds on a short-term basis to meet the REIT distribution requirements, find another alternative for meeting the REIT distribution requirements, or pay U.S. federal income and excise taxes. In addition (and as discussed in more detail below), net income from the sale of properties that are “dealer” properties (a “prohibited transaction” under the Code would be subject to a 100% excise tax. The cost of borrowing or the payment of U.S. federal income and/or excise taxes would reduce the funds available for distribution to stockholders. The sale of the Company’s assets may cause it to be subject to a 100% excise tax on the net income from “prohibited transactions,” which would reduce the amount of its liquidating distributions. REITs are subject to a 100% excise tax on any net income from “prohibited transactions,” which include sales or other dispositions of property held for sale to customers in the ordinary course of the REIT’s trade or business which is not a foreclosure property. The determination of whether property is held for sale to customers in the ordinary course of a trade or business is inherently factual in nature and, thus, cannot be predicted with certainty. The Code provides a “safe harbor” which, if all its conditions are met, would protect a REIT’s property sales from being considered prohibited transactions. The conditions include, among other things, that the property be held by a REIT for at least two years for the production of rental income and that the REIT does not have more than seven property sales in any taxable year (there are alternative conditions to this seven sales condition, but those alternatives could not be met in the context of a complete liquidation). The Company does not expect that all of its properties will have been held for two years for the production of rental income at the time the Asset Sale closes. Accordingly, the Company does not expect to satisfy the safe harbor with respect to all of its properties and will have to rely on an examination of the facts and circumstances to support its position that its properties are held for investment and not for sale to customers in the ordinary course of its trade or business. If the Company were subject to this excise tax, it would reduce the funds available for distribution to stockholders. Distributing interests in a liquidating trust may cause the Company’s stockholders to recognize gain prior to the receipt of cash. The REIT provisions of the Code generally require that each year the Company distribute as a dividend to its stockholders 90% of its REIT taxable income (determined without regard to the dividends paid deduction and excluding net capital gain). Liquidating distributions the Company makes pursuant to the Plan of Liquidation will qualify for the dividends paid deduction, provided that they are made within 24 months of adoption of the Plan of Liquidation. However, conditions may arise that cause the Company not to be able to liquidate within a 24-month period. In such event, rather than retain the Company’s assets and risk losing its status as a REIT, the Company may elect to contribute its remaining assets and liabilities to a liquidating trust in order to meet the 24-month requirement. The Company may also elect to contribute its remaining assets and liabilities to a liquidating trust within the 24-month period to avoid the costs of operating as a public company. Such a contribution would be treated for U.S. federal income tax purposes as a distribution of the Company’s remaining assets to its stockholders, followed by a contribution of the assets to the liquidating trust. As a result, a stockholder would recognize gain to the extent that the stockholder’s share of the cash and the fair market value of any assets received by the liquidating trust was greater than the stockholder’s basis in the stock (reduced by the amount of all prior liquidating distributions made to the stockholder during the liquidation period), notwithstanding that the stockholder would not contemporaneously receive a distribution of cash or any other assets with which to satisfy the resulting tax liability. In addition, it is possible that the fair market value of the assets received by the liquidating trust, as estimated for purposes of determining the extent of the stockholder’s gain at the time interests in the liquidating trust are distributed to the stockholders, will exceed the cash or fair market value of property received by the liquidating trust on a sale of the assets. In this case, the stockholder would recognize a loss in a taxable year subsequent to the taxable year in which the gain was recognized, which loss may be limited under the Code. Pursuant to Internal Revenue Service guidelines, the liquidating trust generally could have up to three years to complete the sale of the Company’s assets and distribute the net proceeds to its stockholders. Any transfer also may have adverse tax consequences for tax-exempt and non-U.S. stockholders, including with respect to the on-going activity of the liquidating trust. 52 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds of Registered Securities. Unregistered Sales of Equity Securities We did not sell any equity securities that were not registered under the Securities Act during the three months ended September 30, 2017 . Use of Proceeds of Registered Securities On August 20, 2014, we commenced our IPO on a "reasonable best efforts" basis of up to a maximum of $3.1 billion of common stock, consisting of up to 125.0 million shares, pursuant to the registration statement initially filed on May 28, 2014 with the SEC under the Securities Act of 1933, as amended (File No. 333-196302). The registration statement, which was declared effective by the SEC on August 20, 2014, also covered 26.3 million shares of common stock pursuant to the DRIP under which common stockholders may elect to have their distributions reinvested in additional shares of common stock. On January 25, 2016, we registered an additional 0.7 million shares to be issued pursuant to the DRIP pursuant to a new registration statement (File No. 333-209117). On August 20, 2016, the IPO lapsed in accordance with its terms. As of September 30, 2017 , we have issued approximately 7.0 million shares of our common stock, including unvested restricted shares and shares issued pursuant to the DRIP, and had received total proceeds from the IPO and the DRIP, net of share repurchases, of $171.1 million . The following table reflects the number of shares repurchased cumulatively through September 30, 2017 : | Number of Shares Repurchased | Weighted-Average Price per Share ------------------------------------------------+------------------------------+--------------------------------- Cumulative repurchases as of December 31, 2016 | 1,021 | | $ | 24.97 ------------------------------------------------+------------------------------+----------------------------------+-------+------ Nine months ended September 30, 2017 (1) | 82,494 | | 22.79 | ------------------------------------------------+------------------------------+----------------------------------+-------+------ Cumulative repurchases as of September 30, 2017 | 83,515 | | $ | 22.82 ------------------------------------------------+------------------------------+----------------------------------+-------+------ _______________ (1) | Represents repurchases related to repurchase requests received during 2016, including 82,494 shares repurchased during the nine months ended September 30, 2017 for approximately $1.9 million at a weighted average price per share of $22.79, net of 1,110 share repurchase requests that were canceled. Excludes rejected repurchase requests received during 2016 with respect to 181,389 shares for $4.0 million at a weighted average price per share of $22.29, which were unfulfilled. On June 16, 2017, in furtherance of the Asset Sale, our Board of Directors determined to suspend the SRP indefinitely and, as authorized by the terms of the SRP, to reject any repurchase requests that we had received or will receive during calendar year 2017. The suspension of the SRP became effective as of July 19, 2017 and no shares have been, or will be, repurchased in connection with requests made during 2017. ----+--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Additionally, we incurred offering costs associated with the issuance of our common stock. We were responsible for offering and related costs from the IPO, excluding selling commissions and dealer manager fees, up to a maximum of 2.0% of gross proceeds received from the IPO, measured at the end of the IPO. Offering costs, excluding selling commissions and dealer manager fees, in excess of the 2.0% limitation as of the end of the IPO are the Advisor's responsibility. As of the end of the IPO, which lapsed in accordance with its terms in August 2016, offering and related costs, excluding commissions and dealer manager fees, exceeded 2.0% of gross proceeds received from the IPO by $3.8 million. The obligation of the Advisor and its affiliates to pay this amounts, will be satisfied through the payment, tender, waiver or assumption of certain fees, expenses and obligations, as applicable, pursuant to the Letter Agreement. For additional discussion on offering and related costs from the IPO and the Letter Agreement see the section titled AR Global Arrangements in Note 8 - Related Party Transactions and Arrangements to the Company's consolidated financial statements. The following table reflects the offering costs associated with the issuance of common stock: | Period from April 24, 2014 (date of inception) to --------------------------------------------+-------------------------------------------------- (In thousands) | September 30, 2017 --------------------------------------------+-------------------------------------------------- Selling commissions and dealer manager fees | $ | 14,368 --------------------------------------------+---------------------------------------------------+------- Other offering costs(1) | 7,071 | --------------------------------------------+---------------------------------------------------+------- Total offering costs | $ | 21,439 --------------------------------------------+---------------------------------------------------+------- _______________ (1) | Includes $3.8 million of other offering costs that are in excess of the limitation of 2.0% of gross proceeds received from the IPO, as described above. ----+-------------------------------------------------------------------------------------------------------------------------------------------------------- 53 We have used substantially all of the net proceeds from our IPO to acquire our real estate portfolio, as shown in the table below. The remaining offering proceeds, after the acquisition of our portfolio, along with cash flows from operations have and will be used for purposes of working capital and to pay distributions to our stockholders. (In thousands) | Proceeds -------------------------------------+--------- Net cash proceeds from the IPO (1) | $ | 171,098 -------------------------------------+----------+-------- Total offering costs | (21,439 | ) -------------------------------------+----------+-------- | $ | 149,659 -------------------------------------+----------+-------- Real estate investments, at cost (2) | $ | 129,901 -------------------------------------+----------+-------- _______________ (1) | Includes shares issued pursuant to the DRIP and net of share repurchases. ----+-------------------------------------------------------------------------- (2) | Amount does not include impact of mortgage notes. See Note 5 - Mortgage Notes Payable. ----+--------------------------------------------------------------------------------------- Item 3. Defaults Upon Senior Securities. None. Item 4. Mine Safety Disclosures. Not applicable. Item 5. Other Information. None. Item 6. Exhibits. The exhibits listed on the Exhibit Index (following the signatures section of this report) are included, or incorporated by reference, in this Quarterly Report on Form 10-Q . 54 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. AMERICAN REALTY CAPITAL HEALTHCARE TRUST III, INC. -------------------------------------------------- By: | /s/ W. Todd Jensen ---------------------------------------------------+--------------------------------------------------------------------------------------------------------------- | W. Todd Jensen ---------------------------------------------------+--------------------------------------------------------------------------------------------------------------- | Interim Chief Executive Officer and President(Principal Executive Officer) ---------------------------------------------------+--------------------------------------------------------------------------------------------------------------- By: | /s/ Katie P. Kurtz ---------------------------------------------------+--------------------------------------------------------------------------------------------------------------- | Katie P. Kurtz ---------------------------------------------------+--------------------------------------------------------------------------------------------------------------- | Chief Financial Officer, Treasurer and Secretary(Principal Financial Officer and Principal Accounting Officer) ---------------------------------------------------+--------------------------------------------------------------------------------------------------------------- Dated: November 13, 2017 55 EXHIBITS INDEX The following exhibits are included, or incorporated by reference, in this Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2017 (and are numbered in accordance with Item 601 of Regulation S-K). Exhibit No. | Description ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 10.1 (1) | Amendment, dated as of September 28, 2017, to the Letter Agreement, dated as of June 16, 2017, by and among American Realty Capital Healthcare Trust III, Inc., American Realty Capital Healthcare III Advisors, LLC and AR Global Investments, LLC ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.1* | Certification of the Principal Executive Officer of the Company pursuant to Securities Exchange Act Rule 13a-14(a) or 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 31.2* | Certification of the Principal Financial Officer of the Company pursuant to Securities Exchange Act Rule 13a-14(a) or 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 32* | Written statements of the Principal Executive Officer and Principal Financial Officer of the Company pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 101* | XBRL (eXtensible Business Reporting Language). The following materials from American Realty Capital Healthcare Trust III, Inc.'s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2017, formatted in XBRL: (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Operations and Comprehensive Income (Loss), (iii) the Consolidated Statements of Changes in Equity, (iv) the Consolidated Statements of Cash Flows and (v) the Notes to the Consolidated Financial Statements. ------------+----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ____________________ * Filed herewith. (1) Filed as an exhibit to the Company’s Current Report on Form 8-K filed with the SEC on October 4, 2017. 56