Axalta Coating Systems Ltd.: Form 10-Q for the period ended Sep 30, 2018

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the interim unaudited condensed consolidated financial statements and the condensed notes thereto included elsewhere in this Quarterly Report on Form 10-Q, as well as the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.

FORWARD-LOOKING STATEMENTS

Many statements made in the following discussion and analysis of our financial condition and results of operations and elsewhere in this Quarterly Report on Form 10-Q that are not statements of historical fact, including statements about our beliefs and expectations, are "forward-looking statements" within the meaning of federal securities laws and should be evaluated as such. Forward-looking statements include information concerning possible or assumed future results of operations, including descriptions of our business plan, strategies and capital structure. These statements often include words such as "anticipate," "expect," "suggests," "plan," "believe," "intend," "estimates," "targets," "projects," "should," "could," "would," "may," "will," "forecast" and other similar expressions. We base these forward-looking statements or projections on our current expectations, plans and assumptions that we have made in light of our experience in the industry, as well as our perceptions of historical trends, current conditions, expected future developments and other factors we believe are appropriate under the circumstances and at such time. As you read and consider this Quarterly Report on Form 10-Q, you should understand that these statements are not guarantees of performance or results. The forward-looking statements and projections are subject to and involve risks, uncertainties and assumptions, including, but not limited to, the risks and uncertainties described in "Non-GAAP Financial Measures" and "Forward-Looking Statements," as well as "Risk Factors" and you should not place undue reliance on these forward-looking statements or projections. Although we believe that these forward-looking statements and projections are based on reasonable assumptions at the time they are made, you should be aware that many factors could affect our actual financial results or results of operations and could cause actual results to differ materially from those expressed in the forward-looking statements and projections. Factors that may materially affect such forward-looking statements and projections include:

• adverse developments in economic conditions and, particularly, in conditions in the automotive and transportation industries;
• volatility in the capital, credit and commodities markets;
• our inability to successfully execute on our growth strategy;
• increased competition;
• weather conditions or severe storms that may temporarily reduce the demand for some of our products;
• reduced demand for some of our products as a result of improved safety features on vehicles and insurance company influence;
• risks of the loss or change in purchasing levels of any of our significant customers or the consolidation of multi-shop operators (MSOs), distributors and/or body shops;
• our reliance on our distributor network and third-party delivery services for the distribution and export of certain of our products;
• credit risk exposure from our customers;
• price increases or interruptions in our supply of raw materials;
• failure to develop and market new products and manage product life cycles;
• business disruptions, security threats and security breaches, including cyber security risks to our information technology systems;
• risks associated with our outsourcing strategies;
• risks associated with our non-U.S. operations;
• currency-related risks;
• terrorist acts, conflicts, wars and natural disasters that may materially adversely affect our business, financial condition and results of operations;
• failure to comply with the anti-corruption laws of the United States and various international jurisdictions;
• failure to comply with anti-terrorism laws and regulations and applicable trade embargoes;
• risks associated with protecting data privacy;
• significant environmental liabilities and costs as a result of our current and past operations or products, including operations or products related to our business prior to our acquisition of DuPont Performance Coatings;
• transporting certain materials that are inherently hazardous due to their toxic nature;
• litigation and other commitments and contingencies;
• our ability to recruit and retain the experienced and skilled personnel we need to compete;
• unexpected liabilities under any pension plans applicable to our employees;
• work stoppages, union negotiations, labor disputes and other matters associated with our labor force;
• our ability to protect and enforce intellectual property rights;
• intellectual property infringement suits against us by third parties;
• our ability to realize the anticipated benefits of any acquisitions and divestitures;
• our joint ventures’ ability to operate according to our business strategy should our joint venture partners fail to fulfill their obligations;
• risk that the insurance we maintain may not fully cover all potential exposures;
• the risk of impairment charges related to goodwill, identifiable intangible assets and fixed assets;
• risks associated with changes in tax rates or regulations, including unexpected impacts of the new U.S. TCJA legislation, which may differ with further regulatory guidance and changes in our current interpretations and assumptions;
• our substantial indebtedness;
• our ability to obtain additional capital on commercially reasonable terms may be limited;
• risks and uncertainties associated with a transition in Axalta's leadership;
• any statements of belief and any statements of assumptions underlying any of the foregoing;
• other factors disclosed in this Quarterly Report on Form 10-Q, our Annual Report on Form 10-K for the year ended December 31, 2017 and our other filings with the Securities and Exchange Commission; and
• other factors beyond our control.

These cautionary statements should not be construed by you to be exhaustive and are made only as of the date of this Quarterly Report on Form 10-Q. We undertake no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

OVERVIEW

We are a leading global manufacturer, marketer and distributor of high performance coatings systems. We have over a 150-year heritage in the coatings industry and are known for manufacturing high-quality products with well-recognized brands supported by market-leading technology and customer service. Our diverse global footprint of 50 manufacturing facilities, four technology centers, 47 customer training centers and approximately 14,000 employees allows us to meet the needs of customers in over 130 countries. We serve our customer base through an extensive sales force and technical support organization, as well as through approximately 4,000 independent, locally based distributors.

We operate our business in two operating segments, Performance Coatings and Transportation Coatings. Our segments are based on the type and concentration of customers served, service requirements, methods of distribution and major product lines.

Through our Performance Coatings segment we provide high-quality liquid and powder coatings solutions to a fragmented and local customer base. We are one of only a few suppliers with the technology to provide precise color matching and highly durable coatings systems. The end-markets within this segment are refinish and industrial.

Through our Transportation Coatings segment we provide advanced coating technologies to OEMs of light and commercial vehicles. These increasingly global customers require a high level of technical support coupled with cost-effective, environmentally responsible, coatings systems that can be applied with a high degree of precision, consistency and speed. The end-markets within this segment are light vehicle and commercial vehicle.

BUSINESS HIGHLIGHTS

General Business Highlights

Our net sales increased 10.1% for the nine months ended September 30, 2018 compared with the nine months ended September 30, 2017, driven by volume growth of 6.3% primarily within our Performance Coatings segment. Acquisitions positively impacted and contributed to 4.7% of the volume increase. Increases in average selling prices across both end-markets within the Performance Coatings segment were slightly offset by pricing concessions within the Transportation Coatings segment and contributed to a net increase of 1.9%. Favorable currency translation contributed to a further increase of net sales of 1.9% due primarily to the impacts of the strengthening Euro and Chinese Renminbi compared with the U.S. Dollar. The following trends have impacted our segment and end-market sales performance:

• Performance Coatings: Net sales increased 16.7% driven primarily by stronger volumes in our industrial end-market, including the impacts of acquisitions combined with organic volume growth in all regions except for Latin America, as well as increases in average selling prices across both end-markets.
• Transportation Coatings: Net sales decreased 0.2% driven primarily by lower selling prices in both our light vehicle and commercial vehicle end-markets, substantially offset by favorable foreign currency translation and higher volumes across both end-markets and all regions except for Europe.

Our business serves four end-markets globally with net sales for the three and nine months ended September 30, 2018 and 2017, as follows:

(In millions)

Acquisitions Highlights

During the nine months ended September 30, 2018, we successfully completed four strategic acquisitions, including two in Asia Pacific and two in North America, all of which benefited our Performance Coatings segment. Our 2018 aggregate spending for these acquisitions was $76.4 million.

In addition, pursuant to the stock purchase agreement for a consolidated joint venture acquisition during the year ended December 31, 2016, during the nine months ended September 30, 2018, we were required to purchase an additional 24.5% interest for $26.9 million, increasing our total ownership percentage to 75.5%.

Belgium Manufacturing Facility Closure

During the nine months ended September 30, 2018, we approved a restructuring plan involving the closure of our manufacturing facility at our Mechelen, Belgium site and transfer of production capabilities to other Axalta facilities. Severance costs incurred in conjunction with these actions were $70.6 million for the three and nine months ended September 30, 2018. Manufacturing assets totaling $55.8 million (€47.7 million) were also assessed given expected closures and as a result, useful lives of the assets were truncated, resulting in impacts to earnings from accelerated depreciation for the three and nine months ended September 30, 2018 of $4.2 million.

Capital and Liquidity Highlights

During the nine months ended September 30, 2018, we completed the Sixth Amendment of our Senior Secured Credit Facilities, which repriced the 2024 Dollar Term Loans and increased the aggregate principal balance by $475.0 million to $2,430.0 million. Proceeds from the Sixth Amendment, along with cash on the balance sheet, were used to extinguish the existing 2023 Euro Term Loans. Concurrent with the refinancing, we executed interest rate and cross-currency swaps to convert $475.0 million of the 2024 Dollar Term Loans principal into Euro fixed-rate debt at an interest rate of 1.95%, which matures in 2023. The combined effect of the refinancing and the swaps are expected to result in annual cash interest savings of approximately $10.0 million.

During the nine months ended September 30, 2018, we repurchased 5.1 million shares for total consideration of $153.5 million as we continue to execute against our share repurchase program.

FACTORS AFFECTING OUR OPERATING RESULTS

There have been no changes in the factors affecting our operating results previously reported in Part II, Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2017.

NON-GAAP FINANCIAL MEASURES

Reconciliation of Net Income to EBITDA and Adjusted EBITDA

To supplement our financial information presented in accordance with U.S. GAAP, we use the following non-GAAP financial measures to clarify and enhance an understanding of past performance: EBITDA and Adjusted EBITDA. We believe that the presentation of these financial measures enhances an investor’s understanding of our financial performance. We further believe that these financial measures are useful financial metrics to assess our operating performance from period-to-period by excluding certain items that we believe are not representative of our core business. We define our core business as those operations relating to the Company's ongoing performance and the concept is used to make resource allocation and performance evaluation decisions. We use certain of these financial measures for business planning purposes and in measuring our performance relative to that of our competitors. We also utilize Adjusted EBITDA as the primary measure of segment performance.

EBITDA consists of net income before interest, taxes, depreciation and amortization. Adjusted EBITDA consists of EBITDA adjusted for (i) non-cash items included within net income, (ii) items the Company does not believe are indicative of ongoing operating performance or (iii) nonrecurring, unusual or infrequent items that have not occurred within the last two years or we believe are not reasonably likely to recur within the next two years. We believe that making such adjustments provides investors meaningful information to understand our operating results and ability to analyze financial and business trends on a period-to-period basis.

We believe these financial measures are commonly used by investors to evaluate our performance and that of our competitors. However, our use of the terms EBITDA and Adjusted EBITDA may vary from that of others in our industry. These financial measures should not be considered as alternatives to income before income taxes, net income, earnings per share or any other performance measures derived in accordance with U.S. GAAP as measures of operating performance.

EBITDA and Adjusted EBITDA have important limitations as analytical tools and you should not consider them in isolation or as substitutes for analysis of our results as reported under U.S. GAAP. Some of these limitations are:

• EBITDA and Adjusted EBITDA:
• do not reflect the significant interest expense on our debt, including the Senior Secured Credit Facilities and the Senior Notes; and
• eliminate the impact of income taxes on our results of operations;
• although depreciation and amortization are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future, and EBITDA and Adjusted EBITDA do not reflect any expenditures for such replacements; and
• other companies in our industry may calculate EBITDA and Adjusted EBITDA differently than we do, limiting their usefulness as comparative measures.

We compensate for these limitations by using EBITDA and Adjusted EBITDA along with other comparative tools, together with U.S. GAAP measurements, to assist in the evaluation of operating performance. Such U.S. GAAP measurements include income before income taxes, net income, earnings per share and other performance measures.

In evaluating these financial measures, you should be aware that in the future we may incur expenses similar to those eliminated in this presentation. Our presentation of EBITDA and Adjusted EBITDA should not be construed as an inference that our future results will be unaffected by the excluded items noted above.

The following table reconciles net income (loss) to EBITDA and Adjusted EBITDA measures discussed above for the periods presented:

(In millions)

(a) During the nine months ended September 30, 2018 and September 30, 2017, we refinanced our term loans, which resulted in losses of $8.4 million and $13.0 million, respectively, including changes to estimates of $0.6 million for the three months ended September 30, 2017. We do not consider these to be indicative of our ongoing operating performance.

(b) Eliminates foreign exchange losses resulting from the remeasurement of assets and liabilities denominated in foreign currencies, net of the impacts of our foreign currency instruments used to hedge our balance sheet exposures.

(c) Eliminates the non-cash, non-service cost components of long-term employee benefit costs.

(d) Represents expenses and associated changes to estimates related to employee termination benefits and other employee-related costs, which includes Axalta CEO recruitment fees. Employee termination benefits are associated with Axalta Way initiatives. These amounts are not considered indicative of our ongoing operating performance.

(e) Represents integration costs and associated changes to estimates related to the 2017 acquisition of the Industrial Wood business that was a carve-out business from Valspar. These amounts are not considered indicative of our ongoing operating performance.

(f) Represents acquisition-related expenses, including changes in the fair value of contingent consideration, which are not considered indicative of our ongoing operating performance.

(g) Represents non-cash costs associated with stock-based compensation.

(h) Represents certain non-operational or non-cash gains and losses unrelated to our core business and which we do not consider indicative of ongoing operations, including indemnity losses associated with the acquisition by Axalta of the DuPont Performance Coatings business, gains and losses from the sale and disposal of property, plant and equipment, gains and losses from the remaining foreign currency derivative instruments and from non-cash fair value inventory adjustments associated with our business combinations.

(i) Represents the payment of dividends to our joint venture partners by our consolidated entities that are not 100% owned, which are reflected to show the cash operating performance of these entities on Axalta's financial statements.

(j) During the nine months ended September 30, 2017, we recorded a loss in conjunction with the deconsolidation of our Venezuelan subsidiary and a non-cash impairment charge related to a real estate investment of $70.9 million. During the three and nine months ended September 30, 2017, we recorded non-cash impairment charges related to certain manufacturing facilities previously announced for closure of $4.4 million and $7.6 million, respectively. We do not consider these to be indicative of our ongoing operating performance.

RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the information contained in the accompanying unaudited condensed consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q. Our historical results of operations set forth below may not necessarily reflect what will occur in the future.

Three months ended September 30, 2018 compared to the three months ended September 30, 2017

The following table was derived from the unaudited condensed consolidated statements of operations for the three months ended September 30, 2018 and 2017 included elsewhere in this Quarterly Report on Form 10-Q.

(In millions)

Net sales

Net sales increased $47.5 million, or 4.4%, to $1,139.3 million for the three months ended September 30, 2018, compared to net sales of $1,091.8 million for the three months ended September 30, 2017. Our net sales increase for the three months ended September 30, 2018 was due primarily to increases in sales volumes of 4.0% across all regions. Recent acquisitions contributed 0.4% to the volume increase. Increases in average selling prices across both end-markets within the Performance Coatings segment were slightly offset by lower average selling prices within our light vehicle end-market and contributed to a net increase of 2.9%. Partially offsetting these increases were unfavorable impacts of currency translation, which reduced net sales by 2.5%, due primarily to the impacts of the weaker Euro and certain currencies within Latin America and Asia compared to the U.S. Dollar.

Other revenue

Other revenue increased $2.2 million, or 48.9%, to $6.7 million for the three months ended September 30, 2018, compared to other revenue of $4.5 million for the three months ended September 30, 2017, primarily driven by increases in service revenues, slightly offset by the impacts of the weakening Euro compared to the U.S. Dollar.

Cost of sales

Cost of sales increased $56.6 million, or 8.1%, to $759.1 million for the three months ended September 30, 2018, compared to $702.5 million for the three months ended September 30, 2017. The increase for the three months ended September 30, 2018 resulted primarily from higher volumes of 4.0% which includes the impacts from acquisitions. The increase was also driven by accelerated depreciation of $4.2 million resulting from the anticipated closure of our Mechelen, Belgium manufacturing facility. Partially offsetting the increase were favorable currency effects resulting from the impacts of the weakening Euro and certain currencies within Latin America and Asia compared to the U.S. Dollar, which contributed to a 1.9% decrease. Cost of sales as a percentage of net sales increased to 66.6% for the three months ended September 30, 2018 compared to 64.3% for the three months ended September 30, 2017, primarily related to the impacts of the new revenue standard, as discussed in Note 3 to the unaudited condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q. Excluding the impacts of the new revenue standard, cost of sales as a percentage of net sales increased to 65.1%, which is primarily driven by increases in raw material costs across both segments and operational costs, partially offset by increases in average selling prices.

Selling, general and administrative expenses

Selling, general and administrative expenses increased $46.9 million, or 19.0%, to $293.4 million for the three months ended September 30, 2018 compared to $246.5 million for the three months ended September 30, 2017. The increase was primarily driven by increases in costs associated with our cost saving initiatives and acquisition-related costs, which were $83.4 million for the three months ended September 30, 2018, including the $70.6 million severance costs resulting from the anticipated closure of our Mechelen, Belgium manufacturing facility, as compared to $8.5 million for the three months ended September 30, 2017, resulting in a $74.9 million increase over the comparable period.

Partially offsetting the increase were favorable currency effects resulting from the impacts of the weakening Euro and certain currencies within Latin America and Asia compared to the U.S. Dollar, which contributed to a 2.0% decrease, the adoption of the new revenue standard which resulted in a decrease of $16.9 million, or 6.9%, as discussed in Note 3 to the unaudited condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q, and a reduction in costs due to operational efficiencies associated with our cost saving initiatives.

Research and development expenses

Research and development expense increased $0.4 million, or 2.4%, to $17.0 million for the three months ended September 30, 2018 compared to $16.6 million for the three months ended September 30, 2017. This increase was primarily driven by overall increased spend, partially offset by the favorable impacts of currency exchange from the weakening Euro and certain currencies within Latin America and Asia against the U.S. Dollar of 5.2%.

Amortization of acquired intangibles

Amortization of acquired intangibles increased $1.9 million, or 7.1%, to $28.7 million for the three months ended September 30, 2018 compared to $26.8 million for the three months ended September 30, 2017. This increase was attributable to amortization of the definite-lived intangible assets acquired through our recent acquisitions, partially offset by the impacts of the weakening of the Euro compared to the U.S. Dollar.

Interest expense, net

Interest expense, net increased $2.1 million, or 5.6%, to $39.8 million for the three months ended September 30, 2018 compared to $37.7 million for the three months ended September 30, 2017. The increase was primarily driven by increases in LIBOR, partially offset by the impacts of our April 2018 refinancing and derivative instruments.

Other expense, net

Other expense, net decreased $2.3 million, or 29.5%, to $5.5 million for the three months ended September 30, 2018 compared to $7.8 million for the three months ended September 30, 2017. This decrease relates primarily to the absence of impairments of $4.4 million for certain manufacturing facilities previously announced for closure incurred during the three months ended September 30, 2017. Partially offsetting this decrease was an increase in exchange losses, net from $7.0 million during the three months ended September 30, 2018 as compared to $3.5 million for the three months ended September 30, 2017.

Provision for income taxes

We recorded an income tax provision of $14.1 million for the three months ended September 30, 2018, which represents a 564.0% effective tax rate in relation to income before income taxes of $2.5 million. The effective tax rate for the three months ended September 30, 2018 differs from the U.S. Federal statutory rate by 543.0%, which is the result of various items that impacted the effective rate both favorably and unfavorably. We recorded the unfavorable impact of pre-tax losses attributable to jurisdictions where a tax benefit is not expected to be realized of $3.6 million, non-deductible expenses and interest of $2.9 million, unrecognized tax benefits of $8.8 million, primarily associated with the financial impacts surrounding the anticipated closure of our Belgium manufacturing facility, and adjustments for earnings and losses in jurisdictions where the statutory rate is lower than the U.S. Federal rate, primarily in Bermuda, Germany, Luxembourg and Switzerland, which had a net unfavorable impact of $5.4 million. These adjustments were partially offset by current year excess tax benefits related to stock-based compensation of $2.4 million and benefit of $9.9 million associated with currency exchange losses.

We recorded an income tax provision of $2.1 million for the three months ended September 30, 2017, which represents a 3.6% effective tax rate in relation to losses before income taxes of $58.4 million. The effective tax rate for the three months ended September 30, 2017 differs from the U.S. Federal statutory rate by 31.4%, which is the result of various items that impacted the effective rate both favorably and unfavorably. We recorded adjustments for earnings in jurisdictions where the statutory rate is lower than the U.S. Federal rate, primarily in Bermuda, China, Germany, Luxembourg, Netherlands and Switzerland, which had a net favorable impact of $34.6 million, current year excess tax benefits related to stock-based compensation of $2.7. Our net favorable adjustments were partially offset by the impact of pre-tax losses attributable to jurisdictions where a tax benefit is not expected to be realized of $0.5 million, non-deductible expenses and interest of $3.1 million and $17.1 million associated with currency exchange losses.

Nine months ended September 30, 2018 compared to the nine months ended September 30, 2017

The following table was derived from the unaudited condensed consolidated statements of operations for the nine months ended September 30, 2018 and 2017 included elsewhere in this Quarterly Report on Form 10-Q.

(In millions)

Net sales

Net sales increased $323.5 million, or 10.1%, to $3,511.6 million for the nine months ended September 30, 2018, compared to net sales of $3,188.1 million for the nine months ended September 30, 2017. Our net sales increase for the nine months ended September 30, 2018 was due to increases in sales volumes of 6.3% across all regions. Recent acquisitions contributed 4.7% to the volume increase. Increases in average selling prices across both end-markets within the Performance Coatings segment were slightly offset by lower average selling prices within our light vehicle end-market and contributed to a net increase of 1.9%. Favorable currency translation contributed to a further increase of net sales of 1.9% due primarily to the impacts of the strengthening Euro and Chinese Renminbi compared to the U.S. Dollar.

Other revenue

Other revenue increased $2.1 million, or 12.7%, to $18.6 million for the nine months ended September 30, 2018, compared to other revenue of $16.5 million for the nine months ended September 30, 2017, primarily driven by increases in service revenues and the impacts of the strengthening Euro compared to the U.S. Dollar.

Cost of sales

Cost of sales increased $295.0 million, or 14.5%, to $2,328.9 million for the nine months ended September 30, 2018 compared to $2,033.9 million for the nine months ended September 30, 2017. The increase for the nine months ended September 30, 2018 resulted primarily from higher volumes of 6.3%, which include the impacts from acquisitions, and unfavorable currency effects resulting from the impacts of the strengthening Euro and Chinese Renminbi compared to the U.S. Dollar, which contributed to a 1.9% increase. Cost of sales as a percentage of net sales increased to 66.3% for the nine months ended September 30, 2018 compared to 63.8% for the nine months ended September 30, 2017 primarily related to the impacts of the new revenue standard, as discussed in Note 3 to the unaudited condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q. Excluding the impacts of the new revenue standard, cost of sales as a percentage of net sales remained relatively consistent, increasing to 65.0%, which is primarily driven by increases in raw material and operational costs across both segments, partially offset by increases in average selling prices.

Selling, general and administrative expenses

Selling, general and administrative expenses increased $28.7 million, or 4.0%, to $745.8 million for the nine months ended September 30, 2018 compared to $717.1 million for the nine months ended September 30, 2017. The increase is primarily driven by increases in costs associated with our cost saving initiatives and acquisition-related costs, which were $81.1 million for the nine months ended September 30, 2018, including the $70.6 million severance costs resulting from the anticipated closure of our Mechelen, Belgium manufacturing facility, as compared to $22.6 million for the nine months ended September 30, 2017, resulting in a $58.5 million increase over the comparable period. Further contributing to the increase was the impact from acquisitions which contributed $7.5 million over the comparable period, and unfavorable currency effects resulting from the impacts of the strengthening Euro and Chinese Renminbi compared to the U.S. Dollar, which contributed to a 2.4% increase.

Partially offsetting the increase were reductions in costs due to operational efficiencies associated with our cost saving initiatives, as well as the benefit resulting from the adoption of the new revenue standard which resulted in a decrease of $45.3 million, or 6.3%, as discussed in Note 3 to the unaudited condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q.

Venezuela deconsolidation charge

During the nine months ended September 30, 2017 we recorded a loss of $70.9 million in conjunction with the deconsolidation of our Venezuelan subsidiary, for which there were no corresponding losses recorded during the nine months ended September 30, 2018.

Research and development expenses

Research and development expenses increased $5.7 million, or 11.7%, to $54.3 million for the nine months ended September 30, 2018 compared to $48.6 million for the nine months ended September 30, 2017. This increase was primarily driven by the impacts from acquisitions of $5.4 million and unfavorable impacts of currency exchange from the strengthening of the Euro and Chinese Renminbi against the U.S. Dollar of 3.8%.

Amortization of acquired intangibles

Amortization of acquired intangibles increased $14.6 million, or 20.2%, to $86.9 million for the nine months ended September 30, 2018 compared to $72.3 million for the nine months ended September 30, 2017. This increase was attributable to amortization of the definite-lived intangible assets from our recent acquisitions, combined with the impacts of the strengthening of the Euro against the U.S. Dollar.

Interest expense, net

Interest expense, net increased $9.4 million, or 8.6%, to $118.5 million for the nine months ended September 30, 2018 compared to $109.1 million for the nine months ended September 30, 2017. The increase was primarily driven by the strengthening of the Euro compared to the U.S. Dollar, the increase in average interest rates due to LIBOR increases over the comparable period and higher average principal balances resulting from the 2017 refinancings which were outstanding for only part of the nine months ended September 30, 2017 compared to the entire period for the nine months ended September 30, 2018. These increases were partially offset by the favorable impacts of our derivative instruments and our refinancings.

Other expense, net

Other expense, net decreased $16.5 million to $11.4 million for the nine months ended September 30, 2018 compared to $27.9 million for the nine months ended September 30, 2017. This decrease relates primarily to the absence of impairments of $7.6 million for certain manufacturing facilities previously announced for closure incurred during the nine months ended September 30, 2017, as well as a reduction in losses on debt extinguishment and refinancing related costs as $8.4 million was incurred during the nine months ended September 30, 2018 compared to $13.0 million incurred during the nine months ended September 30, 2017.

Provision for income taxes

We recorded an income tax provision of $47.9 million for the nine months ended September 30, 2018, which represents a 26.0% effective tax rate in relation to the income before income taxes of $184.4 million. The effective tax rate for the nine months ended September 30, 2018 differs from the U.S. Federal statutory rate by 5.0%, which is the result of various items that impacted the effective rate both favorably and unfavorably. We recorded the impact of pre-tax losses attributable to jurisdictions where a tax benefit is not expected to be realized of $16.3 million, unrecognized tax benefits of $16.0 million, primarily associated with the financial impacts surrounding the anticipated closure of our Belgium manufacturing facility, and non-deductible expenses and interest of $8.0 million. These adjustments were partially offset by adjustments for earnings in jurisdictions where the statutory rate is lower than the U.S. Federal rate, primarily in Bermuda, Germany, Luxembourg and Switzerland, which had a net favorable impact of $16.0 million, current year excess tax benefits related to stock-based compensation of $6.5 million and we recognized a benefit of $10.2 million associated with currency exchange losses. Additionally, we recorded a $12.4 million benefit to revise the provisional charge related to the U.S. TCJA reported in the Annual Report on Form 10-K for the year ended December 31, 2017 based on additional guidance released by the Department of the Treasury.

We recorded a provision for income taxes of $21.5 million for the nine months ended September 30, 2017, which represents a 17.2% effective tax rate in relation to the income before income taxes of $124.8 million. The effective tax rate for the nine months ended September 30, 2017 differs from the U.S. Federal statutory rate by 17.8%, which is the result of various items that impacted the effective rate both favorably and unfavorably. We recorded adjustments for earnings in jurisdictions where the statutory rate is lower than the U.S. Federal rate, primarily related to Bermuda, China, Germany, Luxembourg, Netherlands and Switzerland, which had a net favorable impact of $62.6 million and current year excess tax benefits related to stock-based compensation of $11.6 million. Furthermore, we recorded a deferred tax asset of $26.4 million related to the tax basis in our deconsolidated Venezuelan subsidiary, which was fully offset by a valuation allowance as we do not expect to realize the benefits. Our net favorable adjustments were partially offset by the impact of pre-tax losses attributable to jurisdictions where a tax benefit is not expected to be realized of $8.5 million, non-deductible expenses and interest of $10.9 million and $9.4 million associated with currency exchange losses. In addition, the pre-tax charge of $70.9 million related to the deconsolidation of our Venezuelan subsidiary resulted in an unfavorable impact of $24.8 million on the effective rate.

SEGMENT RESULTS

Three months ended September 30, 2018 compared to the three months ended September 30, 2017

The following table presents net sales by segment and segment Adjusted EBITDA for the periods presented:

(In millions)

Performance Coatings Segment

Net sales increased $61.5 million, or 8.9%, to $755.0 million for the three months ended September 30, 2018 compared to net sales of $693.5 million for the three months ended September 30, 2017. The increase in net sales for the three months ended September 30, 2018 was primarily driven by higher average selling prices across both end-markets which increased net sales by 5.7%. This growth was also driven by a 5.4% increase in sales volumes with contributions from both end-markets inclusive of a 0.6% benefit from acquisitions. Partially offsetting the increase were the unfavorable impacts of currency exchange related to the weakening of the Euro and certain currencies within Latin America and Asia compared to the U.S. Dollar, which contributed to a 2.2% decrease in net sales.

Adjusted EBITDA increased $41.3 million, or 30.6%, to $176.4 million for the three months ended September 30, 2018 compared to Adjusted EBITDA of $135.1 million for the three months ended September 30, 2017. The increase in Adjusted EBITDA for the three months ended September 30, 2018 was primarily driven by higher average selling prices, and increases in sales volumes, including the impacts of our recent acquisitions. This increase was partially offset by higher raw material costs and the unfavorable impacts of currency exchange related to the weakening of the Euro and certain currencies within Latin America and Asia compared to the U.S. Dollar.

Transportation Coatings Segment

Net sales decreased $14.0 million, or 3.5%, to $384.3 million for the three months ended September 30, 2018 compared to net sales of $398.3 million for the three months ended September 30, 2017. The decrease in net sales for the three months ended September 30, 2018 was driven by lower than average selling prices of 1.9% primarily in our light vehicle end-market and the unfavorable impacts of currency exchange related to the weakening of the Euro and certain currencies within Latin America and Asia compared to the U.S. Dollar, which contributed to a 3.1% decrease in net sales. These declines were partially offset by slight increases in sales volumes of 1.5%, driven primarily by our light vehicle end-market.

Adjusted EBITDA decreased $16.1 million, or 21.6%, to $58.3 million for the three months ended September 30, 2018 compared to Adjusted EBITDA of $74.4 million for the three months ended September 30, 2017. The decrease in Adjusted EBITDA in the three months ended September 30, 2018 was driven by lower average selling prices, higher raw material costs and unfavorable impacts of currency exchange related to the weakening of the Euro and certain currencies within Latin America and Asia compared to the U.S. Dollar, which were partially offset by increases in sales volumes across both end-markets.

Nine months ended September 30, 2018 compared to the nine months ended September 30, 2017

The following table presents net sales by segment and segment Adjusted EBITDA for the periods presented:

(In millions)

Performance Coatings Segment

Net sales increased $325.4 million, or 16.7%, to $2,268.2 million for the nine months ended September 30, 2018 compared to net sales of $1,942.8 million for the nine months ended September 30, 2017. The increase in net sales for the nine months ended September 30, 2018 was primarily driven by a 9.7% increase in sales volumes with contributions from both end-markets, inclusive of a 7.7% benefit from acquisitions. Further contributing to the increase was higher average selling prices of 4.7% and the favorable impacts of currency exchange related to the strengthening of the Euro and Chinese Renminbi compared to the U.S. Dollar, which contributed to a 2.3% increase.

Adjusted EBITDA increased $97.3 million, or 24.4%, to $496.1 million for the nine months ended September 30, 2018 compared to Adjusted EBITDA of $398.8 million for the nine months ended September 30, 2017. The increase in Adjusted EBITDA in the nine months ended September 30, 2018 was primarily driven by increases in sales volumes, including the impacts of our recent acquisitions, higher average selling prices and favorable impacts of currency exchange related to the strengthening of the Euro and Chinese Renminbi compared to the U.S Dollar, which were partially offset by higher raw materials costs.

Transportation Coatings Segment

Net sales decreased $1.9 million, or 0.2%, to $1,243.4 million for the nine months ended September 30, 2018 compared to net sales of $1,245.3 million for the nine months ended September 30, 2017. The decrease in net sales for the nine months ended September 30, 2018 was driven by lower average selling prices which resulted in declines of 2.4% primarily in our light vehicle end-market, partially offset by favorable impacts of currency exchange related to the strengthening of the Euro and Chinese Renminbi compared to the U.S. Dollar which contributed to a 1.2% increase, as well as increases in sales volumes of 1.0% across both end-markets and all regions except for Europe.

Adjusted EBITDA decreased $34.8 million, or 14.4%, to $206.2 million for the nine months ended September 30, 2018 compared to Adjusted EBITDA of $241.0 million for the nine months ended September 30, 2017. The decrease in Adjusted EBITDA for the nine months ended September 30, 2018 was driven by lower average selling prices combined with higher raw materials costs and unfavorable impacts of currency exchange related to the weakening of certain currencies in Latin America compared to the U.S Dollar, partially offset by increased volumes across both end-markets.

LIQUIDITY AND CAPITAL RESOURCES

Our primary sources of liquidity are cash on hand, cash flow from operations and available borrowing capacity under our Revolving Credit Facility.

At September 30, 2018, availability under the Revolving Credit Facility was $356.2 million, net of $43.8 million of letters of credit outstanding. All such availability may be utilized without violating any covenants under the credit agreement governing such facility or the indentures governing the Senior Notes. At September 30, 2018, we had $16.8 million of outstanding borrowings under other lines of credit. Our remaining available borrowing capacity under other lines of credit in certain non-U.S. jurisdictions totaled $8.4 million.

We or our affiliates, at any time and from time to time, may purchase shares of our common stock, the Senior Notes or other indebtedness. Any such purchases may be made through the open market or privately negotiated transactions with third parties or pursuant to one or more redemption, tender or exchange offers or otherwise, upon such terms and at such prices, as well as with such consideration, as we, or any of our affiliates, may determine.

Cash Flows

Nine months ended September 30, 2018 and 2017

(In millions)

Nine months ended September 30, 2018

Net Cash Provided by Operating Activities

Net cash provided by operating activities for the nine months ended September 30, 2018 was $245.5 million. Net income before deducting depreciation, amortization and other non-cash items generated cash of $457.7 million. This was partially offset by net uses of working capital of $212.2 million. The most significant drivers of the uses of working capital were accounts receivables of $119.5 million and prepaid expenses and other of $127.9 million, due to the seasonal increase in net sales and upfront customer incentive payments during the nine months ended September 30, 2018. Other drivers of the working capital uses were other accrued liabilities of $33.6 million related to payments of normal operating activities, including interest payments on our long-term indebtedness and timing of cash payments for involuntary termination benefits associated with our productivity initiatives and annual employee performance related benefits.

Net Cash Used for Investing Activities

Net cash used for investing activities for the nine months ended September 30, 2018 was $204.5 million. The primary uses were for business acquisitions of $79.2 million, purchases of property, plant and equipment of $109.5 million and an investment in a non-controlling interest of $26.9 million.

Net Cash Used for Financing Activities

Net cash used for financing activities for the nine months ended September 30, 2018 was $212.5 million. This change was driven by payments of $538.9 million on short-term and long-term borrowings that included the repayment of the 2023 Euro Term Loans, purchases of treasury stock totaling $147.8 million, and payments of $11.9 million consisting of financing-related costs, deferred acquisition-related consideration associated with historical acquisitions, and dividends to noncontrolling interests. These payments were offset by net proceeds of $468.9 million relating to the refinancing of our 2024 Dollar Term Loans and cash received from stock option exercises of $17.2 million.

Other Impacts on Cash

Currency exchange impacts on cash for the nine months ended September 30, 2018 were unfavorable by $10.5 million, which was driven primarily by the Euro, Chinese Renminbi and certain currencies within Latin America.

Nine months ended September 30, 2017

Net Cash Provided by Operating Activities

Net cash provided by operating activities for the nine months ended September 30, 2017 was $306.4 million. Net income before deducting depreciation, amortization and other non-cash items generated cash of $471.1 million. This was partially offset by net uses of working capital of $164.7 million. The most significant drivers in working capital were increases in accounts receivables of $44.5 million, inventory of $37.6 million and other assets of $79.9 million, due to the seasonal increase in net sales, increased inventory builds to support ongoing operational demands and upfront customer incentive payments during the nine months ended September 30, 2017. Other uses were due to reductions in other accrued liabilities of $27.8 million and other liabilities of $9.1 million related to payments of normal operating activities, including interest payments on our long-term indebtedness and timing of cash payments for annual employee performance related benefits, offset by increases in accounts payable of $34.2 million.

Net Cash Used for Investing Activities

Net cash used in investing activities for the nine months ended September 30, 2017 was $646.7 million. This use was driven by business acquisitions of $559.3 million, purchases of property, plant and equipment of $87.2 million and reduction of cash due to Venezuela deconsolidation of $4.3 million, and net cash used for other investing activities of $4.6 million.

Net Cash Provided by Financing Activities

Net cash provided by financing activities for the nine months ended September 30, 2017 was $380.7 million. This change was driven by net proceeds of $456.4 million relating to the refinancing of our 2023 Dollar Term Loans and cash received from stock option exercises of $19.9 million. These proceeds were offset by purchases of treasury stock for $58.4 million and other payments of $37.2 million consisting of financing-related costs, pay-down of short-term and long-term borrowings, deferred acquisition-related considerations, including payments for deferred purchase price consideration and contingent consideration on historical acquisitions, and dividends to noncontrolling interests.

Other Impacts on Cash

Currency exchange impacts on cash for the nine months ended September 30, 2017 were favorable $13.5 million, which was driven by exchange impacts from various foreign currencies.

Financial Condition

We had cash and cash equivalents at September 30, 2018 and December 31, 2017 of $588.1 million and $769.8 million, respectively. Of these balances, $429.1 million and $398.9 million were maintained in non-U.S. jurisdictions as of September 30, 2018 and December 31, 2017, respectively. We believe our organizational structure allows us the necessary flexibility to move funds throughout our subsidiaries to meet our operational working capital needs.

Our business may not generate sufficient cash flow from operations and future borrowings may not be available under our Senior Secured Credit Facilities in an amount sufficient to enable us to pay our indebtedness, or to fund our other liquidity needs, including planned capital expenditures. In such circumstances, we may need to refinance all or a portion of our indebtedness on or before maturity. We may not be able to refinance any of our indebtedness on commercially reasonable terms or at all. If we cannot service our indebtedness, we may have to take actions such as selling assets, seeking additional equity or reducing or delaying capital expenditures, strategic acquisitions, investments and alliances. Our primary sources of liquidity are cash on hand, cash flow from operations and available borrowing capacity under our Senior Secured Credit Facilities. Based on our forecasts, we believe that cash flow from operations, available cash on hand and available borrowing capacity under our Senior Secured Credit Facilities and existing lines of credit will be adequate to service debt, fund our cost saving initiatives, meet liquidity needs and fund necessary capital expenditures for the next twelve months.

Our ability to make scheduled payments of principal or interest on, or to refinance, our indebtedness or to fund working capital requirements, capital expenditures and other current obligations will depend on our ability to generate cash from operations. Such cash generation is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control.

If required, our ability to raise additional financing and our borrowing costs may be impacted by short and long-term debt ratings assigned by independent rating agencies, which are based, in significant part, on our performance as measured by certain credit metrics such as interest coverage and leverage ratios. Our highly leveraged nature may limit our ability to procure additional financing in the future.

The following table details our borrowings outstanding at the end of the periods indicated:

(In millions)

Our indebtedness, including the Senior Secured Credit Facilities and Senior Notes, is more fully described in Note 16 to the unaudited condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q.

We continue to maintain sufficient liquidity to meet our requirements, including our leverage and associated interest as well as our working capital needs. Availability under the Revolving Credit Facility was $356.2 million and $364.5 million at September 30, 2018 and December 31, 2017, respectively, all of which may be borrowed by us without violating any covenants under the credit agreement governing such facility or the indentures governing the Senior Notes.

In April 2018, we entered into the Sixth Amendment, which repriced the 2024 Dollar Term Loans and increased the aggregate principal balance of our 2024 Dollar Term Loans by $475.0 million to $2,430.0 million. Proceeds from the Sixth Amendment, along with cash on the balance sheet, were used to extinguish the existing 2023 Euro Term Loans.

Concurrent with the refinancing, we executed interest rate and cross-currency swaps to convert $475.0 million of the 2024 Dollar Term Loans principal into Euro fixed-rate debt at an interest rate of 1.95%, which matures in 2023. The combined effect of the refinancing and the swaps are expected to result in annual cash interest savings of approximately $10 million.

Contractual Obligations

The following table summarizes our contractual obligations at September 30, 2018:

(In millions)

(1) During the nine months ended September 30, 2018 we repriced our 2024 Dollar Term Loans and increased the aggregate principal balance by $475.0 million, for which the proceeds were used, along with cash on the balance sheet, to extinguish the existing 2023 Euro Term Loan (see Note 16 to the unaudited condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q). Amounts assume that the Senior Secured Credit Facilities and Senior Notes are repaid upon maturity, and the Revolving Credit Facility remains undrawn, which may or may not reflect future events.

(2) Other borrowings exclude debt associated with three of our leases treated as indebtedness, discussed within end-note 4.

(3) Interest payments are based on principal amounts of our Senior Secured Credit Facilities and Senior Notes at September 30, 2018 including commitment fees on the unused portion of the Revolving Credit Facility. Future interest payments assume September 30, 2018 variable rates will prevail throughout all future periods and do not consider the effect of our derivative instruments. See Note 16 and Note 18 to the unaudited condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q for disclosures of our interest rates and derivatives, respectively.

(4) We currently have three lease arrangements that are treated as sale-leaseback financing transactions, for which we reflect the total cash rental costs to be paid over the terms of these leases within the table above.

(5) We expect to make contributions to our defined benefit pension plans beyond 2018; however, the amount of any contributions is dependent on the future economic environment and investment returns, and we are unable to reasonably estimate the pension contributions beyond 2018.

(6) Purchase obligations include various commitments, including contractual commitments to acquire ownership interests in a joint venture and pay deferred consideration, as a result of business acquisitions completed in 2017 and 2018. At September 30, 2018, we are committed to pay $27.0 million in 2019 related to the purchase of a remaining joint venture interest. In addition, we have $11.4 million in interest rate caps which will be paid through 2021 and $60.0 million in commitments to prepay rebates to certain customers in 2018 and 2019, which will be earned or repaid in future periods.

(7) At September 30, 2018, we had approximately $37.4 million of gross uncertain tax positions, including interest and penalties that could result in potential payments. Due to the high degree of uncertainty regarding future timing of cash flows associated with these liabilities, we are unable to estimate the years in which settlement will occur with the respective taxing authorities.

Scheduled Maturities

Below is a schedule of required future repayments of all borrowings outstanding at September 30, 2018.

(In millions)

The table above excludes $18.4 million of debt associated with our sale-leaseback financings that will not be settled with cash.

Off-Balance Sheet Arrangements

See Note 7 "Commitments and Contingencies" to the unaudited condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q for disclosure of our guarantees of certain customers’ obligations to third parties.

Recent Accounting Guidance

See Note 2 "Recent Accounting Guidance" to the unaudited condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q for a summary of recent accounting guidance.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Critical accounting policies are those accounting policies that can have a significant impact on the presentation of our financial condition and results of operations, and that require the use of complex and subjective estimates based upon past experience and management’s judgment. Because of the uncertainty inherent in such estimates, actual results may differ materially from these estimates. The policies applied in preparing our unaudited condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q are those that management believes are the most dependent on estimates and assumptions. There have been no material changes to our critical accounting policies and estimates previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2017. For a description of our critical accounting policies and estimates as well as a listing of our significant accounting policies, see “Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and Estimates” and “Note 3 - Summary of Significant Accounting Policies” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.

There have been no material changes in the market risks previously disclosed in our financial statements and notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.

Evaluation of disclosure controls and procedures

As required by Rules 13a-15(b) or 15d-15(b) under the Securities Exchange Act of 1934 (the “Exchange Act”), the Company carried out an evaluation, under the supervision and with the participation of management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures (as defined in Rules 13a-15(e) or 15d-15(e) under the Exchange Act) as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on the foregoing, the Company's Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures were effective as of September 30, 2018.

Changes in internal control over financial reporting

There were no changes in the Company’s internal control over financial reporting that occurred during the three months ended September 30, 2018 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

There have been no material changes in our risk factors from the risks previously reported in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2017.