ITEM 1A. Risk Factors
The following is a cautionary discussion of risks, uncertainties and assumptions that we believe are material to our business. In addition to the factors discussed elsewhere in this Annual Report on Form 10-K, the following are the material factors that, individually or in the aggregate, we believe could make our actual results differ materially from those described in any forward-looking statements.
Risks Related to Our Business and Operations
We participate in markets that are competitive, and our competitors’ actions could have a material adverse effect on our business, results of operations and financial condition.
Our business operates in competitive markets. We compete against other existing or new global manufacturers of transmissions and propulsion solutions for commercial vehicles on the basis of product performance, quality, price, distribution capability and service in addition to other factors. In addition, we compete with manufacturers developing alternative technologies, including fully electric propulsion solutions, that may or may not require a transmission. In addition, subsidies offered by governmental entities continue to drive the development and adoption of various alternative technologies. Actions by our competitors could lead to downward pressure on prices and/or a decline in our market share, either or both of which could adversely affect our results.
In addition, some of our customers or future customers are OEMs that manufacture or could in the future manufacture transmissions, propulsion solutions or alternate technologies, including electric propulsion solutions, for their own products. Despite their transmission manufacturing capabilities, our existing OEM customers have chosen to purchase certain transmissions and propulsion solutions from us due to customer demand, resulting from the quality of our products and in order to reduce fixed costs, eliminate production risks and maintain company focus. However, we cannot be certain these customers will continue to purchase our products in the future. Increased levels of production insourcing by these customers could result from a number of factors, such as shifts in our customers’ business strategies, acquisition by a customer of another transmission or propulsion solution manufacturer, the inability of third-party suppliers to meet specifications and the emergence of low-cost production opportunities in foreign countries. As a result, these OEMs may use products produced internally or by another manufacturer and no longer choose to purchase products from us. A significant reduction in the level of external sourcing by our OEM customers could significantly impact our net sales and cash flows and, accordingly, have a material adverse effect on our business, results of operations and financial condition.
Our financial condition and results of operations have been and may continue to be materially adversely affected by the coronavirus pandemic.
The global spread of the novel strain of coronavirus (COVID-19) that has been declared a pandemic by the World Health Organization and the preventative measures taken to contain or mitigate the outbreak have caused, and are continuing to cause, significant volatility and uncertainty and economic disruptions. Governments around the world continue to implement measures to contain or mitigate the spread of the virus, including quarantines, “shelter in place” and “stay at home” orders, travel restrictions, business curtailments and other measures, due to the ongoing pandemic. While we continue to operate our plants consistent with applicable government guidelines, during 2020 our global manufacturing facilities periodically cut back on operating levels and shifts and we experienced, and may experience again, production shutdowns at our manufacturing facilities in Hungary, India, and Tennessee during the second quarter of 2020 as a result of government orders, our inability to obtain component parts from suppliers and decreased customer demand. In addition, many of our suppliers and customers have experienced, and may continue to experience, production slowdowns and/or shutdowns, which may further impact our business, sales and results of operation.
The effects of the COVID-19 pandemic on the global economy had a material impact on demand for our products and our results of operations during 2020. While we began to experience a recovery in demand for our products during the third quarter of 2020 and that recovery in demand continued in the fourth quarter of 2020,
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demand for our products and our results of operations in the future may once again be adversely impacted by the effects of the pandemic. The extent to which the COVID-19 pandemic may continue to adversely impact our business depends on future developments, which are highly uncertain and unpredictable, including the severity and duration of the outbreak, emerging variants of the virus that may be more contagious than current variants and the effectiveness of actions taken globally to contain or mitigate its effects, including the availability and pace of distribution of vaccines. Any future financial impact cannot be estimated reasonably at this time, but may materially adversely affect our business, supply chain, sales, results of operations, financial condition and cash flows. Even after the COVID-19 pandemic has subsided, we may experience materially adverse impacts to our business due to any resulting economic recession or depression that may continue to impact customer demand and the financial instability or operating viability of our suppliers and customers. Additionally, concerns over the economic impact of COVID-19 have caused extreme volatility in financial and other capital markets which may adversely impact our ability to access capital markets.
Volatility in and disruption to the global economic environment and changes in the regulatory and business environments in which we operate may have a material adverse effect on our business, results of operations and financial condition.
The commercial vehicle industry as a whole has been more adversely affected by volatile economic conditions than many other industries, as the purchase or replacement of commercial vehicles, which are durable items, can be deferred for many reasons, including reduced spending by end users. Future changes in the regulatory and business environments in which we operate, including increased trade protectionism and tariffs, may adversely affect our ability to sell our products or source materials needed to manufacture our products. Furthermore, financial instability or bankruptcy at any of our suppliers or customers could disrupt our ability to manufacture our products and impair our ability to collect receivables, any or all of which may have a material adverse effect on our business, results of operations and financial condition. In addition, some of our customers and suppliers may experience serious cash flow problems and, thus, may find it difficult to obtain financing, if financing is available at all. As a result, our customers’ need for and ability to purchase our products or services may decrease, and our suppliers may increase their prices, reduce their output or change their terms of sale. Any inability of customers to pay us for our products and services, or any demands by suppliers for different payment terms, may materially and adversely affect our results of operations and financial condition. Furthermore, our suppliers may not be successful in generating sufficient sales or securing alternate financing arrangements, and therefore may no longer be able to supply goods and services to us. In that event, we would need to find alternate sources for these goods and services, and there is no assurance we would be able to find such alternate sources on favorable terms, if at all. Any such disruption in our supply chain could adversely affect our ability to manufacture and deliver our products on a timely basis, and thereby affect our results of operations.
Certain of our end users operate in highly cyclical industries, which can result in uncertainty and significantly impact the demand for our products, which could have a material adverse effect on our business, results of operations and financial condition.
Some of the markets in which we operate, including energy, mining, construction, distribution and motorhomes, exhibit a high degree of cyclicality. Decisions to purchase our transmissions are largely a result of the performance of these and other industries we serve. If demand for output in these industries decreases, the demand for our products will likely decrease. Demand in these industries is impacted by numerous factors including prices of commodities, rates of infrastructure spending, housing starts, real estate equity values, interest rates, consumer spending, fuel costs, energy demands, municipal spending and commercial construction, among others. Increases or decreases in these variables globally may significantly impact the demand for our products, which could have a material adverse effect on our business, results of operations and financial condition. If we are unable to accurately predict demand, we may be unable to meet our customers’ needs, resulting in the loss of potential sales, or we may manufacture excess products, resulting in increased inventories and overcapacity in our production facilities, increasing our unit production cost and decreasing our operating margins.
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Our sales are concentrated among our top five OEM customers and the loss or consolidation of any one of these customers or the discontinuation of particular vehicle models for which we are a significant supplier could reduce our net sales and have a material adverse effect on our results of operations and financial condition.
We have in the past and may in the future derive a significant portion of our net sales from a relatively limited number of OEM customers. For the years ended December 31, 2020, 2019 and 2018, our top five OEM customers accounted for approximately 53%, 54% and 49% of our net sales, respectively. Our top three customers, Daimler AG, PACCAR Inc. and Navistar International Corporation accounted for approximately 20%, 11% and 11%, respectively, of our net sales during 2020. The loss of, or consolidation of, any one of these customers, or a significant decrease in business from, one or more of these customers could harm our business. In addition, the discontinuation of particular vehicle models for which we are a significant supplier could reduce our net sales and have a material adverse effect on our results of operations.
Increases in cost, disruption of supply or shortage of raw materials or components used in our products could harm our business and profitability.
Our products contain various raw materials, including corrosion-resistant steel, non-ferrous metals such as aluminum and nickel, and precious metals such as platinum and palladium. We use raw materials directly in manufacturing and in components that we purchase from our suppliers. We generally purchase components with significant raw material content on the open market. The prices for and availability of these raw materials fluctuate depending on market conditions. Volatility in the prices of raw materials such as steel, aluminum and nickel could increase the cost of manufacturing our products. We may not be able to pass on these costs to our customers, and this could have a material adverse effect on our business, results of operations and financial condition. Even in the event that increased costs can be passed through to customers, our gross margin percentages would decline. Additionally, our suppliers are also subject to fluctuations in the prices of raw materials and may attempt to pass all or a portion of such increases on to us. In the event they are successful in doing so, our margins would decline.
In 2020, approximately 75% of our total spending on components was sourced from approximately 40 suppliers, some of which are the single source for such components. All of the suppliers from which we purchase materials and components used in our business are fully validated suppliers, meaning the suppliers’ manufacturing processes and inputs have been validated under a production part approval process (“PPAP”). Furthermore, there are only a limited number of suppliers for certain of the materials used in our business, such as corrosion-resistant steel. As a result, our business is subject to the risk of additional price fluctuations and periodic delays in the delivery of our materials or components if supplies from a validated supplier are interrupted and a new supplier, if one is available, must be validated or materials and components must be purchased from a supplier without a completed PPAP, which could increase our risk of purchasing non-conforming components. Any such price fluctuations or delays, if significant, could harm our profitability or operations. In addition, the loss of a supplier could result in significant material cost increases or reduce our production capacity. We have experienced, and expect to continue to experience, delays in the availability and receipt of component parts as a result of the COVID-19 pandemic, some of which may materially impact our ability to meet customer demand. We also cannot guarantee we will be able to maintain favorable arrangements and relationships with these suppliers. An increase in the cost or a sustained interruption in the supply or shortage of some of these raw materials or components that may be caused by a deterioration of our relationships with suppliers or by events such as natural disasters, power outages, labor strikes, public health crisis such as pandemics and epidemics or the like could negatively impact our business, results of operations and financial condition. Although we have agreements with many of our customers that we will pass such price increases through to them, such contracts may be canceled by our customers and/or we may not be able to recoup the costs of such price increases. Additionally, if we are unable to continue to purchase our required quantities of raw materials on commercially reasonable terms, or at all, if we are unable to maintain or enter into purchasing contracts for commodities, or if delivery of materials or component parts from suppliers is delayed or non-conforming, our operations could be disrupted, we may not be able to meet customer demand, or our profitability or our financial results may be materially impacted.
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Our sales to the Defense end market are to government entities and contractors for the U.S. and foreign governments, and the loss of a significant number of our contracts, or budgetary declines or future reductions or changes in spending by the U.S. or foreign governments could have a material adverse effect on our results of operations and financial condition.
Our net sales to the Defense end market are derived from contracts (revenue arrangements) with agencies of, and prime system contractors for, the U.S. government and foreign governments. If a significant number of our Defense contracts and subcontracts are simultaneously delayed or cancelled for budgetary, performance or other reasons, it would have a material adverse effect on our results of operations and financial condition. Approximately 9%, or $182 million, of our net sales for the year ended December 31, 2020 were from our Defense end market.
Our future financial results may be adversely affected by:
• increased regulatory requirements for defense contractors.
Our brand and reputation are dependent on the continued participation and level of service of our numerous independent distributors and dealers.
We work with a network of approximately 1,400 independent distributors and dealers that provide post-sale service, service parts and support equipment. Because we depend on the pull-through demand generated by end users for our products, any actions by the independent distributors or dealers, which are not in our control, may harm our reputation and damage the brand loyalty among our customer base. In the event that we are not able to maintain our brand reputation because of the actions of our independent distributors and dealers, we may face difficulty in maintaining our pricing positions with respect to some of our products or have reduced demand for our products, which could negatively impact our business, results of operations and financial condition. In addition, if a significant number of independent dealers were to terminate their contracts, it could adversely impact our business, results of operations and financial condition.
We are subject to cybersecurity risks to operational systems, security systems, or infrastructure owned by Allison or third-party vendors or suppliers.
We are at risk for interruptions, outages, and breaches of: (i) operational systems, including business, financial, accounting, product development, data processing, or manufacturing processes, owned by us or our third-party vendors or suppliers; (ii) facility security systems, owned by us or our third-party vendors or suppliers; and/or (iii) transmission control modules or other in-product technology, owned by us or our third-party vendors or suppliers. Such cyber incidents could materially disrupt operational systems; result in loss of intellectual property, trade secrets or other proprietary or competitively sensitive information; compromise personally identifiable information of employees, customers, suppliers, or others; jeopardize the security of our facilities; and/or affect the performance of transmission control modules or other in-product technology. A cyber incident could be caused by malicious third parties using sophisticated, targeted methods to circumvent firewalls, encryption, and other security defenses, including hacking, fraud, trickery, or other forms of deception. The techniques used by third parties change frequently and may be difficult to detect for long periods of time. A significant cyber incident could impact production capability, harm our reputation and/or subject us to regulatory actions or litigation, any of which could materially affect our business, results of operations and financial condition. While we utilize a number of measures to prevent, detect and mitigate these threats, including employee education, monitoring of networks and systems, and maintenance of backup and protective systems, there is no guarantee such efforts will be successful in preventing a cyber incident. As a result of the COVID-19 pandemic, a significant subset of our global salaried
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employees are working remotely, which may pose a heightened risk for cyber incidents, including cybersecurity attacks and unauthorized dissemination of proprietary or confidential information, or other disruptions of our operational systems, security systems or infrastructure.
In the event of a catastrophic loss of our key manufacturing facility, our business would be adversely affected.
While we manufacture our products in several facilities and maintain insurance covering our facilities, including business interruption insurance, a catastrophic loss of the use of all or a portion of one of our manufacturing facilities due to accident, labor issues, weather conditions, acts of war, political unrest, terrorist activity, natural disaster, public health crisis, such as pandemics and epidemics or otherwise, whether short- or long-term, would have a material adverse effect on our business, results of operations and financial condition. Our most significant concentration of manufacturing is around our corporate headquarters in Indianapolis, Indiana, where we produce approximately 90% of our transmissions. In addition to our Indianapolis manufacturing facilities, we currently operate manufacturing facilities for our fully electric propulsion solutions in Auburn Hills, Michigan, for our transmissions in both Szentgotthard, Hungary and Chennai, India and for our aluminum die cast components in Lewisburg, Tennessee. In the event of a disruption at the Indianapolis facilities, our other facilities may not be adequately equipped to operate at a level sufficient to compensate for the volume of production at the Indianapolis facility due to their size and the fact that they have not yet been tested for such significant increases in production volume.
Labor unrest could have a material adverse effect on our business, results of operations and financial condition.
As of December 31, 2020, approximately 47% of our U.S. employees, representing approximately 42% of our total employees, were represented by the UAW and are subject to a collective bargaining agreement. Our current collective bargaining agreement with UAW Local 933 is effective through November 2023.
In addition to our unionized work force, many of our direct and indirect customers and vendors have unionized work forces. Strikes, work stoppages or slowdowns experienced by these customers or vendors or their other suppliers could result in slowdowns or closings of assembly plants that use our products or supply materials for use in the production of our products. Organizations responsible for shipping our products may also be impacted by strikes. Any interruption in the delivery of our products could reduce demand for our products and could have a material adverse effect on us.
In general, we consider our labor relations with all of our employees to be good. However, in the future we may be subject to labor unrest. If strikes, work stoppages or lock-outs at our facilities or at the facilities of our vendors or customers occur or continue for a long period of time, our business, results of operations and financial condition may be materially adversely affected.
Strategic Risks
Our success depends on research and development efforts, and we may not be successful in developing or introducing new products and technologies and responding to customer needs.
Our success depends on our ability to develop or introduce new products and technologies and improve the efficiency and performance of our current products, and we invest significant resources in research and development in order to do so. We currently have enhancements to our existing products and technologies and new products and technologies under development, including electric hybrid and fully electric propulsion solutions, for planned introduction into certain end markets. The development of new products and technologies is difficult, time-consuming and costly and the timetable for commercial release is uncertain. Not all of our new product launches have been successful, and we may not be successful in the future in introducing other new products and responding to customer needs. In addition, it often takes significant time, in some cases multiple fleet buy cycles,
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before customers gain experience with new products and technologies and those new products and technologies become widely-accepted by the market, if at all. Given the early stages of development of some of these new products and technologies, there can be no guarantee of future market acceptance and investment returns with respect to these products. In addition, the increased adoption of electric propulsion solutions could result in lower demand for our fully automatic transmissions and, over time, the demand for related service parts and support equipment, which would impact our margins. If we do not adequately anticipate the changing needs of our customers by keeping pace with improvements and changes in transmission-related or vehicle propulsion technology and developing and introducing new and effective products and technologies on a timely basis, or if the products and technologies we develop do not become market-leading, our competitive position and prospects could be harmed. If our competitors are able to respond to changing market demands and adopt new technologies more quickly than we do, demand for our products could decline, our competitive position could be harmed, our future research and development activities may be constrained due to intellectual property rights of others, licenses for technologies that would enable us to keep pace with our competitors may not be available on commercially reasonable terms if at all and we may not be able to recoup a return on our development investments. Moreover, changing customer demands as well as evolving regulatory, safety and environmental standards could require us to adapt our products and technologies to address such changes. As a result, in the future we may experience delays in the introduction of some or all of our new products or modifications or enhancements of existing products. Furthermore, there may be production delays due to unanticipated technological setbacks, which may, in turn, delay the release of new products to our end users. If we experience significant delays or increased costs in the production, launch or acceptance of our products and technologies, our net sales and results of operations may be materially adversely affected.
Our long-term growth prospects and results of operations may be impaired if the rate of adoption of fully automatic transmissions in commercial vehicles outside North America does not increase.
Our long-term growth strategy depends in part on an increased rate of automaticity outside North America. As part of that strategy, we have established manufacturing facilities in India and Hungary. We have also dedicated significant human resources to serve markets where we anticipate increased adoption of automaticity, including China, India, Brazil and Russia. However, manual transmissions remain the market leader outside North America and there can be no assurance that adoption of automatic transmissions will increase. Factors potentially impacting adoption of automatic transmissions outside of North America include the large existing installed base of manual transmissions, customer preferences for manual transmissions, commercial vehicle OEM vertical integration into manual transmission and AMT manufacturing, increased competition from AMTs, electric propulsion solutions, and other alternative transmission and propulsion solution technologies and failure to further develop the Allison brand. If the rate of adoption of fully automatic transmissions does not increase as we have anticipated, our long-term growth prospects and results of operations may be impaired.
Our international operations, in particular our emerging markets, are subject to various risks which could have a material adverse effect on our business, results of operations and financial condition.
Our business is subject to certain risks associated with doing business internationally, particularly in emerging markets. Outside-North America net sales represented approximately 21% of our net sales for 2020. Most of our operations are in the U.S., but we also have manufacturing and customization facilities in India and Hungary with a services agreement with Stellantis NV and customization capability in Brazil, The Netherlands, China and Japan. Further, we intend to continue to pursue growth opportunities for our business in a variety of business environments outside the U.S., which could exacerbate the risks set forth below. Our international operations are subject to, without limitation, the following risks:
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• differing local product preferences and product requirements;
Any one of these factors could materially adversely affect our sales of products or services to international customers or harm our reputation, which could have a material adverse effect on our business, results of operations and financial condition.
We may not be able to identify or consummate acquisitions or achieve expected benefits from or effectively integrate acquisitions, which could harm our growth.
From time to time we evaluate selective acquisitions and strategic investments. Potential and completed acquisitions involve many risks that could have an adverse effect on our business, financial condition or results of operations, including:
• the potential incurrence of indebtedness to fund the acquisition;
• excess capacity;
• dilution of earnings.
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We may also face liability with respect to acquired businesses for violations of environmental or other laws occurring prior to the date of our acquisition, and some or all of these liabilities may not be covered by environmental or other insurance secured to mitigate the risk or by indemnification from the sellers from which we acquired these businesses. We could also incur significant costs, including, but not limited to, remediation costs, natural resources damages, civil or criminal fines and sanctions and third-party claims, as a result of past or future violations of, or liabilities associated with, environmental or other laws.
We cannot offer any assurance that we will be able to consummate any future acquisitions, strategic investments or other business combinations. If we are unable to identify suitable acquisition candidates or to consummate and successfully integrate our recent and any future acquisitions, our business and results of operations may be adversely affected as a result.
Legal and Regulatory Risks
Any events that impact our brand name, including if the products we manufacture or distribute are found to be defective, could have an adverse effect on our reputation, cause us to incur significant costs and negatively impact our business, results of operations and financial condition.
We face exposure to product liability claims in the event that the use of our products has, or is alleged to have, resulted in injury, death or other adverse effects. We currently maintain product liability insurance coverage, but we cannot be assured that we will be able to obtain such insurance on acceptable terms in the future, if at all, or that any such insurance will provide adequate coverage against potential claims. Product liability claims can be expensive to defend and can divert the attention of management and other personnel for long periods of time, regardless of the ultimate outcome. An unsuccessful product liability defense could have a material adverse effect on our business, results of operation, financial condition or prospects. If one of our products is determined to be defective, we may face substantial warranty costs and may be responsible for significant costs associated with a product recall or a redesign. We have had defect and warranty issues associated with certain of our products in the past, and we cannot give assurance similar product defects will not occur in the future. See NOTE 10, “Product Warranty Liabilities” of Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for additional details regarding these warranty issues.
Furthermore, our business depends on the strong brand reputation we believe we have developed. In addition to the risk of defective products, we also face significant risks in our efforts to penetrate new markets, where we have limited brand recognition. We also rely on our reputation with end users of our products to specify our products when purchasing new vehicles from our OEM customers. In the event we are not able to maintain or enhance our brand in these new markets or our reputation is damaged in our existing markets as a result of product defects or recalls, we may face difficulty in maintaining our pricing positions with respect to some of our products or experience reduced demand for our products, which could negatively impact our business, results of operations and financial condition.
Additionally, we license the “Allison Transmission” name and certain related trademarks to third parties. If any third party uses the trade name “Allison Transmission” in ways that adversely affect such trade name or trademark, our reputation could suffer damage, which in turn could have a material adverse effect on our business, results of operations and financial condition.
Many of the key patents and unpatented technology we use in our business are licensed to us, not owned by us, and our ability to use and enforce such patents and technology is restricted by the terms of the license.
Protecting our intellectual property rights is critical to our ability to compete and succeed as a company. General Motors Company (“GM”) has granted us an irrevocable, perpetual, royalty-free, worldwide license under a large number of U.S. and foreign patents and patent applications, as well as certain unpatented technology and know-how, to design, develop, manufacture, use and sell fully automatic transmissions and electric hybrid
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propulsion solution for use in certain vocational vehicles, defense vehicles and off-road products. With respect to the bulk of the intellectual property licensed to us, our license is exclusive with respect to the design, development, manufacture, use and sale of fully automatic transmissions and electric hybrid propulsion solution in vocational vehicles above certain weight rating thresholds, certain defense vehicles and certain off-road products. It is non-exclusive with respect to certain other products that are within the scope of the licensed patents or to which the licensed technology can be applied. GM continues to own such patents and technology, and GM has the right, in the first instance, to control the maintenance, enforcement and defense of such patents and the prosecution of the licensed patent applications. In addition, our ability to sublicense our rights is limited.
We rely on unpatented technology, which exposes us to certain risks.
We currently do, and may continue in the future to, rely on unpatented proprietary technology. In such regard, we cannot be assured that any of our applications for protection of our intellectual property rights will be approved or that others will not infringe or challenge our intellectual property rights. It is possible our competitors will independently develop the same or similar technology or otherwise obtain access to our unpatented technology.
Although we believe the loss or expiration of any single patent would not have a material effect on our business, results of operations or financial position, there can be no assurance that any one, or more, of the patents or any other intellectual property owned by or licensed to us, will not be challenged, invalidated or circumvented by third parties. In fact, a number of the patents licensed to us are set to expire in the next few years. When a patent expires, the inventions it discloses can be used freely by others. Thus, the competitive advantage that we gain from the patents licensed to us will decrease over time, and a greater burden will be placed on our own research and development and licensing efforts to develop and otherwise acquire technologies to keep pace with improvements of transmission-related technology in the marketplace. We enter into confidentiality and invention assignment agreements with employees, and into non-disclosure agreements with suppliers and appropriate customers so as to limit access to and disclosure of our proprietary information. We cannot be assured that these measures will provide meaningful protection for our trade secrets, know-how or other proprietary information in the event of any unauthorized use, misappropriation or disclosure. If we are unable to maintain the proprietary nature of our technologies, our ability to sustain margins on some or all of our products may be affected, which could reduce our sales and profitability. Moreover, the protection provided for our intellectual property by the laws and courts of foreign nations may not be as advantageous to us as the protection available under U.S. law.
Environmental, health and safety laws and regulations may impose significant compliance costs and liabilities on us.
We are subject to many environmental, health and safety laws and regulations governing emissions to air, discharges to water, the generation, handling and disposal of waste and the cleanup of contaminated properties. Compliance with these laws and regulations is costly. We have incurred and expect to continue to incur significant costs to maintain or achieve compliance with applicable environmental, health and safety laws and regulations. Moreover, if these environmental, health and safety laws and regulations become more stringent or expand to include a larger portion of our products or our customer’s products in the future, we could incur additional costs in order to ensure that our business and products comply with such regulations. In addition, we may not be successful in complying with, or the vehicle or customer OEMs to which we sell our products may choose not to comply with, such laws and regulations, which could impact our ability to sell our products in certain locations. Furthermore, if our products that are already placed in service are found to be non-compliant with certain laws, regulations and certifications, we may incur additional costs and fines. We cannot assure that we are in full compliance with all environmental, health and safety laws and regulations. Our failure to comply with applicable environmental, health and safety laws and regulations and permit requirements could result in civil or criminal fines, penalties or enforcement actions, third-party claims for property damage and personal injury, requirements to clean up property or to pay for the costs of cleanup or regulatory or judicial orders enjoining or curtailing operations or requiring corrective measures, including the installation of pollution control equipment or remedial actions. Our failure to
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comply could also result in our failure to secure adequate insurance for our business, resulting in significant exposure, diminished ability to hedge our risks and material modifications of our business operations.
We may be subject to liability as a potentially responsible party under the Comprehensive Environmental Response, Compensation and Liability Act and similar state or foreign laws for contaminated properties that we currently own, lease or operate or that we or our predecessors have previously owned, leased or operated, and sites to which we or our predecessors sent hazardous substances. Such liability may be joint and several so that we may be liable for more than our share of any contamination, and any such liability may be determined without regard to causation or knowledge of contamination. We or our predecessors have been named potentially responsible parties at contaminated sites from time to time.
We manage the remediation of historical soil and groundwater contamination at our Indianapolis, Indiana facilities under an Agreed Order of Consent with the EPA. See Part II, Item 8, NOTE 18, “Commitments and Contingencies” of this Annual Report on Form 10-K. There can be no assurances that future environmental remediation obligations will not have a material adverse effect on our results of operations and financial condition. In addition, we occasionally evaluate alternatives with respect to our facilities, including possible dispositions or closings. Investigations undertaken in connection with these activities may lead to discoveries of contamination that must be remediated, and closings of facilities may trigger remediation requirements that are not applicable to operating facilities. We may also face lawsuits brought by third parties that either allege property damage or personal injury as a result of, or seek reimbursement for costs associated with, such contamination.
Our business and financial results may be adversely affected by U.S. government contracting risks.
We are subject to various laws and regulations applicable to parties doing business with the U.S. government, including laws and regulations governing performance of U.S. government contracts, the use and treatment of U.S. government furnished property and the nature of materials used in our products. We may be unilaterally suspended or barred from conducting business with the U.S. government, or become subject to fines or other sanctions if we are found to have violated such laws or regulations. As a result of the need to comply with these laws and regulations, we are subject to increased risks of governmental investigations, civil fraud actions, criminal prosecutions, whistleblower lawsuits and other enforcement actions. The laws and regulations to which we are subject include, but are not limited to, Export Administration Regulations, the Federal Acquisition Regulation, International Traffic in Arms Regulations and regulations from the Bureau of Alcohol, Tobacco and Firearms and the FCPA.
U.S. government contracts are subject to modification, curtailment or termination by the U.S. government without prior written notice, either for convenience or for default as a result of our failure to perform under the applicable contract. If terminated by the U.S. government as a result of our default, we could be liable for additional costs the U.S. government incurs in acquiring undelivered goods or services from another source and any other damages it suffers. Additionally, we cannot assign prime U.S. government contracts without the prior consent of the U.S. government contracting officer, and we are required to register with the Central Contractor Registration Database. Furthermore, the U.S. government periodically audits our governmental contract costs, which could result in fines, penalties or adjustment of costs and prices under the contracts. The result of, or expiration of the statute of limitations for, such audits could have an impact on reported net income and cash flow from operations.
Provisions of our amended and restated certificate of incorporation and amended and restated bylaws and Delaware law might discourage, delay or prevent a change of control of our company or changes in our management and, as a result, depress the trading price of our common stock.
Our amended and restated certificate of incorporation and amended and restated bylaws contain provisions that could discourage, delay or prevent a change in control of our company or changes in our management that the stockholders of our company may deem advantageous. These provisions:
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• limit the ability of stockholders to remove directors only “for cause”;
• prohibit our stockholders from calling a special meeting of stockholders;
These anti-takeover defenses could discourage, delay or prevent a transaction involving a change in control of our company that our stockholders may believe to be in their best interests. These provisions could also discourage proxy contests and make it more difficult for our stockholders to elect directors of their choosing and cause us to take corporate actions other than those they desire.
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Risks Related to Our Indebtedness and Financial Risks
Our substantial indebtedness could adversely affect our financial health, restrict our activities and affect our ability to meet our obligations.
We have a significant amount of indebtedness. As of December 31, 2020, we had total indebtedness of $2,538 million and we would have been able to borrow an additional $645 million, net of $5 million of outstanding letters of credit, under Allison Transmission Inc.’s (“ATI”), our wholly-owned subsidiary, new revolving credit facility with commitments in the amount of $650 million due September 2025 (“New Revolving Credit Facility”). As of December 31, 2020, we had no outstanding borrowings against the New Revolving Credit Facility. At December 31, 2020, $638 million of our total indebtedness was associated with ATI’s new term loan facility due March 2026 (“New Term Loan”, and together with the New Revolving Credit Facility, the “New Senior Secured Credit Facility”), $400 million of our total indebtedness was associated with ATI’s 4.75% Senior Notes due October 2027 (“4.75% Senior Notes”), $500 million of our total indebtedness was associated with ATI’s 5.875% Senior Notes due June 2029 (“5.875% Senior Notes”) and $1,000 million of our total indebtedness was associated with ATI’s 3.75% Senior Notes due January 2031 (“3.75% Senior Notes”, and together with the 4.75% Senior Notes and 5.875% Senior Notes, the “Senior Notes”). For a complete description of the terms of the New Senior Secured Credit Facility and the Senior Notes, please see Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources” of this Annual Report on Form 10-K.
Our substantial indebtedness could have important consequences. For example, it could:
• limit our ability to borrow additional funds.
In addition, the New Revolving Credit Facility contains a maximum total senior secured leverage ratio. The New Senior Secured Credit Facility and the indentures governing the Senior Notes also contain other negative and affirmative covenants that will limit our ability to engage in activities that may be in our long-term best interests. Our failure to comply with any of the covenants could result in an event of default which, if not cured or waived, could result in the acceleration of all of our indebtedness.
Further, the New Term Loan bears interest at fluctuating interest rates, primarily based on the London Interbank Offered Rate ("LIBOR"). In July 2017, the Financial Conduct Authority, a regulator of financial services firms in the United Kingdom, announced its intention to stop persuading or compelling banks to submit LIBOR rates after 2021. In response to concerns regarding the future of LIBOR, the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York convened the Alternative Reference Rates Committee (“ARRC”) to identify alternatives to LIBOR. The ARRC has recommended a benchmark replacement to assist issuers in continued capital market entry while safeguarding against LIBOR’s discontinuation. The initial steps in the ARRC’s recommended provision reference variations of the Secured Overnight Financing Rate (“SOFR”). At this time, it is not possible to predict whether SOFR will attain market traction as a LIBOR replacement.
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On November 30, 2020, ICE Benchmark Administration Limited, the administrator of LIBOR, announced that it will consult on its intention to cease the publication of the one week and two month LIBOR settings immediately following the LIBOR publication on December 31, 2021, and the remaining LIBOR settings immediately following the LIBOR publication on June 30, 2023. The outcome of such consultation and its impact on LIBOR could materially affect the economics as well as the timing of the transition away from LIBOR. We are unable to predict the outcome of this consultation and, accordingly, whether LIBOR will cease to exist after calendar year 2023, the effect of any changes, any establishment of alternative reference rates or any other reforms to LIBOR or any replacement of LIBOR that may be enacted in the United Kingdom or elsewhere. Such changes, reforms or replacements relating to LIBOR could have an adverse impact on the market for or value of any LIBOR-linked securities, loans, derivatives and other financial obligations or extensions of credit held by us or on our overall financial condition or results of operations.
To service our indebtedness, we will require a significant amount of cash, and our ability to generate cash depends on many factors beyond our control.
Our ability to make cash payments on our indebtedness and to fund planned capital expenditures will depend on our ability to generate significant operating cash flow in the future. This, to a significant extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control.
We cannot ensure that our business will generate sufficient cash flow from operations or that future borrowings will be available to us under the New Senior Secured Credit Facility in an amount sufficient to enable us to pay our indebtedness or to fund our other liquidity needs. In such circumstances, we may need to refinance all or a portion of our indebtedness on or before maturity. We cannot ensure that we will 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. We cannot ensure that any such actions, if necessary, could be effected on commercially reasonable terms or at all.
If we fail to pay principal, premium, if any, and interest on our indebtedness or to otherwise comply with the covenants in the instruments governing our indebtedness, we may be forced into bankruptcy or liquidation by our lenders.
If we are unable to generate sufficient cash flow or are otherwise unable to obtain funds necessary to meet required payments of principal, premium, if any, and interest on our indebtedness, or if we otherwise fail to comply with the various covenants in the instruments governing our indebtedness, we could be in default under the terms of the agreements governing such indebtedness. In the event of such default, the holders of such indebtedness could elect to declare all the funds borrowed thereunder to be due and payable, together with accrued and unpaid interest, the lenders under the New Senior Secured Credit Facility could elect to terminate their commitments thereunder, cease making further loans and institute foreclosure proceedings against our assets, and we could be forced into bankruptcy or liquidation. If our operating performance declines, we may in the future need to obtain waivers from the required lenders under the New Senior Secured Credit Facility to avoid being in default. If we or any of our subsidiaries breach the covenants under the New Senior Secured Credit Facility and seek a waiver, we may not be able to obtain a waiver from the required lenders. If this occurs, we would be in default under the New Senior Secured Credit Facility, the lenders could exercise their rights, as described above, and we could be forced into bankruptcy or liquidation.
Despite current indebtedness levels, we and our subsidiaries may still be able to incur additional indebtedness, which could further exacerbate the risks associated with our substantial financial leverage.
We and our subsidiaries may be able to incur additional indebtedness in the future because the terms of our indebtedness do not fully prohibit us or our subsidiaries from doing so. Subject to covenant compliance and certain
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conditions, our indebtedness permits additional borrowing, including total borrowing up to $645 million under the New Revolving Credit Facility, net of $5 million in letters of credit. If new debt is added to our current debt levels and our subsidiaries’ current debt levels, the related risks that we and they now face could intensify.
Our pension and other post-retirement benefits funding obligations could increase as a result of a variety of factors.
Our earnings may be positively or negatively impacted by the amount of income or expense recorded for our defined benefit pension plans and other post-retirement benefits (“OPEB”). Accounting principles generally accepted in the United States of America (“GAAP”) require that income or expense for defined benefit pension plans be calculated at the annual measurement date using actuarial assumptions and calculations. These calculations reflect certain assumptions, the most significant of which relate to the capital markets, interest rates, health care inflation rates and other economic conditions. Changes in key economic indicators can change these assumptions. These assumptions, along with the actual value of assets at the measurement date, will impact the calculation of pension expense for the year. Although GAAP pension expense and pension contributions are not directly related, the key economic indicators that affect GAAP pension expense also affect the amount of cash that we would contribute to our defined benefit pension plans. Because the values of these defined benefit pension plans’ assets have fluctuated and will fluctuate in response to changing market conditions, the amount of gains or losses that will be recognized in subsequent periods, the impact on the funded status of the defined benefit pension plans and the future minimum required contributions, if any, could have a material adverse effect on our business, results of operations and financial condition. The magnitude of such impact cannot be determined with certainty at this time. However, the effect of a one percentage point decrease in the assumed discount rate would result in an increase in the December 31, 2020 defined benefit pension plans obligation of approximately $31 million. Likewise, a one percentage point decrease in the effective interest rate for determining defined benefit pension plans contributions would result in an increase in the minimum required contributions for 2021 of approximately $4 million. Similarly, a one percentage point decrease in the assumed discount rate would result in an increase in the December 31, 2020 OPEB obligation of approximately $16 million. As of December 31, 2020, the unfunded status of our defined benefit pension plans was $7 million and the unfunded status of our OPEB plan was $107 million.
An impairment in the carrying value of goodwill, other intangible assets or long-lived assets could negatively affect our consolidated results of operations and net worth.
Pursuant to GAAP, we are required to assess our goodwill and indefinite-lived intangible assets to determine if they are impaired on an annual basis, or more often if events or changes in circumstances indicate that impairment may have occurred. Intangible assets with finite lives are amortized over the useful life and are reviewed for impairment on triggering events such as events or changes in circumstances indicating that an impairment may have occurred. If the testing performed indicates that impairment has occurred, we are required to record a non-cash impairment charge for the difference between the carrying value of the goodwill and the implied fair value of the goodwill or the carrying value of the intangible assets and the fair value of the intangible assets in the period the determination is made. Disruptions to our business, end market conditions, protracted economic weakness, unsuccessful development of product and unexpected significant declines in operating results may result in charges for goodwill and other asset impairments. See NOTE 2, “Summary of Significant Accounting Policies” and NOTE 6 “Goodwill and Other Intangible Assets” of Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for additional details.
The carrying value of long-lived assets is evaluated whenever events or circumstances indicate that the carrying value of a long-lived asset may not be recoverable. Events or circumstances that would result in an impairment review primarily include a significant change in the use of an asset, a significant change in the projected future cash flows generated by an asset or the planned sale or disposal of an asset. The asset would be considered impaired when there is no future use planned for the asset or the future net undiscounted cash flows generated by the asset or asset group are less than its carrying value. An impairment loss would be recognized based on the amount by which the carrying value exceeds fair value and could have a material adverse effect on the results of
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our operations. See NOTE 2, “Summary of Significant Accounting Policies” and NOTE 5 “Property, Plant and Equipment” of Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for additional details.
Our ability to pay regular dividends on our common stock is subject to the discretion of our Board of Directors and may be limited by our structure and statutory restrictions and restrictions imposed by the New Senior Secured Credit Facility and the indentures governing the Senior Notes as well as any future agreements.
Our Board of Directors increased the quarterly dividend to $0.17 per share of common stock in the first quarter of 2020, an increase from the quarterly dividend of $0.15 per share of common stock maintained since the fourth quarter of 2014. However, the payment of future dividends will be at the discretion of our Board of Directors and will depend on, among other things, our earnings, financial condition, capital requirements, level of indebtedness, statutory and contractual restrictions applying to the payment of dividends and other considerations that our Board of Directors deems relevant. The New Senior Secured Credit Facility and the indentures governing the Senior Notes also effectively limit our ability to pay dividends. As a consequence of these limitations and restrictions, we may not be able to make, or may have to reduce or eliminate, the payment of dividends on our common stock. Accordingly, our stockholders may have to sell some or all of their common stock after price appreciation in order to generate cash flow from their investment. Our stockholders may not receive a gain on their investment when they sell their common stock, and they may lose the entire amount of the investment. Additionally, any change in the level of our dividends or the suspension of the payment thereof could adversely affect the market price of our common stock.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
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ITEM 2. PROPERTIES
Our world headquarters, which we own, is located at One Allison Way, Indianapolis, Indiana 46222. As of December 31, 2020, we have approximately 20 manufacturing and certain other facilities in eight countries. The following table sets forth certain information regarding our significant facilities.
Plant Location Approximate Size (ft2) Owned / Leased Description
Plant #3 Indianapolis 927,000 Own Engineering, Operational Support
Plant #4 Indianapolis 425,900 Own Manufacturing
Plant #6 Indianapolis 431,500 Own Manufacturing
Plant #12 Indianapolis 534,900 Own Manufacturing
Plant #14 and #15 Indianapolis 481,100 Own Manufacturing
Plant #16 Indianapolis 391,700 Own Manufacturing
Plant #17 Indianapolis 389,000 Own Parts Distribution Center
Walker Die Casting Lewisburg, Tennessee, USA 774,100 Own Manufacturing
Szentgotthard Hungary 149,000 Own Manufacturing & Customization
Chennai India 258,500 Own Manufacturing
We believe all our facilities are suitable for their intended purpose, are being efficiently utilized and provide adequate capacity to meet demand for the next several years. The table above does not include sales offices located in various countries.
ITEM 3. LEGAL PROCEEDINGS
We are subject to various contingencies, including routine legal proceedings and claims arising out of the normal course of business. These proceedings primarily involve commercial claims, product liability claims, personal injury claims and workers’ compensation claims. The outcome of these lawsuits, legal proceedings and claims cannot be predicted with certainty. Nevertheless, we believe the outcome of any of these currently existing proceedings, even if determined adversely, would not have a material adverse effect on our financial condition or results of operations. See also NOTE 18, “Commitments and Contingencies” in Part II, Item 8, of this Annual Report on Form 10-K.
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
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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 listed on the NYSE under the symbol “ALSN.”
Holders
As of February 4, 2021, there were approximately 65,900 stockholders of record of our common stock, which includes the actual number of holders registered on the books of the Company and holders of shares in “street name” or persons, partnerships, associations, corporations or other entities identified in security position listings maintained by depositories.
Unregistered Sales of Equity Securities
During the period covered by this Annual Report on Form 10-K, we did not offer or sell any equity securities that were not registered under the Securities Act of 1933, as amended (the “Securities Act”).
Issuer Purchases of Equity Securities
On November 14, 2016, our Board of Directors authorized us to repurchase up to $1,000 million of our common stock pursuant to a stock repurchase program (the “Repurchase Program”). The Board of Directors approved increases of $500 million, $500 million and $1,000 million on November 8, 2017, July 30, 2018 and May 9, 2019, respectively, bringing the authorized total repurchases under the Repurchase Program to $3,000 million. The terms of the Repurchase Program provide that we may repurchase shares of our common stock, from time to time depending on market conditions and corporate needs, in the open market or through privately negotiated transactions in accordance with Rule 10b-18 of the Exchange Act. The Repurchase Program does not have an expiration date.
The following table sets forth information related to our repurchase of our common stock on a monthly basis in the three months ended December 31, 2020:
(1) These values reflect repurchases made under the Repurchase Program.
Issuances Under Equity Compensation Plans
For information regarding the securities authorized for issuance under our equity compensation plans, see Part III, Item 12 of this Annual Report on Form 10-K.
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Comparative Stock Performance Graph
The information included under the heading “Comparative Stock Performance Graph” in this Item 5 of Part II of this Annual Report on Form 10-K shall not be deemed to be “soliciting material” or subject to Regulation 14A or 14C, shall not be deemed “filed” for purposes of Section 18 of the Exchange Act, or otherwise subject to the liabilities of that section, nor shall it be deemed incorporated by reference in any filing under the Securities Act or the Exchange Act.
Set forth below is a graph comparing the total cumulative returns of ALSN, the S&P 500 Index and an index of peer companies selected by us. Our peer group includes Donaldson Company, Inc., Graco Inc., Roper Technologies, Inc., Gentex Corporation, Rockwell Automation, Inc. and Sensata Technologies Holding PLC. The graph assumes $100 was invested on December 31, 2015 in our common stock and each of the indices and that all dividends, if any, are reinvested.
ITEM 6. Selected Financial Data
Omitted at Company’s option.
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ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion contains forward-looking statements regarding industry trends, our expectations regarding our future performance, liquidity and capital resources and other non-historical statements that involve risks and uncertainties. Our actual results may differ materially from those discussed in or implied by the forward looking statements as a result of various factors, including, without limitation, those set forth under Part I, Item 1A, “Risk Factors,” and other matters included elsewhere in this Annual Report on Form 10-K. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the notes thereto included elsewhere in this Annual Report on Form 10-K.
This section of this Annual Report on Form 10-K generally discusses 2020 and 2019 items and year-over-year comparisons between 2020 and 2019. A detailed discussion of 2018 items and year-over-year comparisons between 2019 and 2018 that are not included in this Annual Report on Form 10-K can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2019, as filed with the SEC on February 27, 2020.
Overview
We design and manufacture vehicle propulsion solutions, including commercial-duty on-highway, off-highway and defense fully automatic transmissions and electric hybrid and fully electric systems. The business was founded in 1915 and has been headquartered in Indianapolis, Indiana since inception. Allison was an operating unit of General Motors Corporation from 1929 until 2007, when Allison once again became a stand-alone company. In March 2012, Allison began trading on the New York Stock Exchange under the symbol, “ALSN”.
We have approximately 3,300 employees. Although approximately 79% of revenues were generated in North America in 2020, we have a global presence by serving customers in Europe, Asia, South America and Africa. We serve customers through an independent network of approximately 1,400 independent distributor and dealer locations worldwide.
Trends Impacting Our Business
Our net sales are driven by commercial vehicle production, which tends to be highly correlated to macroeconomic conditions. In March 2020, the World Health Organization categorized the novel coronavirus ("COVID-19") as a pandemic, and it continues to impact the United States and other major markets in which we operate across the world, resulting in severe disruptions to global markets and supply chains, significant uncertainty and a weaker global outlook. The effects of the pandemic on the global economy began having a material adverse impact on demand for our products and on our results of operations during the second quarter 2020 as our suppliers and customers reduced or halted production. Although our suppliers and customers restarted production during the third quarter 2020, production disruptions due to more localized COVID-19 outbreaks as well as the continued uncertainty and weaker global outlook continued to have a material impact on demand for our products and on our results of operations during the third and fourth quarters of 2020.
To limit the spread of COVID-19, governments have taken various actions including travel bans and restrictions, quarantines, curfews, stay-at-home orders, social distancing guidelines and business shutdowns and closures. Despite these disruptions, we have continued our manufacturing operations throughout 2020 allowing us to deliver our products to customers without interruption. However, our global manufacturing facilities cut back on operating levels and shifts during 2020 as a result of government orders, our inability to obtain component parts from suppliers and/or decreased customer demand and in certain locations temporarily suspended operations in the second quarter of 2020. Additional suspensions and cutbacks of our manufacturing operations may occur as the impacts from COVID-19 and related responses continue to develop within our global supply chains and customer base, and additional production slowdowns and shutdowns by our global suppliers and customers may continue and could continue to have a material impact to our financial results.
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We are taking a variety of measures to promote the safety and security of our employees and to maintain operations with as minimal impact as possible to our stakeholders, including increased frequency of cleaning and disinfecting of facilities, social distancing, occupancy limits, mask wearing requirements, onsite testing, remote working when possible, travel restrictions and limitations on visitor access to facilities. During the second and third quarter of 2020, we aligned operations, programs and spending across our entire business with current conditions, including reduced compensation expense through restructuring initiatives of both hourly and salary employees related to voluntary and involuntary separation programs,furloughed a portion of our workforce, reduced overtime, and assessed the timing and cadence of various capital investments and product development initiatives.
Our Net Sales were materially impacted during 2020 by the ongoing COVID-19 pandemic. We began to experience a recovery in customer demand beginning in the third quarter of 2020, which continued through the fourth quarter of 2020. We expect that our Net Sales will improve in 2021. However, the continuation or worsening of the COVID-19 pandemic, a delay in vaccination efforts and continued disruptions to our supply chain may impact our financial results in 2021.
Full Year 2020 and 2019 Net Sales by End Market (in millions)
End Market 2020 Net Sales 2019 Net Sales % Variance
North America Off-Highway 13 30 (57 )%
Outside North America On-Highway 280 390 (28 )%
Outside North America Off-Highway 61 109 (44 )%
Service Parts, Support Equipment and Other 464 544 (15 )%
North America On-Highway end market net sales were down 27% for the year ended December 31, 2020 compared to the year ended December 31, 2019, principally driven by lower demand due to the effects of the COVID-19 pandemic.
North America Off-Highway end market net sales were down $17 million for the year ended December 31, 2020 compared to the year ended December 31, 2019, principally driven by lower demand from hydraulic fracturing applications.
Defense end market net sales were up 21% for the year ended December 31, 2020 compared to the year ended December 31, 2019, principally driven by Tracked vehicle demand.
Outside North America On-Highway end market net sales were down 28% for the year ended December 31, 2020 compared to the year ended December 31, 2019, principally driven by lower global demand due to the effects of the COVID-19 pandemic.
Outside North America Off-Highway end market net sales were down 44% for the year ended December 31, 2020 compared to the year ended December 31, 2019, principally driven by lower demand in energy, mining and construction sectors.
Service Parts, Support Equipment and Other end market net sales were down 15% for the year ended December 31, 2020 compared to the year ended December 31, 2019, principally driven by lower demand for North America service parts and support equipment, partially offset by aluminum die cast component volume associated with the acquisition of Walker Die Casting, Inc. (“Walker Die Casting”) in September 2019.
Key Components of our Results of Operations
Net sales
We generate our net sales primarily from the sale of vehicle propulsion solutions, service and component parts, support equipment, defense kits, engineering services, royalties and extended transmission coverage to a
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wide array of OEMs, distributors and the U.S. government. Sales are recorded net of provisions for customer allowances and other rebates. Engineering services are recorded as net sales in accordance with the terms of the contract. The associated costs are recorded in cost of sales. We also have royalty agreements with third parties that provide net sales as a result of joint efforts in developing marketable products.
Cost of sales
Our primary components of cost of sales are purchased parts, the overhead expense related to our manufacturing operations and direct labor associated with the manufacture and assembly of vehicle propulsion solutions and parts. For the year ended December 31, 2020, direct material costs were approximately 63%, overhead costs were approximately 28% and direct labor costs were approximately 9% of total cost of sales. We are subject to changes in our cost of sales caused by movements in underlying commodity prices. We seek to hedge against this risk by using long-term agreements ("LTAs"). See Part II, Item 7A, “Quantitative and Qualitative Disclosures about Market Risk—Commodity Price Risk” included in this Annual Report on Form 10-K.
Selling, general and administrative
The principal components of our selling, general and administrative expenses are salaries and benefits for our office personnel, advertising and promotional expenses, product warranty expense, expenses relating to certain information technology systems and amortization of our intangible assets.
Engineering — research and development
We incur costs in connection with research and development programs that are expected to contribute to future earnings. Such costs are expensed as incurred.
Non-GAAP Financial Measures
We use Adjusted Earnings before Interest, Taxes, Depreciation, and Amortization (“EBITDA”) and Adjusted EBITDA as a percent of net sales to measure our operating profitability. We believe that Adjusted EBITDA and Adjusted EBITDA as a percent of net sales provide management, investors and creditors with useful measures of the operational results of our business and increase the period-to-period comparability of our operating profitability and comparability with other companies. Adjusted EBITDA as a percent of net sales is also used in the calculation of management’s incentive compensation program. The most directly comparable U.S. generally accepted accounting principles (“GAAP”) measure to Adjusted EBITDA and Adjusted EBITDA as a percent of net sales is Net income and Net income as a percent of net sales, respectively. Adjusted EBITDA is calculated as earnings before interest expense, income tax expense, amortization of intangible assets, depreciation of property, plant and equipment and other adjustments as defined by the Second Amended and Restated Credit Agreement dated as of March 29, 2019 as amended (the “Credit Agreement”) governing Allison Transmission, Inc.’s (“ATI”), our wholly-owned subsidiary, term loan facility in the amount of $638 million due March 2026 (“New Term Loan”). Adjusted EBITDA as a percent of net sales is calculated as Adjusted EBITDA divided by net sales.
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We use Adjusted free cash flow to evaluate the amount of cash generated by our business that, after the capital investment needed to maintain and grow our business and certain mandatory debt service requirements, can be used for repayment of debt, stockholder distributions and strategic opportunities, including investing in our business. We believe that Adjusted free cash flow enhances the understanding of the cash flows of our business for management, investors and creditors. Adjusted free cash flow is also used in the calculation of management’s incentive compensation program. The most directly comparable GAAP measure to Adjusted free cash flow is Net cash provided by operating activities. Adjusted free cash flow is calculated as Net cash provided by operating activities, excluding non-recurring restructuring charges, after additions of long-lived assets.
The following is a reconciliation of Net income and Net income as a percent of net sales to Adjusted EBITDA and Adjusted EBITDA as a percent of net sales and a reconciliation of Net cash provided by operating activities to Adjusted free cash flow:
For the years ended December 31,
plus:
Depreciation of property, plant and equipment 96 81 77
Amortization of intangible assets 52 86 87
Stock-based compensation expense (a) 17 13 13
Restructuring charges (b) 14 — —
Expenses related to long-term debt refinancing (c) 13 1 —
UAW Local 933 retirement incentive (d) 7 5 15
Unrealized loss on foreign exchange (e) 2 — 3
Acquisition-related earnouts (f) 1 1 —
Environmental remediation (g) — (8 ) —
Loss associated with impairment of long-lived assets (h) — 2 4
Technology-related investment expense (i) — — 3
Net income as a percent of net sales (GAAP) 14.4 % 22.4 % 23.6 %
Adjusted EBITDA as a percent of net sales (Non-GAAP) 35.2 % 40.1 % 41.6 %
Net cash provided by operating activities (GAAP) $ 561 $ 847 $ 837
(Deductions) or additions to reconcile to Adjusted free cash flow:
Additions of long-lived assets (115 ) (172 ) (100 )
Restructuring charges (b) 12 — —
Adjusted free cash flow (Non-GAAP) $ 458 $ 675 $ 737
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Results of Operations
The COVID-19 pandemic, and its impact on global demand and supply chains, had a material adverse effect on our results of operations for 2020. We continue to actively monitor the impact of the global pandemic on customer demand and supply chains. While we expect increased customer demand in 2021, the ongoing pandemic may still materially adversely impact our business and results of operations in 2021. See “Trends Impacting our Business” above for additional information on the impact of the COVID-19 pandemic on our results of operations.
The following table sets forth certain financial information for the years ended December 31, 2020 and 2019. The following table and discussion should be read in conjunction with the information contained in our consolidated financial statements and the notes thereto included in Part II, Item 8 of this Annual Report on Form 10-K.
Comparison of years ended December 31, 2020 and 2019
Years ended December 31,
(dollars in millions) 2020 % of net sales 2019 % of net sales
Operating expenses:
Engineering — research and development 147 7 154 6
Environmental remediation — — (8 ) —
Other expense, net:
Interest expense, net (137 ) (7 ) (134 ) (5 )
Other (expense) income, net (4 ) — 10 —
Total other expense, net (141 ) (7 ) (124 ) (5 )
Income tax expense (94 ) (5 ) (164 ) (6 )
Net sales
Net sales for the year ended December 31, 2020 were $2,081 million compared to $2,698 million for the year ended December 31, 2019, a decrease of 23%. The decrease was principally driven by a $393 million, or 27%, decrease in net sales in the North America On-Highway end market principally driven by lower demand due to the effects of the COVID-19 pandemic, a $110 million, or 28%, decrease in net sales in the Outside North America On-Highway end market principally driven by lower global demand due to the effects of the COVID-19 pandemic, a $80 million, or 15%, decrease in net sales in the Service Parts, Support Equipment and Other end market principally driven by lower demand for North America service parts and support equipment partially offset by aluminum die cast component volume associated with the acquisition of Walker Die Casting, a $48 million, or 44%, decrease in net sales in the Outside North America Off-Highway end market principally driven by lower demand in the energy, mining and construction sectors and a $17 million, or 57%, decrease in net sales in the North America Off-Highway end market principally driven by lower demand for hydraulic fracturing applications, partially offset by a $31 million, or 21%, increase in net sales in the Defense end market principally driven by Tracked vehicle demand.
Cost of sales
Cost of sales for the year ended December 31, 2020 was $1,083 million compared to $1,304 million for the year ended December 31, 2019, a decrease of 17%. The decrease was principally driven by decreased direct
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material and manufacturing expenses commensurate with decreased net sales, lower incentive compensation expense and favorable material costs, partially offset by increased depreciation expense and restructuring charges.
Gross profit
Gross profit for the year ended December 31, 2020 was $998 million compared to $1,394 million for the year ended December 31, 2019, a decrease of 28%. The decrease was principally driven by $449 million related to decreased net sales, $8 million of increased depreciation expense and $5 million of restructuring charges, partially offset by lower manufacturing expense commensurate with decreased net sales, $19 million of lower incentive compensation expense, $10 million of price increases on certain products and $7 million of favorable material costs. Gross profit as a percent of net sales for the year ended December 31, 2020 decreased approximately 370 basis points compared to the same period in 2019 principally driven by lower net sales, increased depreciation expense and restructuring charges, partially offset by lower incentive compensation expense, price increases on certain products and favorable material costs.
Selling, general and administrative
Selling, general and administrative expenses for the year ended December 31, 2020 were $317 million compared to $356 million for the year ended December 31, 2019, a decrease of 11%. The decrease was principally driven by $34 million of lower intangible amortization expense, $24 million of lower incentive compensation expense and decreased commercial activities spending, partially offset by unfavorable product warranty adjustments, including a $23 million adjustment in the third quarter of 2020 to address a transmission performance issue associated with shift quality in a defined population of products and $3 million of restructuring charges.
Engineering — research and development
Engineering expenses for the year ended December 31, 2020 were $147 million compared to $154 million for the year ended December 31, 2019, a decrease of 5%. The decrease was principally driven by $9 million of lower incentive compensation expense and the timing of product initiatives spending, partially offset by $4 million of restructuring charges.
Environmental remediation
During the fourth quarter of 2019, the EPA accepted a proposal to reduce our responsibilities for operating, monitoring and maintaining the ongoing environmental remediation activities at our Indianapolis, Indiana manufacturing facilities which resulted in us recording an $8 million favorable adjustment to our associated liability.
Interest expense, net
Interest expense, net for the year ended December 31, 2020 was $137 million compared to $134 million for the year ended December 31, 2019, an increase of 2%. The increase was principally driven by $10 million of increased interest expense on interest rate hedges that became effective in the third quarter of 2019, $3 million of interest expense on ATI’s New Revolving Credit Facility and increased interest expense due to higher interest rates related to long-term debt refinancing in the first quarter of 2019 that extended maturities at fixed interest rates, partially offset by approximately $13 million of lower interest expense on ATI’s New Term Loan due to lower variable interest rates and decreased interest expense due to lower interest rates related to long-term debt refinancing in the fourth quarter of 2020 that extended maturities at lower fixed interest rates.
Other (expense) income, net
Other (expense) income, net for the year ended December 31, 2020 was ($4) million compared to $10 million for the year ended December 31, 2019. The change was principally driven by $13 million of expenses related to the redemption of our 5.0% Senior Notes in the fourth quarter of 2020 and a $2 million settlement charge related to the
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settlement of pension obligations as a result of our voluntary and involuntary separation programs recognized in the second quarter of 2020.
Income tax expense
Income tax expense for the year ended December 31, 2020 was $94 million resulting in an effective tax rate of 24%, compared to $164 million of income tax expense and an effective tax rate of 22% for the year ended December 31, 2019. The decrease in income tax expense was principally driven by decreased taxable income. The increase in the effective tax rate was principally driven by decreased estimated U.S. federal income tax deductions.
Liquidity and Capital Resources
We generate cash primarily from operations to fund our operating, investing and financing activities. Our principal uses of cash are operating expenses, capital expenditures, working capital needs, debt service, dividends on common stock, stock repurchases, and strategic growth initiatives, including acquisitions. Our ability to generate cash in the future and our future uses of cash are subject to general economic, financial, competitive, legislative, regulatory and other factors that may be beyond our control, including the impact to our cash flow that has been experienced due to lower net sales in 2020 related to COVID-19. We had total available cash and cash equivalents of $310 million and $192 million as of December 31, 2020 and 2019, respectively. Of the available cash and cash equivalents, approximately $150 million and $122 million were deposited in operating accounts while approximately $160 million and $70 million were invested in U.S. government backed securities as of December 31, 2020 and 2019, respectively.
As of December 31, 2020, the total of cash and cash equivalents held by foreign subsidiaries was $63 million, the majority of which was located in China and Europe. We manage our worldwide cash requirements considering available funds among the subsidiaries through which we conduct our business and the cost effectiveness with which those funds can be accessed. As a result, we do not currently anticipate that local liquidity restrictions will preclude us from funding our targeted expectations or operating needs with local resources.
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We have not recognized any deferred tax liabilities associated with earnings in foreign subsidiaries, except for our subsidiary located in China, as they are intended to be permanently reinvested and used to support foreign operations or have no associated tax requirements. We have recorded a deferred tax liability of $3 million for the tax liability associated with the remittance of previously taxed income and unremitted earnings for our subsidiary located in China. The remaining deferred tax liabilities, if recorded, related to unremitted earnings that are indefinitely reinvested are not material.
Our liquidity requirements are significant, primarily due to our debt service requirements. As of December 31, 2020, we had $638 million of indebtedness associated with ATI’s New Term Loan, $400 million of indebtedness associated with ATI’s 4.75% Senior Notes due October 2027 (“4.75% Senior Notes”), $500 million of indebtedness associated with ATI’s 5.875% Senior Notes due June 2029 (“5.875% Senior Notes”) and $1,000 million of indebtedness associated with ATI’s 3.75% Senior Notes due January 2031 (“3.75% Senior Notes” and, together with the 4.75% Senior Notes and 5.875% Senior Notes, the “Senior Notes”). Short-term and long-term debt service liquidity requirements consist of $2 million of minimum required quarterly principal payments on ATI’s New Term Loan through its maturity date of March 2026 and periodic interest payments on ATI’s New Term Loan and the Senior Notes. There are no required quarterly principal payments on ATI’s Senior Notes. Long-term debt service liquidity requirements also consist of the payment in full of any remaining principal balance of ATI’s New Term Loan and the Senior Notes upon their respective maturity dates.
We made $6 million and $3 million of principal payments on the New Term Loan during the year ended December 31, 2020 and 2019, respectively. Our ability to make payments on and refinance our indebtedness and to fund planned capital expenditures and growth initiatives will depend on our ability to generate cash in the future.
In November 2020, the Company and ATI entered into an amendment to the Credit Agreement to increase the commitments under the New Revolving Credit Facility by $50 million. The amendment also extended the New Revolving Credit Facility termination date from September 2024 to September 2025. The New Senior Secured Credit Facility, as amended, provides for a $650 million New Revolving Credit Facility, net of an allowance for up to $75 million in outstanding letters of credit commitments. Throughout the year ended December 31, 2020, we made periodic withdrawals and payments on the New Revolving Credit Facility as part of our debt and cash management plans. The maximum amount outstanding at any time during the year ended December 31, 2020 was $500 million. As of December 31, 2020, we had $645 million available under the New Revolving Credit Facility, net of $5 million in letters of credit. If we have commitments outstanding on the New Revolving Credit Facility at the end of a fiscal quarter, the New Senior Secured Credit Facility requires us to maintain a specified maximum first lien net leverage ratio of 5.50x. Additionally, within the terms of the New Senior Secured Credit Facility, a first lien net leverage ratio at or below 4.00x results in the elimination of excess cash flow payments on the New Senior Secured Credit Facility for the applicable year. As of December 31, 2020, our first lien net leverage ratio was 0.45x. The New Senior Secured Credit Facility also provides certain financial incentives based on our first lien net leverage ratio. A first lien net leverage ratio at or below 4.00x and above 3.50x results in a 25 basis point reduction to the applicable margin on the New Revolving Credit Facility. A first lien net leverage ratio at or below 3.50x results in an additional 25 basis point reduction to the applicable margin on the New Revolving Credit Facility. These reductions remain in effect as long as we achieve a first lien net leverage ratio at or below the related threshold.
In addition, the Credit Agreement includes, among other things, customary restrictions (subject to certain exceptions) on our ability to incur certain indebtedness, grant certain liens, make certain investments, engage in acquisitions, consolidations and mergers, declare or pay certain dividends, and repurchase shares of our common stock. The indentures governing the Senior Notes contain negative covenants restricting or limiting our ability to, among other things, incur or guarantee additional indebtedness, incur liens, pay dividends on, redeem or repurchase our capital stock, make certain investments, permit payment or dividend restrictions on certain of our subsidiaries, sell assets, engage in certain transactions with affiliates, and consolidate or merge or sell all or substantially all of our assets. As of December 31, 2020, we are in compliance with all covenants under the New Senior Secured Credit Facility and indentures governing the Senior Notes.
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Our credit ratings are reviewed by Moody’s Investors Service (“Moody’s”) and Fitch Ratings (“Fitch”). Moody’s rates our corporate credit at ‘Ba2’, New Term Loan at ‘Baa3’, 4.75% Senior Notes at ‘Ba3’ and 5.875% Senior Notes at 'Ba3', and the 3.75% Senior Notes are unrated. Fitch rates our corporate credit at ‘BB’, New Term Loan at ‘BB+’, 4.75% Senior Notes at ‘BB’, 5.875% Senior Notes at 'BB' and 3.75% Senior Notes at ‘BB’.
We anticipate an increase in capital expenditures and engineering research and development expenses to fund organic initiatives across all our end markets for the year ending December 31, 2021 compared to the year ended December 31, 2020.
On November 14, 2016, our Board of Directors authorized us to repurchase up to $1,000 million of our common stock pursuant to a stock repurchase program (the "Repurchase Program"). On November 8, 2017, July 30, 2018 and May 9, 2019 our Board of Directors increased the authorization by $500 million, $500 million and $1,000 million, respectively, bringing the total amount authorized under the Repurchase Program to $3,000 million. During 2020, we repurchased approximately $225 million of our common stock under the Repurchase Program. All of the repurchase transactions during 2020 were settled in cash during the same period. As of December 31, 2020, we had approximately $827 million available under the Repurchase Program.
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The following table shows our sources and uses of funds for the years ended December 31, 2020, 2019 and 2018 (in millions):
Years ended December 31,
Cash flows provided by operating activities $ 561 $ 847 $ 837
Cash flows used for investing activities (111 ) (405 ) (103 )
Cash flows used for financing activities (335 ) (480 ) (700 )
Generally, cash provided by operating activities has been adequate to fund our operations. The COVID-19 pandemic, and its impact on global demand and supply chains, had a material adverse effect on our cash provided by operating activities for 2020 and may still have a materially adverse impact in 2021. We have significant liquidity, including $310 million of cash and cash equivalents and $645 million available under the New Revolving Credit Facility as of December 31, 2020. At this time, we believe cash provided by operating activities, cash and cash equivalents and borrowing capacity under the New Senior Secured Credit Facility will be sufficient to meet our cash requirements for the next twelve months.
Cash provided by operating activities
Operating activities for the year ended December 31, 2020 generated $561 million of cash compared to $847 million for the year ended December 31, 2019. The decrease was principally driven by lower gross profit and higher cash interest expense, partially offset by lower cash income taxes, lower operating working capital requirements and decreased commercial activities spending.
Cash used for investing activities
Investing activities for the year ended December 31, 2020 used $111 million of cash compared to $405 million for the year ended December 31, 2019. The decrease was principally driven by $232 million of business acquisition spending in 2019 that did not recur in 2020 and a $57 million decrease in capital expenditures, partially offset by a $4 million net working capital settlement in 2020 related to the acquisition of Walker Die Casting.
Cash used for financing activities
Financing activities for the year ended December 31, 2020 used $335 million of cash compared to $480 million for the year ended December 31, 2019. The decrease was principally driven by $168 million of decreased stock repurchases, partially offset by increased payments related to long-term debt refinancing.
Critical Accounting Policies and Significant Accounting Estimates
The preparation of the consolidated financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts of some assets and liabilities and, in some instances, the reported amounts of net sales and expenses during the applicable reporting period. Differences between actual amounts and estimates are recorded in the period identified. Estimates can require a significant amount of judgment, and a different set of judgments could result in changes to our reported results. A summary of our critical accounting estimates is included below.
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Revenue Recognition
Revenue recognition contains uncertainties because it requires management to make assumptions and to apply judgment to estimate the amount of sales incentives and provision for government price reductions. Distributor and customer sales incentives, consisting of allowances and other rebates, are estimated at the time of sale based upon history and experience and are recorded as a reduction to net sales. Incentive programs are generally product specific or region specific. Some factors used in estimating the cost of incentives include the number of transmissions that will be affected by the incentive program and the rate of acceptance of any incentive program. If the actual number of affected transmissions differs from this estimate, or if a different mix of incentives is actually paid, the impact on net sales would be recorded in the period that the change was identified. Assuming our current mix of sales incentives, a 10% change in sales incentives would have affected our earnings by approximately $5 million to $9 million per year for each of the prior three fiscal years.
Under terms of certain previous U.S. government contracts, there were price reduction clauses and provisions for potential price reductions which are estimated at the time of sale based upon history and experience, and finalized after completion of U.S. government audits. Given our current price reduction reserve for government contracts, a 10% adjustment in our price reduction reserve would have affected our earnings by approximately $6 million per year for each of the prior three fiscal years. Beginning in 2014, Allison contracts with the U.S. Government have generally been firm, fixed price contracts and therefore have not required re-calculation of pricing based on cost principles.
Further information is provided in NOTE 2 “Summary of Significant Accounting Policies” of Notes to Consolidated Financial Statements included in Part II, Item 8, of this Annual Report on Form 10-K.
Goodwill and Other Intangible Assets
Goodwill is tested for impairment at the reporting unit level, which is the same as our one operating and reportable segment. We do not aggregate any components into our reporting unit. We have elected to perform our annual impairment test on October 31 of every year. A multi-step impairment test is performed on goodwill. In Step 0, we have the option to evaluate various qualitative factors to determine the likelihood of impairment. If we determine that the fair value is more likely than not less than the carrying value, then we are required to perform Step 1. If we do not elect to perform Step 0, we can voluntarily proceed directly to Step 1. In Step 1, we perform a quantitative analysis to compare the fair value of our reporting unit to our carrying value including goodwill. If the fair value of the reporting unit exceeds the carrying value of the net assets assigned to that unit, goodwill is not considered impaired, and we are not required to perform further testing. If the carrying value of a reporting unit’s goodwill exceeds its fair value of net assets, then we would record an impairment loss equal to the difference.
A qualitative assessment contains uncertainties because it requires management to make assumptions and to apply judgment to assess business changes, economic outlook, financial trends and forecasts, growth rates, credit ratings, equity ratings, discount rates, industry data and other relevant qualitative factors.
A quantitative analysis contains uncertainties because it is performed utilizing a discounted cash flow model which includes key assumptions, such as net sales growth derived from market information, industry reports, marketing programs and future new product introductions; operating margin improvements derived from cost reduction programs and fixed cost leverage driven by higher sales volumes; and a risk-adjusted discount rate.
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Goodwill impairment testing for 2020 was performed using the Step 1quantitative analysis, which indicated that the fair value of the reporting unit exceeded its carrying value by more than 200%, indicating no impairment. The fair value was determined utilizing a discounted cash flow model which includes key assumptions, such as net sales growth derived from market information, industry reports, marketing programs and certain growth initiatives; operating margin improvements derived from cost reduction programs and fixed cost leverage driven by higher sales volumes; and a risk-adjusted discount rate. Events or circumstances that could unfavorably impact the key assumptions include lower net sales driven by market conditions, our inability to execute on marketing programs and/or growth initiatives, lower gross margins as a result of market conditions or failure to obtain forecasted cost reductions, or a higher discount rate as a result of market conditions. While unpredictable and inherently uncertain, management believes the forecast estimates were reasonable and incorporate assumptions that similar market participants would use in their estimates of fair value.
Other intangible assets have both indefinite and finite useful lives. Intangible assets with indefinite useful lives are not amortized but are tested annually for impairment, or more often if events or circumstances change that could cause intangible assets with indefinite useful lives to become impaired. We have elected to perform our annual indefinite lived intangible assets impairment tests on October 31 of every year and follow a similar multi-step impairment test that is performed on goodwill. Using the relief-from-royalty method under the income valuation approach, our 2020 annual trade name impairment test indicated that the fair value of the trade name exceeded its carrying value by more than 60%, indicating no impairment. Events or circumstances that could unfavorably impact the key assumptions included lower net sales driven by market conditions, our inability to execute on marketing programs and/or growth initiatives, lower gross margin as a result of market conditions or failure to obtain forecasted cost reductions, or a higher discount rate as a result of market conditions. While unpredictable and inherently uncertain, we believe the forecast estimates are reasonable and incorporate those assumptions that similar market participants would use in their estimates of fair value.
Intangible assets with finite lives are amortized over their estimated useful lives and reviewed for impairment when circumstances change that would create a triggering event. Assumptions and estimates about future values and remaining useful lives of our intangible and other long-lived assets are complex and subjective. They can be affected by a variety of factors, including external factors such as industry and economic trends, and internal factors, such as changes in our business strategy and internal forecasts. Although management believes the historical assumptions and estimates are reasonable and appropriate, different assumptions and estimates could materially impact our reported financial results. Further information is provided in NOTE 2 “Summary of Significant Accounting Policies” and NOTE 6 “Goodwill and Other Intangible Assets” of Notes to Consolidated Financial Statements included in Part II, Item 8, of this Annual Report on Form 10-K.
Impairment of Long-Lived Assets
The carrying value of long-lived assets is evaluated whenever events or circumstances indicate that the carrying value of a long-lived asset may not be recoverable. Events or circumstances that would result in an impairment review primarily include a significant change in the use of an asset, or the planned sale or disposal of an asset. The asset would be considered impaired when there is no future use planned for the asset or the future net undiscounted cash flows generated by the asset or asset group are less than its carrying value. An impairment loss would be recognized based on the amount by which the carrying value exceeds fair value.
Assumptions and estimates used to determine cash flows in the evaluation of impairment and the fair values used to determine the impairment are subject to a degree of judgment and complexity. Any changes to the assumptions and estimates resulting from changes in actual results or market conditions from those anticipated may affect the carrying value of long-lived assets and could result in an impairment charge.
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Warranty
Provisions for estimated expenses related to product warranties are made at the time products are sold. Warranty claims arise when a transmission fails while in service during the relevant warranty period. The warranty reserve is adjusted in Selling, general and administrative based on our current and historical warranty claims paid and associated repair costs. These estimates are established using historical information including the nature, frequency, and average cost of warranty claims and are adjusted as actual information becomes available. From time to time, we may initiate a specific field action program. As a result of the uncertainty surrounding the nature and frequency of specific field action programs, the liability for such programs is recorded when we commit to an action. We review and assess the liability for these programs on a quarterly basis. We also assess our ability to recover certain costs from our suppliers and record a receivable from the supplier when we believe a recovery is probable. Warranty costs may differ from those estimated if actual claim rates are higher or lower than our historical rates. Further information is provided in NOTE 10, “Product Warranty Liabilities” of Notes to Consolidated Financial Statements included in Part II, Item 8, of this Annual Report on Form 10-K which contains a summary of the activity in our warranty liability account for 2020, 2019 and 2018 including adjustments to pre-existing warranties.
Pension and Post-retirement Benefit Plans
Pension and OPEB costs are based upon various actuarial assumptions and methodologies as prescribed by authoritative accounting guidance. These assumptions include discount rates, expected return on plan assets, health care cost trend rates, inflation, rate of compensation increases, population demographics, mortality rates and other factors. We review all actuarial assumptions on an annual basis.
A change in the discount rate can have a significant impact on determining our benefit obligations. Our current discount rate is determined by matching the plans’ projected cash flows to a yield curve based on long-term, fixed income debt instruments available as of the measurement date of December 31, 2020. The effect of a one percentage point decrease in the assumed discount rate would result in an increase in the December 31, 2020 defined benefit pension plans obligation of approximately $31 million. Similarly, a one percentage point decrease in the assumed discount rate would result in an increase in the December 31, 2020 OPEB obligation of approximately $16 million.
Further information is provided in NOTE 15 “Employee Benefit Plans” of Notes to Consolidated Financial Statements included in Part II, Item 8, of this Annual Report on Form 10-K, which contains our review on various actuarial assumptions.
Income Taxes
Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the expected future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. The future tax benefits associated with operating loss and tax credit carryforwards are recognized as deferred tax assets. 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. When releasing income tax effects from accumulated other comprehensive loss we utilize the portfolio securities approach.
On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) was signed into law making several changes to the U.S. tax code. The changes include, but are not limited to, increasing the threshold on the amount of deductible interest expense, allowing companies to carryback certain net operating losses, increasing the amount of net operating loss carryforwards that corporations can use to offset taxable income, and making technical changes related to the accounting of qualified improvement property. Some of the tax law changes included in the CARES Act are retroactive. The Company has reviewed and incorporated the applicable changes related to its provision for income taxes for the year ended December 31, 2020 and the effects, both individually and in the aggregate, are not material at this time.
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As of December 31, 2020, our U.S. federal income tax deductions related to our intangible assets were approximately $325 million in 2021, approximately $195 million in 2022 and approximately $10 million annually through 2033. Excluding our intangible asset deductions, our expected tax payments would have increased by approximately $70 million for the year ended December 31, 2020.
The need to establish a valuation allowance against the deferred tax assets is assessed at least quarterly based on a more-likely-than-not realization threshold, in accordance with the Financial Accounting Standard Board’s (“FASB”) authoritative accounting guidance on income taxes. Appropriate consideration is given to all positive and negative evidence related to that realization. This assessment considers, among other matters, the nature, frequency and severity of recent losses, forecasts of future profitability, the duration of statutory carryforward periods, and experience with tax attributes expiring unused and tax planning alternatives. The weight given to these considerations depends upon the degree to which they can be objectively verified.
Further information on income taxes is provided in NOTE 16, “Income Taxes” of Notes to Consolidated Financial Statements included in Part II, Item 8, of this Annual Report on Form 10-K.
Business Combinations
We use the acquisition method to account for business combinations. The assets acquired and liabilities assumed are recorded at their respective estimated fair value at the date of acquisition. Any excess purchase price over the fair values of the acquired net assets is recorded as goodwill. Determining the fair values of assets acquired and liabilities assumed requires management's judgment and includes the use of estimates with respect to timing and amount of future cash flows, market rate assumptions, actuarial assumptions, appropriate discount rates and other relevant factors.
Off-Balance Sheet Arrangements
We are not a party to any off-balance sheet arrangements.
Recently Adopted Accounting Pronouncements
Refer to NOTE 2, “Summary of Significant Accounting Policies” in Part II, Item 8, of this Annual Report on Form 10-K.
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ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk
Our exposure to market risk consists of changes in interest rates, foreign currency rate fluctuations and movements in commodity prices.
Interest Rate Risk
We are subject to interest rate market risk in connection with a portion of our long-term debt. Our principal interest rate exposure relates to outstanding amounts under our New Senior Secured Credit Facility. Our New Senior Secured Credit Facility provides for variable rate borrowings of up to $1,283 million including $645 million under our New Revolving Credit Facility, net of $5 million of letters of credit. A one-eighth percent increase or decrease in assumed interest rates for the New Senior Secured Credit Facility, if fully drawn as of December 31, 2020, would have an impact of approximately $1 million on interest expense. As of December 31, 2020, we had no outstanding borrowings against the New Revolving Credit Facility.
From time to time, we enter into interest rate swap agreements to hedge the risk associated with our variable interest rate debt. During the first quarter of 2019, we entered into $250 million of interest rate swaps and designated them as cash flow hedges under the hypothetical derivative method. As of December 31, 2020, we held interest rate swaps effective from (i) September 2019 to September 2022 with notional values totaling $250 million and a weighted average LIBOR fixed rate of 3.01%, (ii) September 2019 to September 2025 with notional values totaling $250 million and a weighted average LIBOR fixed rate of 3.04% and (iii) September 2022 to September 2025 with notional values totaling $250 million and a weighted average LIBOR fixed rate of 2.82%.
Refer to NOTE 8, “Debt” and NOTE 9, “Derivatives” of Notes to Consolidated Financial Statements included in Part II, Item 8, of this Annual Report on Form 10-K.
Exchange Rate Risk
While our net sales and costs are denominated primarily in U.S. Dollars, net sales, costs, assets and liabilities are generated in other currencies including Japanese Yen, Euro, Indian Rupee, Brazilian Real, Chinese Yuan Renminbi, Canadian Dollar and Hungarian Forint. The expansion of our business outside North America may further increase the risk that cash flows resulting from these activities may be adversely affected by changes in currency exchange rates.
Assuming current levels of foreign currency transactions, a 10% aggregate increase or decrease in the Japanese Yen, Euro, Indian Rupee and Chinese Yuan Renminbi would correspondingly change our earnings, net of tax, by an estimated $4 million per year. We believe other exposure to foreign currencies is immaterial.
Commodity Price Risk
We are subject to changes in our cost of sales caused by movements in underlying commodity prices. Approximately 65% of our cost of sales consists of purchased components with significant raw material content. A substantial portion of the purchased parts are made of aluminum and steel. The cost of aluminum parts includes an adjustment factor on future purchases for fluctuations in aluminum prices based on accepted industry indices. In addition, a substantial amount of steel-based contracts also includes an index-based component. As our costs change, we are able to pass through a portion of the changes in commodity prices to certain of our customers according to our LTAs. We historically have not entered into long-term purchase contracts related to the purchase of aluminum and steel.
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Assuming current levels of commodity purchases, a 10% variation in the price of aluminum and steel would correspondingly change our earnings by approximately $3 million and $4 million per year, respectively.
Many of our LTAs have incorporated a cost-sharing arrangement related to potential future commodity price fluctuations. For purposes of the sensitivity analysis above, the impact of these cost sharing arrangements has not been included.
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ITEM 8. Financial Statements and Supplementary Data
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
Report of Independent Registered Public Accounting Firm 52
Consolidated Balance Sheets 54
Consolidated Statements of Comprehensive Income 55
Consolidated Statements of Cash Flows 56
Consolidated Statements of Stockholders' Equity 57
Notes to Consolidated Financial Statements 58
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Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders of Allison Transmission Holdings, Inc.
Opinions on the Financial Statements and Internal Control over Financial Reporting
We have audited the accompanying consolidated balance sheets of Allison Transmission Holdings, Inc. and its subsidiaries (the “Company”) as of December 31, 2020 and 2019, and the related consolidated statements of comprehensive income, of stockholders’ equity and of cash flows for each of the three years in the period ended December 31, 2020, including the related notes and financial statement schedule listed in the index appearing under Item 15(a)(2) (collectively referred to as the “consolidated financial statements”). We also have audited the Company's internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control - Integrated Framework (2013) issued by the COSO.
Basis for Opinions
The Company's management is responsible for these consolidated financial statements, 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 Report on Internal Control Over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on the Company’s consolidated financial statements and on the Company's internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects.
Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. 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.
Definition and Limitations of Internal Control over Financial Reporting
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
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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.
Critical Audit Matters
The critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that (i) relates to accounts or disclosures that are material to the consolidated financial statements and (ii) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates.
Product Warranty Liabilities
As described in Notes 2 and 10 to the consolidated financial statements, the Company’s consolidated product warranty liability balance was $66 million as of December 31, 2020. Management makes provisions for the estimated product warranty liabilities at the time the products are sold. These estimates are established using historical information including the nature, frequency, and average cost of warranty claims and are adjusted as actual information becomes available.
The principal considerations for our determination that performing procedures relating to the product warranty liabilities is a critical audit matter are (i) the significant judgment by management when determining the product warranty liability estimate; (ii) the high degree of auditor judgment, subjectivity, and effort in performing procedures and evaluating audit evidence relating to the significant assumptions related to the frequency and average cost of warranty claims; and (iii) the audit effort involved the use of professionals with specialized skill and knowledge.
Addressing the matter involved performing procedures and evaluating audit evidence in
connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to management’s process for developing the estimate, significant assumptions, and inputs used to estimate product warranty liabilities. These procedures also included, among others (i) testing the completeness and accuracy of historical warranty claims data used in the estimate and (ii) professionals with specialized skill and knowledge were used to assist in evaluating the reasonableness of the frequency and average cost of warranty claims assumptions.
/s/ PricewaterhouseCoopers LLP
Indianapolis, Indiana
February 18, 2021
We have served as the Company’s auditor since 2008.
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Allison Transmission Holdings, Inc.
Consolidated Balance Sheets
(dollars in millions, except share data)
ASSETS
Current Assets
Cash and cash equivalents $ 310 $ 192
Accounts receivable - net of allowance for doubtful accounts of $1 228 253
Other current assets 37 42
Property, plant and equipment, net 638 616
Other non-current assets 56 65
LIABILITIES
Current Liabilities
Product warranty liability 36 24
Current portion of long-term debt 6 6
Deferred revenue 34 35
Other current liabilities 140 202
Total Current Liabilities 373 417
Product warranty liability 30 28
Other non-current liabilities 260 221
Commitments and Contingencies (see NOTE 18)
STOCKHOLDERS’ EQUITY
Accumulated deficit (974 ) (970 )
Accumulated other comprehensive loss, net of tax (89 ) (52 )
TOTAL STOCKHOLDERS’ EQUITY 756 781
TOTAL LIABILITIES & STOCKHOLDERS’ EQUITY $ 4,477 $ 4,450
The accompanying notes are an integral part of the consolidated financial statements.
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Allison Transmission Holdings, Inc.
Consolidated Statements of Comprehensive Income
(dollars in millions, except per share data)
Years ended December 31,
Selling, general and administrative 317 356 368
Engineering — research and development 147 154 131
Environmental remediation — (8 ) —
Other (expense) income, net (4 ) 10 3
Other comprehensive income (loss), net of tax:
Foreign currency translation 10 (3 ) (9 )
Pension and OPEB liability adjustment (27 ) — 1
Available-for-sale securities and interest rate swaps (20 ) (19 ) (7 )
Total other comprehensive loss, net of tax (37 ) (22 ) (15 )
Comprehensive income, net of tax $ 262 $ 582 $ 624
The accompanying notes are an integral part of the consolidated financial statements.
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Allison Transmission Holdings, Inc.
Consolidated Statements of Cash Flows
(dollars in millions)
Years ended December 31,
CASH FLOWS FROM OPERATING ACTIVITIES:
Depreciation of property, plant and equipment 96 81 77
Amortization of intangible assets 52 86 87
Expenses related to long-term debt refinancing 19 5 —
Stock-based compensation 17 13 13
Amortization of deferred financing costs 4 5 6
Changes in assets and liabilities:
Accounts receivable 28 37 (61 )
Accounts payable (4 ) (25 ) 9
Other assets and liabilities (43 ) (16 ) 22
Net cash provided by operating activities 561 847 837
CASH FLOWS FROM INVESTING ACTIVITIES:
Business acquisitions 4 (232 ) —
Additions of long-lived assets (115 ) (172 ) (100 )
Investments in technology-related initiatives — (1 ) (3 )
Net cash used for investing activities (111 ) (405 ) (103 )
CASH FLOWS FROM FINANCING ACTIVITIES:
Repayments on revolving credit facility (800 ) (90 ) —
Borrowings on revolving credit facility 800 90 —
Repurchases of common stock (225 ) (393 ) (609 )
Dividend payments (78 ) (73 ) (80 )
Debt financing fees (10 ) (12 ) (1 )
Payment of acquisition-related contingent liability (3 ) — —
Taxes paid related to net share settlement of equity awards (2 ) (4 ) (4 )
Proceeds from exercise of stock options 2 5 22
Net cash used for financing activities (335 ) (480 ) (700 )
Effect of exchange rate changes on cash 3 (1 ) (2 )
Net increase (decrease) in cash and cash equivalents 118 (39 ) 32
Cash and cash equivalents at beginning of period 192 231 199
Cash and cash equivalents at end of period $ 310 $ 192 $ 231
Supplemental disclosures:
The accompanying notes are an integral part of the consolidated financial statements.
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Allison Transmission Holdings, Inc.
Consolidated Statements of Stockholders’ Equity
(dollars in millions)
Stock-based compensation — — — 13 — — 13
Pension and OPEB liability adjustment — — — — — 1 1
Foreign currency translation adjustment — — — — — (9 ) (9 )
Available-for-sale securities — — — — — (7 ) (7 )
Issuance of common stock — — — 17 — — 17
Repurchase of common stock — — — — (609 ) — (609 )
Dividends on common stock — — — — (80 ) — (80 )
Impact of adopting accounting standards — — — — 5 5
Stock-based compensation — — — 13 — — 13
Foreign currency translation adjustment — — — — — (3 ) (3 )
Available-for-sale securities and interest rate swaps — — — — — (19 ) (19 )
Issuance of common stock — — — 1 — — 1
Repurchase of common stock — — — — (393 ) — (393 )
Dividends on common stock — — — — (73 ) — (73 )
Impact of adopting accounting standards — — — — (8 ) — (8 )
Stock-based compensation — — — 17 — — 17
Pension and OPEB liability adjustment — — — — — (27 ) (27 )
Foreign currency translation adjustment — — — — — 10 10
Interest rate swaps — — — — — (20 ) (20 )
Issuance of common stock — — — (1 ) — — (1 )
Repurchase of common stock — — — — (225 ) — (225 )
Dividends on common stock — — — — (78 ) — (78 )
The accompanying notes are an integral part of the consolidated financial statements.
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Allison Transmission Holdings, Inc.
Notes to Consolidated Financial Statements
NOTE 1. OVERVIEW
Overview
Allison Transmission Holdings, Inc. and its subsidiaries (“Allison,” or the “Company”) design and manufacture vehicle propulsion solutions, including commercial-duty on-highway, off-highway and defense fully automatic transmissions and electric hybrid and fully electric systems. The business was founded in 1915 and has been headquartered in Indianapolis, Indiana since inception. Allison was an operating unit of General Motors Corporation from 1929 until 2007, when Allison once again became a stand-alone company. In March 2012, Allison began trading on the New York Stock Exchange under the symbol, “ALSN”.
The Company has approximately 3,300 employees. Although approximately 79% of revenues were generated in North America in 2020, the Company has a global presence by serving customers in Europe, Asia, South America and Africa. The Company serves customers through an independent network of approximately 1,400 independent distributor and dealer locations worldwide.
NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation and Principles of Consolidation
The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The information herein reflects all normal recurring material adjustments, which are, in the opinion of management, necessary for a fair statement of the results for the periods presented. The consolidated financial statements herein consist of all wholly-owned domestic and foreign subsidiaries with all significant intercompany transactions eliminated.
These consolidated financial statements present the financial position, results of comprehensive income, cash flows and statements of stockholders’ equity. Certain immaterial reclassifications have been made in the consolidated financial statements of prior periods to conform to the current period presentation. These reclassifications had no impact on previously reported net income, total stockholders’ equity or cash flows.
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, disclosure of contingent assets and liabilities and the reported amounts of revenue and expenses. Estimates include, but are not limited to, sales allowances, government price adjustments, fair market values and future cash flows associated with goodwill, indefinite life intangibles, definite life intangibles, long-lived asset impairment tests, useful lives for depreciation and amortization, warranty liabilities, environmental liabilities, determination of discount and other assumptions for pension and other post-retirement benefit expense, determination of discount rate and period for leases, income taxes and deferred tax valuation allowances, derivative valuation, assumptions for business combinations and contingencies. The Company’s accounting policies involve the application of judgments and assumptions made by management that include inherent risks and uncertainties. Due to the continued uncertainty related to the ongoing COVID-19 pandemic, actual results could differ materially from these estimates and assumptions used in preparation of the financial statements including, but not limited to, future cash flows associated with goodwill, indefinite life intangibles, definite life intangibles, long-lived impairment tests, determination of discount and other assumptions for pension and other post-retirement benefit expense and income taxes. Changes in estimates are recorded in results of operations in the period that the events or circumstances giving rise to such changes occur.
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Segment Reporting
In accordance with the Financial Accounting Standards Board’s (“FASB”) authoritative accounting guidance on segment reporting, the Company has one operating segment and reportable segment. The Company is in one line of business, which is the manufacture and distribution of vehicle propulsion solutions.
Business Combinations
The Company uses the acquisition method to account for business combinations. The assets acquired and liabilities assumed are recorded at their respective estimated fair value at the date of acquisition. Any excess purchase price over the fair values of the acquired net assets is recorded as goodwill. Determining the fair values of assets acquired and liabilities assumed requires management's judgment and includes the use of estimates with respect to timing and amount of future cash flows, market rate assumptions, actuarial assumptions, appropriate discount rates and other relevant factors.
Cash and Cash Equivalents
Cash equivalents are defined as short-term, highly-liquid investments with original maturities of 90 days or less. Under the Company’s cash management system, checks issued but not presented to banks may result in book overdraft balances for accounting purposes and are classified within Accounts payable in the Consolidated Balance Sheets. The change in book overdrafts is reported as a component of operating cash flows for Accounts payable.
Marketable Securities
The Company determines the appropriate classification of all marketable securities as “held-to-maturity,” “available-for-sale” or “trading” at the time of purchase and re-evaluates such classifications as of each balance sheet date. As of December 31, 2020, and 2019, the Company’s marketable securities were classified as trading.
Trading securities are carried at fair value with the unrealized gain or loss recognized in Other (expense) income, net. The fair value of the Company’s investment securities is determined by currently available market prices. See NOTE 7, “Fair Value of Financial Instruments” for more details.
Inventories
Inventories are stated at the lower of cost and net realizable value. The Company determines cost using the first-in, first-out method. The Company analyzes inventory on a quarterly basis to determine whether it is excess or obsolete inventory. Any decline in carrying value of estimated excess or obsolete inventory is recorded as a reduction of inventory and as an expense included in Cost of sales in the period it is identified.
Property, Plant and Equipment
Property, plant and equipment are recorded at cost less accumulated depreciation. Depreciation expense is recorded using the straight-line method over the following estimated lives:
Range in Years
Land improvements 5 – 30
Buildings and building improvements 10 – 40
Machinery and equipment 2 – 20
Software 2 – 5
Special tooling 2 – 10
Software represents the costs of software developed or obtained for internal use. Software costs are amortized on a straight-line basis over their estimated useful lives. Software assets are reviewed for impairment
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when events or circumstances indicate that the carrying value may not be recoverable over the remaining lives of the assets. Upgrades and enhancements are capitalized if they result in added functionality, which enables the software to perform tasks it was previously incapable of performing. Software maintenance, training, data conversion and business process reengineering costs are expensed in the period in which they are incurred.
Special tooling represents the costs to design and develop tools, dies, jigs and other items owned by the Company and used in the manufacture of components by suppliers under long-term supply agreements. Special tooling is depreciated over the tool’s expected life. Special tooling used in the development of new technology is expensed as incurred. Engineering, testing and other costs incurred in the design and development of production parts are expensed as incurred.
Impairment of Long-Lived Assets
The carrying value of long-lived assets is evaluated whenever events or circumstances indicate that the carrying value of an asset may not be recoverable. Events or circumstances that would result in an impairment review primarily include a significant change in the use of an asset or the planned sale or disposal of an asset. The asset would be considered impaired when there is no future use planned for the asset or the future net undiscounted cash flows generated by the asset or asset group are less than its carrying value. An impairment loss would be recognized based on the amount by which the carrying value exceeds fair value.
Assumptions and estimates used to determine cash flows in the evaluation of impairment and the fair values used to determine the impairment are subject to a degree of judgment and complexity. Any changes to the assumptions and estimates resulting from changes in actual results or market conditions from those anticipated may affect the carrying value of long-lived assets and could result in an impairment charge.
Goodwill and Other Intangible Assets
Goodwill represents the excess of purchase price paid over the fair value of net assets acquired. In accordance with the FASB’s authoritative accounting guidance on goodwill, the Company does not amortize goodwill but rather evaluates it for impairment on an annual basis, or more often if events or circumstances change that could cause goodwill to become impaired. Goodwill is tested for impairment at the reporting unit level, which is the same as the Company’s one operating and reportable segment. The Company does not aggregate any components into its reporting unit. The Company has elected to perform its annual goodwill impairment test on October 31 of every year using a multi-step impairment test. In Step 0, the Company has the option to evaluate various qualitative factors to determine the likelihood of impairment. If determined that the fair value is more likely than not less than the carrying value, then the Company is required to perform Step 1. If the Company does not elect to perform Step 0, it can voluntarily proceed directly to Step 1. In Step 1, the Company performs a quantitative analysis to compare the fair value of its reporting unit to its carrying value including goodwill. If the fair value of the reporting unit exceeds the carrying value of the net assets assigned to that unit, goodwill is not considered impaired, and the Company is not required to perform further testing. If the carrying value of a reporting unit’s goodwill exceeds its carrying value of net assets, then the Company would record an impairment loss equal to the difference.
Goodwill impairment testing for 2020 was performed using the Step 1 quantitative analysis. The fair value was determined utilizing a discounted cash flow model which includes key assumptions, such as net sales growth derived from market information, industry reports, marketing programs and certain growth initiatives; operating margin improvements derived from cost reduction programs and fixed cost leverage driven by higher sales volumes; and a risk-adjusted discount rate. Events or circumstances that could unfavorably impact the key assumptions include lower net sales driven by market conditions, our inability to execute on marketing programs and/or growth initiatives, lower gross margins as a result of market conditions or failure to obtain forecasted cost reductions, or a higher discount rate as a result of market conditions. While unpredictable and inherently uncertain, the Company believes the forecast estimates were reasonable and incorporate assumptions that similar market
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participants would use in their estimates of fair value. Refer to NOTE 6, “Goodwill and Other Intangible Assets” for further information.
Other intangible assets have both indefinite and finite useful lives. Intangible assets with indefinite useful lives, such as the Allison Transmission trade name and in-process research and development, are not amortized but are tested annually for impairment, or more often if events or circumstances change that could cause intangible assets with indefinite useful lives to become impaired. The Company has elected to perform its annual indefinite lived intangible assets impairment test on October 31 of every year and follow a similar multi-step impairment test to that performed on goodwill. Events or circumstances that could unfavorably impact the key assumptions include lower net sales driven by market conditions, the Company's inability to execute on growth strategies or marketing programs, delay in introduction of new products and higher discount rate as a result of market conditions. While unpredictable and inherently uncertain, the Company believes the forecast estimates are reasonable and incorporate those assumptions that similar market participants would use in their estimates of fair value. After reviewing various qualitative factors, the Company’s annual 2020 indefinite lived intangible assets impairment test indicated that the fair value of the Company’s indefinite lived intangible assets more likely than not exceeded their carrying value, indicating no impairment. Refer to NOTE 6, “Goodwill and Other Intangible Assets” for further information.
Intangible assets with finite lives are amortized over their estimated useful lives and reviewed for impairment when circumstances change that would create a triggering event. Customer relationships are amortized over the life in which expected benefits are to be consumed. The other remaining finite life intangibles are amortized on a straight-line basis over their useful lives. The Company evaluates the remaining useful life of the other intangible assets on a periodic basis to determine whether events or circumstances warrant a revision to the remaining useful life. Assumptions and estimates about future values and remaining useful lives of the Company’s intangible and other long-lived assets are complex and subjective. Such assumptions and estimates can be affected by a variety of factors, including external factors such as industry and economic trends, and internal factors, such as changes in the Company’s business strategy and internal forecasts. Although management believes the historical assumptions and estimates are reasonable and appropriate, different assumptions and estimates could materially impact the Company’s reported financial results. Refer to NOTE 6 “Goodwill and Other Intangible Assets” for further information.
Deferred Financing Costs
The debt issuance costs related to line-of-credit arrangements is presented as a component of other non-current assets. The debt issuance costs related to other types of debt instruments such as notes and loans are presented as a component of long-term debt. Deferred financing costs continue to be amortized over the life of the related debt using the effective interest method. Amortization of deferred financing costs is recorded as part of interest expense and totaled $4 million, $5 million and $6 million for the years ended December 31, 2020, 2019 and 2018, respectively.
Financial Instruments
The Company’s cash equivalents are invested in U.S. government backed securities and recorded at fair value in the Consolidated Balance Sheets. The carrying values of accounts receivable and accounts payable approximate fair value due to their short-term nature. The Company’s financial derivative instruments, including interest rate swaps, are carried at fair value on the Consolidated Balance Sheets. Refer to NOTE 7, “Fair Value of Financial Instruments” for more detail. The Company’s long-term debt obligations are carried at historical amounts with the Company providing fair value disclosure in NOTE 8, “Debt”.
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Insurable Liabilities
The Company records liabilities for its medical, workers’ compensation, long-term disability, product, general and auto liabilities. The determination of these liabilities and related expenses is dependent on claims experience. For most of these liabilities, claims incurred but not yet reported are estimated based upon historical claims experience.
Revenue Recognition
The Company records sales as each distinct performance obligation within a contract is satisfied. The Company sells extended transmission coverage (“ETC”) for which sales are deferred. ETC sales are recognized ratably over the period of coverage, which typically ranges from one to five years after the standard warranty coverage ends. Costs associated with ETC programs are recorded as incurred during the extended period. Distributor and customer sales incentives, consisting of allowances and other rebates, are recorded as a reduction to Net sales when it is determined that the adjustment is not likely to reverse, historically on a quarterly basis. Incentive programs are generally product specific or region specific. Some factors used in estimating when an adjustment is not likely to reverse are the number of transmissions that will be affected by the incentive program and rate of acceptance of any incentive program.
Sales under U.S. government production contracts are recognized at the point in time when control passes to the customer, or when the U.S. government accepts the transmission and is able to direct its use in certain bill-and-hold arrangements. Deferred revenue arises from cash received in advance of the culmination of the earnings process and is recognized as revenue in future periods when the applicable revenue recognition criteria have been met. Under the terms of previous U.S. government contracts, there were certain price reduction clauses and provisions for potential price reductions which were estimated at the time of sale based upon the Company’s history and experience and were recorded as a reduction to Net sales. Potential reductions may be attributed to a change in projected sales volumes or plant efficiencies which impact overall costs. The Company had $56 million recorded in the price reduction reserve account as of each of December 31, 2020 and 2019.
The Company engages in licensing agreements with certain third parties for the use of the Company’s intellectual property. Deferred revenue arises from cash received in advance of the period of use of the intellectual property. Revenue is recognized over the license period as it is earned.
The Company classifies shipping and handling billed to customers in Net sales and shipping and handling costs in Cost of sales, in accordance with authoritative accounting guidance.
The Company contracts with various third parties to provide engineering services. These services are recorded as Net sales in accordance with the terms of the contract. The saleable engineering recorded was $16 million, $11 million and $3 million for the years ended December 31, 2020, 2019 and 2018, respectively. The associated costs are recorded in Cost of sales.
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Warranty
Provisions for estimated expenses related to product warranties are made at the time products are sold. Warranty claims arise when a transmission or propulsion solution manufactured by us fails while in service during the relevant warranty period. The warranty reserve is adjusted in Selling, general and administrative expense based on the Company’s current and historical warranty claims paid and associated repair costs. These estimates are established using historical information including the nature, frequency, and average cost of warranty claims and are adjusted as actual information becomes available. From time to time, the Company may initiate a specific field action program. As a result of the uncertainty surrounding the nature and frequency of specific field action programs, the liability for such programs is recorded when the Company commits to an action. The Company reviews and assesses the liability for these programs on a quarterly basis. The Company also assesses its ability to recover certain costs from its suppliers and records a receivable from the supplier when it believes a recovery is probable. Warranty costs may differ from those estimated if actual claim rates are higher or lower than the Company's historical rates.
Research and Development
The Company incurs costs in connection with research and development programs that are expected to contribute to future earnings. Such costs are charged to Engineering — research and development as incurred.
Environmental
The Company accrues costs related to environmental matters when it is probable that the Company has incurred a liability related to a contaminated site and the costs can be reasonably estimated. For additional information, see NOTE 18, “Commitments and Contingencies”.
Foreign Currency Translation
Most of the Company’s subsidiaries outside the United States prepare financial statements in currencies other than the U.S. Dollar. The functional currency for all of these subsidiaries is the local currency, except for the Company’s Hong Kong and Middle East subsidiaries which currently use the U.S. Dollar as their functional currency. Balances are translated at period-end exchange rates for assets and liabilities and monthly weighted-average exchange rates for revenues and expenses. The translation gains and losses are stated as a component of Accumulated Other Comprehensive Loss (“AOCL”) as disclosed in NOTE 17, “Accumulated Other Comprehensive Loss”.
Derivative Instruments
In the normal course of business, the Company is exposed to fluctuations in interest rates, foreign currency exchange rates, and commodity prices. The risk is managed through the use of financial derivative instruments, when appropriate. The Company has qualified for and elected hedge accounting treatment on interest rate swap contracts. As necessary, the Company adjusts the values of the derivative instruments for counter-party or credit risk. NOTE 9, “Derivatives” provides further information on the accounting treatment of the Company’s derivative instruments.
Income Taxes
Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the expected future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. The future tax benefits associated with operating loss and tax credit carryforwards are recognized as deferred tax assets. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in
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which those temporary differences are expected to be recovered or settled.When releasing income tax effects from accumulated other comprehensive loss the Company utilizes the portfolio securities approach.