ITEM 1A. RISK FACTORS
The following “risk factors” could materially and adversely affect Valvoline’s business, operations, financial position or future financial performance. This information should be considered when reading the rest of this Annual Report on Form 10-K, including Management’s Discussion and Analysis and the consolidated financial statements and related notes. These factors could cause future results to differ from those in forward-looking statements and from historical trends.
Risks related to the industries in which Valvoline operates
Because of the concentration of Valvoline’s sales to a small number of retailers, the loss of one or more, or a significant reduction in orders from, its top retail customers could adversely affect its financial results, as could the loss of one of its distributor relationships.
Valvoline’s Core North America segment’s sales represented approximately 40% of Valvoline’s total sales in fiscal 2020. Five key retailers together accounted for 49% of Core North America’s fiscal 2020 sales and 45% of the Company’s outstanding trade accounts receivable as of September 30, 2020. One of these key retailers accounted for greater than 19% of Core North America’s fiscal 2020 sales. Valvoline’s volume of sales to these customers fluctuates and can be influenced by many factors, including product pricing, competition for shelf space, purchasing patterns and promotional activities. For example, Valvoline’s retail customers have increasingly shifted shelf distribution towards private label lubricant products, which has negatively impacted Core North America’s retail channel DIY branded lubricant sales. Additionally, many of Valvoline’s retail customers have changed their promotional strategies, increasing the frequency and number of brands promoted at any given time, including private label, which has further negatively impacted branded lubricant sales within the retail channel. In response to these market dynamics, Valvoline has strengthened its consumer messaging, optimized pricing in relation to these promotional strategies and focused its efforts on increasing synthetic lubricant sales; however, if those strategies are not effective, or if Valvoline is unable to adapt to changing market dynamics, Valvoline’s results of operations could be negatively affected. The loss of, or significant reduction in orders from, one of Valvoline’s top five retail customers or any other significant customer could have a material adverse effect on its business, financial condition, results of operations or cash flows, as could customer disputes regarding shipments, fees, merchandise condition or related matters. Valvoline’s inability to collect accounts receivable from one of its major customers, or a significant deterioration in the financial condition of one of these customers, including a bankruptcy filing or a liquidation, could also have a material adverse effect on Valvoline’s financial condition, results of operations or cash flows.
Valvoline also relies on independent distributors to sell and deliver its products. The consolidation of distributors, loss of a relationship with a distributor, significant disagreement with a distributor, or significant deterioration in the financial condition of a distributor could also have a material adverse effect on Valvoline’s financial condition, results of operations or cash flows.
Valvoline faces significant competition from other companies, which places downward pressure on prices and margins and may adversely affect Valvoline’s business and results of operations.
Valvoline operates in highly competitive markets, competing against a number of domestic and international companies. Competition is based on several key criteria, including brand recognition, product performance and quality, product price, product availability and security of supply, ability to develop products in cooperation with customers and customer service, as well as the ability to bring innovative products or services to the marketplace. Certain key competitors, including Shell/Pennzoil, BP/Castrol and Exxon/Mobil, are significantly larger than Valvoline and have greater financial resources and more diverse portfolios of products and services, leading to greater operating and financial flexibility. As a result, these competitors may be better able to withstand adverse changes in conditions within the relevant industry, retail market dynamics, the prices of raw materials and energy or general economic conditions. In addition, competitors’ pricing decisions could compel Valvoline to decrease its prices, which could negatively affect Valvoline’s margins and profitability. Valvoline continues to see increasing competition from private label competitors, which has negatively impacted branded lubricant sales in the retail channel as price gaps between private label and branded products has grown. Further competition from private label competitors, including the entry of new private label competitors, or additional competition in markets served by Valvoline, could adversely affect margins and profitability and could lead to a reduction in market share. Also, Valvoline competes in certain markets that are relatively flat to declining, such as the U.S. passenger car motor oil
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market. If Valvoline’s strategies for dealing with these markets and leveraging market opportunities are not successful, its results of operations could be negatively affected.
Rising and volatile raw material costs and supply-chain constraints or disruptions could adversely affect Valvoline’s results of operations.
Rising and volatile raw material prices, especially for base oil and lubricant additives, have in the past and may in the future, negatively impact Valvoline’s costs, results of operations and the valuation of its inventory. Valvoline may not always be able to raise prices in response to increased costs of raw materials or may experience a lag in passing through such cost increases, as the ability to pass on the costs of such price increases is largely dependent upon market conditions. Likewise, reductions in the valuation of Valvoline’s inventory due to market volatility may not be recovered and could result in losses.
Valvoline purchases certain products and raw materials from suppliers, often pursuant to written supply contracts. If those suppliers are unable to meet Valvoline’s orders in a timely manner or choose to terminate or otherwise avoid contractual arrangements, Valvoline may not be able to make alternative supply arrangements or may face increased costs from alternative suppliers. For base oils, Valvoline’s suppliers are primarily large oil producers, many of whom operate oil lubricant production and sales businesses as part of their enterprise. There are risks inherent in obtaining important raw materials from actual or potential competitors, including the risk that applicable antitrust laws may be inadequate to mitigate Valvoline’s exposure to these risks. Valvoline purchases substantially all of its lubricant additives from four key suppliers.Because the industry is characterized by a limited number of lubricant additives suppliers, there are a limited number of alternative suppliers with whom Valvoline could transact in the event of a disruption to its existing supply relationships; for example, due to disruptions to its suppliers' operations caused by natural disasters, severe weather conditions, climate change or significant changes in trade regulations. The inability of Valvoline’s suppliers to meet its supply demands could also have a material adverse effect on its business.
Also, domestic and global government regulations related to the manufacture or transport of certain raw materials may impede Valvoline’s ability to obtain those raw materials on commercially reasonable terms. If Valvoline is unable to obtain and retain qualified suppliers under commercially acceptable terms, its ability to manufacture and deliver products in a timely, competitive and profitable manner or grow its business successfully could be adversely affected.
Demand for Valvoline’s products and services could be adversely affected by consumer spending trends, declining economic conditions, industry trends and a number of other factors, all of which are beyond its control.
Demand for Valvoline’s products and services may be affected by a number of factors it cannot control, including the number and age of vehicles in current service, regulation and legislation, technological advances in the automotive industry and changes in engine technology, including the adoption rate of electric or other alternative engine technologies, changing automotive OEM specifications and longer recommended intervals between oil changes. In addition, during periods of declining economic conditions, consumers may defer vehicle maintenance. Similarly, increases in energy prices or other factors may cause miles driven to decline, resulting in less vehicle wear and tear and lower demand for maintenance, which may lead to consumers deferring purchases of Valvoline’s products and services. All of these factors, which impact metrics such as drain intervals and oil changes per day, could result in a decline in the demand for Valvoline’s products and services and adversely affect its sales, cash flows and overall financial condition.
Failure to develop and market new products, services and production technologies could impact Valvoline’s competitive position and have an adverse effect on its business and results of operations.
The lubricants industry is subject to periodic technological change and ongoing product improvements. To maintain margins and remain competitive, Valvoline must successfully innovate and introduce new products, improvements or services that appeal to its customers and ultimately to global consumers. Changes in additive technologies, base oil production techniques and sources, and the demand for improved performance by OEMs and consumers place particular pressure on Valvoline to continue to improve its product offerings. In addition, the adoption of electric vehicles is increasing and is expected to increase at a faster pace in future years as certain states and international governments implement limits on the sale of vehicles with internal combustion engines, which reduces demand for lubricants, but expands the opportunity for other products and services required by electric vehicles, including
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coolants, fluids and greases. If Valvoline is unable to develop and market products and services for electric vehicles, its business and results of operations could be adversely impacted. Further, Valvoline’s efforts to respond to changes in consumer demand in a timely and cost-efficient manner to drive growth could be adversely affected by difficulties or delays in product development and service innovation, including the inability to identify viable new products, successfully complete research and development, obtain regulatory approvals, obtain intellectual property protection or gain market acceptance of new products or service techniques. Due to the lengthy development process, technological challenges and intense competition, there can be no assurance that any of the products or services Valvoline is currently developing, or could develop in the future, will achieve substantial commercial success. The time and expense invested in product development may not result in commercial products or provide revenues. Valvoline could be required to write-off its investments related to a new product that does not reach commercial viability. Moreover, Valvoline may experience operating losses after new products are introduced and commercialized because of high start-up costs, unexpected manufacturing costs or problems, or lack of demand.
Damage to Valvoline’s brand and reputation could have an adverse effect on its business.
Maintaining Valvoline’s strong reputation with both consumers and customers is a key component of its business. Product liability claims, false advertising claims, product or service complaints or recalls, its inability to ship, sell or transport affected products and governmental investigations could result in substantial and unexpected expenditures and affect consumer or customer confidence in Valvoline's products and services, which may materially and adversely affect its business operations, decrease sales and increase costs.
Valvoline manufactures and markets a variety of products, such as automotive and industrial lubricants and automotive coolants and chemicals, and provides automotive maintenance services. If allegations are made that some of Valvoline’s products have failed to perform up to consumers’ or customers’ expectations or have caused damage or injury to individuals or property, or that Valvoline’s services were not provided in a manner consistent with its vision and values, the public may develop a negative perception of Valvoline and its brands. In addition, if Valvoline’s franchisees, Express Care and joint venture operators experience service failures or do not successfully operate their quick lube service centers in a manner consistent with Valvoline’s standards, its brand, image and reputation could be harmed, which in turn could negatively impact its business and operating results. In addition, if any party with whom Valvoline has a sponsorship relationship were to generate negative publicity, Valvoline's brand image could be harmed. A negative public perception of Valvoline’s brands, whether justified or not, could impair its reputation, involve it in litigation, damage its brand equity and have a material adverse effect on its business. In addition, damage to the reputation of Valvoline’s competitors or others in its industry could negatively impact Valvoline’s reputation and business.
Risks related to executing Valvoline’s strategy
Valvoline has set aggressive growth goals for its business, including increasing sales, cash flow, market share, margins and number of Quick Lubes stores, to achieve its long-term strategic objectives. Execution of Valvoline’s growth strategies and business plans to facilitate that growth involves a number of risks.
Valvoline has set aggressive growth goals for its business to meet its long-term strategic objectives and improve shareholder value by aggressively growing Quick Lubes organically and through acquisitions, maintaining Core North America and developing International with the goal of becoming a more service-driven business. Valvoline’s failure to meet one or more of these goals or objectives could negatively impact its business and is one of the most important risks that Valvoline faces. Aspects of that risk include, among others, changes to the global economy, failure to identify acquisition targets or real estate for new stores to grow Quick Lubes, construction costs or delays limiting new store growth, failure to develop products or services for electric vehicles, changes to the competitive landscape, including those related to automotive maintenance recommendations and consumer preferences, continued private label growth, entry of new competitors, failure to grow the Valvoline brand internationally, attraction and retention of skilled employees, failure to successfully develop and implement digital platforms to support the Company’s growth initiatives, the potential failure of product innovation plans, failure to comply with existing or new regulatory requirements, failure to maintain a competitive cost structure and other risks outlined in greater detail in this “Risk Factors” section.
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Valvoline may be unable to execute its growth strategy, and acquisitions, joint ventures, strategic alliances and investments could result in operating difficulties, dilution and other harmful consequences that may adversely impact Valvoline’s business and results of operations.
Acquisitions, particularly for the Quick Lubes business segment, are an important element of Valvoline’s overall growth strategy. In addition, building strategic alliances for distribution and manufacturing, particularly in international markets, including through joint venture partnerships, product distribution and toll manufacturing arrangements, are also an important element of Valvoline’s overall growth strategy. Valvoline expects to continue to evaluate and enter into discussions regarding a wide array of potential strategic transactions, and to continue to grow its Quick Lubes business organically and through acquisitions. An inability to execute these plans could have a material adverse impact on Valvoline’s financial condition and results of operations. In addition, the anticipated benefits of Valvoline’s acquisitions may not be realized and the process of integrating an acquired company, business, or product may create unforeseen operating difficulties or expenditures.
Valvoline’s acquisitions, investments and strategic alliances could also result in dilutive issuances of its equity securities, the incurrence of debt, contingent liabilities or amortization expenses, impairment of goodwill or purchased long-lived assets and restructuring charges, any of which could harm its financial condition, results of operations and cash flows.
The business model for Valvoline’s Quick Lubes business, including its relationships with franchisees, presents a number of risks.
The Quick Lubes business is made up of an international network of both company-owned and franchised stores. Valvoline’s success relies in part on the financial success and cooperation of its franchisees. However, Valvoline has limited influence over their operations. Valvoline’s franchisees manage their businesses independently and are responsible for the day-to-day operations of approximately 60% of Quick Lube system stores as of September 30, 2020. Valvoline’s royalty and other payments from franchised stores are largely dependent on franchisee sales. Valvoline’s franchisees may have limited or no sales growth, and Valvoline’s revenues and margins could be negatively affected as a result. In addition, if sales or business performance trends worsen for franchisees, their financial results may deteriorate, which could result in, among other things, store closures, delayed or reduced royalty payments to Valvoline and reduced growth in the number of Quick Lube stores.
Valvoline’s success also depends on the willingness and ability of its independent franchisees to implement major initiatives, which may require additional investment by them, and remain aligned with Valvoline on operating, promotional and capital-intensive reinvestment plans. The ability of Valvoline’s franchisees to contribute to the achievement of Valvoline’s overall plans is dependent in large part on the availability of funding to its franchisees at reasonable interest rates and may be negatively impacted by the financial markets in general or the creditworthiness of individual franchisees. The size of Valvoline’s largest franchisees creates additional risk due to their importance to Quick Lube's growth strategy, requiring their cooperation and alignment with Valvoline’s initiatives.
Valvoline is the primary supplier of products to all Quick Lube stores. The growth and performance of Valvoline’s lubricants and other product lines depends in large part on the performance of its Quick Lubes business, potentially amplifying the negative effect of the other risks related to the Quick Lubes business model.
Valvoline shares in ownership of joint ventures, which may limit its ability to manage third-party risks associated with these projects.
For financial or strategic reasons, Valvoline conducts a portion of its business through joint ventures. Joint ventures, particularly Valvoline’s existing 50/50 joint ventures with Cummins in India, China and Argentina, are an important part of its growth strategy internationally. In these joint ventures, Valvoline shares influence over the operation of the joint venture and its assets, but does not have a controlling interest or vote. Therefore, joint ventures may involve risks such as the possibility that a joint venture partner in an investment might become bankrupt, be unable to meet its capital contribution obligations, have economic or business interests or goals that are inconsistent with Valvoline's business interests or goals, or take actions that are contrary to Valvoline's direction or to applicable laws and regulations. If Valvoline’s relationship with one of its joint venture partners were to deteriorate, it could negatively impact Valvoline’s ability to achieve its growth goals internationally. In addition, joint venture partners could take actions binding on the joint venture without Valvoline's consent, or Valvoline may be unable to take action without the concurrence of its joint venture partners. Consequently, actions by the joint venture, joint venture partner
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or other third-party could expose Valvoline to claims for damages, financial penalties and reputational harm, any of which could have an adverse effect on its business and operations. Although joint ventures may generate positive cash flow, in some cases they may be unable or unwilling to distribute that cash to the joint venture partners.
Risks related to operating Valvoline's business
Valvoline’s significant global operations subject it to risks, which could adversely affect its business, financial condition and results of operations.
Sales from the International business segment accounted for 22% of Valvoline’s sales for fiscal 2020 and Valvoline expects sales from international markets to grow in the future. Also, Valvoline has multiple manufacturing locations outside of the United States, which will increase as Valvoline's new blending and packaging plant in China begins production, expected in fiscal 2021. Accordingly, its business is subject to risks related to the differing legal, political, cultural, social and regulatory requirements and economic conditions of many jurisdictions.
The global nature of Valvoline’s business presents difficulties in hiring and maintaining a workforce in certain countries. Fluctuations in exchange rates may affect product demand and may adversely affect the profitability in U.S. dollars of products and services provided in other countries. In addition, other countries may impose additional withholding taxes or otherwise tax Valvoline’s income, or adopt other restrictions on trade or investment, including currency exchange controls. The imposition of new or additional tariffs or other significant changes in trade regulations are also risks that could impair Valvoline’s financial performance. If Valvoline is subject to new or additional tariffs, operating costs could increase and Valvoline may not be able to recapture those costs.
Certain legal and political risks are also inherent in the operation of a company with Valvoline’s global scope. For example, it may be more difficult for Valvoline to enforce its agreements or collect receivables through other legal systems. There is a risk that non-U.S. governments may nationalize private enterprises in certain countries where Valvoline operates. Social and cultural standards in certain countries may not support compliance with Valvoline’s corporate policies including those that require compliance with substantive laws and regulations. Also, changes in general economic and political conditions in countries where Valvoline operates are a risk to Valvoline’s financial performance and future growth. As Valvoline continues to operate its business globally, its success will depend, in part, on its ability to anticipate and effectively manage these and other related risks. There can be no assurance that the consequences of these and other factors relating to Valvoline’s global operations will not have an adverse effect on its business, financial condition or results of operations.
Adverse developments in the global economy or in regional economies and potential disruptions of financial markets could negatively impact Valvoline’s customers and suppliers, and therefore have a negative impact on its results of operations.
A global or regional economic downturn may reduce customer demand or inhibit Valvoline’s ability to produce and sell products. Valvoline’s business and operating results are sensitive to global and regional economic downturns, credit market tightness, declining consumer and business confidence, fluctuating commodity prices, volatile exchange rates, changes in interest rates, sovereign debt defaults and other challenges, including those related to international sanctions and acts of aggression or threatened aggression that can affect the global economy. With 78% of Valvoline’s sales coming from North America in fiscal 2020, Valvoline is particularly sensitive to the risk of an economic slowdown or downturn in that region. In the event of adverse developments or stagnation in the economy or financial markets, Valvoline’s customers may experience deterioration of their businesses, reduced demand for their products, cash flow shortages and difficulty obtaining financing. As a result, existing or potential customers might delay or cancel plans to purchase products and may not be able to fulfill their obligations to Valvoline in a timely fashion. Further, suppliers may experience similar conditions, which could impact their ability to fulfill their obligations to Valvoline. A weakening or reversal of the global economy or a substantial part of it could negatively impact Valvoline’s business, results of operations, financial condition and ability to grow.
Pandemics, epidemics or disease outbreaks, such as the novel coronavirus, may disrupt Valvoline’s business and operations, which could materially affect Valvoline’s financial condition, results of operations and forward-looking expectations.
Disruptions caused by pandemics, epidemics or disease outbreaks, such as COVID-19, in the United States or globally, could materially affect Valvoline's results of operations, financial condition and forward-looking expectations. The COVID-19 pandemic negatively impacted Valvoline's business and results of operations during
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fiscal 2020 and adverse impacts are expected to continue in future periods, which Valvoline is unable to reasonably predict due to numerous uncertainties, including the duration and severity of the pandemic.
Specifically, COVID-19 lockdowns and stay-at-home guidelines significantly impacted miles driven in most of Valvoline’s key markets in fiscal 2020 resulting in lower lubricant volumes across Valvoline's reportable segments. In addition, Valvoline may voluntarily elect or be required to temporarily close or reduce operations at its Quick Lubes' service center stores, lubricant blending and packaging plants or remove its employees and personnel from the field for their protection. COVID-19 has also had a negative impact on Valvoline’s franchisees. Certain franchises reduced hours or temporarily closed at the discretion of the respective independent operator. The failure of one or more franchisees would have an adverse impact on Valvoline’s business due to their impact on Valvoline's growth, financial and operating performance.
In fiscal 2020, the Company restricted all non-essential travel and implemented work-from-home protocols for employees in virtually all locations globally, other than those in Valvoline's retail service center stores, production and distribution facilities, and those restrictions have largely continued into fiscal 2021. The suspension of travel and doing business in-person could negatively impact the Company's marketing efforts, challenge the ability to enter into customer contracts in a timely manner, or create operational or other challenges, any of which could harm Valvoline's business. During the COVID-19 pandemic, Valvoline also has seen an increase in attempts to breach its information technology systems with the implementation of work-from-home protocols, including cyber-security threats such as phishing, spam emails, hacking, social engineering, and malicious software, increasing the risks associated with a breach of or failure of Valvoline’s information technology systems.
These impacts and any additional developments as a result of COVID-19, or other pandemics, epidemics or disease outbreaks have had adverse impacts on Valvoline's business and results of operations and may continue to adversely affect Valvoline’s business, results of operations, liquidity, financial condition, and forward-looking expectations, particularly if these impacts continue for an extended period of time. The extent to which the spread of COVID-19 impacts Valvoline’s business will depend on future developments, which are highly uncertain and cannot be predicted, including new information which may emerge concerning the duration and the severity of the spread of COVID-19 and the actions to contain the virus or treat its impact, among others. These events, if they continue to grow in scope, intensify in severity or are sustained for a longer period of time may materially adversely affect Valvoline’s ability to implement its growth plans, including, without limitation, delay construction or acquisition of new Quick Lubes service center stores or negatively impact Valvoline’s ability to successfully execute plans to enter into new markets; reduce demand for Valvoline’s products and services; cause Valvoline to experience inefficiencies in the supply chain, including but not limited to, the delivery of products and services to Valvoline’s customers, receipt of raw materials from suppliers or increased costs of raw materials; reduce sales or profitability; negatively impact Valvoline’s ability to maintain operations; or lead to significant disruption of global financial markets, which may reduce the Company’s ability to access capital and, in the future, negatively affect the Company’s liquidity.
Valvoline uses information technology systems to conduct business, and a cyber security threat, privacy/data breach, or failure of a key information technology system could adversely affect Valvoline’s business and reputation.
Valvoline relies on its information technology systems, including systems which are managed or provided by third-party service providers, to conduct its business. Despite employee training and other measures to mitigate them, cyber-security threats to its information technology systems, and those of its third-party service providers, are increasing and becoming more advanced and breaches could occur as a result of denial-of-service attacks or other cyber-attacks, hacking, phishing, viruses, malicious software, ransomware, computer malware, social engineering, break-ins, security breaches or due to error or misconduct by its employees, contractors or third-party service providers. A breach of or failure of Valvoline’s information technology systems could lead to the loss and destruction of trade secrets, confidential information, proprietary data, intellectual property, customer and supplier data, and employee personal information, and could disrupt business operations which could adversely affect Valvoline’s relationships with business partners and harm its brands, reputation and financial results. Valvoline’s customer data may include names, addresses, phone numbers, email addresses and payment account information, among other information. Depending on the nature of the customer data that is compromised, Valvoline may also have obligations to notify users, law enforcement or payment companies about the incident and may need to provide some form of remedy, such as refunds for the individuals affected by the incident. Valvoline could also face fines and penalties should it fail to adequately notify affected parties pursuant to new and evolving privacy laws in various jurisdictions in which it does business.
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Business disruptions from natural, operational and other catastrophic risks could seriously harm Valvoline’s operations and financial performance. In addition, a catastrophic event at one of Valvoline’s facilities or involving its products or employees could lead to liabilities that could further impair its operations and financial performance.
Business disruptions, including those related to operating hazards inherent in the production of lubricants, natural disasters, severe weather conditions, climate change, supply or logistics disruptions, increasing costs for energy, temporary plant and/or power outages, information technology systems and network disruptions, cyber-security breaches, terrorist attacks, armed conflicts, war, pandemic diseases, fires, floods or other catastrophic events, could seriously harm Valvoline’s operations, as well as the operations of Valvoline’s customers and suppliers, and may adversely impact Valvoline’s financial performance. Although it is impossible to predict the occurrence or consequences of any such events, they could result in reduced demand for Valvoline’s products; make it difficult or impossible for Valvoline to manufacture its products, deliver products and services to its customers, or receive raw materials from suppliers; lead to increased costs of raw materials; or create delays and inefficiencies in the supply chain. In addition to leading to a serious disruption of Valvoline’s businesses, a catastrophic event at one of Valvoline’s facilities or involving its products or employees could lead to substantial legal liability to or claims by parties allegedly harmed by the event.
While Valvoline maintains business continuity plans that are intended to allow it to continue operations or mitigate the effects of events that could disrupt its business, Valvoline cannot provide assurances that its plans would fully protect it from all such events. In addition, insurance maintained by Valvoline to protect against property damage, loss of business and other related consequences resulting from catastrophic events is subject to significant retentions and coverage limitations, depending on the nature of the risk insured. This insurance may not be sufficient to cover all of Valvoline’s damages or damages to others in the event of a catastrophe. In addition, insurance related to these types of risks may not be available now or, if available, may not be available in the future at commercially reasonable rates.
Regulatory, legal, and financial risks
Data protection requirements could increase operating costs and requirements and a breach in information privacy or other related risks could negatively impact operations.
Valvoline is subject to federal, state, and non-U.S. laws, directives, and regulations relating to the collection, use, retention, disclosure, security and transfer of personal data relating to its customers and employees. These laws, directives and regulations, and their interpretation and enforcement continue to evolve and may be inconsistent from jurisdiction to jurisdiction. For example, the General Data Protection Regulation (“GDPR”), applies to all of Valvoline’s activities conducted from an establishment in the European Union ("EU") and may also apply to related products and services that Valvoline offers to customers in the EU. Complying with the GDPR and similar emerging and changing privacy and data protection requirements may cause Valvoline to incur substantial costs. Noncompliance with these legal obligations relating to privacy and data protection could result in penalties, legal proceedings by governmental entities or others, and significant legal and financial exposure and could affect its ability to retain and attract customers. Any failure or perceived failure by Valvoline or any third parties with which it does business to comply with these laws, rules and regulations, or with other obligations to which Valvoline may be or become subject, may result in actions against Valvoline by governmental entities, private claims and litigation, fines, penalties or other liabilities. Any such action would be expensive to defend, damage Valvoline’s reputation and adversely affect business, operating results, financial position and cash flows.
The impact of changing laws or regulations or the manner of interpretation or enforcement of existing laws or regulations could adversely impact Valvoline’s financial performance and restrict its ability to operate its business or execute its strategies.
New laws or regulations, or changes in existing laws or regulations or the manner of their interpretation or enforcement, could increase Valvoline’s cost of doing business and restrict its ability to operate its business or execute its strategies. This risk includes, among other things, compliance with a myriad of U.S. and non-U.S. tax laws and regulations; anti-competition laws and regulations; product compliance regulations, including the EU’s Registration, Evaluation, Authorisation and Restriction of Chemicals (“REACH”) regulation; anti-corruption and anti-bribery laws, including FCPA and the U.K. Bribery Act; anti-money-laundering laws; economic sanctions and export control laws and regulations, including those administered by the U.S. Treasury Department’s Office of Foreign Assets Control (“OFAC”); customs laws; and other laws governing Valvoline’s operations.
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Although Valvoline has implemented policies and procedures to ensure compliance with these laws and regulations, it cannot be sure that its policies and procedures are sufficient or that directors, officers, employees, representatives, distributors, consultants and agents have not engaged and will not engage in conduct for which Valvoline may be held responsible, nor can Valvoline be sure that its business partners have not engaged and will not engage in conduct that could materially affect their ability to perform their contractual obligations to Valvoline or even result in its being held liable for such conduct. Violations of the these laws or regulations may result in severe criminal or civil sanctions or penalties, or significant changes in existing laws and regulations may subject Valvoline to other liabilities, which could have a material adverse effect on its business, financial condition, cash flows and results of operations.
Valvoline’s substantial indebtedness may adversely affect its business, results of operations and financial condition.
Valvoline has substantial indebtedness and financial obligations. As of September 30, 2020, Valvoline had outstanding indebtedness of approximately $2.0 billion, with a borrowing capacity remaining under its existing credit facilities of $548 million. Valvoline may incur substantial additional debt from time to time to finance working capital, capital expenditures, investments or acquisitions, or for other general corporate purposes.
Valvoline's substantial indebtedness could adversely affect its business, results of operations and financial condition by, among other things: requiring Valvoline to dedicate a substantial portion of its cash flows to pay principal and interest on its debt, which would reduce the availability of its cash flow to fund working capital, capital expenditures, acquisitions, execution of its growth strategy and other general corporate purposes; limiting Valvoline’s ability to borrow additional amounts to fund working capital, capital expenditures, acquisitions, debt service requirements, execution of its growth strategy and other general corporate purposes; making Valvoline more vulnerable to adverse changes in general economic, industry and regulatory conditions and in its business by limiting its flexibility in planning for or reacting to changing conditions; placing Valvoline at a competitive disadvantage compared with its competitors that have less debt and lower debt service requirements; making Valvoline more vulnerable to increases in interest rates since some of its indebtedness is subject to variable rates of interest; and making it more difficult for Valvoline to satisfy its financial obligations.
In addition, Valvoline may not be able to generate sufficient cash flows to repay its indebtedness when it becomes due and to meet its other cash needs. If Valvoline is not able to pay its debts as they become due, it could be in default under the terms of its indebtedness. Valvoline might also be required to pursue one or more alternative strategies to repay indebtedness, such as selling assets, refinancing or restructuring its indebtedness or selling additional debt or equity securities. Valvoline may not be able to refinance its debt or sell additional debt or equity securities or its assets on favorable terms, if at all, and if it must sell its assets, it may negatively affect Valvoline’s ability to generate revenues.
Valvoline’s pension and other postretirement benefit plan obligations are currently underfunded, and Valvoline may have to make significant cash payments to some or all of these plans, which would reduce the cash available for its business.
In connection with Valvoline’s separation from Ashland, Valvoline assumed certain of Ashland’s historical pension and other postretirement benefit plans and related liabilities. The most significant of these plans, the U.S. qualified pension plans, are estimated to be underfunded by $158 million as of September 30, 2020. The funded status of Valvoline's pension plans is dependent upon many factors, including returns on invested assets, the level of certain market interest rates and the discount rate used to determine pension obligations. Valvoline has taken a number of actions to reduce the risk and volatility associated with the U.S. pension plans, however, changing market conditions or laws and regulations could require material increases in the expected cash contributions to these plans in future years. Specifically, unfavorable returns on plan assets or unfavorable changes in applicable laws or regulations could materially change the timing and amount of required plan funding. In addition, a decrease in the discount rate used to determine pension obligations could result in an increase in the valuation of pension obligations, which could affect the reported funded status of Valvoline’s U.S. pension plans and future contributions. Similarly, an increase in discount rates could increase the periodic pension cost in subsequent fiscal years. If any of these events occur, Valvoline may have to make significant cash payments to its U.S. pension plans, which would reduce the cash available for its business. Finally, Valvoline’s policy to recognize changes in the fair value of the pension assets and liabilities annually and as otherwise required through mark to market accounting could result in volatility in Valvoline’s earnings, which could be material.
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Valvoline may fail to adequately protect its intellectual property rights or may be accused of infringing the intellectual property rights of third parties.
Valvoline relies heavily upon its trademarks, domain names and logos, as well as upon trade secrets, to market its brands and to build and maintain brand loyalty and recognition. Valvoline also relies on a combination of laws and contractual restrictions with employees, customers, suppliers, affiliates and others, to establish and protect its various intellectual property rights. For example, Valvoline has generally registered and continues to register and renew, or secure by contract where appropriate, trademarks and service marks as they are developed and used, and reserve, register and renew domain names as appropriate. Effective trademark protection may not be available or may not be sought in every country in which Valvoline’s products are made available and contractual disputes may affect the use of marks governed by private contract. Similarly, not every variation of a domain name may be available to or be registered by Valvoline, even if available.
Valvoline generally seeks to apply for patents or for other similar statutory protections as and if it deems appropriate, based on then-current facts and circumstances, and will continue to do so in the future. No assurances can be given that any patent application Valvoline has filed or will file will result in a patent being issued, or that any existing or future patents will afford adequate or meaningful protection against competitors or against similar technologies. In addition, no assurances can be given that third parties will not create new products or methods that achieve similar results without infringing upon patents Valvoline owns. Furthermore, the terms of patents are finite and the patents that Valvoline owns will eventually expire after the statutory term of patent protection ends in the jurisdiction where such patents are issued.
Despite these measures, Valvoline’s intellectual property rights may still not be protected in a meaningful manner, challenges to contractual rights could arise and third parties could copy or otherwise obtain and use Valvoline’s intellectual property without authorization, including its trade secrets and other confidential intellectual property. The occurrence of any of these events could result in the erosion of Valvoline’s brands and limit its ability to market its brands using its various trademarks, cause Valvoline to lose such trade secrets, as well as impede its ability to effectively compete against competitors with similar products and services, any of which could adversely affect its business, financial condition and results of operations.
From time to time, Valvoline has been subject to legal proceedings and claims, including claims of alleged infringement of trademarks, copyrights, patents and other intellectual property rights held by third parties. In the future, third parties may sue Valvoline for alleged infringement of their proprietary or intellectual property rights. Valvoline may not be aware of whether its products do or will infringe existing or future patents or other intellectual property rights of others. In addition, litigation may be necessary to enforce Valvoline’s intellectual property rights, protect its trade secrets or determine the validity and scope of proprietary rights claimed by others. Any litigation or other intellectual property proceedings of this nature, regardless of outcome or merit, could result in substantial costs and diversion of management and technical resources, or loss of rights in Valvoline’s intellectual property, any of which could adversely affect Valvoline’s business, financial condition and results of operations.
Valvoline has incurred, and will continue to incur, costs as a result of EHS and hazardous substances liabilities and related compliance requirements. These costs could adversely impact Valvoline’s cash flow, its results of operations or financial condition.
Valvoline is subject to extensive federal, state, local and non-U.S. laws, regulations, rules and ordinances relating to pollution, protection of the environment and human health and safety, as well as the generation, storage, handling, treatment, disposal and remediation of hazardous substances and waste materials. Valvoline has incurred, and will continue to incur, costs and capital expenditures to comply with these laws and regulations.
EHS regulations change frequently, and such regulations and their enforcement have tended to become more stringent over time. Accordingly, changes in EHS laws and regulations and the enforcement of such laws and regulations could interrupt Valvoline’s operations, require modifications to its facilities or cause it to incur significant liabilities, costs or losses that could adversely affect its profitability. Actual or alleged violations of EHS laws and regulations could result in restrictions or prohibitions on plant operations as well as substantial damages, penalties, fines, civil or criminal sanctions and remediation costs.
Valvoline’s business involves the production, storage and transportation of hazardous substances. Under some environmental laws, Valvoline may be strictly liable and/or jointly and severally liable for environmental damages
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caused by releases of hazardous substances and waste materials into the environment. For instance, under relevant laws and regulations Valvoline may be deemed liable for soil and/or groundwater contamination at sites it currently owns and/or operates even though the contamination was caused by a third party such as a former owner or operator, and at sites it formerly owned and operated if the release of hazardous substances or waste materials was caused by it or by a third party during the period it owned and/or operated the site. Valvoline also may be deemed liable for soil and/or groundwater contamination at sites to which it sent hazardous wastes for treatment or disposal, notwithstanding that the original treatment or disposal activity accorded with all applicable regulatory requirements.
Risks related to Valvoline’s separation from Ashland
The Distribution could result in significant tax liability to Ashland, and in certain circumstances, Valvoline could be required to indemnify Ashland for material taxes pursuant to indemnification obligations.
Ashland obtained a written opinion of counsel to the effect that the Distribution should qualify for non-recognition of gain and loss under Section 355 of the Internal Revenue Code of 1986, as amended (the “Code”). The opinion of counsel does not address any U.S. state, local or non-U.S. tax consequences of the Distribution. The opinion assumes that the Distribution is completed according to the terms of the Separation Agreement and relies on the facts as described in the Separation Agreement, the Tax Matters Agreement, other ancillary agreements, the information statement distributed to Ashland’s shareholders in connection with the Distribution and a number of other documents. In addition, the opinion is based on certain representations as to factual matters from, and certain covenants by, Ashland and Valvoline. The opinion cannot be relied on if any of the assumptions, representations or covenants is incorrect, incomplete or inaccurate or is violated in any material respect.
The opinion of counsel is not binding on the Internal Revenue Service (the “IRS”) or the courts, and thus there can be no assurance that the IRS or a court will not take a contrary position. Ashland has not requested, and to the best of Valvoline's knowledge does not intend to request, a ruling from the IRS regarding the U.S. federal income tax consequences of the Distribution.
If the Distribution were determined not to qualify for non-recognition of gain and loss, then Ashland would recognize a gain as if it had sold its Valvoline common stock in a taxable transaction in an amount up to the fair market value of the common stock it distributed in the Distribution. In addition, certain reorganization transactions undertaken in connection with the separation and the Distribution could be determined to be taxable, which could result in additional taxable gain. Under certain circumstances set forth in the Tax Matters Agreement, Valvoline could have a substantial indemnification obligation to Ashland with respect to the tax associated with some or all of such gain, which could have a material adverse impact on Valvoline's financial condition.
Valvoline will have joint and several liability with Ashland for the consolidated U.S. federal income taxes of the Ashland consolidated group for the taxable periods in which Valvoline was part of the Ashland consolidated group. In addition, Valvoline has agreed to indemnify Ashland for certain pre-IPO U.S. taxes that arise on audit and are directly attributable to neither the Valvoline business nor Ashland’s specialty ingredients and performance materials businesses (collectively, the “Chemicals business”).
Valvoline and Ashland as well as their respective subsidiaries were part of U.S. federal consolidated group tax returns and certain combined or similar group tax returns (together, “Combined Tax Returns”) through the date of the Distribution. Therefore, Valvoline has joint and several liability with Ashland to the respective taxing authorities for the Combined Tax Returns for the periods up to and including the date of the Distribution.
Pursuant to the Tax Matters Agreement, Valvoline is required to indemnify Ashland for: (a) certain U.S. federal, state or local taxes of Ashland and/or its subsidiaries for any tax period ending on or prior to the (i) Distribution that arise on audit or examination and are directly attributable to Valvoline or (ii) IPO that arise on audit or examination and are directly attributable to neither the Valvoline business nor the Chemicals business; and (b) certain non-U.S. taxes of Ashland and/or its subsidiaries for any tax period ending on or prior to the Distribution that arise on audit or examination and are directly attributable to Valvoline. This indemnification obligation could be material if Ashland receives a material tax assessment for pre-IPO tax periods, several of which are currently under IRS audit.
The Tax Matters Agreement also requires Valvoline to indemnify Ashland for any taxes (and reasonable expenses) resulting from the failure of the Distribution to qualify for non-recognition of gain and loss or certain reorganization transactions related to the separation or the IPO and Distribution to qualify for their intended tax treatment
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(“Transaction Taxes”), where the taxes result from: (1) breaches of representations or covenants that Valvoline made or agreed to in connection with these transactions, (2) the application of certain provisions of U.S. federal income tax law to the Distribution with respect to acquisitions of Valvoline common stock or (3) any other actions that Valvoline knows or reasonably should expect would give rise to such taxes.
The Tax Matters Agreement also requires Valvoline to indemnify Ashland for a portion of certain other taxes arising from the separation allocated to Valvoline generally based on Valvoline’s market capitalization relative to the market capitalization of Ashland at the time of the Distribution.
Valvoline’s inability to resolve favorably any disputes that arise between Valvoline and Ashland with respect to their past relationship may adversely affect its operating results.
Disputes may arise between Ashland and Valvoline in a number of areas relating to their past relationship, including labor; tax; employee benefits, including pension liabilities; indemnification; services provided to one another; and other matters arising from Valvoline’s separation from Ashland. Valvoline may not be able to resolve disputes with Ashland, and even if it does, the resolution may not be favorable and could adversely affect Valvoline’s operating results.
Ashland has agreed to indemnify Valvoline for certain liabilities. However, there can be no assurance that the indemnity will be sufficient to insure Valvoline against the full amount of such liabilities, or that Ashland’s ability to satisfy its indemnification obligation will not be impaired in the future.
Pursuant to the terms of the Separation Agreement entered into between Ashland and Valvoline (the “Separation Agreement”) and certain other agreements with Ashland, Ashland agreed to indemnify Valvoline for certain liabilities. However, third parties could also seek to hold Valvoline responsible for any of the liabilities that Ashland agreed to retain, and there can be no assurance that the indemnity from Ashland will be sufficient to protect Valvoline against the full amount of such liabilities, or that Ashland will be able to fully satisfy its indemnification obligations in the future. Even if Valvoline ultimately succeeded in recovering from Ashland any amounts for which Valvoline is held liable, Valvoline may be temporarily required to bear these losses. Each of these risks could negatively affect Valvoline’s business, financial position, results of operations and cash flows.
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ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2. PROPERTIES
Valvoline is headquartered in Lexington, Kentucky, where the Company leases and owns over 230,000 square feet of office, research and development and warehouse space to support operations across its reportable segments. Valvoline owns and leases several additional facilities throughout North America, Europe, Australia, and Asia that comprise nearly 4 million square feet of blending, warehouse, research and development and office space. In addition, Valvoline owns or leases the property associated with 584 company-owned quick-lube service center stores under the Valvoline Instant Oil ChangeSM and Valvoline Great Canadian Oil Change brands throughout the United States and Canada, respectively. The properties leased by Valvoline generally have expiration dates ranging from less than one year to more than 20 years, with certain renewal options available.
In addition, Valvoline contracts with third parties to provide blending, packaging, warehousing and distribution services. Valvoline believes its physical properties are suitable and adequate for the Company’s business, and none of the property owned by Valvoline is subject to any major known encumbrances. Additional information regarding lease obligations may be found in Note 3 of the Notes to Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K.
ITEM 3. LEGAL PROCEEDINGS
From time to time, Valvoline is party to lawsuits, claims and other legal proceedings that arise in the ordinary course of business. For a description of Valvoline's legal proceedings, refer to Note 12 of the Notes to Consolidated Financial Statements in Item 8 of Part II 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
Valvoline common stock is listed on the NYSE and trades under the symbol “VVV.” Prior to September 23, 2016, the pricing date of the IPO, there was no public market for Valvoline’s common stock.
As of November 17, 2020, there were approximately 9,600 registered holders of Valvoline common stock.
Dividend policy
Valvoline expects to continue to pay quarterly cash dividends to the holders of its common stock; however, the declaration and payment of dividends to holders of Valvoline common stock will be at the discretion of Valvoline's Board of Directors (the "Board") in accordance with applicable law after taking into account various factors, including Valvoline’s financial condition, operating results, current and anticipated cash needs, cash flows, impact on Valvoline’s effective tax rate, indebtedness, legal requirements and other factors that the Board considers relevant. In addition, the instruments governing Valvoline’s indebtedness may limit its ability to pay dividends. Therefore, no assurance is given that Valvoline will pay any dividends to its stockholders, or as to the amount of any such dividends if the Board determines to do so.
Stock performance graph
The following graph compares the cumulative total stockholder return on a $100 investment in Valvoline common stock, the S&P MidCap 400 Index, and the S&P MidCap 400 Consumer Staples Index for the period from September 23, 2016 (the date Valvoline common stock commenced trading) to September 30, 2020. This graph assumes an investment in the Valvoline common stock and each index were $100 on September 23, 2016 and that all dividends were reinvested.
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Purchases of Company common stock
The Companydid not repurchase any shares of its common stock during the three months ended September 30, 2020 pursuant to the Board authorization on January 31, 2018 to repurchase up to $300 million of common stock through September 30, 2020. This authorization expired on September 30, 2020.
On November 12, 2020, Valvoline's Board of Directors authorized the repurchase of up to $100 million of the Company's common stock through September 30, 2021. The timing and amount of any share repurchases will be based on the level of Valvoline's liquidity, general business and market conditions and other factors, including alternative investment opportunities.
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ITEM 6. SELECTED FINANCIAL DATA
Valvoline Inc. and Consolidated Subsidiaries
Five-Year Selected Financial Information (a) (b)
For the years ended September 30
Summary of operations
Common stock information
Cash flow information
Less: Additions to property, plant and equipment (151) (108) (93) (68) (66)
Plus: Discretionary contributions to pension plans — — — 394 —
As of September 30
Balance sheet information
For the years ended September 30
Other financial and operational data
Company-owned same-store sales growth (f) 2.6 % 9.7 % 8.7 % 7.0 % 6.2 %
Franchised same-store sales growth (f) (g) 2.1 % 10.4 % 8.0 % 7.5 % 8.0 %
Combined same-store sales growth (f) (g) 2.3 % 10.1 % 8.3 % 7.4 % 7.5 %
(a)At the beginning of fiscal 2020, Valvoline adopted the new lease accounting standard using the optional transitional approach as of October 1, 2019. Refer to Notes 2 and 3 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for details regarding the impact of adoption.
(b)At the beginning of fiscal 2019, Valvoline adopted the new revenue recognition accounting standard using the modified retrospective method to those contracts that were not completed as of October 1, 2018. Accordingly, the new revenue recognition guidance was applied prospectively from the date of adoption, while prior period financial statements are reported in accordance with the previous guidance. The cumulative effect of the changes at adoption was recognized through an increase to stockholders' deficit of $13 million, net of tax.
(c)Net income includes the impact of immediately recognizing actuarial gains and losses for defined benefit pension and other postretirement plan remeasurements. Valvoline recognized the following pre-tax remeasurements: a gain of $22 million in fiscal 2020, a loss of $69 million in fiscal 2019, a loss of $38 million in fiscal 2018, a gain of $68 million in fiscal 2017, and a gain of $18 million in fiscal 2016. Net income also includes the impact of the enactment of U.S. and Kentucky tax reform legislation, which resulted in an income tax benefit of $5 million in fiscal 2019 and income tax expense of $78 million in fiscal 2018.
(d)The weighted average common shares outstanding for the year ended September 30, 2016 are based on the 170 million shares issued to Ashland in the Contribution.
(e)In addition to cash flows from operating activities determined in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP"), Valvoline uses free cash flow as a non-GAAP metric of cash flow generation. By deducting capital
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expenditures from operating cash flows and adding discretionary contributions to pension plans, the Company is able to provide an indication of the ongoing cash being generated that is ultimately available for both debt and equity holders as well as other investment opportunities. Unlike cash flow from operating activities, free cash flow includes the impact of capital expenditures, providing a supplemental view of cash generation. Free cash flow has certain limitations, including that it does not reflect adjustments for certain non-discretionary cash flows, such as mandatory debt repayments. The amount of mandatory versus discretionary expenditures can vary significantly between periods. Valvoline’s results of operations are presented based on its management structure and internal accounting practices. The structure and practices are specific to Valvoline; therefore, its financial results and free cash flow are not necessarily comparable with similar information for other comparable companies. Free cash flow has limitations as an analytical tool and should not be considered in isolation from, or as an alternative to, or more meaningful than, cash flows provided by operating activities as determined in accordance with U.S. GAAP. In evaluating free cash flow, be aware that in the future Valvoline may have expenditures similar to those for which adjustments are made in calculating free cash flow. Valvoline’s presentation of free cash flow should not be construed as a basis to infer that its future results will be unaffected by unusual or nonrecurring items. Because of these limitations, one should rely primarily on cash flows provided by operating activities as determined in accordance with U.S. GAAP and use free cash flow only as a supplement.
(f)Valvoline determines same-store sales growth on a fiscal year basis, with new stores excluded from the metric until the completion of their first full fiscal year in operation. Refer to "Key Business Measures" in Item 7 of Part II of this Annual Report on Form 10-K for a description of management's use and determination of key metrics, including same-store sales.
(g)Valvoline franchisees are distinct legal entities and Valvoline does not consolidate the results of operations of its franchisees.
(h)In addition to net income determined in accordance with U.S. GAAP, Valvoline evaluates operating performance using certain non-GAAP measures including Earnings before interest, taxes, depreciation and amortization (“EBITDA”), which management defines as net income/loss, plus income tax expense/benefit, net interest and other financing expenses, and depreciation and amortization; and Adjusted EBITDA, which Valvoline defines as EBITDA adjusted for key items and net pension and other postretirement plan income/expense. Key items consist of income or expenses associated with certain unusual, infrequent or non-operational income or expenses not directly attributable to the underlying business, which management believes impacts the comparability of operational results between periods and are also often related to legacy matters or market-driven events that are not directly related to the underlying business and do not have an immediate, corresponding impact on the Company’s ongoing performance. Key items may consist of adjustments related to: the impairment of an equity investment; legacy businesses, including the separation from Ashland and associated impacts of related indemnities; significant acquisitions or divestitures, restructuring-related matters, and other matters that are non-operational or unusual in nature. Net pension and other postretirement plan income/expense includes several elements impacted by changes in plan assets and obligations that are primarily driven by changes in the debt and equity markets, as well as those that are predominantly legacy in nature and related to prior service to the Company from employees (e.g., retirees, former employees, current employees with frozen benefits). These elements include (i) interest cost, (ii) expected return on plan assets, (iii) actuarial gains/losses, and (iv) amortization of prior service cost/credit. Significant factors that can contribute to changes in these elements include changes in discount rates used to remeasure pension and other postretirement obligations on an annual basis or upon a qualifying remeasurement, differences between actual and expected returns on plan assets, and other changes in actuarial assumptions, such as the life expectancy of plan participants. Accordingly, management considers that these elements are more reflective of changes in current conditions in global financial markets (in particular, interest rates) and are outside the operational performance of the business and are also primarily legacy amounts that are not directly related to the underlying business and do not have an immediate, corresponding impact on the compensation and benefits provided to eligible employees for current service. Adjusted EBITDA includes pension and other postretirement service costs related to current employee service as well as the costs of other benefits provided to employees for current service.
Valvoline believes the use of non-GAAP measures assists investors in understanding the ongoing operating performance of its business by presenting comparable financial results between periods. The non-GAAP information provided is used by management and may not be comparable to similar measures disclosed by other companies, because of differing methods used by other companies in calculating EBITDA and Adjusted EBITDA. EBITDA and Adjusted EBITDA provide a supplemental presentation of Valvoline’s operating performance.
EBITDA and Adjusted EBITDA each have limitations as analytical tools and should not be considered in isolation from, or as an alternative to, or more meaningful than, net income as determined in accordance with U.S. GAAP. Because of these limitations, one should rely primarily on net income as determined in accordance with U.S. GAAP and use EBITDA and Adjusted EBITDA only as supplements. In evaluating EBITDA and Adjusted EBITDA, one should be aware that in the future Valvoline may experience activity similar to that for which adjustments were made in calculating EBITDA and Adjusted EBITDA. Valvoline’s presentation of EBITDA and Adjusted EBITDA should not be construed as a basis to infer that future results will be unaffected by unusual or nonrecurring items.
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The following table reconciles net income to EBITDA and Adjusted EBITDA for the periods presented:
For the years ended September 30
Net interest and other financing expenses 93 73 63 42 9
Net pension and other postretirement plan (income) expenses (59) 60 — (138) (35)
Net legacy and separation-related (income) expenses (a) (30) 3 14 11 6
Compensated absences benefits change (a) (11) — — — —
Business interruption (recovery) expenses (a) (2) 6 — — —
Acquisition and divestiture-related costs (income) (b) 2 (4) 3 — 1
Restructuring and related expenses (a) — 14 — — —
(a)These (income) expense amounts were included in operating income in the respective years ended September 30.
(b)Acquisition and divestiture-related costs (income) were included in operating income in each year presented, other than in fiscal 2016 when reported below operating income.
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Business Overview 33
Results of Operations - Consolidated Review 39
Results of Operations - Reportable Segment Review 42
Financial Position, Liquidity and Capital Resources 46
Off-Balance Sheet Arrangements 51
New Accounting Pronouncements 51
Critical Accounting Policies 51
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with the consolidated financial statements and the accompanying Notes to Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K.
BUSINESS OVERVIEW
Valvoline is a worldwide marketer and supplier of engine and automotive maintenance products and services. Established in 1866, Valvoline’s heritage spans over 150 years, during which it has developed powerful name recognition across multiple product and service channels. In addition to the iconic Valvoline-branded passenger car motor oils and other automotive lubricant products, Valvoline provides a wide array of lubricants used in heavy duty equipment, as well as automotive chemicals and fluids designed to improve engine performance and lifespan. Valvoline’s premium branded product offerings enhance its high-quality reputation and provide customers with solutions that address a wide variety of needs.
In the United States and Canada, Valvoline’s products and services are sold to retailers with over 55,000 retail outlets, to installer customers with approximately 15,000 locations, and through 1,462 franchised and company-owned stores. Valvoline also has a strong international presence with products sold in more than 140 countries. Valvoline serves its customer base through its sales force and technical support organization, allowing Valvoline to leverage its technology portfolio and customer relationships globally, while meeting customer demands locally. This combination of scale and strong local presence is critical to the Company’s success.
Valvoline's fiscal year ends on September 30 of each year and Valvoline has three reportable segments: Quick Lubes, Core North America, and International, with certain corporate and non-operational items included in Unallocated and Other to reconcile to consolidated results. Refer to Item 1 included in Part I of this Annual Report on Form 10-K for a description of Valvoline's reportable segments.
RECENT DEVELOPMENTS
The outbreak of COVID-19 was concentrated in China in late January 2020 and spread quickly, resulting in the World Health Organization declaring a global pandemic on March 11, 2020. COVID-19 has created significant volatility in the global economy and led to reduced economic activity. There have been extraordinary actions taken by international, federal, state, and local public health and governmental authorities to contain and combat the spread of COVID-19 in most regions throughout the world, including restricting non-essential travel, quarantines, “stay-at-home” orders, and similar mandates for many individuals to substantially restrict daily activities and for many businesses to modify or cease normal operations to minimize personal interaction and contact. While certain regions began to relax restrictions beginning in March, a resurgence in cases has led to reinstated limitations across the globe. The duration and extent of restrictions that will remain in place currently remains unclear.
The COVID-19 pandemic led to significant economic disruption which impacted Valvoline's business and results during the fiscal year ended September 30, 2020. Management cannot reasonably quantify the financial impacts on full year results; however, believes that the pandemic resulted in an overall immaterial unfavorable impact to earnings. The most substantial negative effects were estimated to have occurred during the third fiscal quarter of
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2020 when restrictions were the most severe and miles driven and volumes significantly declined. The Company also experienced certain benefits in its costs, some of which is believed to have been prolonged due to or as a result of the pandemic and coupled with the recovery in miles driven, which remain behind prior year trends, is estimated to have minimized the severity of the impact on fiscal 2020 results. While the Company cannot predict the duration or the scale of the COVID-19 pandemic or the effect it may continue to have on Valvoline's business, results of operations, or liquidity, it is important to share the impact to-date, how the Company's response is progressing and how Valvoline's results and financial condition could be impacted going forward.
Retail and Manufacturing Operations
As automotive maintenance has generally been deemed essential business during the pandemic, Valvoline has substantially maintained its operations and continued to serve its customers to help engines run and keep vehicles reliably on the road. Valvoline’s wholly-owned lubricant blending and packaging plants and Quick Lubes retail service center stores have substantially remained open and operational during the pandemic. Over 98% of Valvoline's system-wide service center stores have remained open during the pandemic to-date. The Company remains committed to operating safely and keeping as many of its stores open as possible for the communities they serve.
Short-term incremental pay and benefit programs, including additional paid sick leave and increased pay rates for hourly and salaried store employees were introduced in Quick Lubes to recognize team members who continued to service customers throughout pandemic. In response to the abrupt decline in miles driven due to COVID-19 restrictions and the resulting significant volume and sales declines in the second half of March and continuing through late April, Valvoline responded quickly by flexing store labor at company-owned retail service center stores and adjusting shifts across its lubricant blending and packaging plants and throughout its distribution networks. In China, construction on the lubricants plant resumed after a temporary suspension and was recently completed.
Remote Work Arrangements
Valvoline took global actions designed to help further prevent the spread of COVID-19, including implementing work-from-home arrangements. Beginning March 18, 2020, employees, other than those in Valvoline's retail service center stores, production and distribution facilities, began working remotely in nearly all locations globally, except China where work-from-home protocols were implemented earlier and substantially ended in March. These remote work arrangements remain in place and have been designed to allow for continued operation of certain business-critical functions, including financial reporting systems and internal control, which have incorporated remote work arrangements using appropriate digital tools.
Valvoline is continually monitoring the global COVID-19 situation and following the White House Guidelines supported by COVID-19 trend data to make decisions regarding the reopening of corporate offices. Valvoline has developed a set of criteria and guidelines that will be used in returning to the office to ensure the safety and well- being of the Company's employees, including social distancing, enhanced cleaning procedures and availability of personal protective equipment. All return-to-office decisions will be made based on the COVID-19 trends in the countries, states and locations where the Company's offices are located.
Liquidity
Valvoline's revenues are primarily generated from the sale and service delivery of engine and automotive maintenance products to its customers. Accordingly, declines in miles driven as a result of a reduction in the ability or willingness to travel due to the COVID-19 pandemic has and is expected to continue to adversely impact Valvoline's volumes and results of operations. Miles driven were significantly lower due to the COVID-19 pandemic, which is estimated to have impacted most of Valvoline's key markets by late March 2020 and continued during most of April 2020, with trends steadily improving throughout the remainder of the fiscal year but still below pre-COVID-19 levels. While management believes Valvoline has sufficient liquidity to meet its operating cash needs, required pension and other postretirement plan contributions, debt servicing obligations, and tax-related and other contractual commitments for the next twelve months, certain precautionary steps were taken as outlined herein to strengthen the Company's cash position in response to the COVID-19 pandemic.
As a precautionary measure to enhance financial flexibility in response to the uncertainty resulting from the COVID-19 pandemic, the Company borrowed under its revolving and trade receivables facilities to increase its cash balance by $540 million in late March. The Company subsequently paid its revolving facility borrowings in May 2020
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with the net proceeds from the offering of $400 million senior notes due 2025 and cash and cash equivalents on hand. As of September 30, 2020, Valvoline had $760 million in cash and cash equivalents available for working capital, general corporate purposes, or other purposes permitted under its borrowing facilities. Further, Valvoline temporarily suspended its share repurchase program and took other steps to preserve cash, including limiting or deferring certain non-essential operating expenses and delaying certain capital expenditures, while continuing to invest in high-return, long-term strategic growth initiatives. Since drawing on its credit facilities in March, the Company has maintained its liquidity and generated positive cash flows from operations during the year ended September 30, 2020.
As of September 30, 2020, the Company has access to more than $1.3 billion in total liquidity, with no meaningful maturities of its outstanding borrowings until 2024.
COVID-19 Relief
On March 27, 2020, the U.S. federal government enacted the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”). Among other provisions, the CARES Act includes forms of payroll and income tax relief for corporations. The Company continues to examine the impacts the CARES Act may have on its business and consolidated financial statements and continues to expect modest cash flow benefits in fiscal 2020 and 2021 related to the deferred payment of certain employer payroll-related taxes and accelerated tax deductions. Additionally, other non-U.S. governments are providing various forms of COVID-19 relief, which Valvoline is monitoring and evaluating to determine whether the Company may qualify for additional benefits. The CARES Act and other global COVID-19 relief efforts did not have a material impact on the Company's consolidated financial statements for the year ended September 30, 2020, though modest cash flow and profitability benefits were realized related to the deferred payment of certain employer payroll-related taxes, non-US subsidies received, and expanded tax deductions related to bonus depreciation.
Enhanced Safety Standards
Valvoline's priority remains the health and safety of its employees, customers and business partners. Quick Lubes' drive-through, stay-in-your-car service experience previously produced minimal contact with customers, and the Company took additional actions to modify in-store procedures to further reduce contact between store teams and customers. Procedures in Valvoline's plants, service center stores and offices have also been modified to encourage social distancing and proper handwashing, increase cleaning cycles, adjust labor and shifts, and provide personal protective equipment. Valvoline has taken actions designed to help further prevent the spread of COVID-19, including restricting travel and implementing broad work-from-home protocols, in addition to following government regulations in each of its locations.
Franchisee Support
Valvoline is providing its franchisees with flexibility to respond to the evolving circumstances of the COVID-19 pandemic. Certain franchisees elected to reduce store operating hours or temporarily close some stores in order to better align to local changes in demand. Additionally, other operational changes were made to in-store operating procedures, enhancing the safe operating environment already afforded through Valvoline's stay-in-your-car service experience. Valvoline's franchises were provided access to detailed information on stimulus-related provisions and federal employee assistance programs that may be utilized to provide financial relief.
Valvoline also provided various types of financial assistance to support the long-term health of its Quick Lubes franchisee network, including low-interest term loans, waiving royalties for one-and-a-half months, and the temporary extension of payment terms to provide increased financial flexibility and enable franchisees to better support their employees and customers as a result of the impact of the COVID-19 pandemic. These actions have not and are not expected to have an impact on Valvoline's ability to meet its cash needs in the ordinary course, or to comply with the covenants under its debt obligations.
COVID-19 Support
Valvoline made contributions to relief and response funds in the U.S. and China and donated personal protective equipment in China, India and the U.S. Valvoline's support also extended to its customers, as orders were supplied and delivered with the same on-time metrics through no-contact deliveries, and in some cases, extended payment terms were permitted. Valvoline provided benefits to its employees to cover the cost of COVID-19 testing, promoted
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its telehealth benefits, amended its 401(k) savings plan to enhance hardship loan eligibility and payment terms, and provided additional paid sick leave for quarantined employees.
FISCAL 2020 OVERVIEW
The following were the significant events for fiscal 2020, each of which is discussed more fully in this Annual Report on Form 10-K:
•The durability of the Valvoline business model was reflected in the Company’s rapid improvement from the significant headwinds during depths of the COVID-19 pandemic, leading to strong year-over-year growth in profitability. For the full year, net income increased $109 million to $317 million, while diluted earnings per share of $1.69 increased $0.59 versus the prior year.
•Quick Lubes sales grew 7% to $883 million in fiscal 2020 with system-wide same-store sales growth of 2.3% year-over-year, the 14th consecutive year of same-store sales growth. System-wide same-store sales in the fourth fiscal quarter grew 8.3%, returning to pre-COVID-19 growth rates. This growth was driven by average ticket and transaction growth attributable to favorable premium mix, increased revenue from non-oil change services, new customer acquisition and strong in-store execution of the Company's safety-focused, stay-in-your-car service model. The Quick Lubes system added 77 net new stores in fiscal 2020, including 36 newly-built company-owned service center stores.
•Core North America operating income increased by 33% from the prior year and was driven by favorable channel and product mix, lower raw material costs and benefits from the cost savings program that began in fiscal 2019. Improved unit margins combined with expense reductions implemented during the early stages of the COVID-19 pandemic offset lower volume from the installer customer channel.
•International sales and volume decreased due to impacts from COVID-19 across all regions, particularly in Latin America. Volume in unconsolidated joint ventures also declined due to pandemic impacts, particularly in India, which was partially offset by growth in the China joint venture.
•The Company completed two issuances of senior unsecured notes during the year ended September 30, 2020 with $600 million issued in February 2020 and $400 million issued in May 2020. Net proceeds from the two issuances, as well as cash and cash equivalents, were used to redeem $375 million of senior unsecured notes due in 2024 and pay an early redemption premium of $15 million, to prepay $100 million of its term loan, and repay $450 million under its senior secured revolving credit facility.
•During fiscal 2020, Valvoline returned $144 million of capital to shareholders through dividends and share repurchases.
Results for Fiscal 2019 compared to Fiscal 2018
For comparisons of Valvoline's consolidated and segment results of operations and consolidated cash flows for the fiscal years ended September 30, 2019 to September 30, 2018, refer Item 7 of Part II of the Annual Report on Form 10-K for the fiscal year ended September 30, 2019, filed with the SEC on November 22, 2019.
Use of Non-GAAP Measures
To aid in the understanding of Valvoline’s ongoing business performance, certain items within this document are presented on an adjusted, non-GAAP basis. These non-GAAP measures are not defined within U.S. GAAP and do not purport to be alternatives to net income/loss or cash flows from operating activities as measures of operating performance or cash flows. The following are the non-GAAP measures management has included and how management defines them:
•EBITDA, which management defines as net income/loss, plus income tax expense/benefit, net interest and other financing expenses, and depreciation and amortization;
•Adjusted EBITDA, which management defines as EBITDA adjusted for key items, as further described below, and net pension and other postretirement plan expense/income; and
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•Free cash flow, which management defines as operating cash flows less capital expenditures and certain other adjustments as applicable.
These measures are not prepared in accordance with U.S. GAAP and management believes the use of non-GAAP measures assists investors in understanding the ongoing operating performance of Valvoline’s business by presenting comparable financial results between periods. The non-GAAP information provided is used by Valvoline’s management and may not be comparable to similar measures disclosed by other companies, because of differing methods used by other companies in calculating EBITDA, Adjusted EBITDA and free cash flow. EBITDA, Adjusted EBITDA, and free cash flow provide a supplemental presentation of Valvoline’s operating performance. For a reconciliation of non-GAAP measures, refer to the “Results of Operations” and “Financial Position, Liquidity and Capital Resources” sections below.
Due to depreciable assets associated with the nature of the Company’s operations and interest costs related to Valvoline’s capital structure, management believes EBITDA is an important supplemental measure to evaluate the Company’s operating results between periods on a comparable basis.
Management also believes Adjusted EBITDA provides investors with a meaningful supplemental presentation of Valvoline’s operating performance. Adjusted EBITDA excludes the impact of the following:
•Key items - Key items consist of income or expenses associated with certain unusual, infrequent or non-operational income or expenses not directly attributable to the underlying business, which management believes impacts the comparability of operational results between periods. Key items may consist of adjustments related to: the impairment of an equity investment; legacy businesses, including the separation from Ashland and associated impacts of related indemnities; significant acquisitions or divestitures; restructuring-related matters; and other matters that are non-operational or unusual in nature. Key items are considered by management to be outside the comparable operational performance of the business and are also often related to legacy matters or market-driven events that are not directly related to the underlying business and do not have an immediate, corresponding impact on the Company’s ongoing performance. Details with respect to the composition of key items recognized during the respective periods presented herein are set forth below in the “EBITDA and Adjusted EBITDA” section of “Results of Operations” that follows.
•Net pension and other postretirement plan expense/income - Net pension and other postretirement plan expense/income includes several elements impacted by changes in plan assets and obligations that are primarily driven by changes in the debt and equity markets, as well as those that are predominantly legacy in nature and related to prior service to the Company from employees (e.g., retirees, former employees, current employees with frozen benefits). These elements include (i) interest cost, (ii) expected return on plan assets, (iii) actuarial gains/losses, and (iv) amortization of prior service cost/credit. Significant factors that can contribute to changes in these elements include changes in discount rates used to remeasure pension and other postretirement obligations on an annual basis or upon a qualifying remeasurement, differences between actual and expected returns on plan assets, and other changes in actuarial assumptions, such as the life expectancy of plan participants. Accordingly, management considers that these elements are more reflective of changes in current conditions in global financial markets (in particular, interest rates) and are outside the operational performance of the business and are also primarily legacy amounts that are not directly related to the underlying business and do not have an immediate, corresponding impact on the compensation and benefits provided to eligible employees for current service. Adjusted EBITDA will continue to include pension and other postretirement service costs related to current employee service as well as the costs of other benefits provided to employees for current service.
Management uses free cash flow as an additional non-GAAP metric of cash flow generation. By including capital expenditures and certain other adjustments, as applicable, management is able to provide an indication of the ongoing cash being generated that is ultimately available for both debt and equity holders as well as other investment opportunities. Unlike cash flow from operating activities, free cash flow includes the impact of capital expenditures, providing a supplemental view of cash generation. Free cash flow has certain limitations, including that it does not reflect adjustments for certain non-discretionary cash flows, such as mandatory debt repayments. The amount of mandatory versus discretionary expenditures can vary significantly between periods.
Valvoline’s results of operations are presented based on Valvoline’s management structure and internal accounting practices. The structure and practices are specific to Valvoline; therefore, Valvoline’s financial results, EBITDA,
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Adjusted EBITDA and free cash flow are not necessarily comparable with similar information for other comparable companies. EBITDA, Adjusted EBITDA and free cash flow each have limitations as analytical tools and should not be considered in isolation from, or as an alternative to, or more meaningful than, net income and cash flows from operating activities as determined in accordance with U.S. GAAP. Because of these limitations, net income and cash flows from operating activities should primarily be relied upon as determined in accordance with U.S. GAAP, and EBITDA, Adjusted EBITDA, and free cash flow should only be used as supplements. In evaluating EBITDA, Adjusted EBITDA, and free cash flow, one should be aware that in the future Valvoline may incur expenses/income similar to those for which adjustments are made in calculating EBITDA, Adjusted EBITDA, and free cash flow. Valvoline’s presentation of EBITDA, Adjusted EBITDA, and free cash flow should not be construed as a basis to infer that Valvoline’s future results will be unaffected by unusual or nonrecurring items.
Key Business Measures
Valvoline tracks its operating performance and manages its business using certain key measures, including system-wide, company-owned and franchised store counts and same-store sales; lubricant volumes sold by unconsolidated joint ventures; and total lubricant volumes sold and percentage of premium lubricants sold. Management believes these measures are useful to evaluating and understanding Valvoline’s operating performance and should be considered as supplements to, not substitutes for, Valvoline's sales and operating income, as determined in accordance with U.S. GAAP.
Sales in the Quick Lubes reportable segment are influenced by the number of service center stores and the business performance of those stores. Stores are considered open upon acquisition or opening for business. Temporary store closings remain in the respective store counts with only permanent store closures reflected in the end of period store counts and activity. Same-store-sales ("SSS") is defined as sales by U.S. Quick Lubes service center stores (company-owned, franchised and the combination of these for system-wide SSS), with new stores excluded from the metric until the completion of their first full fiscal year in operation as this period is generally required for new store sales levels to begin to normalize. Differences in SSS are calculated to determine the percentage change between comparative periods. Quick Lubes revenue is limited to sales at company-owned stores, sales of lubricants and other products to independent franchisees and Express Care operators, and royalties and other fees from franchised stores. Although Valvoline does not recognize store-level sales from franchised stores as revenue in its Consolidated Statements of Comprehensive Income, management believes system-wide and franchised SSS comparisons and store counts are useful to assess the operating performance of the Quick Lube reportable segment and the operating performance of an average Quick Lubes store.
Lubricant volumes sold by unconsolidated joint ventures are used to measure the operating performance of the International operating segment. Valvoline does not record lubricant sales from unconsolidated joint ventures as International reportable segment revenue. International revenue is limited to sales by Valvoline's consolidated affiliates. Although Valvoline does not record sales by unconsolidated joint ventures as revenue in its Consolidated Statements of Comprehensive Income, management believes lubricant volumes including and sold by unconsolidated joint ventures is useful to assess the operating performance of its investments in joint ventures.
Management also evaluates lubricant volumes sold in gallons by each of its reportable segments and premium lubricant percentage, defined as premium lubricant gallons sold as a percentage of U.S. branded lubricant volumes for the Quick Lubes and Core North America segments and as a percentage of total segment lubricant volume for the International segment. Premium lubricant products generally provide a higher contribution to segment profitability and the percentage of premium volumes is useful to evaluating and understanding Valvoline’s operating performance.
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RESULTS OF OPERATIONS
Consolidated review
The following table summarizes the results of the Company’s operations for the years ended September 30:
(In millions) Amount % of Sales Amount % of Sales Amount % Change
Sales
The following table provides a reconciliation of the changes in sales from fiscal 2019 to 2020:
(In millions) 2020 Change
Mix and price $ 66
Currency exchange (11)
Acquisitions 12
Change in sales $ (37)
Total sales were down 2% year-over-year and lubricant volumes decreased 6% from the prior year, primarily driven by the significant impacts of COVID-19 restrictions, particularly in the third quarter. Declines in Core North America and International were partially offset by increases in Quick Lubes with unit growth and full year system-wide same-store sales increases of 2.3%. The decline in Core North America volumes from COVID-19 was partially offset by improved channel and product mix, while International volumes were down across most regions due to COVID-19 impacts. The changes to reportable segment sales and the drivers thereof are discussed in further detail in “Reportable Segment Review” below.
Gross profit
The following table provides a reconciliation of the changes in gross profit from fiscal 2019 to 2020:
(In millions) 2020 Change
Volume and mix $ (14)
Price and cost 69
Currency exchange (3)
Acquisitions 1
Change in gross profit $ 53
Despite lower volumes, gross profit increased compared to the prior year driven by the benefit of mix improvements in Quick Lubes and Core North America, and lower costs, which included a favorable raw material cost environment, benefits from the cost savings program that began in fiscal 2019, and the favorable impact from the resumed operations at the Company's second largest domestic blending facility that was temporarily shut down in the prior year due to a nearby third-party fire.
The increase in gross profit margin of 2.8% compared to the prior year period was driven by a more favorable cost structure primarily as a result of the cost savings program and benefits from the raw material and cost environment.
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The changes to reportable segment gross profit and the drivers thereof are discussed in further detail in “Reportable Segment Review” below.
Net operating expenses
The table below provides details of the components of net operating expenses during the years ended September 30:
(In millions) Amount % of Sales Amount % of Sales Amount % Change
Equity and other income, net (34) (1.4) % (40) (1.7) % 6 (15.0) %
The decrease in selling, general and administrative expenses was primarily due to the benefits recognized related to the compensated absences benefits change rolled out during the fourth fiscal quarter of 2020. Lower costs in fiscal 2020 related to the substantial completion of restructuring activities associated with the cost savings program commenced in the prior year and lower expenses due to controlled spending, which included reduced travel expenses resulting from the impacts of the COVID-19 pandemic, were largely offset by higher incentive compensation-related costs due to improved Company performance and an increase in rent expense due to the reclassification of a build-to-suit arrangement in adoption of the lease accounting standard.
The decrease in net legacy and separation-related expenses was driven by the reduction of the estimated indemnity obligation under the Tax Matters Agreement related to management's determination that it is no longer more likely than not to realize certain legacy tax attributes which were transferred from Ashland as a result of the Contribution. This benefit was offset by a valuation allowance recorded in income tax expense for no net impact to earnings in the fiscal year ended September 30, 2020.
The decrease in equity and other income, net was primarily driven by other income recognized during the prior year related to the bargain purchase gain in connection with the acquisition of an Eastern European lubricant production company, incentives for operating in a free trade zone outside the U.S., and fees associated with the termination of certain contracts, in addition to lower profit contributions from unconsolidated joint ventures as a result of the COVID-19 pandemic. These decreases were partially offset by a business interruption recovery received in the fourth fiscal quarter of 2020.
Net pension and other postretirement plan expense
Net pension and other postretirement plan expense decreased $119 million from the prior year primarily due to a gain on pension and other postretirement plan remeasurement of $22 million compared to a loss of $69 million in fiscal 2019. This change was primarily attributed to higher than expected returns on plan assets and favorable changes in mortality assumptions, which were partially offset by decreases in discount rates.
Net interest and other financing expenses
Net interest and other financing expense increased $20 million during fiscal 2020 compared to 2019. The increase was primarily due to the loss on extinguishment in connection with the redemption of the 2024 Notes in March 2020.
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Income tax expense
The following summarizes income tax expense and the effective tax rate during the years ended September 30:
Income tax expense $ 134 $ 57
Effective tax rate percentage 29.7 % 21.5 %
Higher income tax expense in fiscal 2020 from the prior year was principally driven by higher pre-tax earnings and income tax expense recognized during the year to establish a $30 million valuation allowance on certain legacy tax attributes. This increase in expense coupled with prior year benefits from the release of a valuation allowance and the clarification of certain provisions of Kentucky tax reform legislation led to a higher effective tax rate in fiscal 2020.
EBITDA and Adjusted EBITDA
The following table reconciles net income to EBITDA and Adjusted EBITDA for the years ended September 30:
Net interest and other financing expenses 93 73
Depreciation and amortization 66 61
Net pension and other postretirement plan (income) expenses (59) 60
Net legacy and separation-related (income) expenses (30) 3
Compensated absences benefits change (11) —
Business interruption (recovery) expenses (2) 6
Acquisition and divestiture-related costs (income) 2 (4)
Restructuring and related expenses — 14
Adjusted EBITDA (a) $ 510 $ 478
(a)Net pension and other postretirement plan income includes remeasurement gains and losses and recurring non-service pension and other postretirement net periodic income, which consists of interest cost, expected return on plan assets and amortization of prior service credit. Refer to Note 11 of the Notes to Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for further details.
The increase in Adjusted EBITDA of $32 million in fiscal 2020 was driven by the performance of Core North America, which included product and channel mix benefits and favorable costs, inclusive of lower raw material costs and benefits from the costs savings initiative program, which more than offset lower volumes attributed to the COVID-19 pandemic and increased incentive compensation-related costs.
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Reportable Segment Review
Valvoline’s business is managed within the following three reportable segments:
•Quick Lubes - services the passenger car and light truck quick lube market through company-owned and independent franchised retail quick lube service center stores and independent Express Care stores that service vehicles with Valvoline products, as well as through investment in a joint venture in China to pilot expansion of retail quick lube service center stores outside of North America.
•Core North America - sells engine and automotive maintenance products in the United States and Canada to retailers, installers, and heavy-duty customers to service vehicles and equipment.
•International - sells engine and automotive products in more than 140 countries outside of the United States and Canada for the maintenance of consumer and commercial vehicles and equipment.
Valvoline’s reportable segments are measured for profitability based on operating income; therefore, Valvoline does not generally allocate items to each reportable segment below operating income, such as net pension and other postretirement plan expense, net interest and other financing expenses or income tax expense. Operating income by segment includes the allocation of shared corporate costs, which are allocated consistently based on each segment’s proportional contribution to various financial measures. Valvoline does not allocate certain significant corporate and non-operational matters, including, but not limited to, company-wide restructuring activities and costs or adjustments that relate to former businesses that Valvoline no longer operates. These matters are attributed to Unallocated and other. Results of Valvoline’s reportable segments are presented based on how operations are managed internally, including how the results are reviewed by the chief operating decision maker. The structure and practices are specific to Valvoline; therefore, the financial results of its reportable segments are not necessarily comparable with similar information for other comparable companies.
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Quick Lubes
Management believes the number of company-owned and franchised service center stores as provided in the following tables is useful to assess the operating performance of the Quick Lubes reporting segment.
Company-owned
For the years ended September 30
Conversions between company-owned and franchised 17 5
Closed — —
Franchised (a)
For the years ended September 30
Acquired — 31
Conversions between company-owned and franchised (17) (5)
Closed (7) (5)
(a)Valvoline's franchisees are distinct legal entities and Valvoline does not consolidate the results of operations of its franchisees.
(b)Included in the store counts at September 30, 2020 was one franchised service center store temporarily closed at the discretion of the independent operator due to the impacts of COVID-19.
The Quick Lubes system added 77 net new company-owned and franchised stores in fiscal 2020. Company-owned store growth was comprised of 36 newly constructed stores and 29 acquired stores and franchised stores added 12 net new stores.
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The following table summarizes the results of the Quick Lubes reportable segment for the years ended September 30:
Depreciation and amortization $ 43 $ 36
Gross profit as a percent of sales (a) 37.9 % 39.1 %
Operating income as a percent of sales 19.1 % 21.7 %
Operating information
Lubricant sales gallons 28.9 28.1
Premium lubricants (percent of U.S. branded volumes) 67.6 % 65.0 %
Same-store sales growth (b) - Company-owned 2.6 % 9.7 %
Same-store sales growth (b) - Franchised (c) 2.1 % 10.4 %
Same-store sales growth (b) - Combined (c) 2.3 % 10.1 %
(a)Gross profit as a percent of sales is defined as sales, less cost of sales, divided by sales.
(b)Valvoline determines same-store sales growth on a fiscal year basis, with new stores excluded from the metric until the completion of their first full fiscal year in operation.
(c)Valvoline's franchisees are distinct legal entities and Valvoline does not consolidate the results of operations of its franchisees.
Quick Lubes sales increased $61 million, or 7%, during fiscal 2020. Same-store sales grew 2.3% system-wide driven by favorable pricing, premium mix improvements and increased revenue from non-oil change services, which combined to improve average ticket and increase sales. Unit growth of 6% across the Quick Lubes system also contributed to the increase in sales. Volumes were impacted by a decline in miles driven as shelter-in-place directives implemented across North America limited travel in response to the COVID-19 pandemic. Substantially all service center stores remained open, with fewer transactions adversely impacting sales.
Gross profit margin decreased 1.2% during fiscal 2020 compared to fiscal 2019. Gross profit margin was negatively impacted by a temporary increase in labor costs earlier in the fiscal year, as well as higher costs associated with the ramp up phase of newly built company stores within their first year of operation.
Operating income decreased $9 million, or 5%, during fiscal 2020. Lower transactions resulting from the COVID-19 pandemic combined with increased costs, including labor and the allocation of shared corporate costs, drove lower operating income.
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Core North America
The following table summarizes the results of the Core North America reportable segment for the years ended September 30:
Depreciation and amortization $ 16 $ 18
Gross profit as a percent of sales (a) 38.9 % 33.0 %
Operating income as a percent of sales 21.4 % 15.3 %
Operating information
Lubricant sales gallons 84.4 92.1
Premium lubricants (percent of U.S. branded volumes) 58.0 % 52.6 %
(a) Gross profit as a percent of sales is defined as sales, less cost of sales, divided by sales.
Core North America sales decreased $49 million, or 5%, during fiscal 2020 primarily related to reduced volumes due to the COVID-19 pandemic, particularly in the installer channel where recovery was slower due to the decline in miles driven. These declines were partially offset by improved channel and product mix in addition to favorable adjustments to trade and promotion cost estimates.
Gross profit margin increased 5.9% during fiscal 2020 compared to fiscal 2019. The primary drivers for increased gross profit margin were favorable channel and product mix and price-cost lag, in addition to benefits from the operating expense reduction program launched last fiscal year.
Operating income increased $50 million, or 33%, during fiscal 2020, which benefited from margin improvement and reduced expenses. This increase was largely driven by favorable product and channel mix in addition to cost structure benefits driven by lower raw material costs and the operating expense reduction program. Improved margins combined with the expense reductions implemented during the early stages of the COVID-19 pandemic offset the impact of lower installer channel volume.
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International
The following tables summarizes the results of the International reportable segment for the years ended September 30:
Operating income $ 73 $ 85
Depreciation and amortization $ 7 $ 7
Gross profit as a percent of sales (a) 29.7 % 28.1 %
Operating income as a percent of sales 13.9 % 14.8 %
Operating information
Lubricant sales gallons (b) 54.7 58.2
Lubricant sales gallons, including unconsolidated joint ventures (c) 91.7 99.0
Premium lubricants (percent of lubricant volume) 25.9 % 28.2 %
(a)Gross profit as a percent of sales is defined as sales, less cost of sales, divided by sales.
(b)Excludes volumes from unconsolidated subsidiaries.
(c)Valvoline's unconsolidated joint ventures are distinct legal entities and Valvoline does not consolidate the result of operations of its unconsolidated joint ventures.
International sales decreased $49 million, or 9%, in fiscal 2020. The decline in sales was largely attributable to lower volumes and unfavorable currency exchange that more than offset the benefits from the Eastern European acquisition completed in late fiscal 2019. The majority of the volume decline occurred in Latin America where recovery is lagging due to extended COVID-19 impacts. Partially offsetting this decline was solid volume growth in the Asia-Pacific region, notably China and Australia, during the fourth quarter of 2020.
Gross profit margin increased 1.6% during fiscal 2020 compared to fiscal 2019, which was primarily driven by favorable geographic mix and the benefits from a more stable and favorable raw material cost environment, including the impact from resumed operations at the Company's second largest domestic blending facility that was temporarily shut down in the prior year due to a nearby third-party fire.
Operating income decreased $12 million during fiscal 2020, primarily due to lower volumes attributed to the COVID-19 pandemic, as well as other income recognized during the prior year related to a bargain purchase gain resulting from an acquisition and incentives received for operating in a free trade zone outside the U.S. These declines were partially offset by overall gross margin improvements.
FINANCIAL POSITION, LIQUIDITY AND CAPITAL RESOURCES
Overview
The Company closely manages its liquidity and capital resources. Valvoline’s liquidity requirements depend on key variables, including the level of investment needed to support business strategies, the performance of the business, capital expenditures, borrowing arrangements, and working capital management. Capital expenditures, acquisitions, share repurchases, and dividend payments are components of the Company’s cash flow and capital management strategy, which to a large extent, can be adjusted in response to economic and other changes in the business environment. The Company has a disciplined approach to capital allocation, which focuses on investing in key priorities that support Valvoline’s business and growth strategies and returning capital to shareholders, while funding ongoing operations.
As of September 30, 2020, the Company had $760 million in cash and cash equivalents, of which approximately $122 million was held by Valvoline’s non-U.S. subsidiaries. The Company has various means to deploy cash with low tax consequences in the locations where it is needed due to U.S. tax reform legislation enacted in fiscal 2018.
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Cash flows
Valvoline’s cash flows as reflected in the Consolidated Statements of Cash Flows are summarized as follows for the years ended September 30:
Cash provided by (used in):
Operating activities $ 372 $ 325
Investing activities (222) (188)
Financing activities 450 (71)
Increase in cash, cash equivalents, and restricted cash $ 602 $ 63
Operating activities
The increase in cash flows provided by operating activities during fiscal 2020 compared to 2019 was primarily due to higher cash earnings which was partially offset by an increase in cash paid for income taxes of $19 million.
Investing activities
The increase in cash flows used in investing activities for fiscal 2020 compared to 2019 was primarily due to increases in capital expenditures of $43 million related to investments in new stores and the blending and packaging plant in China, and the COVID-19 relief loans extended to franchisees of approximately $30 million, partially offset by lower cash consideration paid for acquisitions of $38 million.
Financing activities
The increase in cash flows from financing activities for fiscal 2020 compared to 2019 was primarily driven by the issuance of the 2030 Notes and borrowings under the Trade Receivables Facility in response to the COVID-19 pandemic to provide enhanced financial flexibility. In addition, share repurchases and transaction costs associated with borrowing activities in fiscal 2020 led to higher cash outflows.
Free cash flow and other liquidity information
The following table sets forth free cash flow for the disclosed periods and reconciles cash flows from operating activities to free cash flow. As previously noted, free cash flow has certain limitations, including that it does not reflect adjustments for certain non-discretionary cash flows, such as mandatory debt repayments. Refer to “Use of Non-GAAP Measures” within this Item 7 for additional information regarding this non-GAAP measure.
For the years ended September 30
Cash flows provided by operating activities $ 372 $ 325
Additions to property, plant and equipment (151) (108)
At September 30, 2020, working capital (current assets minus current liabilities, excluding long-term debt due within one year) was $994 million compared to $389 million in 2019. Liquid assets (cash, cash equivalents, and accounts receivable) were 269% of current liabilities as of September 30, 2020 and 132% as of September 30, 2019. The increase in working capital is primarily related to increases in cash primarily due to increased borrowing activity taken as a precautionary measure by the Company to preserve liquidity in response to the COVID-19 pandemic.
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Debt
The following table summarizes Valvoline’s debt as of September 30:
Trade Receivables Facility (c) 88 —
China Credit Facility (d) 18 —
Other (e) — 1
(a)Issued 4.250% senior notes in February 2020 with the net proceeds used to redeem the 2024 Notes, repay $100 million on the Term Loan, and the remainder preserved to maintain liquidity and expected to be used for general corporate purposes, including acquisitions, repayment of indebtedness, working capital needs, and capital expenditures.
(b)Comprised of two issuances of 4.375% $400 million senior notes, one issued in August 2017, and the other in May 2020 when the net proceeds, together with cash and cash equivalents on hand, were utilized to repay $450 million in borrowings from the revolving credit facility under the Senior Credit Agreement, which had a remaining borrowing capacity of $469 million as of September 30, 2020. These borrowings were a precautionary measure to further strengthen the Company's liquidity position and provide financial flexibility in response to the COVID-19 pandemic.
(c)Amendments in fiscal 2020 to extend maturity to November 2021 and modify the eligibility requirements for certain receivables, which increased the remaining eligible borrowing capacity. During fiscal 2020, Valvoline borrowed $90 million to proactively increase its cash position and enhance financial agility in light of the uncertainty resulting from the COVID-19 pandemic. As of September 30, 2020, the remaining borrowing capacity was $79 million based on the availability of eligible receivables.
(d)Five-year credit agreement entered into in May 2020 for approximately $40 million to finance the completion of construction of the blending and packaging plant in China. The proceeds are restricted for capital expenditures directly related to the construction of the plant. As of September 30, 2020, the China Credit Facility had remaining borrowing capacity of approximately $22 million.
(e)Other includes debt acquired through acquisitions.
As of September 30, 2020, Valvoline was in compliance with all covenants of its debt obligations. Following the interest rate swap agreements Valvoline entered into during fiscal 2020, approximately 88% of its outstanding borrowings as of September 30, 2020 had fixed rates, with the remainder bearing variable interest rates. Refer to Note 9 of the Notes to Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional details regarding the Company’s debt instruments.
On November 16, 2020, the Company entered into a one-year revolving credit facility of approximately $23 million to finance the working capital needs of the blending and packaging plant in China, as needed. Borrowings will bear interest at the local prime rate less the applicable interest rate margin with interest due monthly and repayment of borrowings due at maturity.
Guarantor financial information
Valvoline has outstanding fixed rate senior notes as of September 30, 2020, which consist of 4.375% senior unsecured notes due 2025 with an aggregate principal amount of $800 million (the "2025 Notes"). The 2025 Notes are comprised of two issuances from Valvoline Inc., as the parent company, of 4.375% senior unsecured notes due 2025 each with an aggregate principal amount of $400 million, one issuance that was completed in August 2017 (the "Existing 2025 Notes") and the other that was completed in May 2020 (the "Additional 2025 Notes"). The 2025 Notes were registered in exchange offers in which no additional proceeds were received. The exchange offer for the Existing 2025 Notes was completed in December 2017, and the exchange offer for the Additional 2025 Notes was completed in August 2020. The 2025 Notes remain subject to Rule 3-10 of SEC Regulation S-X.
The 2025 Notes are guaranteed on a senior unsecured basis, jointly and severally, by certain wholly-owned subsidiaries of the Company (the "Guarantor Subsidiaries"). Refer to Exhibit 22 for a summary of the Company's Guarantor Subsidiaries. Other subsidiaries (the "Non-guarantor Subsidiaries") largely represent the international operations of the Company, which do not guarantee the 2025 Notes. Under the terms of the indentures, governing the 2025 Notes, Valvoline Inc. and the Guarantor Subsidiaries (the "Obligor Group") each fully and unconditionally, jointly and severally, guarantee the payment of interest, principal and premium, if any, on the 2025 Notes. Refer to
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Note 9 of the Notes to Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional information regarding the 2025 Notes.
The Guarantor Subsidiaries are subject to release in certain circumstances, including (i) the sale of all of the capital stock of the subsidiary, (ii) the designation of the subsidiary as an "Unrestricted Subsidiary" under the indenture governing the 2025 Notes, or (iii) the release of the subsidiary as a guarantor from the Company's Senior Credit Agreement described further in Note 9.
In March 2020, the SEC adopted final rules that amend the financial disclosure requirements for subsidiary issuers and guarantees of registered debt securities under Rule 3-10 of Regulation S-X, permitting registrants to disclose summarized financial information for each subsidiary issuer and guarantor. These final rules were codified in Rule 13-01 of Regulation S-X and Valvoline has early adopted this guidance. In compliance thereof, the Company is including summarized financial information for the Obligor Group on a combined basis after transactions and balances within the combined entities have been eliminated.
The following table presents the summarized statement of comprehensive income for the period ended September 30, 2020:
(In millions) Obligor Group
Intercompany revenue with non-obligor subsidiaries, net $ 37
Gross profit $ 710
Operating income $ 441
Net income attributable to group $ 281
The following table presents the summarized balance sheet for the period ended September 30, 2020:
(In millions) Obligor Group
Assets
Current assets $ 863
Intercompany receivable $ 42
Noncurrent assets $ 1,365
Liabilities
Current liabilities $ 334
Noncurrent liabilities $ 2,534
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Contractual obligations and other commitments
The following table sets forth Valvoline’s obligations and commitments to make future payments under existing contracts at September 30, 2020. Excluded from the table are contractual obligations for which the ultimate settlement of quantities or prices are not fixed and determinable.
(In millions) Total Less than 1 Year 1-3 years 3-5 years More than 5 years
Contractual obligations (a)
Purchase commitments 10 8 2 — —
(a)Other long-term liabilities of approximately $103 million are excluded from this table as the uncertainty related to the amount and period of cash settlements prevents the Company from making a reasonably reliable estimate. These other long-term liabilities include the Company’s net obligations to its former parent company, deferred compensation, unrecognized tax benefits, and self-insurance liabilities that primarily related to workers’ compensation claims, among others.
(b)Includes interest expense on both variable and fixed rate debt assuming no prepayments. Variable interest rates have been assumed to remain constant through the end of the term at the rates that existed as of September 30, 2020.
(c)Includes estimated funding of pension plans for fiscal 2021, as well as projected benefit payments through fiscal 2030 for Valvoline’s unfunded pension plans. Excludes benefit payments from pension plan trust funds.
Pension and other postretirement plan obligations
During fiscal 2020, the Company made cash and non-cash contributions of approximately $22 million to its U.S. non-qualified and non-U.S. pension plans. Refer to Note 11 of the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K for additional information relating to the Company's pension and other postretirement plans.
Dividend payments and share repurchases
During the year ended September 30, 2020, the Company paid $84 million of cash dividends for $0.452 per common share and repurchased approximately 3 million shares of its common stock for $60 million. Share repurchases were made pursuant to the Board authorization on January 31, 2018 to repurchase up to $300 million of common stock that expired September 30, 2020.
On November 12, 2020, the Board declared a quarterly cash dividend of $0.125 per share of Valvoline common stock, which is payable on December 15, 2020 to shareholders of record on November 30, 2020. Also on November 12, 2020, the Board authorized Valvoline to repurchase up to $100 million of its common stock through September 30, 2021. The dividend and share repurchase authorization is part of a broader capital allocation framework to deliver value to shareholders by first driving growth in the business, organically and through acquisitions, and then returning excess cash to shareholders through dividends and share repurchases. Future declarations of quarterly dividends are subject to approval by the Board and may be adjusted as business needs or market conditions change. The timing and amount of any share repurchases will be based on the level of Valvoline's liquidity, general business and market conditions and other factors, including alternative investment opportunities.
Restructuring and related expenses
In the second fiscal quarter of 2019, the Company outlined a broad-based restructuring and cost-savings program that is expected to reduce costs, simplify processes and focus the organization’s structure and resources on key growth initiatives. Part of this program includes employee separation actions, which were generally completed during fiscal 2019, with the associated termination benefits substantially paid by the end of 2020.
Since program inception, Valvoline recognized cumulative costs of $14 million that were primarily recognized during the year ended September 30, 2019. Restructuring expenses include employee severance and termination benefits
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provided to employees pursuant to the restructuring program. Restructuring-related expenses consist of those costs beyond those normally included in restructuring and incremental to the Company’s normal operating costs. These restructuring-related costs were expensed as incurred and primarily related to third-party professional service fees incurred in connection with execution of the restructuring program. The Company does not expect to incur material remaining costs from these actions.
Results by segment do not include these restructuring and related expenses, which is consistent with the manner by which management assesses the performance and evaluates the results of each segment. Accordingly, these expenses were included in Unallocated and other.
Valvoline’s restructuring actions are expected to generate annualized pre-tax savings in the anticipated range of approximately $40 million to $50 million from the end of fiscal 2020 with significant benefits delivered during fiscal 2020. The ongoing annual savings are anticipated to benefit operating expenses, including Cost of sales and Selling, general and administrative expenses within the Consolidated Statements of Comprehensive Income, with a portion expected to be reinvested in the business to provide flexibility to address market dynamics in Core North America and to invest in growth opportunities.
Refer to Note 8 of the Notes to Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional details regarding this restructuring program.
Summary
As of September 30, 2020, cash and cash equivalents totaled $760 million, total debt was $2.0 billion, and total remaining borrowing capacity was $548 million. Valvoline’s ability to generate positive cash flows from operations is dependent on general economic conditions, the competitive environment in the industry, and is subject to the business and other risk factors described in Item 1A of Part I of this Annual Report on Form 10-K. If the Company is unable to generate sufficient cash flows from operations, or otherwise comply with the terms of its credit facilities, Valvoline may be required to seek additional financing alternatives.
Management believes that the Company has sufficient liquidity based on its current cash and cash equivalents position, cash generated from business operations, and existing financing to meet its required pension and other postretirement plan contributions, debt servicing obligations, tax-related and other contractual commitments, and operating requirements for the next twelve months.
OFF-BALANCE SHEET ARRANGEMENTS
As of September 30, 2020, Valvoline has no contractual obligations that are reasonably likely to have a material effect on the Company’s consolidated financial statements that are not fully recorded within the Consolidated Balance Sheets or fully disclosed in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K. As part of Valvoline’s normal course of business, it is a party to certain financial guarantees and other commitments, and while these arrangements involve elements of performance and credit risk that are not included in the Consolidated Balance Sheets, such risk is not currently considered reasonably likely to have a material effect on the Company’s consolidated financial statements. The possibility that Valvoline would have to make actual cash expenditures in connection with these obligations is largely dependent on the performance of the party whose obligations Valvoline guarantees, or the occurrence of future events.
NEW ACCOUNTING PRONOUNCEMENTS
For a discussion and analysis of recently issued and adopted accounting pronouncements and the impact on Valvoline, refer to Note 2 of the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of Valvoline’s consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, sales and expenses, and the disclosures of contingent matters. Significant items that are subject to such estimates and assumptions include, but are not limited to, long-lived assets (including intangible assets and goodwill), customer incentives, employee benefit obligations and income taxes. Although management bases its estimates on historical
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experience and various other assumptions that are believed to be reasonable under the circumstances, actual results could differ significantly from the estimates under different assumptions or conditions.
Valuation of goodwill and other intangible assets
Goodwill and other intangible assets are primarily established based on the allocation of purchase consideration to the assets acquired and liabilities assumed based on their fair values as of the acquisition date. Valvoline acquired 35 service center stores during fiscal 2020 for an aggregate purchase price of $40 million. The excess of the fair value of purchase consideration over the fair value of these assets acquired and liabilities assumed is recorded as goodwill or if the fair value of the assets acquired and liabilities assumed exceed the purchase price consideration, a bargain purchase gain is recorded. When determining the fair values of assets acquired and liabilities assumed, management makes significant estimates and assumptions, particularly with respect to intangible assets. Critical estimates in valuing intangible assets include, but are not limited to, expected future cash flows, which includes consideration of future growth rates and margins, customer attrition rates, future changes in technology and brand awareness, and discount rates. Fair value estimates are based on the assumptions management believes a market participant would use in pricing the asset or liability. Identifiable intangible assets are primarily comprised of trademarks and trade names, reacquired franchise rights, and customer relationships.
Goodwill
Goodwill is tested at the reporting unit level for impairment on an annual basis during the fourth fiscal quarter as of July 1 or more frequently if certain events occur indicating that the carrying value of goodwill may be impaired. Judgment is involved in determining if an indicator of impairment has occurred. Such indicators may include a decline in expected cash flows, a significant adverse change in legal factors or in the business climate, a decision to sell a business, unanticipated competition, or slower growth rates, among others. Valvoline’s reporting units are consistent with its reportable segments of Quick Lubes ($316 million in goodwill as of September 30, 2020), Core North America ($89 million in goodwill as of September 30, 2020), and International ($40 million in goodwill as of September 30, 2020).
In evaluating goodwill for impairment, Valvoline has the option to first perform a qualitative "step zero" assessment to determine whether further impairment testing is necessary or to perform a quantitative "step one" assessment by comparing the fair value of a reporting unit to its carrying amount, including goodwill. Under the qualitative assessment, an entity is not required to calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its fair value is less than its carrying amount. Qualitative factors include macroeconomic conditions, industry and market conditions, cost factors, and overall financial performance, among others. The consideration of these factors requires significant judgment and estimates and application of alternative assumptions could produce different results.
Under the step one assessment, if the fair value of a reporting unit is less than its carrying amount, then the amount of the impairment loss, if any, must be measured under "step two" of the impairment analysis. In step two of the analysis, an impairment loss will be recorded equal to the excess of the carrying value of the reporting unit’s goodwill over its implied fair value. Fair values of the reporting units are estimated using a weighted methodology considering the output from both the income and market approaches. The income approach incorporates the use of a discounted cash flow (“DCF”) analysis. A number of significant assumptions and estimates are involved in the application of the DCF model to forecast operating cash flows, including markets and market shares, sales volumes and prices, costs to produce, tax rates, capital spending, discount rate and working capital changes. Several of these assumptions vary among reporting units, and the cash flow forecasts are generally based on approved strategic operating plans. The market approach is performed using the Guideline Public Companies method which is based on earnings multiple data. The Company also performs a reconciliation between market capitalization and the estimate of the aggregate fair value of the reporting units, including consideration of a control premium.
Valvoline elected to perform a qualitative assessment during fiscal 2020 and determined that it is more likely than not that the fair values of Valvoline’s reporting units are in excess of carrying amounts. Valvoline performed a quantitative assessment during fiscal 2019, though no qualitative factors were present that indicated the existence of a potential impairment, and determined that each reporting unit had a fair value that exceeded its carrying value by 130% and more.
Valvoline’s goodwill impairment assessment could change in future periods if any or all of the following events were to occur with respect to a particular reporting unit: a significant change in projected business results, a divestiture
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decision, significant changes to certain cash flow assumptions, economic deterioration that is more severe or of a longer duration than anticipated, or other significant economic events.
Other intangible assets
Total other intangible assets were $84 million, net of $28 million of accumulated amortization as of September 30, 2020. Other intangible assets are evaluated for impairment whenever events or changes in circumstances indicate the carrying amount may not be recoverable. Various factors are considered in determining whether a trigger requiring impairment assessment has occurred, such as changes in the expected use of the assets, changes in technology or development of alternative assets, changes in economic conditions, changes in operating performance and changes in expected future cash flows.
If a trigger requiring impairment assessment occurred and the future undiscounted cash flows result in a value that is less than the carrying value, the intangible asset is considered impaired and a loss is recognized based on the amount by which the carrying amount exceeds the estimated fair value. Fair value is determined based on the highest and best use of the assets considered from the perspective of market participants, which may be different than the Company’s actual intended use of the assets. Judgment is involved in identifying impairment triggering events, determining asset groups, future undiscounted cash flows and the fair value of asset groups.
There were no significant impairments recognized by the Company during fiscal 2020, 2019, or 2018.
Customer incentives
Valvoline records revenue for the amount that reflects the consideration the Company is expected to be entitled to based on when control of the promised good or service is transferred to the customer. The nature of Valvoline’s contracts with customers often give rise to variable consideration that generally decrease the transaction price and consist primarily of promotional rebates and customer pricing discounts based on achieving certain levels of sales activity. Variable consideration is recorded as a reduction of the transaction price at the time of sale and is primarily estimated utilizing the most likely amount method that is expected to be earned as the Company is able to estimate the anticipated discounts within a sufficiently narrow range of possible outcomes based on its extensive historical experience with certain customers, similar programs and management’s judgment with respect to estimating customer participation and performance levels. Variable consideration is reassessed at each reporting date and adjustments are made, when necessary. The cost of these programs recognized as a reduction of sales totaled $332 million, $346 million and $357 million in the Consolidated Statements of Comprehensive Income for the years ended September 30, 2020, 2019 and 2018, respectively. A 10% change in the reserves for customer incentive programs as of September 30, 2020 would have affected net earnings by approximately $6 million in fiscal 2020.
Employee benefit obligations
Valvoline sponsors defined benefit pension and other postretirement plans in the U.S and in certain countries outside the U.S. The majority of these plans were transferred to and assumed by the Company in the Contribution of certain of Ashland’s pension and other postretirement benefit obligations and plan assets in late fiscal 2016. As of September 30, 2020, Valvoline’s net unfunded pension and other postretirement plan liabilities included in the Consolidated Balance Sheet totaled $328 million, and the U.S. plans represented 96% of this total obligation. Total pension and other postretirement net periodic benefit income included in the Consolidated Statements of Comprehensive Income for the year ended September 30, 2020 was comprised of the following:
Service costs $ 3
Non-service pension and other postretirement net periodic income (a) (37)
Gain on pension and other postretirement plans remeasurement (b) (22)
Total pension and other postretirement net periodic benefit income $ (56)
(a)Non-service pension and other postretirement net periodic income includes the expected return on plan assets and amortization of prior service credit, net of interest costs.
(b)Gains on pension and other postretirement plans remeasurement include the change in the actual return on plan assets and net actuarial gains upon remeasurement as of September 30, 2020.
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Valvoline recognizes the change in the fair value of plan assets and the net actuarial gains and losses calculated using updated actuarial assumptions as of the measurement date, which for Valvoline is September 30, and when a plan qualifies for an interim remeasurement. The remaining components of pension and other postretirement benefits income are recorded ratably on a quarterly basis. Due to the freeze of U.S. pension benefits effective September 30, 2016, continuing service costs are limited to certain international pension plans, and are reported in the same caption of the Consolidated Statements of Comprehensive Income as the related employee payroll expenses. All components of net periodic benefit income other than service cost are recognized below operating income within Net pension and other postretirement plan income in the Consolidated Statements of Comprehensive Income. The gain on pension and other postretirement plans remeasurement of $22 million in fiscal 2020 was primarily attributed to higher than expected returns on plan assets and favorable changes in mortality assumptions, partially offset by decreases in discount rates.
Actuarial assumptions
The Company’s pension and other postretirement benefit costs and obligations are dependent on actuarial valuations and various assumptions that attempt to anticipate future events and are used in calculating the expense and liabilities relating to these plans. These assumptions include estimates and judgments the Company makes about interest rates, expected long-term investment return on plan assets, and mortality. Though management considers current market conditions and other relevant factors in establishing these assumptions, the actuarial assumptions used may differ materially from actual results due to changing market and economic conditions, longer or shorter life spans of participants, and differences between the actual and expected return on plan assets. These differences may result in a significant impact to the amount of pension or other postretirement benefits cost recorded or that may be recorded.
Changes in assumptions or asset values may have a significant effect on the measurement of expense or income. Significant assumptions the Company must review and set annually and at each measurement date related to its pension and other postretirement benefit obligations are:
•Expected long-term return on plan assets — Based on long-term historical actual asset return information, the mix of investments that comprise plan assets and future estimates of long-term investment returns. The Company also deducts various expenses using the fair value of plan assets to estimate expense. The weighted-average long-term expected rate of return on assets assumption was 4.64% for fiscal 2020. In fiscal 2020, the global pension plan assets generated an actual weighted-average return of 14.1%, primarily driven by the market performance of U.S. plan assets based on the Company’s investment strategy to hedge plan assets with the movement in liabilities related to changes in the interest rates. However, the expected return on plan assets is designed to be a long-term assumption, and therefore, actual returns will be subject to year-to-year variances. The U.S. pension plans comprise the most significant portion of plan assets, and for fiscal 2021, the expected rate of return on assets assumption for the U.S. pension plans will be 4.40%. The expected long-term return on plan assets assumption has no impact on the reported net liability or net actuarial gains or losses upon remeasurement, but does impact the recognition of recurring non-service net periodic income recorded ratably on a quarterly basis.
Valvoline’s pension plans hold a variety of investments designed to diversify risk. Plan assets are invested in equity securities, government and agency securities, corporate debt, and other non-traditional assets such as hedge funds. The investment goal of the pension plans is to achieve an adequate net investment return to provide for future benefit payments to its participants. U.S. target asset allocation percentages as of September 30, 2020 were 25% equity and 75% fixed income investments. The U.S. pension plans are managed by professional investment managers that operate under investment management contracts that include specific investment guidelines, requiring among other actions, adequate diversification and prudent use of risk management practices such as portfolio constraints relating to established benchmarks. Valvoline’s investment strategy and management practices relative to plan assets of non-U.S. plans generally are consistent except in those countries where investment of plan assets is dictated by applicable regulations.
•Discount rate — Reflects the rates at which benefits could effectively be settled and is based on current investment yields of high-quality corporate bonds. Consistent with historical practice, the Company uses an actuarially-developed full yield curve approach, the above mean yield curve, to match the timing of cash flows of expected future benefit payments from the plans by applying specific spot rates along the yield curve to determine the assumed discount rate. Valvoline’s fiscal 2020 expense, excluding actuarial gains
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and losses, for both U.S. and non-U.S. pension plans was determined using the spot discount rate as of the beginning of the fiscal year. The service cost and interest cost discount rates for fiscal 2020 pension expense were 1.49% and 2.79%, respectively, and 3.12% and 2.69%, respectively, for other postretirement expense. The weighted-average discount rate at the end of fiscal 2020 was 2.59% for the pension plans and 2.39% for the postretirement health and life plans.
The following table illustrates the estimated impact on hypothetical pension and other postretirement expense that would have resulted from a one percentage point change in discount rates in isolation of impacts on other significant assumptions in the years ended September 30:
Increase in pension expense from:
Decrease in the discount rate of 1.00% $ 263 $ 268
Increase in other postretirement expense from:
Decrease in the discount rate of 1.00% $ 5 $ 5
The U.S. qualified pension plans comprise a substantial portion of Valvoline’s total employee benefit plan obligation, where the investing strategy for plan assets is targeted to match the duration of the obligation and hedge approximately 90% of the movement in liabilities related to changes in interest rates.
•Mortality — Based on the Society of Actuaries PRI-2012 mortality base tables and a mortality improvement scale that follows the 2020 Trustees Report of the Social Security Administration Intermediate Alternative as reflected in the MSS-2020 improvement scale. Valvoline believes the updated mortality improvement scales provide a reasonable assessment of current mortality trends and is an appropriate estimate of future mortality projections.
Other assumptions, including the rate of compensation increase and healthcare cost trend rate, do not have a significant impact on Valvoline's pension and other postretirement benefit plan costs and obligations based upon current plan provisions that have generally frozen benefits and limited costs.
Income taxes
Valvoline is subject to income taxes in the United States and numerous international jurisdictions. Judgment in forecasting taxable income using historical and projected future operating results is required in determining Valvoline’s provision for income taxes and the related assets and liabilities. Each increase of $5 million to income tax expense would impact the fiscal 2020 effective tax rate by one percentage point.
The provision for income taxes includes current income taxes as well as deferred income taxes. Under U.S. GAAP, deferred tax assets and liabilities are determined based on differences between the financial reporting and tax basis of assets and liabilities and are measured using enacted tax rates and laws that are expected to be in effect when the deferred assets or liabilities are expected to be settled or realized. The effect of changes in tax rates on deferred taxes is recognized in the period in which such changes are enacted.