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[February 25, 2013]
LEUCADIA NATIONAL CORP - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations.
(Edgar Glimpses Via Acquire Media NewsEdge) The purpose of this section is to discuss and analyze the Company's consolidated financial condition, liquidity and capital resources and results of operations. This analysis should be read in conjunction with the consolidated financial statements, related footnote disclosures and "Cautionary Statement for Forward-Looking Information," which appear in Part I and elsewhere in this Report.
Liquidity and Capital Resources General The Company's investment portfolio, equity and results of operations can be significantly impacted by the changes in market values of certain securities, particularly during times of increased volatility in security prices. Changes in the market values of publicly traded available for sale securities are reflected in other comprehensive income (loss) and equity. However, changes in the market prices of investments for which the Company has elected the fair value option, declines in the fair values of equity securities that the Company deems to be other than temporary, and declines in the fair values of debt securities related to credit losses are reflected in the consolidated statements of operations and equity. JHYH also owns public securities with changes in market values reflected in its earnings. Since the Company accounts for JHYH on the equity method of accounting, it records its share of JHYH's earnings in the consolidated statement of operations which increases the Company's exposure to volatility in the public securities markets.
The Company's largest publicly traded available for sale equity security with changes in market values reflected in other comprehensive income (loss) is Inmet. During the year ended December 31, 2012, the market value of the Company's investment in the common shares of Inmet increased from $708,193,000 to $823,757,000. The market value of the Company's investment in Jefferies, for which the fair value option was elected, increased during the year with unrealized gain reflected in operations as a component of income related to associated companies. During the year ended December 31, 2012, the Company recognized an unrealized gain related to its investment in Jefferies of $279,589,000.
Liquidity Leucadia National Corporation is a holding company whose assets principally consist of the stock of its direct subsidiaries, cash and cash equivalents and other non-controlling investments in debt and equity securities. The Company continuously evaluates the retention and disposition of its existing operations and investments and investigates possible acquisitions of new businesses in order to maximize shareholder value. Accordingly, further acquisitions, divestitures, investments and changes in capital structure are possible. Its principal sources of funds are its available cash resources, liquid investments, public and private capital market transactions, repayment of subsidiary advances, funds distributed from its subsidiaries as tax sharing payments, management and other fees, and borrowings and dividends from its subsidiaries, as well as dispositions of existing businesses and investments.
32 -------------------------------------------------------------------------------- In addition to cash and cash equivalents, the Company also considers investments classified as current assets and investments classified as non-current assets on the face of its consolidated balance sheet as being generally available to meet its liquidity needs. Securities classified as current and non-current investments are not as liquid as cash and cash equivalents, but they are generally easily convertible into cash within a relatively short period of time. As of December 31, 2012, the sum of these amounts aggregated $3,566,534,000. However, since $561,641,000 of this amount is pledged as collateral pursuant to various agreements, is subject to trading restrictions, represents investments in non-public securities or is held by subsidiaries that are party to agreements that restrict the Company's ability to use the funds for other purposes, the Company does not consider those amounts to be available to meet its liquidity needs. The $3,004,893,000 that is available is comprised of cash and short-term bonds and notes of the U.S. Government and its agencies, U.S. Government-Sponsored Enterprises and other publicly traded debt and equity securities (including the Inmet common shares). The Company's available liquidity, and the investment income realized from cash, cash equivalents and marketable securities is used to meet the Company's short-term recurring cash requirements, which are principally the payment of interest on its debt and corporate overhead expenses.
The holding company's only long-term cash requirement is to make principal payments on its long-term debt ($958,131,000 principal outstanding as of December 31, 2012), of which $401,909,000 is due in 2013, $97,581,000 is due in 2014 and $458,641,000 is due in 2015. Historically, the Company has used its available liquidity to make acquisitions of new businesses and other investments, but, except as disclosed in this Report, the timing of any future investments and the cost cannot be predicted.
From time to time in the past, the Company has accessed public and private credit markets and raised capital in underwritten bond financings. The funds raised have been used by the Company for general corporate purposes, including for its existing businesses and new investment opportunities. The Company's senior debt obligations are rated four levels below investment grade by Moody's Investors Services, two levels below investment grade by Fitch Ratings and one level below investment grade by Standard & Poor's. Ratings issued by bond rating agencies are subject to change at any time. The bond rating agencies are reviewing the Company's ratings pending completion of the Jefferies Merger; however, based on the Company's conversations with the agencies it expects its ratings will be increased after the transaction closes.
During 2012, the Company sold its remaining common shares of Fortescue for net cash proceeds of $659,416,000, which resulted in the recognition of a net securities gain of $543,713,000. The Company also received $202,221,000 from Chichester (net of $22,469,000 in withholding taxes) in payment of interest due on the FMG Note for the period from July 1, 2011 through June 30, 2012. During the fourth quarter of 2012, Chichester redeemed the FMG Note for aggregate cash consideration of $715,000,000, resulting in the recognition of a pre-tax gain of $526,184,000, and the parties agreed to settle all pending litigation and disputes without any additional payment. As a result, the Company will no longer receive interest payments on the FMG Note.
In May 2012, the Company invested an additional $50,000,000 in Sangart, which increased its ownership interest to approximately 97.2%. The Company has not provided any commitment to provide Sangart any additional funds in the future.
In September 2012, Mueller repurchased the Company's entire investment in Mueller for aggregate cash consideration of $427,337,000. The Mueller common shares were originally acquired at a cost of $408,558,000.
33 --------------------------------------------------------------------------------In September 2012, the Company sold its small Caribbean-based telecommunications provider for aggregate consideration of $27,509,000, net of working capital adjustments.
In October 2012, the Company sold Keen for cash consideration of $100,000,000 and a four-year interest bearing promissory note issued by the purchaser which was valued at $37,500,000. The Company also retained Keen's net working capital, principally customer receivables and trade payables.
In February 2009, the Board of Directors authorized the Company, from time to time, to purchase its outstanding debt securities through cash purchases in open market transactions, privately negotiated transactions or otherwise. Such repurchases, if any, depend upon prevailing market conditions, the Company's liquidity requirements and other factors; such purchases may be commenced or suspended at any time without notice.
In November 2012, the Board of Directors increased the number of the Company's common shares that the Company is authorized to purchase. Such purchases may be made from time to time in the open market, through block trades or otherwise. Depending on market conditions and other factors, such purchases may be commenced or suspended at any time without notice. During the three year period ended December 31, 2012, the only common shares acquired by the Company were in connection with the exercise of stock options. As of February 14, 2013, the Company is authorized to repurchase 25,000,000 common shares.
The Company and certain of its subsidiaries have substantial NOLs and other tax attributes. The amount and availability of the NOLs and other tax attributes are subject to certain qualifications, limitations and uncertainties. In order to reduce the possibility that certain changes in ownership could impose limitations on the use of the NOLs, the Company's certificate of incorporation contains provisions which generally restrict the ability of a person or entity from acquiring ownership (including through attribution under the tax law) of five percent or more of the common shares and the ability of persons or entities now owning five percent or more of the common shares from acquiring additional common shares. The restrictions will remain in effect until the earliest of (a) December 31, 2024, (b) the repeal of Section 382 of the Internal Revenue Code (or any comparable successor provision) or (c) the beginning of a taxable year to which certain tax benefits may no longer be carried forward. For more information about the NOLs and other tax attributes, see Note 19 of Notes to Consolidated Financial Statements.
Jefferies Merger At closing, the Company expects to issue approximately 117,698,000 common shares in exchange for Jefferies publicly held common stock, and the Company will issue a new series of 3.25% Convertible Cumulative Preferred Stock ($125,000,000 at mandatory redemption value) in exchange for Jefferies outstanding 3.25% Series A Convertible Cumulative Preferred Stock. In addition, each outstanding stock option to purchase shares of Jefferies common stock, each restricted share of Jefferies common stock and each restricted stock unit of Jefferies common stock will be converted at the Exchange Ratio into an award of options, restricted shares or restricted stock units of the Company, with all such awards subject to the same terms and conditions, including, without limitation, vesting and, in the case of performance-based restricted stock units, performance being measured at existing targets. Following the transaction, 35.2% of the Company's common shares will be owned by Jefferies' stockholders (excluding the Jefferies common stock owned by the Company and including Jefferies vested restricted stock units) and Jefferies will become a wholly-owned subsidiary of the Company. The Company will not assume or guarantee any of Jefferies' outstanding debt securities, but Jefferies' 3.875% Convertible Senior Debentures due 2029 ($345,000,000 principal amount outstanding) will become convertible into common shares of the Company. As specified in the indenture governing the debentures, the debentures are not currently convertible nor will they be after consummation of the merger. However, after giving effect to the Jefferies Merger, if the debentures were currently convertible, the conversion price would be $45.93 per common share of the Company.
34-------------------------------------------------------------------------------- The merger will be accounted for using the acquisition method of accounting. The aggregate purchase price will be equal to the sum of the fair value of the Company's common shares issued at closing, the fair value of employee stock based awards attributable to periods prior to closing, the fair value of the Jefferies common stock owned by the Company and the redemption value of the new series of preferred shares issued by the Company at closing, which represents its fair value. The fair values of the Jefferies common stock owned by the Company and the common shares and employee stock based awards issued by the Company will be determined by using market prices at closing. Based on current market prices the aggregate purchase price would be approximately $4,800,000,000; including the Company's investment in JHYH, the aggregate investment in Jefferies would be approximately $5,100,000,000.
The completion of the merger is subject to satisfaction or waiver of customary closing conditions, including approval by the Company's shareholders (by the vote of a majority of the shares cast, assuming a majority of shares outstanding are voted), approval by the Jefferies' stockholders (by the vote of a majority of the outstanding shares) and the receipt of opinions that the merger will qualify for federal income tax purposes as a "reorganization" within the meaning of Section 368(a) of the Internal Revenue Code of 1986, as amended. The completion of the merger is not conditioned on receipt of financing by the Company. The transaction is expected to close promptly after shareholder approval is received from both companies; shareholder meetings are scheduled to occur on February 28, 2013.
Jefferies will be the Company's largest investment, and will continue to operate as a full-service global investment banking firm in its current form. Jefferies will retain a credit rating that is separate from the Company's credit rating. Jefferies' existing long-term debt will remain outstanding and Jefferies intends to remain an SEC reporting company, regularly filing annual, quarterly, and periodic financial reports. Jefferies has historically reported its balance sheet on an unclassified basis while the Company has historically reported a classified balance sheet, with assets and liabilities separated between current and non-current. However, after giving consideration to the nature of Jefferies business and the impact the inclusion of its balance sheet will have on the Company's consolidated balance sheet, upon completion of the merger the Company will report its consolidated balance sheet on an unclassified basis, and the Company's consolidated balance sheet captions will be generally based on Jefferies captions.
Upon consummation of the Jefferies Merger, Jefferies current Chief Executive Officer and current Executive Committee Chairman will become the Company's new Chief Executive Officer and new President, respectively. In connection with presentations made to credit rating agencies with respect to the Jefferies Merger, Jefferies senior management advised the agencies that, after the Jefferies Merger, the Company's management would target specific concentration, leverage and liquidity principles in the future, expressed in the form of certain ratios and percentages, although there is no legal requirement to do so. These targets and calculations of the Company's actual ratios and percentages are detailed below at December 31, 2012 (dollars in thousands): 35 -------------------------------------------------------------------------------- Total equity $ 6,767,635 Less, investment in Jefferies (1,077,172 ) Less, investment in JHYH (351,835 ) Equity excluding Jefferies 5,338,628 Less, the Company's two largest investments: National Beef (860,080 ) Inmet, net of tax (709,606 ) Equity in a stressed scenario $ 3,768,942 Balance sheet amounts: Available liquidity, per above $ 3,004,893 Parent company debt (see Note 13 of Notes to Consolidated Financial Statements) $ 954,941 Maximum ratio of parent company debt to stressed equity: Target .50 x Actual .25 x Minimum ratio of available liquidity to parent company debt: Target 1.0 x Actual 3.1 x In addition, Jefferies management has indicated that the Company's largest single investment will be not more than 20% of equity excluding Jefferies (currently National Beef), and that the next largest investment will be no more than 10% of equity excluding Jefferies, in each case measured at the time such investment was made.
The Company will distribute the common shares of Crimson to its shareholders on February 25, 2013. The distribution was a condition to the Jefferies Merger. As a result, during the first quarter of 2013, the Company will record a dividend of approximately $197,000,000.
Consolidated Statements of Cash Flows As discussed above, the Company has historically relied on its available liquidity to meet its short-term and long-term needs, and to make acquisitions of new businesses and investments. Except as otherwise disclosed herein, the Company's operating businesses do not generally require significant funds to support their operating activities, and the Company does not depend on positive cash flow from its operating segments to meet its liquidity needs. The components of the Company's operating businesses and investments change frequently as a result of acquisitions or divestitures, the timing of which is impossible to predict but which often have a significant impact on the Company's consolidated statements of cash flows in any one period. Further, the timing and amounts of distributions from investments in associated companies may be outside the control of the Company. As a result, reported cash flows from operating, investing and financing activities do not generally follow any particular pattern or trend, and reported results in the most recent period should not be expected to recur in any subsequent period.
Net cash of $221,857,000 and $9,084,000 was provided by operating activities in 2012 and 2011, respectively. The change in operating cash flows reflects funds provided by National Beef of $141,358,000, which was acquired on December 30, 2011, interest payments received from Chichester ($202,221,000 in 2012 and $171,718,000 in 2011, net of withholding taxes), lower interest payments, premiums paid to redeem debt ($17,138,000 in 2012 and $6,352,000 in 2011) and greater income tax payments. Premier generated funds of $27,637,000 and $26,516,000 during 2012 and 2011, respectively; the Company's manufacturing segments generated funds of $27,435,000 and $12,819,000 during 2012 and 2011, respectively; and Keen, a discontinued operation, generated funds of $14,019,000 and $23,446,000 during 2012 and 2011, respectively. Funds used by Sangart, a development stage company, increased to $42,612,000 during 2012 from $39,396,000 during 2011. During 2012, distributions from associated companies principally include earnings distributed by Berkadia ($37,561,000), Jefferies ($4,351,000), JHYH ($5,223,000), Mueller ($23,925,000) and the Garcadia companies ($18,440,000). During 2011, distributions from associated companies principally include earnings distributed by Berkadia ($23,636,000), Jefferies ($7,789,000) and Garcadia ($5,654,000). Net gains related to real estate, property and equipment, and other assets in 2012 include $526,184,000 from the redemption of the FMG Note, and in 2011 include a gain of $81,848,000 on forgiveness of debt related to the Myrtle Beach project. Funds provided by operating activities include $5,663,000 and $4,690,000 in 2012 and 2011, respectively, from funds distributed by Empire Insurance Company ("Empire"), a discontinued operation.
36 -------------------------------------------------------------------------------- Net cash of $9,084,000 and $431,266,000 was provided by operating activities in 2011 and 2010, respectively. The change in operating cash flows reflects interest payments received from Chichester ($171,718,000 in 2011 and $154,930,000 in 2010, net of withholding taxes), greater income tax payments, lower interest payments and the proceeds received from the sale of AmeriCredit Corp. ("ACF") in excess of the cost of the investment in 2010 ($404,700,000). Premier generated funds of $26,516,000 and $26,524,000 during 2011 and 2010, respectively; the Company's manufacturing segments generated funds of $12,819,000 and $28,333,000 during 2011 and 2010, respectively; and Keen generated funds of $23,446,000 and $7,311,000 during 2011 and 2010, respectively. Funds used by Sangart increased to $39,396,000 during 2011 from $23,757,000 during 2010. During 2011, distributions from associated companies principally include earnings distributed by Berkadia ($23,636,000), Jefferies ($7,789,000) and the Garcadia companies ($5,654,000). In 2010, distributions from associated companies principally include ACF, earnings distributed by Berkadia ($29,000,000) and Jefferies ($14,575,000). Net gains related to real estate, property and equipment, and other assets in 2011 include a gain of $81,848,000 on forgiveness of debt related to the Myrtle Beach project, and in 2010 a gain of $383,369,000 on the sale of Las Cruces. Funds provided by operating activities include $4,690,000 and $11,640,000 in 2011 and 2010, respectively, from funds distributed by Empire.
Net cash of $407,321,000 was provided by investing activities in 2012, principally reflecting the $715,000,000 in proceeds received from the redemption of the FMG Note, as compared to net cash flow used for investing activities of $175,297,000 and $208,718,000 in 2011 and 2010, respectively. The increase in acquisitions of property, equipment and leasehold improvements during 2012 principally reflects capital expenditures at National Beef ($43,498,000). During 2011, proceeds from disposals of real estate, property and equipment, and other assets include $12,040,000 from the sale of certain of Keen's rigs, and in 2010 include the sale of Las Cruces ($149,910,000). In 2012, acquisitions, net of cash acquired, relates to Conwed Plastic's acquisition of certain assets of a lightweight netting business. In 2011, acquisitions, net of cash acquired, primarily relates to the Company's acquisition of National Beef ($932,835,000) and Seghesio Family Vineyards ($86,018,000). Proceeds from disposal of discontinued operations, net of expenses and cash of operations sold in 2012 principally includes Keen ($104,185,000) and a small Caribbean-based telecommunications provider ($26,957,000); in 2011 principally includes the telecommunications operations of STi Prepaid, LLC ("STi Prepaid"), which was sold during 2010 ($10,644,000); and in 2010 principally includes the property management and services operations of ResortQuest International, LLC ("ResortQuest") ($52,135,000), a shopping center ($17,064,000) and STi Prepaid ($9,819,000). Investments in associated companies include Linkem ($23,709,000) in 2012; Jefferies ($167,753,000), Mueller ($408,558,000), Linkem ($88,575,000) and the Garcadia companies ($32,400,000) in 2011; and Berkadia ($292,544,000), Las Cruces ($2,687,000), Jefferies ($17,998,000) and ACF ($7,236,000) in 2010. Capital distributions and loan repayment from associated companies include Berkadia ($34,981,000), Mueller ($406,539,000), Jefferies ($17,401,000) and the Garcadia companies ($11,976,000) in 2012; Berkadia ($283,530,000), JHYH ($8,710,000), Jefferies ($8,326,000) and the Garcadia companies ($10,382,000) in 2011; and ACF ($425,842,000), Berkadia ($44,544,000), JHYH ($17,077,000) and the Garcadia companies ($8,778,000) in 2010.
Net cash of $651,708,000 and $106,637,000 was used for financing activities in 2012 and 2011, respectively, as compared to net cash provided by financing activities of $64,664,000 in 2010. Issuance of long-term debt primarily reflects the increase in repurchase agreements of $16,358,000 and $202,539,000 for 2011 and 2010, respectively, and in 2011, $75,947,000 borrowed by National Beef under its revolving credit facility. Immediately after the Company's acquisition of its interest in National Beef, National Beef borrowed funds to redeem the interest of its chief executive officer pursuant to pre-existing put rights.
Reduction of debt for 2012 includes redemptions of $423,140,000 principal amount of the Company's 7 1/8% Senior Notes due 2017, $88,204,000 principal amount of the Company's 8.65% Junior Subordinated Deferrable Interest Debentures due 2027 and $4,836,000 principal amount of the Company's 7% Senior Notes due in August 2013; a decrease in repurchase agreements of $25,774,000; and repayments under National Beef's term loans and bank credit facility of $29,727,000. Reduction of debt for 2011 includes $19,275,000 in full satisfaction of the Myrtle Beach real estate project's non-recourse indebtedness, $32,881,000 on the maturity of debt of a subsidiary that was collateralized by certain of the Company's corporate aircraft, $8,500,000 for the repayment of Keen's line of credit and $82,531,000 in the aggregate for the buyback of $21,359,000 principal amount of the Company's 8 1/8% Senior Notes due 2015, $54,860,000 principal amount of the Company's 7 1/8% Senior Notes due 2017 and $1,350,000 principal amount of the Company's 8.65% Junior Subordinated Deferrable Interest Debentures due 2027. Reduction of debt for 2010 includes $10,226,000 for repayment of debt by a subsidiary, and $80,859,000 in the aggregate for the buyback of $5,500,000 principal amount of the 7 3/4% Senior Notes, $27,200,000 principal amount of the 7% Senior Notes, $20,000,000 principal amount of the 8 1/8% Senior Notes, $22,000,000 principal amount of the 7 1/8% Senior Notes, and $2,146,000 principal amount of the 8.65% Junior Subordinated Deferrable Interest Debentures. Purchase of interest in subsidiary by noncontrolling interest for 2011 represents the acquisition of a minority interest in National Beef by its chief executive officer immediately after the Company acquired its interest. Issuance of common shares reflects the exercise of employee stock options for all periods.
37 -------------------------------------------------------------------------------- Current liabilities includes $391,705,000 and $417,479,000 at December 31, 2012 and 2011, respectively, relating to repurchase agreements of one of the Company's subsidiaries. These fixed rate repurchase agreements have a weighted average interest rate of approximately 0.4%, mature in January 2013 and are secured by non-current investments with a carrying value of $406,828,000 at December 31, 2012. They are used solely to fund a portion of the purchase price of a segregated portfolio of mortgage pass-through certificates issued by U.S.
Government agencies (GNMA) and by U.S. Government-Sponsored Enterprises (FHLMC or FNMA). The securities purchased are generally adjustable rate certificates, secured by seasoned pools of securitized, highly rated residential mortgages, and the certificates acquired generally represent all of the certificates issued by the securitization.
The Company's senior note indentures contain covenants that restrict its ability to incur more Indebtedness or issue Preferred Stock of Subsidiaries unless, at the time of such incurrence or issuance, the Company meets a specified ratio of Consolidated Debt to Consolidated Tangible Net Worth, limit the ability of the Company and Material Subsidiaries to incur, in certain circumstances, Liens, limit the ability of Material Subsidiaries to incur Funded Debt in certain circumstances, and contain other terms and restrictions all as defined in the senior note indentures. The Company has the ability to incur substantial additional indebtedness or make distributions to its shareholders and still remain in compliance with these restrictions. If the Company is unable to meet the specified ratio, the Company would not be able to issue additional Indebtedness or Preferred Stock, but the Company's inability to meet the applicable ratio would not result in a default under its senior note indentures. The senior note indentures do not restrict the payment of dividends. Certain of the debt instruments of subsidiaries of the Company require that collateral be provided to the lender; principally as a result of such requirements, the assets of subsidiaries which are subject to limitations on transfer of funds to the Company were $2,198,605,000 at December 31, 2012.
As shown below, at December 31, 2012, the Company's contractual cash obligations totaled $2,269,742,000.
Payments Due by Period (in thousands) Less than 1 Contractual Cash Obligations Total Year 1-3Years 4-5 Years After 5 Years Indebtedness, including current maturities, and repurchase agreements $ 1,753,590 $ 832,228 $ 636,134 $ 283,228 $ 2,000 Estimated interest expense on debt 155,515 68,948 81,638 4,901 28 Cattle commitments 117,371 117,371 - - - Planned funding of pension obligations 81,544 7,860 73,684 - - Operating leases, net of sublease income 93,190 20,783 33,275 11,167 27,965 Asset purchase obligations 19,062 6,373 7,892 2,542 2,255 Other 49,470 17,385 7,652 5,222 19,211 Total Contractual Cash Obligations $ 2,269,742 $ 1,070,948 $ 840,275 $ 307,060 $ 51,459 The estimated interest expense on debt includes interest related to variable rate debt which the Company determined using rates in effect at December 31, 2012. Amounts related to the Company's pension liability ($81,544,000) are included in the table in the less than 1 year period ($7,860,000) and the remainder in the 1-3 years period; however, the exact timing of those cash payments is uncertain. The above amounts do not include liabilities for unrecognized tax benefits as the timing of payments, if any, is uncertain. Such amounts aggregated $15,800,000 at December 31, 2012; for more information, see Note 19 of Notes to Consolidated Financial Statements.
When the Company sold its former telecommunications subsidiary, WilTel Communications Group, LLC ("WilTel") in 2005, WilTel's defined benefit pension plan was not transferred in connection with the sale. At December 31, 2012, the Company had recorded a liability of $81,544,000 on its consolidated balance sheet for WilTel's unfunded defined benefit pension plan obligation. This amount represents the difference between the present value of amounts owed to former employees of WilTel (referred to as the projected benefit obligation) and the market value of plan assets set aside in segregated trust accounts. Since the benefits in this plan have been frozen, future changes to the unfunded benefit obligation are expected to principally result from benefit payments, changes in the market value of plan assets, differences between actuarial assumptions and actual experience and interest rates.
38 -------------------------------------------------------------------------------- The Company expects to make substantial contributions to the segregated trust account for the WilTel defined benefit pension plan in the future to reduce its plan liabilities although the timing after 2013 is uncertain. The Company expects to contribute $7,860,000 to WilTel's defined benefit pension plan in 2013. The tax deductibility of contributions is not a primary consideration, principally due to the availability of the Company's NOLs to otherwise reduce taxable income.
As of December 31, 2012, certain amounts for the WilTel plan are as follows (dollars in thousands): Projected benefit obligation $ 275,858 Funded status - balance sheet liability at December 31, 2012 81,544 Deferred losses included in other comprehensive income (loss) 118,176 Discount rate used to determine the projected benefit obligation 3.85 % Calculations of pension expense and projected benefit obligations are prepared by actuaries based on assumptions provided by management. These assumptions are reviewed on an annual basis, including assumptions about discount rates, interest credit rates and expected long-term rates of return on plan assets. The timing of expected future benefit payments was used in conjunction with the Citigroup Pension Discount Curve to develop a discount rate that is representative of the high quality corporate bond market.
This discount rate will be used to determine pension expense in 2013. Holding all other assumptions constant, a 0.25% change in this discount rate would affect pension expense by $467,000 and the benefit obligation by $9,925,000.
The deferred losses included in other comprehensive income (loss) primarily result from differences between the actual and assumed return on plan assets and changes in actuarial assumptions, including changes in discount rates and changes in interest credit rates. Deferred losses are amortized to expense if they exceed 10% of the greater of the projected benefit obligation or the market value of plan assets as of the beginning of the year; such amount aggregated $90,060,000 at December 31, 2012. A portion of these excess deferred losses will be amortized to expense during 2013 based on an amortization period of twelve years.
The assumed long-term rates of return on plan assets are based on the investment objectives of the plan, which are more fully discussed in Note 20 of Notes to Consolidated Financial Statements.
Off-Balance Sheet Arrangements At December 31, 2012, the Company's off-balance sheet arrangements consist of guarantees and letters of credit. Pursuant to an agreement that was entered into before the Company sold CDS Holding Corporation ("CDS") to HomeFed in 2002, the Company agreed to provide project improvement bonds for the San Elijo Hills project. These bonds, which are for the benefit of the City of San Marcos, California and other government agencies, are required prior to the commencement of any development at the project. CDS is responsible for paying all third party fees related to obtaining the bonds. Should the City or others draw on the bonds for any reason, CDS and one of its subsidiaries would be obligated to reimburse the Company for the amount drawn. At December 31, 2012, the amount of outstanding bonds was $1,789,000, almost all of which expires in 2014.
Subsidiaries of the Company have outstanding letters of credit aggregating $29,463,000 at December 31, 2012, principally to secure various obligations. The majority of these letters of credit expire during 2013 and the remainder expire no later than 2016.
During 2009, a subsidiary of Berkshire Hathaway provided Berkadia with a five-year, $1 billion secured credit facility, which was used to fund outstanding mortgage loans and servicer advances, purchase mortgage servicing rights and for working capital needs. In 2011, Berkadia fully repaid the amount outstanding under its secured credit facility with funds generated by commercial paper sales of an affiliate of Berkadia. Effective as of December 31, 2011, the secured credit facility was terminated. All of the proceeds from the commercial paper sales are used by Berkadia to fund new mortgage loans, servicer advances, investments and other working capital requirements. Repayment of the commercial paper is supported by a $2,500,000,000 surety policy issued by a Berkshire Hathaway insurance subsidiary and corporate guaranty, and the Company has agreed to reimburse Berkshire Hathaway for one-half of any losses incurred. As of December 31, 2012, the aggregate amount of commercial paper outstanding was $2,470,000,000.
39 --------------------------------------------------------------------------------Critical Accounting Estimates The Company's discussion and analysis of its financial condition and results of operations are based upon its consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires the Company to make estimates and assumptions that affect the reported amounts in the financial statements and disclosures of contingent assets and liabilities. On an on-going basis, the Company evaluates all of these estimates and assumptions. The following areas have been identified as critical accounting estimates because they have the potential to have a significant impact on the Company's financial statements, and because they are based on assumptions which are used in the accounting records to reflect, at a specific point in time, events whose ultimate outcome won't be known until a later date. Actual results could differ from these estimates.
Income Taxes - The Company records a valuation allowance to reduce its net deferred tax asset to the net amount that is more likely than not to be realized. If in the future the Company determines that it is more likely than not that the Company will be able to realize its net deferred tax asset in excess of its net recorded amount, an adjustment to increase the net deferred tax asset would increase income in such period. If in the future the Company were to determine that it would not be able to realize all or part of its recorded net deferred tax asset, an adjustment to decrease the net deferred tax asset would be charged to income in such period. The Company is required to consider all available evidence, both positive and negative, and to weight the evidence when determining whether a valuation allowance is required and the amount of such valuation allowance. Generally, greater weight is required to be placed on objectively verifiable evidence when making this assessment, in particular on recent historical operating results.
During 2010, the Company realized significant gains from the sale of certain investments, recorded significant unrealized gains in the fair values of other investments and began to experience modest improvement in the operating results in some business segments. Additionally, the Company's cumulative taxable income for recent years became a positive amount, reflecting the realized gains on the sales of ACF and Las Cruces during the fourth quarter of 2010. With this recent positive evidence the Company gave greater weight to its revised projections of future taxable income, which consider significant unrealized gains in its investment portfolio, and to its long-term historical ability to generate significant amounts of taxable income when assessing the amount of its required valuation allowance. As a result, the Company was able to conclude that it is more likely than not that it will have future taxable income sufficient to realize a significant portion of the Company's net deferred tax asset; accordingly, $1,157,111,000 of the deferred tax valuation allowance was reversed as a credit to income tax expense on December 31, 2010. In addition to its projections of future taxable income, the Company is relying upon the sale of investments that have unrealized gains before the NOLs expire and the corresponding reversal of related deferred tax liabilities to realize a portion of its net deferred tax asset.
The Company's estimate of future taxable income considers all available evidence, both positive and negative, about its operating businesses and investments, included an aggregation of individual projections for each significant operating business and investment, estimated apportionment factors for state and local taxing jurisdictions and included all future years that the Company estimated it would have available NOLs (until 2029). The Company believes that its estimate of future taxable income is reasonable but inherently uncertain, and if its current or future operations and investments generate taxable income different than the projected amounts, further adjustments to the valuation allowance are possible. In addition to the reversal of deferred tax liabilities related to unrealized gains, the Company will need to generate approximately $3,600,000,000 of future U.S. pre-tax income to fully realize its net deferred tax asset. The current balance of the deferred tax valuation allowance principally reserves for NOLs of certain subsidiaries that are not available to offset income generated by other members of the Company's consolidated tax return group.
The Company also records reserves for contingent tax liabilities based on the Company's assessment of the probability of successfully sustaining its tax filing positions.
Impairment of Long-Lived Assets - The Company evaluates its long-lived assets for impairment whenever events or changes in circumstances indicate, in management's judgment, that the carrying value of such assets may not be recoverable. When testing for impairment, the Company groups its long-lived assets with other assets and liabilities at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities (or asset group). The determination of whether an asset group is recoverable is based on management's estimate of undiscounted future cash flows directly attributable to the asset group as compared to its carrying value. If the carrying amount of the asset group is greater than the undiscounted cash flows, an impairment loss would be recognized for the amount by which the carrying amount of the asset group exceeds its estimated fair value.
40 -------------------------------------------------------------------------------- One of the Company's real estate subsidiaries (MB1) had been the owner and developer of a mixed use real estate project located in Myrtle Beach, South Carolina. The project was comprised of a retail center with approximately 346,000 square feet of retail space, 41,000 square feet of office space and 195 residential apartment rental units. The acquisition and construction costs were funded by capital contributed by the Company and nonrecourse indebtedness that was collateralized by the real estate. MB1's indebtedness matured during 2009, but it was not repaid since MB1 did not have sufficient funds and the Company was under no obligation to provide the funds to MB1 to pay off the loan. The Company recorded an impairment charge of $67,826,000 during 2009.
During the second quarter of 2010, MB1 entered into an agreement with its lenders under which, among other things, MB1 agreed not to interfere with or oppose foreclosure proceedings and the lenders agreed to release MB1 and various guarantors of the loan. A receiver was put in place at the property, foreclosure proceedings commenced and an auction of the property was conducted; however, the Company was informed during the fourth quarter of 2010 that the highest bidder for the property failed to close. In December 2010, the Company was invited to make a bid for the property, with the condition that a foreclosure sale to the Company must close as soon as possible without any due diligence period, which new bidders for the property would require. A subsidiary of the Company offered $19,275,000 for the property (including net working capital amounts); the offer was accepted and the foreclosure sale closed on January 7, 2011.
As a result of the failure of the initial buyer to purchase the property and the subsequent sale to the Company in 2011, the Company concluded that the carrying value of the property was further impaired at December 31, 2010; accordingly, the Company recorded an additional impairment charge in 2010 of $47,074,000 to reflect the property at its fair value of $18,094,000. At closing in 2011, MB1 was released from any remaining liability under the bank loan ($100,524,000 outstanding at December 31, 2010); accordingly, the remaining balance due after payment of the purchase price ($81,848,000) was recognized in other income in 2011.
The Company recorded impairment charges in selling, general and other expenses for various other real estate projects of $4,171,000 in 2012 and $2,357,000 in 2010; and $1,449,000 in 2010 in the corporate segment for one of its corporate aircraft that was later sold.
Recent economic conditions have adversely affected most of the Company's operations and investments. A worsening of current economic conditions could cause a decline in estimated future cash flows expected to be generated by the Company's operations and investments. If future undiscounted cash flows are estimated to be less than the carrying amounts of the asset groups used to generate those cash flows in subsequent reporting periods, particularly for those with large investments in intangible assets and property and equipment (for example, beef processing, manufacturing, gaming entertainment, real estate and certain associated company investments), impairment charges would have to be recorded.
Impairment of Equity Method Investments - The Company evaluates equity method investments for impairment when operating losses or other factors may indicate a decrease in value which is other than temporary. For investments in investment partnerships that are accounted for under the equity method, the Company obtains from the investment partnership financial statements, net asset values and other information on a quarterly basis and annual audited financial statements. On a quarterly basis, the Company also makes inquiries and discusses with investment managers whether there were significant procedural, valuation, composition and other changes at the investee. Since these investment partnerships record their underlying investments at fair value, after application of the equity method the carrying value of the Company's investment is equal to its share of the investees' underlying net assets at their fair values. Absent any unusual circumstances or restrictions concerning these investments, which would be separately evaluated, it is unlikely that any additional impairment charge would be required.
41-------------------------------------------------------------------------------- For equity method investments in operating businesses, the Company considers a variety of factors including economic conditions nationally and in their geographic areas of operation, adverse changes in the industry in which they operate, declines in business prospects, deterioration in earnings, increasing costs of operations and other relevant factors specific to the investee. Whenever the Company believes conditions or events indicate that one of these investments might be significantly impaired, the Company will obtain from such investee updated cash flow projections and impairment analyses of the investee assets. The Company will use this information and, together with discussions with the investee's management, evaluate if the book value of its investment exceeds its fair value, and if so and the situation is deemed other than temporary, record an impairment charge.
Impairment of Securities - Declines in the fair value of equity securities considered to be other than temporary and declines in the fair values of debt securities related to credit losses are reflected in net securities gains (losses) in the consolidated statements of operations. The Company evaluates its investments for impairment on a quarterly basis.
The Company's determination of whether a security is other than temporarily impaired incorporates both quantitative and qualitative information; GAAP requires the exercise of judgment in making this assessment, rather than the application of fixed mathematical criteria. The various factors that the Company considers in making its determination are specific to each investment. For publicly traded debt and equity securities, the Company considers a number of factors including, but not limited to, the length of time and the extent to which the fair value has been less than cost, the financial condition and near term prospects of the issuer, the reason for the decline in fair value, changes in fair value subsequent to the balance sheet date, the ability and intent to hold investments to maturity, and other factors specific to the individual investment. For investments in private equity funds and non-public securities, the Company bases its determination upon financial statements, net asset values and/or other information obtained from fund managers or investee companies.
The Company recorded impairment charges for securities in the consolidated statement of operations of $2,461,000, $3,586,000 and $2,474,000 for 2012, 2011 and 2010, respectively. The Company's assessment involves a high degree of judgment and accordingly, actual results may differ significantly from the Company's estimates and judgments.
Business Combinations - At acquisition, the Company allocates the cost of a business acquisition to the specific tangible and intangible assets acquired and liabilities assumed based upon their fair values. Significant judgments and estimates are often made by the Company's management to determine these values, and may include the use of appraisals, consideration of market quotes for similar transactions, use of discounted cash flow techniques or consideration of other information the Company believes to be relevant. The finalization of the purchase price allocation will typically take a number of months to complete, and if final values are significantly different from initially recorded amounts adjustments to prior periods may be required. Any excess of the cost of a business acquisition over the fair values of the net assets and liabilities acquired is recorded as goodwill, which is not amortized to expense. If the fair values of the net assets and liabilities acquired are greater than the purchase price, the excess is treated as a bargain purchase and recognized in income. Recorded goodwill of a reporting unit is required to be tested for impairment on an annual basis, and between annual testing dates if events or circumstances change that would more likely than not reduce the fair value of a reporting unit below its net book value. At December 31, 2012, the book value of goodwill was $24,195,000 and was not impaired.
Subsequent to the finalization of the purchase price allocation, any adjustments to the recorded values of acquired assets and liabilities would be reflected in the Company's consolidated statement of operations. Once final, the Company is not permitted to revise the allocation of the original purchase price, even if subsequent events or circumstances prove the Company's original judgments and estimates to be inaccurate. In addition, long-lived assets recorded in a business combination like property and equipment, intangibles and goodwill may be deemed to be impaired in the future resulting in the recognition of an impairment loss. The assumptions and judgments made by the Company when recording business combinations will have an impact on reported results of operations for many years into the future.
42 -------------------------------------------------------------------------------- In December 2011, the Company acquired 78.9% of National Beef and it became a consolidated subsidiary of the Company. The allocation of the purchase price included $444,030,000 to property, equipment and leasehold improvements, $811,019,000 to amortizable intangible assets, $14,991,000 to goodwill, $237,952,000 to net working capital accounts, $328,267,000 to long-term debt and $304,356,000 to redeemable non-controlling interests.
To assist the Company's management in its determination of the fair value of National Beef's property and equipment, identifiable intangible assets and equity value, the Company engaged an independent valuation and appraisal firm. The methods used by the Company's management to determine the fair values included estimating National Beef's business enterprise value through the use of a discounted cash flow analysis. Property and equipment asset valuations included an analysis of depreciated replacement cost and current market prices. The Company considered several factors to determine the fair value of property and equipment, including local market conditions, recent market transactions, the size, age, condition, utility and character of the property, the estimated cost to acquire replacement property, an estimate of depreciation from use and functional obsolescence and the remaining expected useful life of the assets.
Amounts allocated to product inventories were principally based on quoted commodity prices on the acquisition date. For other components of working capital, the historical carrying values approximated fair values. National Beef's long-term debt principally consists of its senior credit facility payable to its bank group, which was renegotiated in June 2011. In December 2011, the lenders consented to the acquisition as required by the credit facility, and to certain other amendments to the facility's covenants; the pricing of the credit facility remained the same. In addition to these factors, the Company also analyzed changes in market interest rates from June 2011 and concluded that the principal amount due under the credit facility approximated its fair value on the acquisition date.
The fair value of certain pre-existing redeemable noncontrolling interests was the amount paid to redeem such interests immediately after the Company's acquisition of its controlling interest in National Beef. The fair value of other redeemable noncontrolling interests was determined based upon the purchase price paid by the Company for its interest.
Use of Fair Value Estimates - Under GAAP, fair value is defined as the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (the exit price), and may be based on observable or unobservable inputs. Observable inputs are inputs that market participants would use in pricing the asset or liability based on market data obtained from independent sources. Unobservable inputs reflect assumptions made by the Company that market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. GAAP also establishes a hierarchy to prioritize and categorize fair value measurements based on the transparency of inputs as follows: Level 1: Quoted prices are available in active markets for identical assets or liabilities as of the reporting date.
Level 2: Pricing inputs are other than quoted prices in active markets, which are either directly or indirectly observable as of the reporting date. The nature of these financial instruments include cash instruments for which quoted prices are available but traded less frequently, derivative instruments whose fair value have been derived using a model where inputs to the model are directly observable in the market, or can be derived principally from or corroborated by observable market data, and instruments that are fair valued using other financial instruments, the parameters of which can be directly observed.
Level 3: Instruments that have little to no pricing observability as of the reporting date. These financial instruments are measured using management's best estimate of fair value, where the inputs into the determination of fair value require significant management judgment or estimation.
43 -------------------------------------------------------------------------------- Substantially all of the Company's investment portfolio is classified as available for sale securities, which are carried at estimated fair value in the Company's consolidated balance sheet. The estimated fair values are principally based on publicly quoted market prices (Level 1 inputs), which can rise or fall in reaction to a wide variety of factors or events, and as such are subject to market-related risks and uncertainties. The Company has a segregated portfolio of mortgage pass-through certificates issued by U.S. Government-Sponsored Enterprises (FHLMC or FNMA) and by U.S. Government agencies (GNMA), which are carried on the balance sheet at their estimated fair value of $601,418,000 at December 31, 2012. Although the markets that these types of securities trade in are generally active, market prices are not always available for the identical security. The fair value of these investments are based on observable market data including benchmark yields, reported trades, issuer spreads, benchmark securities, bids and offers. These estimates of fair value are considered to be Level 2 inputs, and the amounts realized from the disposition of these investments has not been significantly different from their estimated fair values.
The Company also has a segregated portfolio of non-agency mortgage-backed securities which are carried on the balance sheet at their estimated fair value of $36,580,000 at December 31, 2012. Although these securities trade in brokered markets, the market for these securities is sometimes inactive. The fair values of these investments are based on bid and ask prices, quotes obtained from independent market makers and pricing services. These estimates of fair values are also considered to be Level 2 inputs.
Contingencies - The Company accrues for contingent losses when the contingent loss is probable and the amount of loss can be reasonably estimated. Estimates of the likelihood that a loss will be incurred and of contingent loss amounts normally require significant judgment by management, can be highly subjective and are subject to significant change with the passage of time as more information becomes available. Estimating the ultimate impact of litigation matters is inherently uncertain, in particular because the ultimate outcome will rest on events and decisions of others that may not be within the power of the Company to control. The Company does not believe that any of its current litigation will have a significant adverse effect on its consolidated financial position, results of operations or liquidity; however, if amounts paid at the resolution of litigation are in excess of recorded reserve amounts, the excess could be significant in relation to results of operations for that period. During 2012, the Company accrued $20,000,000 for losses it estimates are probable in connection with the Sykes action discussed above. The Company will continue to evaluate the adequacy of its accrual as the case develops and more information becomes available. The recognition of increases to its estimated loss in future periods is possible.
Results of Operations Substantially all of the Company's operating businesses sell products or services that are impacted by general economic conditions in the U.S. and to a lesser extent internationally. Poor general economic conditions have reduced the demand for products or services sold by the Company's operating subsidiaries and/or resulted in reduced pricing for products or services. Troubled industry sectors, like the residential real estate market, have had an adverse direct impact not only on the Company's real estate segments, but have also had an adverse indirect impact on some of the Company's other operating segments, including manufacturing and gaming entertainment. The discussions below concerning revenue and profitability by segment consider current economic conditions and the impact such conditions have had and may continue to have on each segment; however, should general economic conditions worsen the Company believes that all of its businesses would be adversely impacted.
A summary of results of continuing operations for the Company for the three years in the period ended December 31, 2012 is as follows (in thousands): 44 -------------------------------------------------------------------------------- 2012 2011 2010 Income (loss) from continuing operations before income taxes and income (losses) related to associated companies: Beef Processing $ 59,048 $ - $ - Manufacturing: Idaho Timber 6,397 (3,787 ) 547 Conwed Plastics 11,453 5,916 8,803 Gaming Entertainment 13,209 12,616 (2,159 ) Domestic Real Estate (11,895 ) 80,919 (54,935 ) Medical Product Development (44,963 ) (42,696 ) (25,443 ) Other Operations (44,814 ) (24,374 ) (17,487 ) Corporate 978,085 648,861 473,614 Total consolidated income from continuing operations before income taxes and income (losses) related to associated companies 966,520 677,455 382,940 Income (losses) related to associated companies before income taxes 420,008 (612,362 ) 375,021 Total consolidated income from continuing operations before income taxes 1,386,528 65,093 757,961 Income taxes: Income from continuing operations before income (losses) related to associated companies (376,494 ) (270,316 ) 1,136,968 Associated companies (143,729 ) 218,321 5,745 Total income taxes (520,223 ) (51,995 ) 1,142,713 Income from continuing operations $ 866,305 $ 13,098 $ 1,900,674 Beef Processing Services As more fully discussed above, National Beef was acquired in December 2011. A summary of results of operations for National Beef for the year ended December 31, 2012 is as follows (in thousands): 2012 Revenues and other income $ 7,480,934 Expenses: Cost of sales 7,269,912 Interest 12,431 Salaries and incentive compensation 26,889 Depreciation and amortization 83,063 Selling, general and other expenses 29,591 7,421,886 Income before income taxes $ 59,048 National Beef's profitability is dependent, in large part, on the spread between its cost for live cattle, the primary raw material for its business, and the value received from selling boxed beef and other products. Because National Beef operates in a large and liquid commodity market, it does not have much influence over the price it pays for cattle or the selling price it receives for the products it produces. National Beef's profitability typically fluctuates seasonally as well as cyclically, with relatively higher margins in the spring and summer months and during times of cattle herd expansion.
45 -------------------------------------------------------------------------------- The USDA regularly reports market values for cattle, beef, offal and other products produced by ranchers, farmers and beef processors. Generally, National Beef expects its profitability to improve as the ratio of the USDA comprehensive boxed beef cutout (a weekly reported measure of the total value of all USDA inspected beef primal cuts, grind and trim produced from fed cattle) to the USDA 5-area weekly average slaughter cattle price increases and for profitability to decline as the ratio decreases. The ratio during 2012 was the lowest ratio for the corresponding periods during the past ten years. Due in part to the declining U.S. cattle herd, which has been exacerbated by drought conditions across key cattle raising areas, during this period average cattle prices increased to record levels; however, National Beef's per head revenue did not increase as much as its per head cost for cattle, resulting in reduced margins.
During 2012, revenues from beef processing operations increased compared to the pre-acquisition periods, principally due to price increases. However, gross margins declined due to the lower trending cutout ratio described above. Depreciation and amortization expenses include $45,248,000 of amortization expenses related to identifiable intangible assets recorded at the date of acquisition.
The drought across much of the country caused prices for corn, hay and certain other cattle feedstuffs to increase and pastures to wither; as such some cattle producers reduced and continue to reduce the size of their cow herds. National Beef's profitability is primarily dependent upon the spread between what it pays for fed cattle and the price it receives for its products, along with the efficiency of its processing facilities. The drought contributed to a decline in the beef cow herd and affected the supply of fed cattle; this caused the price National Beef pays for fed cattle to increase more than it can pass along in the form of higher selling prices for its products, resulting in reduced profitability.
National Beef has received notice from Walmart that it intends to discontinue using National Beef as a provider of its case-ready products in 2013. National Beef has two case-ready processing facilities, one of which is completely dedicated to Walmart's business and the other substantially so dedicated, with an aggregate book value of $45,727,000 at December 31, 2012. Total case-ready revenues were approximately 7% of National Beef consolidated revenues during 2012, but as a value-added product, case-ready products have historically constituted a higher percentage of National Beef's gross margin. Since 2008, case-ready products have represented from 10% to 26% of National Beef's total gross margin, and are at the higher end of that range in 2012 due, in part, to reduced gross margin from other National Beef products. During the first quarter of 2013, the two case-ready facilities will begin to operate at reduced levels, resulting in an approximate 50% reduction in the number of personal employed at the facilities. In connection with the reduction in the labor force, National Beef will record a charge estimated to be approximately $2,900,000 during the first quarter of 2013.
National Beef is currently pursuing replacement business for its case-ready facilities; however, it may not be able to fully replace the operating cash flow generated by these facilities in the near future, if at all. The Company has evaluated National Beef's tangible and intangible assets for impairment and has concluded that they are not impaired; its evaluation included an estimate of expected future cash flows to be generated by the case-ready facilities from prospective customers who have not, as yet, committed to purchase case-ready products from National Beef. If National Beef is unsuccessful in securing any new case-ready business, the Company does not believe it will need to record any impairment to its intangible assets or goodwill. However, if National Beef concludes its best course of action is to close one or both case-ready facilities, impairment charges may be recorded if the fair value of those facilities on a held for sale basis is less than the book value.
Manufacturing - Idaho Timber A summary of results of operations for Idaho Timber for the three years in the period ended December 31, 2012 is as follows (in thousands): 46 -------------------------------------------------------------------------------- 2012 2011 2010 Revenues and other income $ 163,513 $ 159,026 $ 172,908 Expenses: Cost of sales 144,193 150,651 159,689Salaries and incentive compensation 5,901 5,390 5,938 Depreciation and amortization 4,148 4,136 4,138 Selling, general and other expenses 2,874 2,636 2,596 157,116 162,813 172,361 Income (loss) before income taxes $ 6,397 $ (3,787 ) $ 547 Idaho Timber's revenues reflect a 10% decrease in shipment volume and a 14% increase in average selling prices during 2012 as compared to 2011. Idaho Timber's revenues for 2011 decreased as compared to 2010; shipment volume and average selling prices decreased 6% and 2%, respectively. Shipment volume continues to reflect the depressed state of the U.S. housing market. The decline in shipment volume also reflects business that was not pursued during periods of higher raw material cost in 2012, which would have resulted in too narrow a spread between expected selling prices and the material cost. While housing starts increased during 2012 as compared to 2011, they remain low by historical standards. Idaho Timber believes that stringent mortgage-lending standards and high unemployment will continue to impact housing starts and Idaho Timber's revenues.
Raw material costs, the largest component of cost of sales (approximately 79% of cost of sales), principally reflect this lower shipment volume during the three year period. Raw material cost per thousand board feet increased approximately 5% during 2012 as compared to 2011. Raw material cost per thousand board feet was largely unchanged in 2011 as compared to 2010. The difference between Idaho Timber's selling price and raw material cost per thousand board feet (spread) is closely monitored, and the rate of change in pricing and cost is not necessarily the same. Idaho Timber's spread increased approximately 61% in 2012 as compared to 2011; the spread in 2011 decreased approximately 14% as compared to 2010.
Manufacturing - Conwed Plastics A summary of results of operations for Conwed Plastics for the three years in the period ended December 31, 2012 is as follows (in thousands): 2012 2011 2010 Revenues and other income $ 89,357 $ 85,961 $ 87,073 Expenses: Cost of sales 65,641 65,312 64,614Salaries and incentive compensation 6,376 6,092 6,493 Depreciation and amortization 280 301 327 Selling, general and other expenses 5,607 8,340 6,836 77,904 80,045 78,270 Income before income taxes $ 11,453 $ 5,916 $ 8,803 Conwed Plastics' revenues increased in 2012 as compared to 2011 primarily due to greater revenue in the erosion control market related to its third quarter acquisition of a lightweight netting business as well as a new customer in Europe. Revenues in 2012 also reflect declines in the packaging market principally due to the sale of Conwed Plastics' Mexican plant in 2011, and in the consumer products market due to certain customers carrying excess inventory into the current year and some of its products no longer being used in certain of its customers' products.
47-------------------------------------------------------------------------------- Conwed Plastics' revenues decreased in 2011 as compared to 2010, primarily reflecting declines in the housing, construction and filtration markets. The ongoing slump in the domestic housing and construction industries unfavorably impacted Conwed Plastics' revenues in 2011, and the drop in filtration product revenues in 2011 reflects greater sales during 2010 related to the 2010 gulf oil spill. In addition, revenues in some markets declined due to tighter inventory control by certain customers, loss of customers to competitors and general economic conditions. The turf, erosion control and agricultural markets reflect increased revenues during 2011, principally due to increases in market share and new customers.
The primary raw material in Conwed Plastics' products is a polypropylene resin, which is a byproduct of the oil refining process, whose price has historically fluctuated with the price of oil. Conwed Plastics' polypropylene resin costs were lower in 2012 as compared to 2011. The volatility of oil and natural gas prices along with current general economic conditions worldwide make it difficult to predict future raw material costs. The increase in gross margin during 2012 as compared to 2011 was primarily due to lower resin costs, changes in the product mix and greater sales volume. Gross margins declined in 2011 as compared to 2010 due to higher resin costs and changes in product mix.
Selling, general and other expenses in 2011 include losses of $1,404,000 related to the loss of a major customer and the sale of the plant in Mexico, and $634,000 of severance costs and professional fees related to employment matters.
Gaming Entertainment A summary of results of operations for Premier for the three years in the period ended December 31, 2012 is as follows (in thousands): 2012 2011 2010 Revenues and other income $ 119,339 $ 117,238 $ 114,809 Expenses: Direct operating expenses 88,127 84,795 83,075 Interest - 33 244Salaries and incentive compensation 2,487 2,460 2,459 Depreciation and amortization 12,882 16,785 16,657 Selling, general and other expenses 2,634 549 14,533 106,130 104,622 116,968 Income (loss) before income taxes $ 13,209 $ 12,616 $ (2,159 ) Premier's gaming revenues increased slightly during 2012 as compared to 2011, principally due to higher slot machine revenue. Gaming revenues for the entire Biloxi market were largely unchanged in 2012 as compared to the prior year. Premier's gaming revenues increased 3% in 2011 as compared to 2010, principally due to slot machine revenue, which increased due to customer loyalty programs and enhancements, offset in part by a larger amount of table game payouts. During 2011, overall gaming revenues for the entire Biloxi market declined slightly as compared to 2010.
The increase in direct operating expenses during 2012 as compared to 2011 primarily reflects greater costs for marketing and promotions, food and beverage, contract labor, employee benefits and insurance. The increase in direct operating expenses in 2011 as compared to 2010 primarily reflects greater marketing and promotional costs.
48 --------------------------------------------------------------------------------Depreciation and amortization expense decreased during 2012 as compared to 2011 principally due to certain assets becoming fully depreciated.
Selling, general and other expenses during 2012 include a charge of $568,000 relating to Hurricane Isaac, primarily for cleanup and repairs. Selling, general and other expenses for 2010 include a loss for the award of $11,200,000, including interest, to the former holders of Premier's bond debt as a result of a decision by the Bankruptcy Court for the Southern District of Mississippi. Premier filed a notice of appeal of the Bankruptcy Court's decision and no amounts were paid while the appeal was pending. In 2011, Premier entered into an agreement to settle the litigation with its former noteholders for $9,000,000. As a result, Premier reduced the liability for the award and credited selling, general and other expenses for $2,241,000 in 2011. All litigation with respect to Premier's chapter 11 restructuring has been settled.
Domestic Real Estate A summary of results of operations for the domestic real estate segment for the three years in the period ended December 31, 2012 is as follows (in thousands): 2012 2011 2010 Revenues and other income $ 10,925 $ 96,501 $ 17,075 Expenses: Interest - 34 2,034 Depreciation and amortization 3,582 3,461 6,163Other operating expenses, including impairment charges described below 19,238 12,087 63,813 22,820 15,582 72,010 Income (loss) before income taxes $ (11,895 ) $ 80,919 $ (54,935 ) Pre-tax results for the domestic real estate segment are largely dependent upon the performance of the segment's operating properties, the current status of the Company's real estate development projects and non-recurring gains or losses recognized when real estate assets are sold. As a result, pre-tax results for this segment for any particular period is not predictable and does not follow any consistent pattern.
The Company did not have any major real estate sales during the last three years. Revenues and other income in 2010 include a gain of $1,200,000 for the favorable settlement of an insurance claim and a lawsuit.
Revenues and other income in 2011 period include a gain on forgiveness of debt of $81,848,000 related to the Myrtle Beach project. As is more fully discussed above, in January 2011 a subsidiary of the Company paid $19,275,000 to the lenders of the Myrtle Beach project in full satisfaction of the project's non-recourse indebtedness, which had a balance of $100,524,000 at December 31, 2010. The Company had previously recorded impairment charges for this project aggregating $114,900,000 (including $47,074,000 in 2010).
Other operating expenses include impairment charges for real estate projects of $4,171,000 and $2,357,000 in 2012 and 2010, respectively, in addition to charges related to the Myrtle Beach project. In 2012, operating expenses also include additional commissions at the Myrtle Beach project and a charge for the value of certain land that was contributed by this project.
49 -------------------------------------------------------------------------------- Although there has been some recent improvement, residential property sales volume, prices and new building starts have remained low in many U.S. markets compared to historical standards, including markets in which the Company has real estate projects. The slowdown in residential sales was exacerbated by turmoil in the mortgage lending and credit markets, resulting in stricter lending standards and reduced liquidity for prospective home buyers. The Company has deferred its development plans for certain of its real estate development projects, and is not actively soliciting bids for its fully developed projects. The Company intends to wait for market conditions to improve before marketing certain of its projects for sale.
Medical Product Development A summary of results of operations for Sangart for the three years in the period ended December 31, 2012 is as follows (in thousands): 2012 2011 2010 Revenues and other income $ 377 $ 378 $ 123 Expenses:Salaries and incentive compensation 13,973 12,415 9,710 Depreciation and amortization 853 845 870 Selling, general and other expenses 30,514 29,814 14,986 45,340 43,074 25,566 Loss before income taxes $ (44,963 ) $ (42,696 ) $ (25,443 ) Sangart's selling, general and other expenses include research and development costs of $17,580,000, $22,130,000 and $5,428,000 for the years ended December 31, 2012, 2011 and 2010, respectively. Research and development costs in 2011 include $10,000,000 related to a new patent license. Sangart's research and development costs exclusive of the new patent license increased in 2012 as compared to 2011, primarily due to increased clinical trial activity related to a larger Phase 2 clinical study of MP4OX in trauma patients. The increase in research and development costs in 2011 primarily related to preparation for and commencement of this larger Phase 2 clinical study, as well as the new patent license.
Sangart's results reflect charges (reductions) to selling, general and other expenses of $(4,447,000) and $261,000 in 2011 and 2010, respectively, related to share-based awards previously granted to a former officer. The fair value of these share-based awards increased during 2010 but declined during 2011; accordingly, in 2011 Sangart reduced the liability and credited selling, general and other expenses. Salaries and incentive compensation expense increased in 2012 and 2011 principally due to higher headcount.
Sangart is a development stage company that does not have any revenues from product sales. Sangart recently completed a Phase 2 clinical trial of MP4OX in 316 trauma patients. The primary efficacy goal of the study was not met, as the MP4OX treated group did not show a statistically significant improvement in the number of patients discharged and alive after 28 days as compared to the control group that received normal standard of care treatment. But clinically significant improvements were observed in some other measures of efficacy and no significant safety concerns were identified. Sangart is now evaluating plans for its next clinical trial of MP4OX in trauma patients. Sangart also recently completed a Phase 1b clinical trial of its MP4CO product in sickle cell disease patients not currently in crisis. Study results are considered to be successful and capable of supporting Sangart's plans to conduct a Phase 2 clinical study involving sickle cell disease patients in crisis. If this Phase 2 study was to be successful, Sangart would then have to conduct a Phase 3 clinical study in sickle cell patients. Completing these studies will take several years at substantial cost and until they are successfully completed, if ever, Sangart will not be able to request marketing approval and generate revenues from sales in either the trauma or the sickle cell disease markets.
50 -------------------------------------------------------------------------------- In addition to obtaining requisite regulatory approvals for the manufacture and sale of MP4 products, including approval of a manufacturing facility which has yet to be built, Sangart would have to create sales, marketing and distribution capabilities prior to any commercial launch, either directly or in partnership with a service provider. In recent years, substantially all of the funding needed for MP4 development has come from the Company. Significant additional funding will be needed prior to regulatory approval and commercial launch; the Company is not committed to provide such funding and Sangart is currently exploring potential external sources of funding and support. The Company is unable to predict when, if ever, it will report operating profits for this segment.
Other Operations A summary of results of operations for other operations for the three years in the period ended December 31, 2012 is as follows (in thousands): 2012 2011 2010 Revenues and other income $ 69,620 $ 69,038 $ 67,119 Expenses: Interest - 1 12Salaries and incentive compensation 9,705 8,930 8,445 Depreciation and amortization 5,588 5,605 4,094 Selling, general and other expenses 99,141 78,876 72,055 114,434 93,412 84,606 Loss before income taxes $ (44,814 ) $ (24,374 ) $ (17,487 ) Revenues and other income for 2012 and 2011 include $9,640,000 and $14,592,000, respectively, of increased revenues at the winery operations; substantially all of the 2012 increase and $9,628,000 of the 2011 increase results from the acquisition of Seghesio Family Vineyards in the second quarter of 2011. As discussed above, the Company's winery operations will be distributed to shareholders in February 2013. Other income for 2011 and 2010 includes $5,366,000 and $11,143,000, respectively, with respect to government grants to reimburse the Company for certain of its prior expenditures related to energy projects; such amounts were not significant in 2012. Revenues and other income for 2012 and 2011 also reflect $5,079,000 and $2,303,000, respectively, of less income from purchased delinquent credit card receivables, and for 2011 $4,540,000 of less income from a property rental business.
Selling, general and other expenses for 2012 include a charge of $20,000,000 for estimated potential losses related to a legal proceeding, which is discussed in Item 3, above. Selling, general and other expenses include $33,235,000, $33,606,000 and $26,776,000 for 2012, 2011 and 2010, respectively, related to the investigation and evaluation of energy projects (principally professional fees and other costs). Selling, general and other expenses for 2010 also reflect $4,326,000 for other operations' portion of a settlement charge in connection with the termination and settlement of the Company's frozen defined benefit pension plan, and a $3,000,000 charge for a settlement with certain insurance companies. The change in selling, general and other expenses for 2012 and 2011 as compared to the prior year also reflects $2,138,000 and $12,152,000, respectively, of greater costs at the winery operations, and for 2011 $1,412,000 of lower costs at the property rental business. Selling, general and other expenses also include charges of $1,513,000 in 2010 at the winery operations to reduce the carrying amount of wine inventory.
51 --------------------------------------------------------------------------------Corporate A summary of results of operations for corporate for the three years in the period ended December 31, 2012 is as follows (in thousands): 2012 2011 2010 Revenues and other income (including net securities gains) $ 1,259,624 $ 906,480 $ 744,337 Expenses: Interest 80,150 111,672 121,285 Salaries and incentive compensation 95,726 41,425 60,464 Depreciation and amortization 19,727 23,296 20,979 Selling, general and other expenses 85,936 81,226 67,995 281,539 257,619 270,723 Income before income taxes $ 978,085 $ 648,861 $ 473,614 Net securities gains for Corporate aggregated $590,581,000, $641,480,000 and $179,494,000 for the years ended December 31, 2012, 2011 and 2010, respectively. Net securities gains include gains of $543,713,000, $628,197,000 and $94,918,000 for 2012, 2011 and 2010, respectively, resulting from the sale of the Company's investment in the common shares of Fortescue, and in 2010 include a gain of $66,200,000 from the sale of the Company's investment in LPH. Net securities gains are net of impairment charges of $2,461,000, $3,586,000 and $2,474,000 during 2012, 2011 and 2010, respectively. The Company's decision to sell securities and realize security gains or losses is generally based on its evaluation of an individual security's value at the time, the prospect for changes in its value in the future and/or the Company's liquidity needs. The decision could also be influenced by the status of the Company's tax attributes. The timing of realized security gains or losses is not predictable and does not follow any pattern from year to year.
Investment income declined $23,564,000 in 2012 as compared to 2011, principally due to decreased cash dividends of $12,462,000 paid on Fortescue's common shares and less investment income due to a smaller amount of fixed income securities. Investment income increased $23,008,000 in 2011 as compared to 2010, principally due to cash dividends of $13,726,000 paid on Fortescue's common shares and greater investment income due to a larger amount of fixed income securities.
Other income, which increased $427,607,000 in 2012 as compared to 2011 and decreased $322,851,000 in 2011 as compared to 2010, includes $116,809,000, $214,455,000 and $149,257,000 for 2012, 2011 and 2010, respectively, related to Fortescue's Pilbara iron ore and infrastructure project in Western Australia. Other income in 2012 includes a gain of $526,184,000 recognized on redemption of the FMG Note. Depreciation and amortization expenses include prepaid mining interest amortization related to the FMG Note of $6,942,000, $11,800,000 and $9,943,000 for 2012, 2011 and 2010, respectively, which was being amortized over time in proportion to the amount of ore produced. Other income in 2010 includes a gain on the sale of Las Cruces to Inmet of $383,369,000.
The decrease in interest expense primarily reflects the repurchases of certain of the Company's debt securities during each of the last three years.
For the years ended December 31, 2012, 2011 and 2010, salaries and incentive compensation includes accrued incentive bonus expenses of $71,238,000, $8,390,000 and $45,948,000, respectively, of which $37,028,000, $(2,059,000) and $21,400,000, respectively, related to the Company's Senior Executive Annual Incentive Bonus Plan. Bonus accruals under the Senior Executive Annual Incentive Bonus Plan are based on a percentage of pre-tax profits as defined in the plan. Other Corporate incentive bonuses are discretionary and not determined based on any mathematical formula. The Company recorded share-based compensation expense relating to grants made under the Company's senior executive warrant plan and the fixed stock option plan of $14,305,000, $23,019,000 and $4,067,000 in 2012, 2011 and 2010, respectively. The change in share-based compensation expense in 2012 and 2011 as compared to the prior year was principally due to the warrants granted under the Company's senior executive warrant plan in the second quarter of 2011, which were issued and vested 20% upon shareholder approval in the second quarter of 2011.
52 -------------------------------------------------------------------------------- Selling, general and other expenses include expenses related to the repurchase of certain of the Company's debt securities of $24,154,000, $6,352,000 and $5,138,000 in 2012, 2011 and 2010, respectively. Selling, general and other expenses include costs for the investigation of investment opportunities and fees due for consummated transactions of $5,539,000, $18,820,000 and $3,377,000 in 2012, 2011 and 2010, respectively, including $14,834,000 related to the acquisition of National Beef in 2011. Selling, general and other expenses for 2010 include $8,403,000 for Corporate's portion of the defined benefit pension plan settlement charge and an impairment charge of $1,449,000 for a corporate aircraft. Selling, general and other expenses for 2012 and 2011 also reflect $2,003,000 of less severance expense and $1,342,000 of greater severance expense, respectively; $932,000 and $1,029,000 of higher corporate aircraft expense, respectively; and for 2011 $1,326,000 of increased insurance expense.
Income Taxes As discussed above, the income tax provision for 2010 reflects a credit of $1,157,111,000 as a result of the reversal of a portion of the valuation allowance for the net deferred tax asset. The Company adjusted the valuation allowance since it believes it is more likely than not that it will have future taxable income sufficient to realize a substantial portion of the net deferred tax asset. The tax provision for 2012, 2011 and 2010 also includes state and foreign income taxes of $42,540,000, $32,256,000 and $20,743,000, respectively.
The Worker, Homeownership, and Business Assistance Act of 2009 provided taxpayers a special election for extended net operating loss carryback benefits, and with respect to any net operating loss for which the election was made, eliminated the limitation that applies to using the NOL to reduce alternative minimum taxable income. In 2010, the Internal Revenue Service provided additional guidance with respect to application of the law, and the Company made the election with respect to its 2008 NOL. As a result, approximately $830,000,000 of the NOLs referred to above can be used to fully offset federal minimum taxable income, and no federal regular or minimum income tax would be payable on such income. During 2010, the Company reversed deferred federal minimum tax liabilities which had been recorded in prior periods of $11,594,000 to income related to associated companies and $22,678,000 to accumulated other comprehensive income.
The income tax provision reflects the reversal of tax reserves aggregating $600,000 for the year ended December 31, 2010 as a result of the expiration of the applicable statute of limitations and the favorable resolution of various state and federal income tax contingencies.
Associated Companies Income (losses) related to associated companies includes the following for the years ended December 31, 2012, 2011 and 2010 (in thousands): 53 -------------------------------------------------------------------------------- 2012 2011 2010 Jefferies $ 301,341 $ (668,282 ) $ 157,873 Mueller 30,018 (6,093 ) - ACF - - 183,572 Berkadia 38,026 29,033 16,166 Garcadia companies 31,738 19,996 14,424 JHYH 33,938 11,211 20,053 Linkem (18,890 ) (2,243 ) - HomeFed 1,891 1,410 1,108 Las Cruces - - (16,159 ) Other 1,946 2,606 (2,016 ) Income (losses) related to associated companies before income taxes 420,008 (612,362 ) 375,021 Income tax (expense) benefit (143,729 ) 218,321 5,745 Income (losses) related to associated companies, net of taxes $ 276,279 $ (394,041 ) $ 380,766 The Company elected the fair value option to account for its investments in Jefferies, Mueller and ACF, with changes in market values reflected directly in earnings. The Company sold its investment in Mueller in 2012 and ACF in 2010.
The Company owns approximately 31.4% of HomeFed, a California real estate development company, which it acquired in 2002. The Company's share of HomeFed's reported earnings fluctuates with the level of real estate sales activity at HomeFed's development projects.
The Company's equity investment in Las Cruces was sold in 2010.
Discontinued Operations Oil and Gas Drilling Services In October 2012, the Company sold Keen, recorded a pre-tax loss on sale of discontinued operations of $18,045,000 ($11,729,000 after taxes) and classified its historical operating results as a discontinued operation. Pre-tax income (losses) of Keen were $(5,344,000), $3,533,000 and $(13,937,000) for the years ended December 31, 2012, 2011 and 2010, respectively.
Domestic Real Estate In August 2010, the Company sold its operating retail shopping center in Long Island, New York and recorded a pre-tax and after tax gain on sale of discontinued operations of $4,526,000. The Company has not classified this business' historical results of operations or its assets and liabilities as discontinued operations because such amounts were not significant.
Property Management and Services In September 2010, the Company sold ResortQuest, recognized a pre-tax and after tax gain on sale of discontinued operations of $35,367,000 and classified its historical operating results as a discontinued operation. Pre-tax income of ResortQuest was $13,552,000 for the year ended December 31, 2010.
54 --------------------------------------------------------------------------------Telecommunications In October 2010, the Company sold STi Prepaid, recognized a pre-tax and after-tax gain on sale of discontinued operations of $21,104,000 and classified its historical operating results as a discontinued operation. During 2011, additional final payments were received from the buyer and the Company recognized a gain from discontinued operations of $9,669,000. Pre-tax income of STi Prepaid was $1,863,000 for the year ended December 31, 2010.
Other Operations During 2012, the Company sold its small Caribbean-based telecommunications provider for aggregate consideration of $27,509,000, net of working capital adjustments, and recognized a pre-tax gain on sale of discontinued operations of $11,696,000 ($7,602,000 after taxes). The Company has not classified this business' historical results of operations or its assets and liabilities as discontinued operations because such amounts were not significant.
In 2010 the Company classified its power production business that burns waste biomass to produce electricity as a held for sale discontinued operation and recorded a charge of $25,321,000 to reduce the carrying amount of the business to its fair value. Pre-tax income (losses) of this business, including the impairment charge, were $414,000, $(3,722,000) and $(36,917,000) for the years ended December 31, 2012, 2011 and 2010, respectively.
Other During the years ended December 31, 2012, 2011 and 2010, the Company received distributions of $5,663,000, $4,690,000 and $11,640,000, respectively, from Empire, a subsidiary of the Company that had been classified as a discontinued operation in 2001 and fully written-off. For income tax purposes, the payments are treated as non-taxable distributions paid by a subsidiary.
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