Quarterly report pursuant to Section 13 or 15(d)

DERIVATIVES

v2.4.0.6
DERIVATIVES
6 Months Ended
Jul. 01, 2012
DERIVATIVES  
DERIVATIVES

NOTE 11.  DERIVATIVES

 

We are exposed to financial risk resulting from volatility in foreign exchange rates, commodity prices and interest rates.  This risk is closely monitored and managed through the use of financial derivative instruments including foreign currency forward contracts, commodity swap contracts and interest rate swaps.  As stated in our policies and procedures, financial derivatives are used expressly for hedging purposes, and under no circumstances are they used for speculative purposes.  When material, we adjust the value of our derivative contracts for counter-party or our credit risk.

 

Foreign Exchange Rates

 

As a result of our international business presence, we are exposed to foreign currency exchange risks.  We transact business in foreign currencies and, as a result, our income experiences some volatility related to movements in foreign currency exchange rates.  To help manage our exposure to exchange rate volatility, we use foreign exchange forward contracts on a regular basis to hedge forecasted intercompany and third-party sales and purchases denominated in non-functional currencies.  Our internal policy allows for managing anticipated foreign currency cash flows for up to one year.  These foreign currency forward contracts are designated and qualify as foreign currency cash flow hedges under GAAP.  The effective portion of the unrealized gain or loss on the forward contract is deferred and reported as a component of “Accumulated other comprehensive loss” (AOCL).  When the hedged forecasted transaction (sale or purchase) occurs, the unrealized gain or loss is reclassified into income in the same line item associated with the hedged transaction in the same period or periods during which the hedged transaction affects income.  The ineffective portion of the hedge, unrealized gain or loss, if any, is recognized in current income during the period of change.  As of July 1, 2012, the amount we expect to reclassify from AOCL to income over the next year is an unrealized net loss of $2 million.  For the six month periods ended July 1, 2012 and June 26, 2011, there were no circumstances that would have resulted in the discontinuance of a foreign currency cash flow hedge.

 

To minimize the income volatility resulting from the remeasurement of net monetary assets and payables denominated in a currency other than the functional currency, we enter into foreign currency forward contracts, which are considered economic hedges.  The objective is to offset the gain or loss from remeasurement with the gain or loss from the fair market valuation of the forward contract.  These derivative instruments are not designated as hedges under GAAP.

 

The table below summarizes our outstanding foreign currency forward contracts.  Only the U.S. dollar forward contracts are designated and qualify for hedge accounting as of each period presented below.  The currencies in this table represent 96 percent and 98 percent of the notional amounts of contracts outstanding as of July 1, 2012 and December 31, 2011, respectively.

 

 

 

Notional amount in millions

 

 

 

July 1,

 

December 31,

 

Currency denomination

 

2012

 

2011

 

United States Dollar (USD)

 

167

 

181

 

British Pound Sterling (GBP)

 

271

 

347

 

Euro (EUR)

 

18

 

47

 

Singapore Dollar (SGD)

 

9

 

20

 

Indian Rupee (INR)

 

1,815

 

1,701

 

Japanese Yen (JPY)

 

2,207

 

3,348

 

Canadian Dollar (CAD)

 

57

 

39

 

South Korea Won (KRW)

 

47,667

 

36,833

 

Chinese Renmimbi (CNY)

 

62

 

61

 

 

Commodity Price Risk

 

We are exposed to fluctuations in commodity prices due to contractual agreements with component suppliers.  In order to protect ourselves against future price volatility and, consequently, fluctuations in gross margins, we periodically enter into commodity swap contracts with designated banks to fix the cost of certain raw material purchases with the objective of minimizing changes in inventory cost due to market price fluctuations.  Certain commodity swap contracts are derivative contracts that are designated as cash flow hedges under GAAP.  We also have commodity swap contracts that represent an economic hedge, however do not qualify for hedge accounting and are marked to market through earnings.  For those contracts that qualify for hedge accounting, the effective portion of the unrealized gain or loss is deferred and reported as a component of AOCL.  When the hedged forecasted transaction (purchase) occurs, the unrealized gain or loss is reclassified into income in the same line item associated with the hedged transaction in the same period or periods during which the hedged transaction affects income.  The ineffective portion of the hedge, if any, is recognized in current income in the period in which the ineffectiveness occurs.  As of July 1, 2012, we expect to reclassify an unrealized net loss of $5 million from AOCL to income over the next year.  Our internal policy allows for managing these cash flow hedges for up to three years.

 

The following table summarizes our outstanding commodity swap contracts that were entered into to hedge the cost of certain raw material purchases:

 

Dollars in millions

 

July 1, 2012

 

December 31, 2011

 

Commodity

 

Notional Amount

 

Quantity

 

Notional Amount

 

Quantity

 

Copper

 

$

67

 

8,191

 

metric tons (1)

 

$

78

 

9,220

 

metric tons (1)

 

Platinum

 

81

 

51,150

 

troy ounces (2)

 

84

 

50,750

 

troy ounces (2)

 

Palladium

 

8

 

11,952

 

troy ounces (2)

 

5

 

7,141

 

troy ounces (2)

 

 

 

(1)A metric ton is a measurement of mass equal to 1,000 kilograms.

(2)A troy ounce is a measurement of mass equal to approximately 31 grams.

 

Interest Rate Risk

 

We are exposed to market risk from fluctuations in interest rates.  We manage our exposure to interest rate fluctuations through the use of interest rate swaps.  The objective of the swaps is to more effectively balance our borrowing costs and interest rate risk.

 

In November 2005, we entered into an interest rate swap to effectively convert our $250 million debt issue, due in 2028, from a fixed rate of 7.125 percent to a floating rate based on a LIBOR spread.  The terms of the swap mirror those of the debt, with interest paid semi-annually.  This swap qualifies as a fair value hedge under GAAP.  The gain or loss on this derivative instrument as well as the offsetting gain or loss on the hedged item attributable to the hedged risk are recognized in current income as “Interest expense.”  The following table summarizes these gains and losses for the three and six month interim reporting periods presented below:

 

 

 

Three months ended

 

Six months ended

 

In millions

 

July 1, 2012

 

June 26, 2011

 

July 1, 2012

 

June 26, 2011

 

Income Statement

 

Gain/(Loss) on

 

Gain/(Loss) on

 

Gain/(Loss) on

 

Gain/(Loss) on

 

Gain/(Loss) on

 

Gain/(Loss) on

 

Gain/(Loss) on

 

Gain/(Loss) on

 

Classification

 

Swaps

 

Borrowings

 

Swaps

 

Borrowings

 

Swaps

 

Borrowings

 

Swaps

 

Borrowings

 

Interest expense

 

$

17

 

$

(17

)

$

18

 

$

(18

)

$

5

 

$

(5

)

$

10

 

$

(10

)

 

Cash Flow Hedging

 

The following table summarizes the effect on our Condensed Consolidated Statements of Income for derivative instruments classified as cash flow hedges for the three and six month interim reporting periods presented below.  The table does not include amounts related to ineffectiveness as it was not material for the periods presented.

 

 

 

 

 

Three months ended

 

Six months ended

 

 

 

Location of

 

 

 

 

 

 

 

 

 

 

 

Gain/(Loss)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Reclassified

 

Amount of Gain/(Loss)

 

Amount of Gain/(Loss)

 

Amount of Gain/(Loss)

 

Amount of Gain/(Loss)

 

 

 

into Income

 

Recognized in

 

Reclassified from

 

Recognized in

 

Reclassified from

 

In millions

 

(Effective

 

AOCL on Derivative

 

AOCL into Income

 

AOCL on Derivative

 

AOCL into Income

 

Derivatives in Cash 

 

Portion)

 

(Effective Portion)

 

(Effective Portion)

 

(Effective Portion)

 

(Effective Portion)

 

Flow Hedging

 

 

 

July 1,

 

June 26,

 

July 1,

 

June 26,

 

July 1,

 

June 26,

 

July 1,

 

June 26,

 

Relationships

 

 

 

2012

 

2011

 

2012

 

2011

 

2012

 

2011

 

2012

 

2011

 

Foreign currency forward contracts

 

Net sales

 

$

(5

)

$

1

 

$

 

$

3

 

$

3

 

$

5

 

$

(2

)

$

4

 

Commodity swap contracts

 

Cost of sales

 

(10

)

(7

)

(2

)

8

 

3

 

(5

)

(5

)

14

 

Total

 

 

 

$

(15

)

$

(6

)

$

(2

)

$

11

 

$

6

 

$

 

$

(7

)

$

18

 

 

Derivatives Not Designated as Hedging Instruments

 

The following table summarizes the effect on our Condensed Consolidated Statements of Income for derivative instruments that are not classified as hedges for the three and six month interim reporting periods presented below.

 

 

 

 

 

Three months ended

 

Six months ended

 

 

 

 

 

Amount of Gain/(Loss) Recognized in

 

Amount of Gain/(Loss) Recognized in

 

In millions

 

Location of Gain/(Loss)

 

Income on Derivatives

 

Income on Derivatives

 

Derivatives Not Designated as

 

Recognized in Income

 

July 1,

 

June 26,

 

July 1,

 

June 26,

 

Hedging Instruments

 

on Derivatives

 

2012

 

2011

 

2012

 

2011

 

Foreign currency forward contracts

 

Cost of sales

 

$

 

$

1

 

$

(3

)

$

(3

)

Foreign currency forward contracts

 

Other income (expense), net

 

(9

)

(10

)

5

 

(5

)

Commodity swap contracts

 

Cost of sales

 

(6

)

 

(1

)

 

 

Fair Value Amount and Location of Derivative Instruments

 

The following tables summarize the location and fair value of derivative instruments on our Condensed Consolidated Balance Sheets:

 

 

 

Derivative Assets

 

 

 

Fair Value

 

 

 

 

 

July 1,

 

December 31,

 

 

 

In millions

 

2012

 

2011

 

Balance Sheet Location

 

Derivatives designated as hedging instruments

 

 

 

 

 

 

 

Interest rate contract

 

$

87

 

$

82

 

Other assets

 

Total derivative assets

 

$

87

 

$

82

 

 

 

 

 

 

Derivative Liabilities

 

 

 

Fair Value

 

 

 

 

 

July 1,

 

December 31,

 

 

 

In millions

 

2012

 

2011

 

Balance Sheet Location

 

Derivatives designated as hedging instruments

 

 

 

 

 

 

 

Commodity swap contracts

 

$

8

 

$

16

 

Other accrued expenses

 

Foreign currency forward contracts

 

2

 

7

 

Other accrued expenses

 

Total derivatives designated as hedging instruments

 

10

 

23

 

 

 

 

 

 

 

 

 

 

 

Derivatives not designated as hedging instruments

 

 

 

 

 

 

 

Commodity swap contracts

 

4

 

6

 

Other accrued expenses

 

Foreign currency forward contracts

 

 

1

 

Other accrued expenses

 

Total derivatives not designated as hedging instruments

 

4

 

7

 

 

 

Total derivative liabilities

 

$

14

 

$

30