NOTE 12.  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, commodity zero-cost collars 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.  None of our derivative instruments are subject to collateral requirements.  Substantially all of our derivative contracts are subject to master netting arrangements which provide us with the option to settle certain contracts on a net basis when they settle on the same day with the same currency.  In addition, these arrangements provide for a net settlement of all contracts with a given counterparty in the event that the arrangement is terminated due to the occurrence of default or a termination event.

 

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, if any, is recognized in current income during the period of change.  As of March 31, 2013, the amount we expect to reclassify from AOCL to income over the next year is an unrealized net loss of $6 million.  For the three month periods ended March 31, 2013 and April 1, 2012, 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 93 percent and 95 percent of the notional amounts of contracts outstanding as of March 31, 2013 and December 31, 2012, respectively.

 

		Notional amount in millions
		March 31,		December 31,
Currency denomination		2013		2012
United States Dollar (USD)		121		110
British Pound Sterling (GBP)		197		227
Euro (EUR)		31		28
Singapore Dollar (SGD)		—		3
Indian Rupee (INR)		2,418		1,943
Japanese Yen (JPY)		199		384
Canadian Dollar (CAD)		54		59
South Korea Won (KRW)		30,350		35,266
Chinese Renmimbi (CNY)		60		45

 

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 but are not designated 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 March 31, 2013, we expect to reclassify an unrealized net gain of $1 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		March 31, 2013					December 31, 2012
Commodity		Notional Amount			Quantity		Notional Amount			Quantity
Copper		$	12		1,500 metric tons (1)		$	24		3,025 metric tons (1)
Platinum		59			36,735 troy ounces (2)		71			45,126 troy ounces (2)
Palladium		10			14,066 troy ounces (2)		10			14,855 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.

 

In 2012 we began to use a combination of call and put option contracts for copper in net-zero-cost collar arrangements (zero-cost collars) that establish ceiling and floor prices for copper. These contracts are used strictly for hedging and not for speculative purposes. For these zero-cost collars, if the average price of the copper during the calculation period is within the call and put price, the call and put contracts expire at no cost to us. If the price falls below the floor, the counter-party to the collar receives the difference from us, and if the price rises above the ceiling, the counter-party pays the difference to us. We believe that these zero-cost collars will act as economic hedges; however we have chosen not to designate them as hedges for accounting purposes, therefore we present the calls and puts on a gross basis on our Condensed Consolidated Balance Sheets.

 

The following table summarizes our outstanding commodity zero-cost collar contracts that were entered into to hedge the cost of copper purchases:

 

		March 31, 2013					December 31, 2012
		Average Floor			Quantity in		Average Floor			Quantity in
Commodity		or Cap			metric tons (1)		or Cap			metric tons (1)
Copper call options		$	8,294		5,312		$	8,196		4,100
Copper put options		7,327			5,312		7,005			4,100

 

 

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

 

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 month interim reporting periods presented below:

 

		Three months ended
In millions		March 31, 2013						April 1, 2012
Income Statement Classification		Gain/(Loss) on Swaps			Gain/(Loss) on Borrowings			Gain/(Loss) on Swaps			Gain/(Loss) on Borrowings
Interest expense		$	(11	)	$	11		$	(12	)	$	12

 

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 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
		Location of Gain/(Loss) Reclassified into Income (Effective Portion)		Amount of Gain/(Loss) Recognized in AOCL on Derivative (Effective Portion)						Amount of Gain/(Loss) Reclassified from AOCL into Income (Effective Portion)
In millions				March 31,			April 1,			March 31,			April 1,
Derivatives in Cash Flow Hedging Relationships				2013			2012			2013			2012
Foreign currency forward contracts		Net sales		$	(9	)	$	8		$	—		$	(2	)
Commodity swap contracts		Cost of sales		3			13			2			(3		)
Total				$	(6	)	$	21		$	2		$	(5	)

 

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 month interim reporting periods presented below.

 

				Three months ended
In millions		Location of Gain/(Loss)		Amount of Gain/(Loss) Recognized in Income on Derivatives
Derivatives Not Designated as		Recognized in Income		March 31,			April 1,
Hedging Instruments		on Derivatives		2013			2012
Foreign currency forward contracts		Cost of sales		$	3		$	(3	)
Foreign currency forward contracts		Other income (expense), net		(27		)	14
Commodity zero-cost collars		Cost of sales		(2		)	—
Commodity swap contract		Cost of sales		—			(2		)

 

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
		March 31,			December 31,
In millions		2013			2012			Balance Sheet Location
Derivatives designated as hedging instruments
Interest rate contract		$	77		$	88		Other assets
Commodity swap contracts		2			1			Prepaid expenses and other current assets
Foreign currency forward contracts		—			2			Prepaid expenses and other current assets
Total derivatives designated as hedging instruments		79			91
Derivatives not designated as hedging instruments
Foreign currency forward contracts		1			1			Prepaid expenses and other current assets
Commodity call option contracts		1			1			Other assets
Total derivatives not designated as hedging instruments		2			2
Total derivative assets		$	81		$	93

 

		Derivative Liabilities
		Fair Value
		March 31,			December 31,
In millions		2013			2012			Balance Sheet Location
Derivatives designated as hedging instruments
Foreign currency forward contracts		$	7		$	—		Other accrued expenses
Commodity swap contracts		1			2			Other accrued expenses
Total derivatives designated as hedging instruments		8			2
Derivatives not designated as hedging instruments
Commodity put option contracts		1			1			Other accrued expenses
Commodity swap contracts		1			—			Other accrued expenses
Foreign currency forward contracts		1			—			Other accrued expenses
Total derivatives not designated as hedging instruments		3			1
Total derivative liabilities		$	11		$	3

 

We have elected to present our derivative contracts on a gross basis in our Condensed Consolidated Balance Sheets.  Had we chosen to present on a net basis, we would have derivatives in a net asset position of $77 million and derivatives in a net liability position of $7 million.